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Chapter 18: Money Supply & Money Demand
Chapter 18: Money Supply & Money Demand
M=C+D
(M/P)s
10
80 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
investment
Fractional Banking System
R = RR + ER
RR = rr R
ER = (1 – rr)R
5
(M/P)d
80 100
Quantity of Money
Money Market Equilibrium
Interest Rate (%)
(M/P)s
(M/P)d
80 Quantity of Money
Expansionary Monetary Policy
5
4
(M/P)d
80 85 Quantity of Money
Portfolio Theory of Money Demand
Define
– 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
Cost
Total cost of bank withdrawal
The FED uses this rate as the basis for its interest rate
policy