Money in the Economy

Mmmmmmm, money!

The Money Supply• M1:Currency + travelers checks + checkable

deposits• M2:M1 + small time deposits + overnight

repurchase agreements + overnight Eurodollars + money market mutual fund balances

• M3:M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money

market fund balances

The Creators of Money

• The three major players whose decisions and actions determine the rate of growth in the money supply are:– The Federal Reserve (Fed)– The Commercial Banking System– The Non-Bank Public

Money Creation• Banks create money in their normal, day-to-

day profit seeking activities

• Banks do not try to create money

• Money creation occurs because we have a fractional reserve commercial banking system.– Banks must hold a fraction of their deposits idle

as reserves. They may lend the remainder.• As they make loans, new deposits are created,

causing the money supply to expand.

Bank Reserves: Definitions• Total Reserves = Required reserves plus

excess reserves– Required reserves = Deposits X reserve

requirement– Excess reserves = Total reserves - required

reserves

Money Creation: Assumptions• Assumptions:

– Banks lend all their excess reserves– The non-bank public does not use cash– Only demand or checkable deposits exist– The required reserve ratio is 10%

Money Creation: Step 1• Assume the Federal Reserve injects $100 into

the banking system by granting a loan.– Excess reserves increase by $100 in Bank #1

• Banks do not face reserve requirements on injections of reserves by the Fed

• Bank #1, therefore, has $100 to lend

Money Creation: Step 2• Let Bank #1 make a $100 loan to a member of

the non-bank public – It does this by crediting the borrower’s checking

account with $100.

• Let the borrower spend the money.

• Let the recipient of the money bank at Bank #2

• When Bank #1 honors the check, Bank #1’s deposits and reserves fall by $100.

Money Creation: Bank #1

Assets Liabilities

Bank # 1

Reserves 100 Discount Loan 100

Loan 100Reserves (100)

Demand Deposit 100 Demand Deposit (100)

Loan 100 Discount Loan 100

Money Creation: Step 3• A second bank, Bank #2, has received a new

deposit of $100.– Its total reserves increase by ?

• Its required reserves increase by ?

• Its excess reserves increase by ?

– Bank #2 may now make a loan of ?

Money Creation: Step 4• Bank #2 makes a loan of $90 in the form of a

new demand deposit.– When the money is spent and Bank #2 honors the

check, deposits and reserves at Bank #2 fall by $90

• But Bank #3 now has a new deposit of $90 and may make a loan equal to ?

Money Creation: Summary

New Deposit Req Res Ex Res New Loan

$100 $100$100 $10 $ 90 $ 90$ 90 $ 9.00 $ 81 $ 81$ 81 $ 8.10 $72.90 $ 72.90$ 72.90 $ 7.29 $65.61 $ 65.61$ 65.61 $ 6.51 $59.05 $ 59.05

$1,000 $100 $900 $900

Some Simple Formulas

• Note that in our simple example, demand deposits are a multiple of required reserves– Let R = required reserves– Let r = % reserve requirement– Let D = demand deposits– R = r x D or– D = 1/r x R

• A change in deposits will be a multiple of the change in reserves – /\D = 1/r x /\R

The Multiplier• The simple deposit expansion multiplier is 1/r or

1/reserve requirement– r is a leakage of the lending process

• If r gets bigger, expansion of deposits gets smaller because banks have fewer excess reserves to lend.

• If r gets smaller, expansion of deposits gets larger because banks have more excess reserves to lend.

• The real world multiplier is smaller than our 1/r because– Banks hold idle excess reserves – People hold and use cash

The Fed and the Money Supply Process

Control of the Money Supply• The Fed controls the money supply with...

– Open Market Operations• Purchases and sales of government securities by the Fed

on the open market

– Discount Window• Loans made by the Fed to banks

• The Fed influences the multiplier with– Changes in the reserve requirement

Open Market Operations

Fed BankPresidents

Federal OpenMarket Comm.

Fed Board of Governors

Securities Dealers

Federal Reserve Bank of New York

Commercial Banks

Change inReserves

Change in Money Supply

Open Market Operations

• When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves.– Banks can now make more loans.

• When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed– Banks can now make fewer loans.

Discount Loans• When the Fed makes a discount loan to a bank,

the bank is credited with an increase in reserves.– Banks can now make more loans.

• When a bank repays the Fed, the bank’s reserves are debited.– Banks can now make fewer loans.

Reserve Requirements• If the Fed increases reserve requirements,

banks have fewer excess reserves to lend, causing the expansion of deposits to decrease.– Banks can made fewer loans.

• If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.– Banks can make more loans.

Excess Reserves

• Banks determine the level of excess reserves– Increases in excess reserves diminish the

expansion of deposits.– Decreases in excess reserves increase the

expansion of deposits

Currency Changes

• Members of the non-bank public determine currency in circulation– Increases in currency drains from the banking

system, diminish the expansion of deposits– Decreases in currency drains from the banking

system, increase the expansion of deposits

Monetary Policy

I see rates rising;no, falling; no rising; no --

Monetary Policy• A tool of macroeconomic policy under the

control of the Federal Reserve that seeks to attain stable prices and economic growth through changes in the rate of growth of the money supply.

Monetary Policy Channels

PolicyTools

Level & GrowthBank Reserves

Size and Growth Rate of Money Supply

Volume and Growth of Borrowing andSpending by the Public

FullEmployment

Growth

PriceStability

Monetary Transmission Mechanism

• A monetary transmission mechanism describes the chain of events that occur in an economy as a result of a change in the rate of growth in the money supply.

• Good monetary policy decisions depend on understanding the way money can cause changes in economic activity.

Monetary Policy Transmission Mechanism: Interest Rates

Change in Change in Change inMoney Supply Interest Rates GDP

Change in Interest Sensitive Spending

Change in Exchange Rates

Change in Net Exports

Monetary Policy, Interest Rates and GDP

• Let the Fed raise interest rates– As interest rates increase, the cost of

borrowing increases, causing investment (I), consumer durables (C), and GDP to fall.

• Let the Fed decrease interest rates– As interest rates decrease, the cost of

borrowing decreases, causing investment (I), consumer durables (C), and GDP to rise.

Monetary Transmission Mechanism: Exchange Rates

Change inMoney Supply

Change inGDP

Change inInterest Rates

Change inExchange Rates

• The exchange rate is the price of a currency expressed in terms of another currency.

• The exchange rate and the interest rate are positively related.– The higher domestic real rates of interest are

compared to foreign real interest rates, the higher will be the foreign exchange rate for the domestic economy.

Explaining Exchange Rates with Interest Rates

Interest Rate Parity

• Interest rate parity says that the interest rate differential between any two countries is equal to the expected rate of change in the exchange rate between those two countries.

Interest Rate Parity: Example

• Assume that U.S. real interest rates are higher than those in other countries.– The high rates of return on U.S. assets will

attract foreign buyers, but in order to buy U.S. financial assets, foreigners must first buy dollars.

• The demand for dollars increases in the global marketplace, causing the dollar to appreciate.

• The supply of the other currency increases in the global marketplace, causing the other currency to depreciate.

Monetary Policy, Exchange Rates and GDP

• Let the Fed raise short-term interest rates– As interest rates increase, exchange rates increase,

causing net exports (X - M) and GDP to fall.• As the value of the dollar increases, we export fewer

goods and import more.

Monetary Policy, Exchange Rates and GDP

• Let the Fed decrease short-term interest rates– As interest rates decrease, exchange rates decrease,

causing net exports (X - M) and GDP to rise.• As the value of the dollar decreases, we export more

goods and import fewer.

Modeling Monetary Policy

Money Market Model

• Interest rates are determined in the money market through the interaction of money supply and money demand.

Money Supply

• The real money supply is assumed to be fixed in supply and invariant with respect to the interest rate.– The supply of real money balances is defined as

the ratio of nominal money balances and the price level.

• Real money supply = MS/P

Money Supply

Money

Interest Rate

MS

The money supply is shown as avertical line because we are assuming that it does not changeas interest rates increase or decrease.

0

Money Demand and Interest Rates

• Money demand is assumed to be determined by both interest rates and the level of income.– MD = L(i, Y).

• The interest rate is the cost of holding money.– As i rises, the opportunity cost of holding money

rises so people hold less money and more interest bearing assets.

– As i falls, the opportunity cost of holding money falls so people hold more money and fewer interest bearing assets.

Money Demand

Money

MD

iMoney demand is drawn as adownward sloping line.

Note that at high rates of interestpeople do not want to hold verymuch money, but at low rates ofinterest they are willing to hold higher money balances.

i2

MD1

i1

MD20

Money Demand and Income

• Money demand is also assumed to be determined by the level of income.– MD = L(i, Y).

• People hold money to make transactions.– Higher levels on Y are associated with more

transactions. Money demand increases.– Lower levels of Y are associated with fewer

transactions. Money demand decreases.

Money Demand

i

Money

MD(Y2)

Increases in Y from Y1 to Y3 shiftmoney demand to the right.

Decreases in Y from Y3 to Y2 shift money demand to the left.

MD(Y1)

MD(Y3)

0

The Money Market

i

MoneyMS

MD

The equilibrium rate of interest isdetermined by the intersection ofmoney demand and money supply.

Money supply is vertical because itdoes not vary with the interest rate byassumption.

Money demand slopes down becausethe opportunity cost of holding moneyrises and falls with i.

ie

0

The Money Market: Shifts

i

MoneyMS3

MD

Increases in the money supplyshift the MS line to the right.

Decreases in the money supplyshift the MS line to the left.

Note that increases in the money supplycause the equilibrium rate of interest todecrease while decreases in the moneysupply cause the equilibrium rate of interest to increase.

MS1 MS2

i2

i1

i3

0

Money Demand

i

MoneyMS

MD2

Increases in Y shift money demandto the right.

Decreases in Y shift money demandto the left.

Note that an increase in money demand causes the equilibrium rate of interest to increase whilea decrease in money demand causesthe equilibrium rate of interestto decrease.MD1

MD3

0

The Money Market: Monetary Policy

i

MoneyM1 M2 M3

MD

Contractionary monetary policy shiftsMS to the left, increasing the equilibrium interest rate.

Expansionary monetary policy shiftsMS to the right, decreasing the equilibrium interest rate.

i1

i3

i2

0

i i

I1 I3

i1

i3

MS1 MS2

i1

i3

AE

Y

AS

Y1 Y3

AE1 (i1)

AE3 (i3)

InvestmentMD(Y1)

Expansionary MonetaryPolicy: Step 1

1

11

3

3 3

0 0

0

Expansionary Monetary Policy: Transmission Mechanism: Step 1

• An increase in the money supply, other things remaining the same, causes interest rates to fall.– As interest rates fall, interest sensitive spending and

net exports increase.– As spending increases, the aggregate expenditure

line shifts up to AE3

• Inventories fall, inventories are replaced

• Y rises, consumption rises, inventories fall, etc.

– Y begins to rise towards Y3, BUT……..

Expansionary Monetary Policy: Transmission Mechanism: Step 2

• As Y rises, money demand rises– The increase in money demand puts upward

pressure on interest rates causing some investment spending

– And net exports to be crowded out

• As interest sensitive spending and net exports fall we more toward Y2.

i i

I1 I2 I3

i1

i2

i3

MS1 MS2

i1

i2

i3

AE

Y

AS

Y1 Y2 Y3

AE1 (i1)

AE4 (i3)

InvestmentMD(Y1)

MD(Y2)

AE3 (i2)

Expansionary MonetaryPolicy: Step 2.

1 1

1

2 2

2

3

33

0

00

Y

YP

AE1(P1)

AE

AE3(P1)

AS

AS

Y1 Y2 Y3

Y1 Y2 Y3

AD1

AD2

P2

P1

0

0

1

1

3

2

2

We begin at Y1, where AD< AS*. The economy is in a recessionary gap.

To close the gap, the government engages in expansionary monetary policy.

The decrease in interest rates causes aggregate expenditures to increase from AE1 to AE3.

Aggregate demand shifts from AD1 to AD2 and Y rises toward Y3.

At point 2, AD > AS*. As the price level rises, AD decreases along the aggregate demand curve.

The rising price level causes AE3 to shift down to AE2. Equilibrium is established at Y2 and P2.

AE2(P2)

3

Fiscal Policy, One More Time

• An increase in government spending or a decrease in taxes causes aggregate expenditures to rise.– The shift up in AE sets off the multiplier

process, causing Y to rise.– As Y rises, money demand rises, causing interest

rates to rise.– As interest rates rise, some investment and net

exports are crowded out.

i i

I3 I1 I

i3

i1

MS1

i3

i1

AE

Y

AS

Y1 Y2 Y3

AE1 (i1)

AE3 (i1)

InvestmentMD(Y1)

MD(Y2)

AE2 (i3)

11

1

2 2

2

3

Expansionary fiscal policywith money demand and money supply

0

00

Expansionary Fiscal Policy with Rising Interest Rates

• Transmission mechanism:– G up or T down, AE shifts up to AE3, inventories

fall, production increases, Y rises, consumption rises, inventories fall, etc. Y moves toward Y3.

– As Y rises MD shifts up to MD2, causing interest rates to rise.

– As interest rates rise, investment spending and net exports decrease so AE shifts down to AE2.

– Equilibrium occurs at Y2.

Combining Expansionary Fiscal and Monetary Policy

• Transmission mechanism:– But if as interest rates rise, the Fed increases the

rate of growth in the MS from MS1 to MS2, interest rates do not rise and investment and net exports are not crowded out

– If investment and net exports are not crowded out or less investment and net exports are crowded out, the expansion of Y is larger. Y moves toward Y3.

i i

I3 I1 I

i3

i1

MS1 MS2

i3

i1

AE

Y

AS

Y1 Y2 Y3

AE1 (i1)

AE3 (i1)

InvestmentMD(Y1)

MD(Y2)

AE2 (i2)Expansionary Fiscaland Monetary Policy

1 1,

1

2 2

2

3

33

0

0

0

Money and Inflation

The Equation of Exchange

The Equation of Exchange• Early Monetarist View: MV = PY

– A change in the money supply accompanied by no change in the velocity of money leads to an equal change in nominal GDP.

– Fact: Velocity is not a constant and, since the deregulation of the banking system in the 1980s, is increasingly unpredictable

The Equation of Exchange• MV = PY where

– M = Money supply– V = Velocity of money

• The number of times the money supply turns over purchasing a given GDP

– P = Price level– Y = Output

• PY = Nominal GDP

The Equation of Exchange

• Given a fixed V,– If the Fed increases M, PY must increase– If the Fed decreases M, PY must decrease

• If V is not fixed, however, changes in the money supply will not have a predictable effect on PY.

The Equation of Exchange

• Given a fixed Y,– If the Fed increases M, P must increase– If the Fed decreases M, P must decrease

• In the long-run, Y is fixed. If the Fed increases the money supply when Y cannot respond, the inflation rate rises.

• This is why economists say that inflation is always a monetary phenomenon.

Monetary Transmission Mechanisms

Change in the Change in Change in Change inMoney Supply Interest Rates Spending GDP & Exchange Rates

Keynesian: The Interest Rate Channel

Monetarist: The Asset Price Channel

Change in the Change in Change inMoney Supply Spending GDP

i i

I1

i1

MS1

AE

Y

AS

Y1

InvestmentMD1

AE1

0

00

i i

I1

i1

MS1

i1

AE

Y

AS

Y1

InvestmentMD1

AE1

00 0

0