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Intermediate macroeconomics chapt18

Chapter 18: Money Supply
& Money Demand

Federal Reserve System, FED
The central bank of the U.S.
Independent decision making unit with regional banks
In charge of money supply management and economic

Money Supply

C = Currency: coins & bills (25%)
D = Demand Deposits: checking account deposits

Money Supply Line
The quantity of money in circulation is controlled by the

central bank in real value
Interest Rate (%)


Quantity of Money

Fractional Banking System
Banks are required by law to hold a percentage of all
deposits with the FED to be able to return the deposits:
– R = reserves: deposits
– RR = required reserves: reserves held by the FED
– rr = reserve-deposit ratio: percentage determined by the FED
(rr = R/D)
– ER = excess reserves: reserves used by banks to lend or

Fractional Banking System
R = RR + ER
RR = rr R
ER = (1 – rr)R
Banks’ lending and investing ER will create money through
a multiplier effect

A Model of Money Supply
The monetary base (B) is money held by the public in
currency and by banks as reserves R
The currency-deposit ratio (cr) is the amount of currency
people hold as a fraction of their demand deposits
cr = C / D

A Model of Money Supply

Divide M = C + D by B = C + R:
M/B = (C + D) / (C + R)
Divide the numerator and denominator by D:
M/B = (C/D + 1) / (C/D + R/D)
M/B = (cr + 1) / (cr + rr)
M = [(cr + 1) / (cr + rr)]B = m  B
Define money multiplier m = (cr + 1) / (cr + rr),so far any $1
increase in the monetary base, money supply increases by

A Model of Money Supply
Example: B = $500 billion, cr = 0.6 and rr = 0.1:
m=(0.6 + 1) / (0.6 +0.1) = 2.3
M = 2.3(500) = $1,150 billion

Change in Money Supply
The money supply is proportional to the monetary base.
So, an increase in B increases M m-fold.
The lower the reserve-deposit ratio, the more loans banks
make and the higher is the money multiplier
The lower the currency deposit ratio, the fewer dollars of
the monetary base the public holds as currency and the
lower is the money multiplier

Tools of Monetary Policy
Reserve-deposit ratio: ratio of cash reserves to deposits
that banks are required to maintain
By lowering the ratio, banks will have more reserves to
lend and invest, increasing the money supply

Tools of Monetary Policy
Discount rate: rate of interest the FED charges on loans to
By lowering the rate, banks encourage borrowing from the
FED and lending to the public, increasing the money

Tools of Monetary Policy
Open Market Operations: FED’s purchases and sales of
government bonds
By purchasing bonds and paying the sellers, the FED
increases the money supply

Expansionary Monetary Policy
Increase the money supply by any one or combination of
the above tools
Reduce the interest rate to encourage investment
Increase employment & income

Money Demand
The amount of money demanded for transaction and
speculative purposes depends: personal income and
interest rate
At any level of personal income, quantity demanded of
money is a negative function of interest rate; (M/P)d = L(i,

Money Demand Line
M/P = L(Y, i)
Y = income
i = interest rate

Interest Rate (%)




Quantity of Money

Money Market Equilibrium
Interest Rate (%)



Quantity of Money

Expansionary Monetary Policy
Interest Rate (%)



80 85

Quantity of Money

Portfolio Theory of Money Demand
(M/P)d = L(rs, rb, πe, W)
M/P = real money balances
rs = expected real rate of return on stocks
rb = expected real rate of return on bonds
πe = expected rate of inflation
W = real wealth

(M/P)d is positively related to W and negatively
affected by rs, rb, πe

The Baumol-Tobin Model
– Y = transactionary money an individual holds in bank
– N = annual number of trips to bank an individual makes to
withdraw money
– F = cost of a trip to the bank
– i = nominal interest rate

Optimal Conditions
Total cost of money withdrawal = Foregone interest + Cost
of trips
TC = iY/2N + FN
The annual number of trips that minimizes the total cost of
bank trips is
N* = (iY/2F)1/2
Average transactionary money holding is
MH = Y /2N* = (YF/2i)1/2

Optimal Conditions
Total cost of bank withdrawal
Cost of bank trips = FN

Foregone interest = iY/2N

Number of trip to bank, N

Speculative Demand for Money
Money individuals hold for investment in the financial
Near money consists of non-monetary, interest-bearing
assets such as stocks and bonds

The Federal Funds Rate
The short-term interest rate at which banks make loans to
each other
The FED uses this rate as the basis for its interest rate policy
Taylor’s rule for the determination of the nominal federal
funds rate:
Inflation rate + 2 + 0.5(Inflation rate + 2) – 0.5(GDP gap)

Actual vs. Taylor’s Rule


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