Chapter

Money and Monetary policy

 Chapter objectives

• Money
• Banks and the money supply
• Money market
• Monetary policy

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1. Money
1.1 Definition of Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other people
1.2 Functions of money
– Medium of exchange
– Unit of account
– Store of value

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1. Money
• Medium of exchange
– Item that buyers give to sellers
• When they want to purchase goods and services
• Unit of account
– Yardstick people use to post prices and record
debts
• Store of value
– Item that people can use to transfer
purchasing power
• From the present to the future
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2. Banks and the money supply
2.1 Basic concepts
• The money supply (MS): the quantity of money
available in the economy
• The money supply equals currency plus
demand deposits:
MS = C + D

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2. Banks and the money supply
• Reserves : Deposits that banks have received but
have not loaned out.
• Reserve ratio (rr): Fraction of deposits that banks
hold as reserves. It includes reserve requirement
- minimum set by the central bank and excess
reserves - above the legal minimum.
• T-account which is a simplified accounting
statement that shows changes in a bank’s assets
and liabilities.

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2. Banks and the money supply
• 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.

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2. Banks and the money supply
2.2 How Banks affect money supply
SCENARIO 1: 100 – Percent - Reserve Banking
▪ Initially C = $100, D = $0, MS =
▪ Now suppose households deposit the $100 at “First
National Bank.”
▪ After the deposit,
FIRST NATIONAL BANK C = $0,
Assets Liabilities D = $100,
MS =
Reserves Deposits
▪ 100% Reserve
Banking has no
impact on size of
money supply.
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2. Banks and the Money Supply
• SCENARIO 2: Fractional - Reserve Banking
– Reserve ratio = 1/10 (10 percent)

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2. Banks and the Money Supply
FIRST NATIONAL BANK
Assets Liabilities
Reserves Deposits $100
Loans
SECOND NATIONAL BANK
Assets Liabilities
Reserves Deposits $90
Loans

THIRD NATIONAL BANK

Assets Liabilities
Reserves Deposits $81
Loans
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2. Banks and the Money Supply
• How much money is eventually created in the
economy?
• Original deposit = $100
• First National lending = $ …
• Second National lending = $ …
• Third National lending = $ …
•…
• Total money supply = $...

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2. Banks and the Money Supply

- Banks hold only a fraction of deposits in

reserve
– Banks create …
– But it doesn’t create …

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2. Banks and the Money Supply
2.3 A model of the money supply
• Monetary base, B = C + R controlled by the
central bank
• Reserve ratio, rr = R/D
depends on regulations & bank policies
• Currency-deposit ratio, cr = C/D
depends on households’ preferences

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2. Banks and the Money Supply
2.3 A model of the money supply
• Solving for money multiplier (m)
• B=C+R
• MS = C + D
• MS / B = C + D / C + R

Money multiplier (m)

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 2. Banks and the Money Supply
• m is the money multiplier
➢ how much the ...... will change if there is a
change in the .....
➢ rr < 1, then m ...

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 Question
Given some data in the money supply model, find
the missing values:
a. cr = 20%, rr = 10%, MS = 2000. Find B?
b. rr = 15%, MS = 3000, B = 500. Find cr?
c. cr + rr = 40%, MS = 1500, B = 500. Find cr and
rr?

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2. Banks and the Money Supply
2.4 Central bank and tools of monetary control
• A central bank: an institution designed to
oversee the banking system and regulate the
quantity of money in the economy
• The Federal Reserve System (“the Fed”) serves
as the central bank for the United States.

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2. Banks and the Money Supply
• Tools of monetary control
a. Open-market operations
– Purchase and sale of government bonds by
the central bank
– To increase the money supply
• The central bank … government bonds
– To reduce the money supply
• The central bank … government bonds

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2. Banks and the Money Supply
• Tools of monetary control
b. Reserve requirements
– Regulations on minimum amount of reserves
• That banks must hold against deposits
– An increase in reserve requirement
•… the money supply
– A decrease in reserve requirement
•… the money supply

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2. Banks and the Money Supply
• Tools of monetary control
c. The discount rate
– Interest rate on the loans that the central
bank makes to banks
– Higher discount rate
•… the money supply
– Smaller discount rate
•… the money supply

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2. Banks and the Money Supply
2.5 Problems in controlling the money supply
• The central bank
– Does not control

• The central bank

– Does not control

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 Bank runs and the money supply

• Bank runs
– Depositors suspect that a bank may go bankrupt
• “Run” to the bank to withdraw their deposits
– Problem for banks under fractional-reserve banking
• Cannot satisfy withdrawal requests from all depositors
– When a bank run occurs
• The bank - is forced to close its doors
• Until some bank loans are repaid
• Or until some lender of last resort provides it with the
currency it needs to satisfy depositors
– Complicate the control of the money supply
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• Homework: What is a bank run? Analyze causes
and consequences of bank runs. Give an
example.

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3. Money market
❖ The theory of liquidity preference
• Interest rate (denoted r) adjusts to balance supply and
demand for money
– The nominal interest rate is the interest rate as
usually reported
– the real interest rate is the interest rate corrected for
the effects of inflation

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3.1 Money supply
• Money supply: assume fixed by central
bank, does not depend on interest rate
Interest
rate

Money supply (MS)

Quantity Quantity of Money

Fixed by the central bank

2255
3.2 Money demand
• The demand for money refers to how much assets
people wish to hold in the form of money
• For simplicity, suppose household wealth includes
only two assets:
– Money – liquid but pays no interest rate
– Interest - bearing assets – pay interest rate but
not as liquid
• Interest rate is the opportunity cost of holding
money

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3.2 Money demand

Interest
rate

Money
Demand (MD)

Quantity of Money

2277
3.3 Equilibrium in the money market
Explain the adjustment mechanism for the
Interest equilibrium point in the money market.
rate

Money supply (MS)

r1
Equilibrium
Interest rate

r2

Money
Demand (MD)
Md1 Quantity Md 2 Quantity of Money
Fixed by the central bank

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4. Monetary Policy
• Monetary policy: the supply of money set by the
central bank
• The central bank increases the money supply -
Expansionary monetary policy
– Money-supply curve shifts right
– Interest rate (r) falls
– A fall in r increases I
– At any given price level, AD increases
– Thus, aggregate-demand curve shifts right

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The central bank increases the money
supply
(a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
rate level
MS1 MS2
1. When the central bank
increases the
r1 money supply . . .
P

r2

AD2
MD AD1

0 Quantity 0 Y1 Y2 Quantity of output

2. . . . the equilibrium of money 3. . . . which increases the quantity of goods and
interest rate falls . . . services demanded at a given price level.

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4. Monetary Policy
• The central bank decreases the money supply –
Contractionary monetary policy
– Money-supply curve shifts left
– Interest rate increases
– A rise in r decreases I
– At any given price level, AD decrease
- Thus, aggregate-demand curve shifts left

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The central bank decreases the money
supply
(a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
rate level
MS2 MS1
1. When the central bank
decreases the
r2 money supply . . .
P

r1

AD1
MD , AD2

0 Quantity 0 Y2 Y1 Quantity of output

2. . . . the equilibrium of money 3. . . . which decreases the quantity of goods and
interest rate rises . . . services demanded at a given price level.

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 Question
Suppose the Fed makes an open market purchase of
$3 million. Assume that the money multiplier equals
2.
a/ What is the change in the money supply?
b/ Use graphs to explain how the change in money
supply is related to changes in interest rates,
aggregate demand, and real GDP.
 Chapter Summary

1. Fractional reserve banking creates money

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. In the theory of liquidity preference,
the interest rate adjusts to balance
the demand for money with the supply of money.

5. An increase in the money supply causes the

interest rate to fall, which stimulates investment
and shifts the aggregate demand curve rightward.