1. Quantity of Money Demanded
The Money Market
Potential Confusion: Money and Income Differ.
Conceptual Definition of Money: The medium of exchange. The financial assets that you own that can be used to purchase goods and services.
Operational Definition of Money:
M1 = Cash + Checking Deposits
M2 = M1 + Savings Deposits
Income: How much you earn over the course of a year.
i (%) MS
Preview of the Money Market
Demand Curve for Money: How much money would be demanded if the nominal interest rate were ______, given that everything else relevant to the demand for money remains the same? i*
The demand curve for money is downward sloping. MD
Supply Curve for Money M
The supply curve for money is vertical.
Notation:
r = Real interest rate
The Federal Reserve Board (the Fed) fixes the quantity of money.
i = Nominal interest rate
 = Inflation rate
Equilibrium Nominal Interest Rate (i*)
Real Nominal Rate interest = interest  of
rate rate inflation r = i  
Quantity of Money Demanded
Quantity
of Money Supplied =

2. Ginny’s Gift
Ginny’s uncle deposited $10,000 in her checking account but stipulated that Ginny could not spend the money until she graduates; that is, she can’t spend it for one year.
Ginny’s checking account pays no interest.
Purchasing a CD requires Ginny to miss two hours of work.
Ginny earns $20 per hour.
Suppose that the CD’s nominal interest rate is 0.1 percent.
How much interest would the CD earn in one year?
10,0000.1% = 10,000 0.001 = $10
How much income would Ginny lose by missing work?
220 = $40
Would expect Ginny to missing work to buy the CD? No
Instead, suppose that the CD’s nominal interest rate is 10 percent.
How much interest would the CD earn in one year?
10,00010% = 10,000 0.1 = $1,000
How much income would Ginny lose by missing work?
220 = $40
Would expect Ginny to missing work to buy the CD?
Yes
Generalize. As the nominal interest rate increases:
What happens to the number of CD’s individuals purchase?
Increase.
What happens to the checking account balances of individuals?
Decrease
Do individuals hold more or less money?
Less
Conceptual (Webster’s) definition of money: Money is the medium of exchange.
Operational definition of money:
M1 = Cash + Checking Deposits
M2 = M1 + Savings Deposits

3. Ginny’s checking account pays no interest.
Ginny’s Gift
Ginny’s uncle deposited $10,000 in her checking account but stipulated that Ginny could not spend the money until she graduates; that is, she can’t spend it for one year.
Ginny’s checking account pays no interest.
Purchasing a CD requires Ginny to miss two hours of work.
Ginny earns $20 per hour.
Suppose that the CD’s nominal interest rate is 0.1 percent.
Instead, suppose that the CD’s nominal interest rate is 10 percent.
How much interest would the CD earn in one year?
10,0000.1% =
10,000 0.001 = $10
10,00010% = 10,000 0.1 = $1,000
How much income would Ginny lose by missing work?
220 = $40
220 = $40
Would expect Ginny to miss work to buy the CD? No
Yes
Generalize. As the nominal interest rate increases:
What happens to the number of CD’s individuals purchase?
Increase.
What happens to the checking account balances of individuals?
Decrease
Do individuals hold more or less money?
Less
Conceptual (Webster’s) definition of money: Money is the medium of exchange.
Operational definition of money:
M1 = Cash + Checking Deposits
M2 = M1 + Savings Deposits

4. The Demand Curve for Money Downward Sloping
Demand Curve for Money: How much money would be held if the nominal interest rate were ______, given that everything else relevant to the demand for money remains the same?
NB: Money earns no (or nearly no) interest.
i (%)
The nominal interest (i) rate rises:
The demand curve for money is downward sloping 
Interest earning assets (CD’s, Treasury bonds, corporate bonds, etc.) become more attractive because they are earning more interest. 
Individuals seek to hold more interest earning assets. MD M 
To hold more interest earning assets individuals hold less money.
i (%) MS
Supply Curve for Money: Vertical
Claim: The supply curve for money is vertical.
The Federal Reserve Board (the Fed) fixes the quantity of money.
Strategy: To explain this, we will study the banking system by introducing a tool of the accountant, balance sheets. M

5. Required reserve ratio
Banks Balance Sheet:
Your Balance Sheet:
Assets: Everything you own and everything others owe you
Assets: Everything the bank owns and everything others owe the bank
Liabilities: Everything you owe to others
Liabilities: Everything the bank owe to others
Banking System Balance Sheet: October 15, 2015
Assets
Liabilities
Billion Dollars
(Bank’s) Cash Assets
2,770
(Customers’) Deposits at Bank
10,930
(Bank’s) Securities
3,040
(Bank’s) Loans to Customers
8,460
(Bank’s) Borrowing
1,890
(Bank’s) Other Assets
1,300
(Bank’s) Other Liabilities
1,060
Cash Assets 2,770
Deposits 10,930
Securities 3,040
Borrowing 1,890
Loans 8,460
Other Liabilities 1,060
Other Assets 1,300
Bank Assets = 2, , ,300 = 15,570
Bank Liabilities = 10, , ,060 = 13,880
Bank Net Worth = Assets  Liabilities
= 15,570  13,880 = 1,690
The Federal Reserve Board (Fed) and the Fractional Reserve Banking System
The Fed is the banks’ bank:
Banks borrow funds from the Fed – this is part of the Borrowing balance sheet entry.
Banks deposit funds from the Fed – this is part of the Cash Assets balance sheet entry.
The Fed regulates banks:
Note that banks do not have enough cash assets to cover all of their customers’ deposits.
The Fed requires banks to keep a fraction of its deposits as reserves:
(Actual) Reserves = Vault Cash + Deposits at Fed
NB: A bank’s (actual) reserves cannot fall short of its required reserves.
Required reserves
Required reserve ratio = ×
Deposits

6. Required reserve ratio
Banking System Balance Sheet: October 15, 2015
Conceptual (Webster’s) definition of money: Money is the medium of exchange.
Assets
Liabilities
Cash Assets 2,770
Deposits 10,930
Operational definition of money:
Securities 3,040
Borrowing 1,890
M1 = Cash + Checking Deposits
Loans 8,460
Other Liabilities 1,060
Other Assets 1,300
M2 = M1 + Savings Deposits
Question: Which balance sheet item generates profits for banks?
Answer: Loans.
Question: Which balance sheet entry counts as money?
Answer: Deposits.
We can purchase goods and services by writing as long as our checking account balance is sufficient. Also, in the age of smart phones we can transfer funds from our saving accounts to our checking accounts in seconds. So, effectively our savings account deposits also constitute money.
i (%) MS
By regulating banks, the Fed does fixes the money supply.
Required reserves play the critical role:
Required reserves
Required reserve ratio = ×
Deposits M

7.  Lab 5.1 “Nuts and Bolts” of the Fractional Reserve Banking System
Simplified Banking System
Liabilities
Assets
Vault cash 30
Deposits at Fed 20
Securities 60
Loans
380
Deposits
400
Borrowing from Fed 10
Required reserve ratio
10%
RES 50
DEP
500
410
400
Vault Cash 30
Dep at Fed 20
SEC 60
LOANS
480
390
380
BOR 10
Required reserves =
Required reserve ratio 
Deposits
Excess reserves =
Actual reserves 
Required reserves
Bank Assets:
Everything the banks own and everything others owe the banks.
Bank Liabilities:
Everything the banks owe others.
= 50  50 40 41
= 0
= 10
= 9
= 10% 
410
400
500
= 41
= 40
= 50
Question: Is the bank loaned up?
Answer: No.
Answer: Yes.
NB: When a bank has excess reserves, it can issue more loans.
When a bank issues a new loan:
How many more loans?
LOANS and DEP increase by the amount of the new loan.
Answer: 90
Let’s try 10.
RES are unaffected.
 Lab 5.1
Key Questions to Pose
With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______ 50 10
500
Why 500?
Because 10%  500 = 50
Since loans and deposits increase by the same amount when a bank issues a new loan and reserves are unaffected, how many ____________ loans can banks issue? _________
more 90