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Macroeconomics ECO 403
VU
LESSON 44
MONEY
Money Supply
·
Earlier, we introduced the concept of money supply in a highly simplified way.
·
We defined quantity of money as the number of rupees held by public, and assumed that
central bank controls the supply of money by increasing or decreasing the number of
rupees in circulation through open-market operations.
·
Although a good approximation, this definition omits the role of banking system in
determining the money supply.
·
Here, we'll see that the money supply is determined not only by the Central Bank, but also
by the behavior of households (which hold money) and banks (where money is held).
·
Recall, the Money supply includes both currency in the hand of public and deposits at
banks that households use on demand for transactions.
M=C+D
Where
M ---> Money Supply
C ---> Currency
D ---> Demand Deposits
100% Reserve Banking
·
Imagine a world without banks, where all the money takes the form of currency, and the
quantity of money is simply the amount of currency that public holds (assume $1,000).
·
Now a new bank comes in and accepts deposits but does not make loans. Its only purpose
is to provide a safe place for depositors to keep money
The deposits that banks have received but have not lent out are called reserves.
Some Reserves are held in the vaults of local banks but most are held at the central bank.
Consider the case where all deposits are held as reserves: banks accept deposits, place the
money in reserve, and leave the money there until the depositor makes a withdrawal or writes
a check against the balance.
In a 100% reserve banking system, all deposits are held in reserve and thus the banking
system does not affect the supply of money.
·
Suppose that households deposit the economy's entire $1,000 in First bank. This bank's
balance sheet will look like:
Assets
Liabilities
Reserves
$1,000
Deposits
$1,000
·
The bank is not making loans so it is not earning profit rather a small fee to cover its cost.
·
The money supply in the economy before and after the creation of bank remains the same,
i.e. $1,000. So 100% reserve deposit does not affect money supply in economy
Fractional Reserve Banking
·
Now, if the banks start to use some of their deposits to make loans (e.g. to households for
house finance and to firms for capital finance), they can charge interest on the loans.
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Macroeconomics ECO 403
VU
·
The banks must keep some reserve on hand so that reserves are available whenever
depositors want to make withdrawals.
·
As long as the amount of new deposits approximately equals the amount of withdrawals, a
bank need not keep all its deposits in reserves.
·
Note: a reserve-deposit ratio is the fraction of deposits kept in reserve. Excess reserves
are reserves above the reserve requirement.
·
Fractional-reserve banking, a system under which banks keep only a fraction of their
deposits in reserve. In a system of fractional reserve banking, banks create money.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand