Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134

The University of Akron Administration This Week’s Assignments Farnham Chapter 13 (Role of Money) Homework 08 (due before Thanksgiving) Next week Thanksgiving Weeks after break Assignments Farnham Chapter 14 (AD/AS) Homework 09 (review) Essay 2 5/17/2019 The University of Akron Decision Tree

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron Introduction Functions of Money Medium of exchange Unit of account Store of value Standard of deferred payment We have used it primarily as unit of account and medium of exchange 5/17/2019 The University of Akron

The University of Akron Introduction Many assets might be used as money Money most liquid assets Medium of exchange M1 – in non-banking public’s hands Currency, Demand Deposits, and Travelers’ checks 5/17/2019 The University of Akron

The University of Akron Introduction M2 – M1 plus Money market fund shares Savings accounts Small time deposits Data sources Monetary Aggregates Official Definitions 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

Financial Intermediaries Financial Intermediaries channel savings to loans From those who spend less than their income To those who wish to spend more than their income 5/17/2019 The University of Akron

Financial Intermediaries Consumption Product Markets Revenues Investment House-holds Firms Borrowing Borrowing Saving Financial Markets Factor Markets 5/17/2019 The University of Akron Income Expenses

Financial Intermediaries Remember S = Yd – C So that And that 5/17/2019 The University of Akron

Financial Intermediaries PS 10% 8% Real interest rate 3% Id $12 $22 $40 Billions of dollars 5/17/2019 The University of Akron

Financial Intermediaries Some special institutions Commercial banks Thrift institutions The Federal Reserve System http://www.federalreserveeducation.org/ 5/17/2019 The University of Akron

Financial Intermediaries These institutions accept short term deposits (demand deposits) If they hold all funds – 100% reserves But they earn no income They learn that not all funds are requested each day, but that only a fraction of the funds are needed daily. If they hold some – fractional reserves They can loan the rest to earn an income 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron Nominal Money Stock Banks create money by making loans They convert assets that are NOT counted as money into assets that are counted as money Fractional reserve system allows the creation of money Click here to view exercise detailing how money is created using T-accounts 5/17/2019 The University of Akron

The University of Akron Nominal Money Stock Money Supply (stock) is M1 Currency + Demand Deposits + Travelers’ Checks Non-banking public Monetary Base Currency + Total Reserves 5/17/2019 The University of Akron

The University of Akron Nominal Money Stock Simple deposit multiplier (d) 1/rr or 1/FRR If excess reserves increase by “E”, the maximum by which the money supply can increase is 1/rr * E Money multiplier (mm) Money Supply / Monetary Base Takes into account currency drain 5/17/2019 The University of Akron

The University of Akron Nominal Money Stock Money multiplier (mm) Money Supply / Monetary Base c = currency / deposit ratio rr = reserve requirement e = excess reserve ratio 5/17/2019 The University of Akron

The University of Akron Nominal Money Stock Money multiplier (mm) Money Supply / Monetary Base If excess reserves increase by “DER”, the money supply can increase by 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron Central Bank The Federal Reserve System Board of Governors Federal Open Market Committee 12 Regional banks Functions Bank for banks Bank for federal government Bank supervision Monetary Policy 5/17/2019 The University of Akron

The University of Akron Central Bank Monetary Policy Tools Impact excess reserves and thus MS Federal reserve requirement (rr) Discount rate (primary and secondary) Federal Funds Market and Federal Funds rate Open Market Operations Buying and selling of securities Influences banks’ excess reserves 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron Money Market Nominal and Real Money Supply Nominal and Real Money Demand Money Market Equilibrium 5/17/2019 The University of Akron

The University of Akron Money Market (supply) The FED influences the Nominal Money Supply through monetary policy Real Money Supply controls for changes in the price level, which we are holding constant at the moment RLMS = MS / P 5/17/2019 The University of Akron

The University of Akron Money Market (supply) 5/17/2019 The University of Akron

The University of Akron Money Market (demand) Why do we hold some of our assets as money? Benefits of holding money Comparative advantage for transactions Transaction demand Precautionary demand Asset demand (part of portfolio) 5/17/2019 The University of Akron

The University of Akron Money Market (demand) Transaction and Precautionary Depends on planned spending Depends primarily on Real Income Real Interest rates Technology that changes the opportunity cost of holding money 5/17/2019 The University of Akron

The University of Akron Money Market (demand) Asset demand (part of portfolio) Depends on cost of holding money Forgone income from interest earning assets Depends primarily on Nominal Interest rates Real r = nominal r – inflation rate If prices constant: real r = nominal r 5/17/2019 The University of Akron

The University of Akron Money Market (demand) The Real Demand for money shows the relationship between Quantity of money held Real Interest rates (r) Real income or output (Y) Asset demand Transaction demand 5/17/2019 The University of Akron

The University of Akron Money Market (demand) 5/17/2019 The University of Akron

Money Market (equilibrium) RLMD = RLMS 5/17/2019 The University of Akron

Money Market (equilibrium) 5/17/2019 The University of Akron

Money Market (equilibrium) Increase the supply of money Monetary policy Equilibrium interest rate decreases 5/17/2019 The University of Akron

Money Market (equilibrium) 5/17/2019 The University of Akron

Money Market (equilibrium) Increase the demand for money Increase Y Equilibrium interest rate increases 5/17/2019 The University of Akron

Money Market (equilibrium) 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron LM Curve The LM (Liquidity=Money) curve shows all combinations of the real interest rate (r) and Real Output (Y) for which: The demand for money (MD) = Supply of money (MS) Thus it is a relationship between the real interest rate (r) and equilibrium real output (Ye) 5/17/2019 The University of Akron

The University of Akron LM Curve Thus it is the relationship between the real interest rate (r) and equilibrium real output (Ye) 5/17/2019 The University of Akron

The University of Akron LM Curve 5/17/2019 The University of Akron

The University of Akron LM Curve (shifters) Any factor that shifts MD or MS (other than r) will shift the LM curve Real income Prices Monetary policy 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs

The University of Akron Money Market (demand) Demand for money Transaction demand Asset demand (part of portfolio) 5/17/2019 The University of Akron

The University of Akron LM Curve Ma = f(r) Mt = k(Y) Mt + Ma = Ms 5/17/2019 The University of Akron

The University of Akron LM Curve 5/17/2019 The University of Akron

The University of Akron LM Curve (increase Ms) 5/17/2019 The University of Akron

The University of Akron LM Curve (decrease Ms) 5/17/2019 The University of Akron

Decision Tree Graphs Introduction Financial Intermediaries Nominal Money stock Central Bank (The FED) and Monetary Policy The Money Market (Md and Ms) The LM curve Graphs