MACROECONOMICS, 7th. Edition N. Gregory Mankiw Mannig J. Simidian
MACROECONOMICS, 7th. Edition N. Gregory Mankiw Mannig J. Simidian
MACROECONOMICS, 7th. Edition N. Gregory Mankiw Mannig J. Simidian
CHAPTER 19
Money Supply, Money Demand
and the Banking System
A PowerPointTutorial
To Accompany
Chapter Nineteen 2
M=C+D
Money Supply Currency Demand Deposits
In this chapter, we’ll see that the money supply is determined not only
by the Federal Reserve, but also by the behavior of households
(which hold money) and banks (where money is held).
Chapter Nineteen 3
The deposits that banks have received but have not lent out are called
reserves. 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-percent-reserve banking system, all deposits are held in
reserve; thus the banking system does not affect the supply of money.
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1,000
Firstbank Lending = (1- rr) $1,000 The process of transferring funds
Secondbank Lending = (1- rr)2 $1,000 from savers to borrowers is called
Thirdbank Lending = (1- rr)3 $1,000
Fourthbank Lending =. (1- rr)4 $1,000
financial intermediation.
..
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] $,1000
= (1/rr) $1,000
Money and Liquidity Creation
Chapter Nineteen
= (1/.2) $1,000 6
(but not wealth creation)
= $5,000
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 the money supply and the monetary base:
M =C+D
B =C+R
Solving for M as a function of the 3 exogenous variables:
M/B = C/D + 1
C/D + R/D
Making the substitutions for the fractions above, we obtain:
cr + 1 Let’s call this the money multiplier, m.
M= B
cr + rr
Chapter Nineteen 7
M=mB
Chapter Nineteen 10
Bank Capital, Leverage
and Capital Requirements
Securities
Chapter Nineteen
$300 Capital (Owner’s Equity) $5011
On the balance sheet on the previous slide, the reserves, loans, and
Securities are on the left side of the balance sheet must equal, in
total, the deposits, debt, and capital on the right side of the
balance sheet.
In 2008 and 2009, many banks found themselves with too little
capital after they incurred losses on mortgage loans and mortgage-
backed securities. The shortage of bank capital reduced bank
lending, contributing to a severe economic downturn. In response
to this problem, the U.S. Treasury, working together with the
Federal Reserve started putting public funds into the banking system,
increasing the amount of bank capital and making the U.S. taxpayer
a part owner of many banks. The goal of this unusual policy was to
recapitalize the banking system so bank lending could return to normal.
Chapter Nineteen 13
Chapter Nineteen 14
Classical Theory of Money Demand
According to the quantity theory of money, (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
Later we adopted a more realistic money demand function, where the demand for
real money balances depends on i and Y: (M/P)d = L(i, Y).
Portfolio Theories of Money Demand
They emphasize the role of money as a store of value; people hold money as a part
of their portfolio of assets. Key insight: money offers a different risk and return
than other assets. Money offers a safe nominal return, while other investments may
fall in both real and nominal terms. (M/P)d= L (rs, rb, E, W), where rs is the
expected return in the stock market, rb is the expected return on bonds, E is the
expected inflation rate, and W is real wealth.
Transactions Theories of Money Demand
They emphasize the role of money as a medium of exchange; they acknowledge
that money is a dominated asset and stress that people hold money, unlike other
assets, to make purchases. They explain why people hold narrow measures of
money like currency or checking accounts.
Let’s examine one transaction theory called the Baumol-Tobin model.
Chapter Nineteen 15
Total Cost = Forgone Interest + Cost of
Trips
Total Cost = iY/(2N) + FN# of trips
interest # of trips
income travel
cost
There is only one value of N that minimizes total cost.
The optimal value of N is denoted N*.
N* = iY/2F
N*
Number of trips to bank
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
Chapter Nineteen rate and income. 17
The Baumol-Tobin model’s square root formula implies that the
income elasticity of money demand is ½: a 10-percent-increase in income
should lead to a 5-percent increase in the demand for real balances.
But, if you imagine a world in which there are two kinds of people:
Baumol-Tobins with elasticities of ½. The others have a fixed N, so
they have an income elasticity of 1 and an interest elasticity of zero.
In this case, the overall demand looks like a weighted average of the
demands for both groups. Income elasticity will be between ½ and 1,
and the interest elasticity will be between ½ and zero– just as the
empirical evidence shows.
Chapter Nineteen 18
ssets are grouped into two categories:
MONEY: Assets used as a medium of exchange as well as a store
of currency (currency, checking accounts)
NEAR MONEY: Assets used a store of value (stocks, bonds, and
savings accounts).
ear money consists of assets that have acquired the liquidity of money
g., checks that can be written against mutual fund accounts).
ear money causes instability in money demand and can give faulty
gnals about aggregate demand.
Since then, the Fed has set a target for the federal funds rate, the
short-term interest rate at which banks make loans to one another. It
adjusts the target interest rate in response to changing economic
conditions.
Chapter Nineteen 20
Reserves Open-market operations
100-percent-reserve banking Reserve requirements
Balance sheet Discount rate
Fractional-reserve banking Excess reserves
Financial intermediation Bank capital
Monetary base Leverage
Reserve-deposit ratio Capital requirement
Currency-deposit ratio Portfolio theories
Money multiplier Dominated asset
High-powered money Transactions theories
Baumol-Tobin model
Near money
Chapter Nineteen 21