1. Money creation and money demand
Outline
Money creation
Money multiplier
Money demand
Theories on money demand

2. Money creation (I)
In a broad sense, money creation is the process by which money is produced or issued.
money creation leads to an increase in money supply (MS).
There are two different ways to create money:
physically manufacturing a new monetary unit, such as paper money or metal coins (currency issue – an important function of central bank - CB).
loaning out a monetary unit multiple times through fractional-reserve lending (money creation):
the banking system creates and destroys money by posting amounts in a computer file.
CB may create new deposit money (“expansionary monetary policy”) by purchasing financial assets or lending money to financial institutions.
The law requires banks to hold only a fraction of the amount of deposits received from the public as reserves, thus freeing up of majority of incoming funds for making loans and purchasing securities.

3. Bank’s reserves
Each bank’s legal reserves (LR) may be divided into two categories:
Required reserves (RR) – are equal to the legal reserve requirement ratio times the volume of deposits:
if a bank holds 500 million RON in deposits and the law requires it to hold 10% of its deposit accounts in LR, the RR = 50 million RON.
Excess reserves (ER) – are equal to the difference between the total LR held by a bank and the amount of its RR:
if a bank is required to hold LR = 50 million RON, but it has 500,000 RON in cash and 50 million RON on deposit with the CB, it holds 500,000 RON in ER.
LR usually earn no interest income:
most banks try to keep their holdings of ER as close to zero as possible.
The distinction between ER and RR plays a key role in the growth of credit in the economy and the creation of money.

4. Deposits creation
Assume that the CB has set a legal reserve requirement ratio (r) of 10%.
Suppose that a deposit of 1,000 is made by a customer at bank A:
RR = 100
ER = earns no interest income:
the bank will loan out these ER.
bank makes loan by simple bookkeeping entry, creating a checking account in the borrower’s name.
Borrower spends the funds money flows to bank B a new deposit:
RR = 90
ER = is quickly loaned out.
New borrower spends its funds a new deposit at bank C:
RR = 81,
ER = 729- will loan up these funds.
And the process can continue
By making loans whenever ER appear, banks create total deposits and loans several times larger then the original volume of funds received by bank A.

5. Creation of deposits (assuming r =10% and a new deposit of 1,000)
Bank
Increase in deposits
Increase in loans
Increase in reserves A
1,000
900
100 B
810 90 C
729 81 D
656.1
72.9 .
Total for all banks
10,000
9,000

6. Money multiplier (I)
The total amount of money created by the banking system can be estimated using a concept known as the money multiplier. It is the most common mechanism used to measure the increase in the MS.
The money multiplier, m, is the inverse of the reserve requirement ratio:
m = 1/r.
Example: if r = 10%, the money multiplier is m = 1/0.1 =10.
This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. In our example: 1,000*10 = 10,000.
Although no new money was physically created in addition to the initial 1,000 deposit, new commercial bank money is created through loans.
If we take in consideration the public’s holdings of currency, the formula is:
m = (1+c)/(r + c).
Example: if currency ratio c =10% m = 1.1/( ) = 5.5
The total amount of money creation would be 5,500.

7. Money multiplier (II)
There is a close link between the m and monetary base (cash and bank’s reserve with the CB) – one of the principal determinants of the MS:
m*M0 = M1
Fractional-reserve banking system is a financial system in which some fraction of the deposits can be used to finance investments by making loans.
There are two types of money in a fractional-reserve banking:
M0: CB money (coins, paper money + banks’ reserves with CB)
M1: commercial bank money (money created through loans):
When a loan is supplied, new commercial bank money is created.
As a loan is paid back, the commercial bank money disappears from existence.
The M0 – m relationship:
identifies the most important factors that explain changes in the MS;
shows how a CB can influence the MS creation process.

8. Money destruction
Money destruction (reverse of money creation), can occur in two different ways, depending on how the money was created:
The destruction of physically created money occurs when:
the coins are scrapped to recover their precious metal content, or
the issuer redeems the securities.
The destruction of money created by banking system through loans occurs as the loans are paid back.
In a growing economy MS is always increasing because the volume of the new loans is higher than the volume of the loans that are paid back.
The money creation can be:
Temporary – when it occurs by lending activity, because the loans will be paid back, which leads to money destruction.
Definitive – when the balance of payment has a surplus (excess), because the inflows of foreign currencies are higher than the outflows, which leads to the increase in MS.

9. Classical Theory/ Monetarist Theory versus Keynesian Theory
Money demand (MD)
The demand for money is the desired holding of financial assets in the form of money (cash or bank deposits).
The study of the effect of money on the economy is called monetary theory.
A central question in monetary theory is whether or to what extent the quantity of money demanded is affected by changes in interest rates.
The two basic approaches about how money affects real output/income and the average price level are:
Classical Theory/ Monetarist Theory versus Keynesian Theory
These two fundamental theoretical constructs conflict and complete with each other.
They are both concern how money affect the aggregate demand for goods and services.

10. I. Classical Quantity Theory (I)
The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher.
He developed the equation of exchange:
MS*V = P*Y
where: MS – the money supply
V – the velocity of money
P – the price level
Y – real GDP (the quantity of all final goods and services)
P*Y – the nominal GDP (the current market value of all final goods and services)
The classicals’s assumption was that V is fairly constant.
If V is constant, then nominal income (PY) is determined by MS.
implies MS↑ P*Y↑

11. Classical Quantity Theory (II)
An additional assumption was that Y is fairly constant, based on the classical theory belief that flexible wages and prices would allow output (Y) to “always” be at or near its full employment level.
If both V and Y are constant, then the price level is strictly determined by MS;
implies MS↑ P↑
Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is in fact a theory of MD.
When the money market is in equilibrium, the quantity of money that people hold (MS) equals the quantity of money demanded MD (MS = MD), so we can replace MS in the equation by MD.
Then, we can rewrite the equation as:

12. Classical Quantity Theory (III)
Therefore, Fisher’s quantity theory of money suggests that:
money demand is purely a positive function of income, and
interest rates have no effect on the money demand.
Cambridge equation
While Fisher was developing his quantity theory approach to the demand for money, a group of classical economists in Cambridge, England, came to similar conclusions, although with slightly different reasoning.
These economists, Alfred Marshall and Arthur Cecil Pigou identified two motives for holding money:
as a medium of exchange: the amount of money held as a medium of exchange is a function of nominal income (P*Y)
as a store of wealth: the amount of money held as a store of wealth is also a function of nominal income (P*Y)
Although the Cambridge economists thought wealth would play a role, the wealth is often omitted from the equation for simplicity.

13. Classical quantity theory (IV)
This leads to the MD being expressed by the Cambridge Equation:
MD = k*P*Y
where k – the constant of proportionality or the constant proportion of nominal income that people hold as money.
The Cambridge equation indicates that MD is proportional to nominal income.
If you consider that k can be written as 1/V, that both k and V are treated as constant, the Cambridge equation and the classical money demand function appear to be identical.
However, a major difference, in addition to analyzing the motives behind MD, is in the role that the interest rate plays in money demand.
Although the interest rate does not appear in the Cambridge equation, interest rate changes could cause short-run fluctuations in k.

14. Keynesian Theory (I) It is also known as liquidity preference.
Since Keynes was at Cambridge, his theory is built in the Cambridge tradition by starting with motives behind (reasons for) the MD.
Keynes distinguished three motives for holding money:
the transaction motive (to meet day-to-day needs): holding money to carry out planned or expected transactions: the MD for transactions is proportional to income;
the precautionary motive (to meet unexpected future payments): holding money to carry out unplanned or unexpected transactions; the MD for precautionary money balances is proportional to income;
the speculative motive (in anticipation of a fall in the price of assets): holding money to exploit any attractive investment opportunity requiring a cash expenditure that might arise; MD for speculation is negatively related to the level of interest rates.

15. Keynesian Theory (II)
The transaction and precautionary motives don’t challenge the classical theory.
It is only the speculative motive that leads to a different conclusion.
Keynes reasoned that people want to hold a certain amount of real money balances (the quantity of money in real terms):
an amount that his three motives indicated would be related to real income Y and to interest rates i.
Keynes wrote down the demand for money equation = liquidity preference function, which says that:
the demand for real money balances MD/P is a function of i and Y:
where: = real MD
After people satisfy their consumption needs, they can choose to hold the remainder of their income in money or to buy securities (bonds).

16. Keynesian Theory (III)
Keynes considers that:
money and bonds are the only two types of assets that can serve as a store of wealth, and
all people hold all their wealth in money or in bonds.
MD for transactions and precautions is a positive function of real income.
MD for speculation is a negative function of interest rate:
as interest rates rise, people will be prompted to convert their money holdings into bond holdings;
as interest rates fall, people will be prompted to convert their bond holdings into money holdings.
By deriving the liquidity preference function for velocity (V=PY/M), Keynes’s theory of MD implies that V is not constant, but fluctuates with interest rates.
The liquidity preference equation can be rewritten as:

17. Keynesian Theory (IV)
Multiplying both sides of equation by Y and recognizing that MD = MS in money market equilibrium, we solve for velocity:
We know that the MD is negatively related to interest rates: when i goes up, f (i,Y) declines, and therefore V rises
interest rates and velocity are positively related:
i↑ f(Y,i) V↑
Interest rates are procyclical:
rising in expansions
falling in recessions.
The liquidity preference theory indicates that a rise in interest rates will cause velocity to rise also:
velocity is also procyclical.

18. Tobin’s Theory (I)
There were problems with basing the relationship between MD and interest rates on Keynes’ speculative demand:
1) The implication of the speculative demand argument is that people will either hold all bonds or all money with no diversification:
a serious shortcoming.
2) The very existence of the speculative demand is questionable.
These problems prompted later efforts to explain MD as a function of interest rates without relying on the questionable speculative demand.
The Baumol-Tobin Model of the Transactions Demand for Money
Baumol and Tobin independently developed models of MD in which the transactions demand for money is sensitive to the interest rate.
People have an incentive to economize on transaction money balances when interest rates rise, thus:
i↑ (lost income due to holding money) ↑ MD

19. Tobin’s Theory (II)
Similar models of precautionary demand produced a similar resuts.
Conclusion: transactions and precautionary demand for money are also negative correlated with interest rate.
The Tobin Model of the Speculative Demand for Money
A second Tobin model introduced risk and assumed that people want high returns but are risk averse:
If bonds have risk, even at high interest rates people will always hold some money.
A problem with the second Tobin model, in addition to the fact that the speculative demand may not exist:
there are assets that have virtually no risk (treasury bills, money market mutual funds) but have a higher return than money.
The only advantage of money is that transactions cost are virtually zero.

20. Friedman’s Monetarist Theory (I)
Friedman views MD as function of wealth and the relative return of other assets.
Friedman assumed that people want to hold an amount of real money balances:
where:
- Friedman’s measure of wealth, permanent income (expected average long-run income)
- expected return on bonds
- expected return on money
- expected return on equity (common stocks)
- expected inflation rate
- real MD.

21. Friedman’s Theory (II)
1. Permanent income:
People base their MD on their expectations of their permanent income: people demand more money as their permanent income grows.
MD is positive correlated with permanent income. 2.
if this difference increases, the demand for money decreases. 3. 4.
an increase in the expected inflation rate prompts people to convert their cash into inflation safe real assets (real estate, gold, commodities) MD will decrease.
MD is negatively related to these differences.

22. Characteristics of Friedman’s MD as different from Keynes
1) People hold other assets besides money and bonds (equities and real goods).
2) The return on money is not constant as banks offer:
more services for checking account owners
higher interest on saving deposits.
3) Given 2), interest rates have little effect on MD.
4) Given 3) and the fact that permanent income is stable over the business cycle, both MD and V are stable.
5) If current income fluctuates around permanent income, the relationship between them is predictable. Combining this with 4) implies that V is predictable. This leads to the Quantity Theory of money view that changes in MS lead to predictable changes in nominal income (P*Y).
6) Holding (buying) real goods as an alternative to money, implies that the quantity of money has a direct effect on spending (aggregate demand):
MS ↑ MS > MD spending ↑ AD ↑

23. Characteristics of Friedman’s MD as different from Keynes
1) People hold other assets besides money and bonds (equities and real goods).
2) The return on money is not constant as banks offer:
more services for checking account owners
higher interest on interest earning checkable accounts
3) Given 2), interest rates have little effect on MD.
4) Given 3) and the fact that permanent income is stable over the business cycle, both MD and V are stable.
5) If current income fluctuates around permanent income, the relationship between them is predictable:
Combining this with 4) implies that V is predictable.
This leads to the Quantity Theory of money view that changes in MS lead to predictable changes in nominal income (P*Y).
6) Holding (buying) real goods as an alternative to other assets, especially money, implies that the quantity of money has a direct effect on spending (aggregate demand):
MS ↑ MS > MD spending ↑ AD ↑