SEVENTH EDITION

MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich

CHAPTER
19
Money Supply, Money Demand,
and the Banking System
Modified for EC 204
by Bob Murphy

© 2010 Worth Publishers, all rights reserved

 In this chapter, you will learn:
 how the banking system “creates” money
 three ways the Fed can control the money
supply, and why the Fed can’t control it
precisely
 leading theories of money demand
 a portfolio theory
 a transactions theory: the Baumol-Tobin
model
 Banks’ role in the money supply
 The money supply equals currency plus
demand (checking account) deposits:
M = C + D
 Since the money supply includes demand
deposits, the banking system plays an
important role.

CHAPTER 19 Money Supply, Money Demand, Banking System 3

 A few preliminaries

 Reserves (R ): the portion of deposits that

banks have not lent.
 A bank’s liabilities include deposits,
assets include reserves and outstanding loans.
 100-percent-reserve banking: a system in
which banks hold all deposits as reserves.
 Fractional-reserve banking:
a system in which banks hold a fraction of their
deposits as reserves.
CHAPTER 19 Money Supply, Money Demand, Banking System 4
 Banks’ role in the money supply
 To understand the role of banks, we will
consider three scenarios:
1. No banks
2. 100-percent reserve banking
(banks hold all deposits as reserves)
3. Fractional-reserve banking
(banks hold a fraction of deposits as reserves,
use the rest to make loans)
 In each scenario, we assume C = $1000.

CHAPTER 19 Money Supply, Money Demand, Banking System 5

 SCENARIO 1:
No banks

With no banks,
D = 0 and M = C = $1000.

CHAPTER 19 Money Supply, Money Demand, Banking System 6

 SCENARIO 2:
100-percent reserve banking
 Initially C = $1000, D = $0, M = $1,000.
 Now suppose households deposit the $1,000 at
“Firstbank.”
 After the deposit:
C = $0,
FIRSTBANK’S
D = $1,000,
balance sheet
M = $1,000
Assets Liabilities
reserves $1,000 deposits $1,000
 LESSON:
100%-reserve
banking has no
impact on size of
money supply.
CHAPTER 19 Money Supply, Money Demand, Banking System 7
 SCENARIO 3:
Fractional-reserve banking
 Suppose banks hold 20% of deposits in reserve,
LESSON:
making loans with theinrest.
a fractional-reserve
 Firstbank
banking system,
will make $800 banks create money.
in loans.

FIRSTBANK’S The money supply

now equals $1,800:
balance sheet
Assets Liabilities  Depositor has
$1,000 in
$1,000 deposits $1,000
reserves $200 demand deposits.
loans $800  Borrower holds
$800 in currency.

CHAPTER 19 Money Supply, Money Demand, Banking System 8

 SCENARIO 3:
Fractional-reserve banking
 Suppose the borrower deposits the $800 in
Secondbank.
 Initially, Secondbank’s balance sheet is:

SECONDBANK’S  Secondbank will

balance sheet loan 80% of this
Assets Liabilities deposit.
$160 deposits $800
reserves $800
loans $0
$640

CHAPTER 19 Money Supply, Money Demand, Banking System 9

 SCENARIO 3:
Fractional-reserve banking
 If this $640 is eventually deposited in Thirdbank,
 then Thirdbank will keep 20% of it in reserve,
and loan the rest out:

THIRDBANK’S
balance sheet
Assets Liabilities
$128 deposits $640
reserves $640
loans $0
$512

CHAPTER 19 Money Supply, Money Demand, Banking System 10

 Finding the total amount of money:

Original deposit = $1000

+ Firstbank lending = $ 800
+ Secondbank lending = $ 640
+ Thirdbank lending = $ 512
+ other lending…

Total money supply = (1/rr )  $1,000

where rr = ratio of reserves to deposits
In our example, rr = 0.2, so M = $5,000

CHAPTER 19 Money Supply, Money Demand, Banking System 11

 Money creation in the banking system

A fractional reserve banking system creates

money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.

CHAPTER 19 Money Supply, Money Demand, Banking System 12

 A model of the money supply
exogenous variables

 Monetary base, B = C + R
controlled by the central bank

 Reserve-deposit ratio, rr = R/D

depends on regulations & bank policies

 Currency-deposit ratio, cr = C/D

depends on households’ preferences

CHAPTER 19 Money Supply, Money Demand, Banking System 13

 Solving for the money supply:

where

CHAPTER 19 Money Supply, Money Demand, Banking System 14

 The money multiplier

where

 If rr < 1, then m > 1

 If monetary base changes by ΔB,
then ΔM = m  ΔB
 m is the money multiplier,
the increase in the money supply
resulting from a one-dollar increase
in the monetary base.
CHAPTER 19 Money Supply, Money Demand, Banking System 15
NOW YOU TRY:
The Money Multiplier
where

Suppose households decide to hold more of their

money as currency and less in the form of demand
deposits.
1. Determine impact on money supply.
2. Explain the intuition for your result.
SOLUTION:

Impact of an increase in the currency-deposit ratio

Δcr > 0.
 An increase in cr increases the denominator
of m proportionally more than the numerator.
So m falls, causing M to fall.
 If households deposit less of their money,
then banks can’t make as many loans,
so the banking system won’t be able to
“create” as much money.
 Three instruments of monetary policy
1. Open-market operations
2. Reserve requirements
3. The discount rate

CHAPTER 19 Money Supply, Money Demand, Banking System 18

 Open-market operations

 definition:
The purchase or sale of government bonds by
the Federal Reserve.
 how it works:
If Fed buys bonds from the public,
it pays with new dollars,
increasing B and therefore M.

CHAPTER 19 Money Supply, Money Demand, Banking System 19

 Reserve requirements

 definition:
Fed regulations that require banks to hold a
minimum reserve-deposit ratio.
 how it works:
Reserve requirements affect rr and m:
If Fed reduces reserve requirements,
then banks can make more loans and
“create” more money from each deposit.

CHAPTER 19 Money Supply, Money Demand, Banking System 20

 The discount rate

 definition:
The interest rate that the Fed charges on loans
it makes to banks.
 how it works:
When banks borrow from the Fed, their reserves
increase, allowing them to make more loans and
“create” more money.
The Fed can increase B by lowering the
discount rate to induce banks to borrow more
reserves from the Fed.
CHAPTER 19 Money Supply, Money Demand, Banking System 21
 Which instrument is used most often?
 Open-market operations:
most frequently used.
 Changes in reserve requirements:
least frequently used.
 Changes in the discount rate:
largely symbolic.
The Fed is a “lender of last resort,”
does not usually make loans to banks
on demand.

CHAPTER 19 Money Supply, Money Demand, Banking System 22

 New Instruments of Monetary Policy
 Financial Crisis led Fed to use New Tools
 Term Auction Facility:
 Allows banks to borrow reserves through an
auction mechanism.
 Affects the monetary base just like borrowing
through the discount window.
 Paying Interest on Reserves:
 Higher interest rate on reserves held on
deposit at the Fed leads banks to hold more
reserves.
 Affects the reserve-deposit ratio and, in turn,
the money multiplier.
CHAPTER 19 Money Supply, Money Demand, Banking System 23
 Why the Fed can’t precisely control M
where

 Households can change cr,

causing m and M to change.
 Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves,
then rr, m, and M change.

CHAPTER 19 Money Supply, Money Demand, Banking System 24

 CASE STUDY:
Bank failures in the 1930s
 From 1929 to 1933:
 over 9,000 banks closed
 money supply fell 28%
 This drop in the money supply may have caused
the Great Depression, but certainly contributed
to its severity.

CHAPTER 19 Money Supply, Money Demand, Banking System 25

 CASE STUDY:
Bank failures in the 1930s

where

 Loss of confidence in banks

⇒ ↑cr ⇒ ↓m
 Banks became more cautious
⇒ ↑rr ⇒ ↓m

CHAPTER 19 Money Supply, Money Demand, Banking System 26

CASE STUDY:
Bank failures in the 1930s
August 1929 March 1933 % change
M 26.5 19.0 –28.3%
C 3.9 5.5 41.0
D 22.6 13.5 –40.3
B 7.1 8.4 18.3
C 3.9 5.5 41.0
R 3.2 2.9 –9.4
m 3.7 2.3 –37.8
rr 0.14 0.21 50.0
cr 0.17 0.41 141.2
 Could this happen again?
 Many policies have been implemented since the
1930s to prevent such widespread bank
failures.
 E.g., Federal Deposit Insurance,
to prevent bank runs and large swings in the
currency-deposit ratio.

CHAPTER 19 Money Supply, Money Demand, Banking System 28

 Bank capital, leverage, and capital
requirements
 Bank capital: the resources a bank’s owners have
put into the bank
 A more realistic balance sheet:

Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans $500 Debt $200

Capital
Securities $300 $50
(owners’ equity)

CHAPTER 19 Money Supply, Money Demand, Banking System 29

 Bank capital, leverage, and capital
requirements
 Leverage: the use of borrowed money to
supplement existing funds for purposes of investment
 Leverage ratio = assets/capital
= ($200+500+300)/$50 = 20
Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans $500 Debt $200

Capital
Securities $300 $50
(owners’ equity)

CHAPTER 19 Money Supply, Money Demand, Banking System 30

 Bank capital, leverage, and capital
requirements
 Being highly leveraged makes banks vulnerable.
 Example: Suppose a recession causes our bank’s
assets to fall by 5%, to $950.
 Then, capital = assets – liabilities = 950 – 950 = 0
Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans $500 Debt $200

Capital
Securities $300 $50
(owners’ equity)

CHAPTER 19 Money Supply, Money Demand, Banking System 31

 Bank capital, leverage, and capital
requirements
Capital requirement:
 minimum amount of capital mandated by regulators
 intended to insure that banks will be able to pay off
depositors
 higher for banks that hold more risky assets
2008-2009 financial crisis:
 Losses on mortgages shrunk bank capital, slowed
lending, exacerbated the recession.
 Government injected $ billions of capital into banks
to ease crisis and encourage more lending.
CHAPTER 19 Money Supply, Money Demand, Banking System 32
 Money Demand
Two types of theories
 Portfolio theories
 emphasize “store of value” function
 relevant for M2, M3
 not relevant for M1. (As a store of value,
M1 is dominated by other assets.)
 Transactions theories
 emphasize “medium of exchange” function
 also relevant for M1
CHAPTER 19 Money Supply, Money Demand, Banking System 33
 A simple portfolio theory

where
rs = expected real return on stocks
rb = expected real return on bonds
π e = expected inflation rate
W = real wealth

CHAPTER 19 Money Supply, Money Demand, Banking System 34

 The Baumol-Tobin Model
 a transactions theory of money demand
 notation:
Y = total spending, done gradually over the year
i = interest rate on savings account
N = number of trips consumer makes to the bank

to withdraw money from savings account

F = cost of a trip to the bank
(e.g., if a trip takes 15 minutes and
consumer’s wage = $12/hour, then F = $3)
CHAPTER 19 Money Supply, Money Demand, Banking System 35
 Money holdings over the year
Money
holdings N=1
Y
Average
= Y/ 2

1 Time

CHAPTER 19 Money Supply, Money Demand, Banking System 36

 Money holdings over the year
Money
holdings N=2
Y

Y/ 2 Average
= Y/ 4

1/2 1 Time

CHAPTER 19 Money Supply, Money Demand, Banking System 37

 Money holdings over the year
Money
holdings N=3
Y

Average
Y/ 3
= Y/ 6

1/3 2/3 1 Time

CHAPTER 19 Money Supply, Money Demand, Banking System 38

 The cost of holding money

 In general, average money holdings = Y/2N

 Foregone interest = i (Y/2N )
 Cost of N trips to bank = F N
 Thus,

 Given Y, i, and F,
consumer chooses N to minimize total cost

CHAPTER 19 Money Supply, Money Demand, Banking System 39

 Finding the cost-minimizing N

N*
CHAPTER 19 Money Supply, Money Demand, Banking System 40
 The money demand function

 The cost-minimizing value of N :

 To obtain the money demand function,
plug N* into the expression for average
money holdings:

 Money demand depends positively on Y and F,

and negatively on i.

CHAPTER 19 Money Supply, Money Demand, Banking System 42

 The money demand function
 The Baumol-Tobin money demand function:

How this money demand function differs from

previous chapters:
B-T shows how F affects money demand.
B-T implies:
income elasticity of money demand = 0.5,
interest rate elasticity of money demand = −0.5
CHAPTER 19 Money Supply, Money Demand, Banking System 43
 Financial Innovation, Near Money, and
the Demise of the Monetary Aggregates

 Examples of financial innovation:

 many checking accounts now pay interest
 very easy to buy and sell assets
 mutual funds are baskets of stocks that are
easy to redeem - just write a check
 Non-monetary assets having some of the
liquidity of money are called near money.
 Money & near money are close substitutes,
and switching from one to the other is easy.

CHAPTER 19 Money Supply, Money Demand, Banking System 45

 Financial Innovation, Near Money, and
the Demise of the Monetary Aggregates

 The rise of near money makes money demand

less stable and complicates monetary policy.
 1993: the Fed switched from targeting monetary
aggregates to targeting the Federal Funds rate.
 This change may help explain why the U.S.
economy was so stable during the rest of the
1990s.

CHAPTER 19 Money Supply, Money Demand, Banking System 46

 Chapter Summary
1. Fractional reserve banking creates money because
each dollar of reserves generates many dollars of
demand deposits.
2. The money supply depends on the:
 monetary base
 currency-deposit ratio
 reserve ratio
3. The Fed can control the money supply with:
 open market operations
 the reserve requirement
 the discount rate
 Chapter Summary
4. Bank capital, leverage, capital requirements
 Bank capital is the owners’ equity in the bank.
 Because banks are highly leveraged, a small
decline in the value of bank assets can have a
huge impact on bank capital.
 Bank regulators require that banks hold sufficient
capital to ensure that depositors can be repaid.
 Chapter Summary
5. Portfolio theories of money demand
 stress the store of value function
 posit that money demand depends on risk/return
of money & alternative assets
6. The Baumol-Tobin model
 a transactions theory of money demand,
stresses “medium of exchange” function
 money demand depends positively on spending,
negatively on the interest rate,
and positively on the cost of converting
non-monetary assets to money