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MONEY (Continued…):Three Instruments of Money Supply, Money Demand

<< MONEY:Money Supply, Fractional Reserve Banking,
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Macroeconomics ECO 403
VU
LESSON 45
MONEY (Continued...)
How does the Central Bank control the money supply?
1) Open Market Operations
2) Changing the Reserve Requirements
3) Changing Discount rate
Three Instruments of Money Supply
·
Open market operations are the purchase and sale of government bonds by the central
bank.
­  When the central bank buys bonds from public, the money it pays for the bonds
increases the monetary base and thus increase the money supply
­  When the central bank sells the bonds to the public, the money it receives reduces
monetary base and hence reduce money supply
·
Reserve requirements are central banks regulations that impose on banks a minimum
reserve-deposit ratio.
­  An increase in reserve requirements raises reserve deposit ratio and thus lowers the
money multiplier and the money supply
·
The Discount rate is the interest rates that central bank charges when it lends to the banks.
·
Banks borrow from central bank when they find themselves with too few reserves to meet
reserve requirements. The lower the discount rate, the cheaper are borrowed reserves and
more demands for such loans
·
Hence a reduction in discount rate raises the monetary base and the money supply.
·
Although these instrument give central bank substantial power to influence the the money
supply, yet it can't do it perfectly. Bank discretion in conditioning business can cause the
money supply to change the way central bank did not anticipate.
­ Excessive Reserves
­ No limit on the amount of bank borrowings from discount window
Money Demand
Classical Theory of Money Demand
·
The Quantity Theory of Money assumes that the demand for real money balances is
directly proportional to income,
(M/P) d = kY
·
Where k is a constant measuring how much people want to hold for every dollar of
income.
Keynesian Theory of Money Demand
·
It presents a more realistic money demand function where the demand for real money
balances depends on i and Y:
(M/P) d = L (i, Y)
·
Recall, that money serves three functions
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Macroeconomics ECO 403
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1. Unit of Account
2. A store of value
3. A medium of Exchange
·
The first function can not by itself generate any demand for money, because we can
quote prices in any currency without holding any amount of it. So we shall focus on the
rest of the two functions as we look at theories of money demand
Portfolio Theories of Money Demand
·
Theories of money demand that emphasize the role of money as a store of value are called
portfolio theories. According to these theories, people hold money as part of their portfolio
of assets.
·
The key point is that money offers a different combination of risk and return than other
assets, particularly a safe return (nominal). While other assets may fall in both real and
nominal terms.
·
These theories predict that demand for money should depend on the risk and return offered
by money and other assets.
·
Also money demand should depend on total wealth, because wealth measures the size of
portfolio to be allocated among money and other assets.
·
So we may write the money demand function as
(M/P)  d = L (rs, rb, še, W)
Where
­  rs = expected real return on stock
­  rb = expected real return on bonds
­  še = expected inflation rate
­  W = real wealth
·
If rs or rb rises, money demand reduces, because other assets become more attractive
·
A rise in še also reduces the money demand because money becomes less attractive
·
An increase in W raises money demand because higher wealth means higher portfolio.
·
Money Demand Function L(i,Y): A useful simplification:
­  Uses real income Y as proxy for real wealth W
­
Nominal interest rate i = rb + še
·
Are these theories useful for studying money demand?
·
The answer depends on which measure of money are we using.
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Symbol
Assets included
C
Currency
M1
C + demand deposits, travelers' checks, other checkable deposits
M2
M1 + small time deposits, savings deposits, money market mutual funds, money
market deposit accounts
M3
M2 + large time deposits, repurchase agreements, institutional money market
mutual fund balances
·
Economists say that M1 is a dominated asset: as a store of value, it exists alongside other
assets that are always better.
·
Thus it is not optimal for people to hold money as part of their portfolio and portfolio theories
cannot explain the demand for these dominated forms of money
·
But these theories would be more plausible if we adopt a broader measure of money like
M2.
Transactions Theories of Money Demand
·
Theories which emphasize the role money as a medium of exchange acknowledge that
money is a dominated assets and stress that people hold money, unlike other assets, to
make purchases.
·
These theories best explain why people hold narrow measure of money as opposed to
holding assets that dominate them.
·
These theories take many forms depending on how one models the process of obtaining
money and making transactions assuming
­  Money has the cost of earning a low rate of return
­  Money makes transactions more convenient
·
One prominent model to explain the money demand function is Baumol-Tobin Model
developed in 1950.
Baumol-Tobin Model of Cash Management
·
This model analyzes the cost and benefits of holding money.
­  Benefit: Convenience (much less trips to banks)
­  Costs: foregone interest on money had it been deposited in a savings account
·
Example:
­  A person plans to spend Y dollars over the course of an year (assuming constant price
levels and real spending). What should be the optimal size of cash balances for him?
·  Possibilities
­ Withdraw Y dollars at the beginning of the year and gradually spend the money balance
averaging Y/2 over the year
­Draw Y/2 at the beginning of year, spend it in six months then draw the rest Y/2 to be
spent in next ˝ year. Average balance = Y/4
­Generalizing: money holding vary between Y/N and zero, averaging Y/(2N), where N is
the number of trips to bank
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·
One implication of the Baumol-Tobin model is that any change in the fixed cost of going to
the bank F alters the money demand function-- that is, it changes the quantity of money
demanded for a given interest rate and income.
A Closer Look at Money Creation
Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is
$1000.
First bank Balance Sheet
Assets
Liabilities
Reserve $200
Deposits $1,000
Loans  $800
Second bank Balance Sheet
Assets
Liabilities
Reserve $160
Deposits $800
Loans  $640
Third bank Balance Sheet
Assets
Liabilities
Reserve $128
Deposits $640
Loans
$512
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit
= $1000
= (1-rr) × $1000
First bank Lending
= (1-rr)2 × $1000
Second bank Lending
= (1-rr)3 × $1000
Third bank Lending
= (1-rr)4 × $1000
Fourth bank Lending
:
:
-----------------------------------------------------------------
= [1 + (1-rr) + (1-rr) 2+ (1-rr) 3+...] × $1000
Total Money Supply
= (1/rr) × $1000
= (1/.2) × $1000
= $5000
·
The banking system's ability to create money is the primary difference between banks and
other financial institutions.
·
Financial markets have the important function of transferring the economy's resources from
households (who wish to save some of their income for the future) to those households and
firms that wish to borrow to buy investment goods to be used in future production
·
The process of transferring funds from savers to borrowers is called financial
intermediation.
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A model of Money supply
·  Three exogenous variables:
The monetary base B is the total number of dollars held by the public as currency
·
C and by the banks as reserves R.
The reserve-deposit ratio rr is the fraction of deposits D that banks hold in
·
reserve R.
The currency-deposit ratio cr is the amount of currency C people hold as a
·
fraction of their holdings of demand deposits D.
Definitions of money supply and monetary base:
M = C+D
B = C+R
Solving for M as a function of 3 exogenous variables:
M/B =  C/D + 1
C/D + R/D
Making substitutions for the fractions above, we obtain:
M= cr + 1
xB
cr + rr
Lets call this money multiplier, m
So
M=m×B
Because the monetary base has a multiplied effect on the money supply, the monetary base is
sometimes called high-powered money.
·
An Example
­ Suppose, monetary base B is $500 billion, the reserve deposit ratio rr is 0.1 and
currency deposit ratio cr is 0.6
­ The money multiplier is:
0.6 + 1   = 2.3
m=
0.6 + 0.1
­ And the money supply is:
M = 2.3 x $ 500 billion = $1,150 billion
Let's go back to our three exogenous variables to see how their changes cause the money
supply to change:
1. The money supply M is proportional to the monetary base B. So, an increase in the
monetary base increases the money supply by the same percentage.
2. The lower the reserve-deposit ratio rr (R/D), the more loans banks make, and the more
money banks create from every dollar of reserves.
3. The lower the currency-deposit ratio cr (C/D) , the fewer dollars of the monetary base
the public holds as currency, the more base dollars banks hold in reserves, and the
more money banks can create. Thus a decrease in the currency-deposit ratio raises
the money multiplier and the money supply.
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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