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To understand the money supply, we must understand the interaction
between currency and demand deposits and how the Fed policy
influences these two components of the money supply.

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R
Roney 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).

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The deposits that banks have received but have not lent out are called
„  „ 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 a  affect the supply of money.

u  
         
ussets Liabilities
Reserves Deposits
|   $1,000 $1,000 
us long as the amount of new deposits approximately equals the
amount of withdrawals, a bank need not keep all its deposits in
reserves. Note: a „  „    „ is the fraction of deposits
kept in reserve. `  „  „  are reserves above the reserve
requirement.

„„  „  , a system under which banks keep


only a fraction of their deposits in reserve. In a system of
fractional-reserve banking, banks create money.
u            
ussets Liabilities Let¶s look
Reserves $200 Deposits $1,000 at how money
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Loans $800 creation works«

ussume each bank maintains a „  „    „ „„ of -    and that the initial deposit is
.
Firstbank Secondbank Thirdbank
Balance Sheet Balance Sheet Balance Sheet
ussets Liabilities ussets Liabilities ussets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512

Rathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1,000
Firstbank Lending = (1- „„) º $1,000 The process of transferring funds
Secondbank Lending = (1- „„)2 º $1,000 from savers to borrowers is called
Thirdbank Lending = (1- „„)3 º $1,000
Fourthbank Lending =& (1- „„)4 º $1,000
'      .
&&
2    = [1 + (1-„„) + (1-„„)2 + (1-„„)3 + «] º $,1000
= (1‰„„) º $1,000
      ! 
|   = (1/.2) º $1,000 
"#  $  %
  
Three exogenous variables:
The    # r is the total number of dollars held by the
public as currency C and by the banks as reserves @
The     „„ is the fraction of deposits  that banks
hold in reserve @
The      „ is the amount of currency C
people hold as a fraction of their holdings of demand deposits 
˜'   '           #(
R 
r @
 ) '    '  '  * +)   #(
R‰r  ‰  1
‰  @‰
 )  #  '  '    # $ # (
„,  Let¶s call this the ë
ë  „ ë.
  ºr
„, „„ 
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Rºr

Roney Supply Roney multiplier Ronetary Base

Because the monetary base has a multiplied effect on the money


supply, the monetary base is sometimes called YY „ ë
&
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Let¶s go back to our three exogenous variables to see how their
changes cause the money supply to change:
The  a 
 R is proportional to the  a „  r. So,
an increase in the monetary base increases the money supply by
the same percent.
The lower the „  „    „ „„ (@‰), the more loans
banks make, and the more money banks create from every dollar
of reserves.
The lower the 
„„ a    „ „ (‰) , the fewer dollars
of the monetary base the public holds as currency, the more base
dollars banks hold in reserves, and the more money banks can
create. Thus, a decrease in the currency-deposit ratio raises the
money multiplier and the money supply.
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How the Fed controls the money
How the Fed controls the money supply
supply
1) Open-market operations (buying and selling U.S. Treasury
bonds).
  Reserve requirements (least frequently used instrument).
3)  Discount rate at which member banks (not meeting the reserve
requirements) can borrow from the Fed.

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r    
 
     

Starting a bank requires financial resources to get the bank


started; the equity of the bank¶s owners is called #  &

-   $  # . #   $  (

ussets Liabilities and Owners¶ Equity


_________________________________________________

Reserves $200 Deposits $750

Loans $500 Debt $200

Securities
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$300 Capital (Owner¶s Equity) $50

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.

This business strategy relies on a phenomenon called  )


which is the use of borrowed money to supplement existing funds
for purposes of investment. The  „ „ is the ratio of the
bank¶s total assets (the left side of the balance sheet) to bank
capital (the one item on the right side of the balance sheet that
represents the owner¶s equity.

The implication of leverage is that, in bad times, a bank can lose


much its capital very quickly. The fear that bank capital may be
running out, and thus that depositors may not be fully repaid is
typically what generates bank runs when there is no deposit
insurance.
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One of the restrictions that bank regulators put on banks is that the
banks must hold sufficient capital. The goal of such a capital
requirement is to ensure that banks will be able to pay off their
depositors. The amount of capital required depends on the kind of
assets a bank holds. If the bank holds safe assets such as government
Bonds, regulators require less capital than if the bank holds risky assets
such as loans to borrowers whose credit is of dubious quality.

In 2008 and 2009, many banks found themselves with too little
capital after they incurred losses on mortgage loans and mortgage-
backed securities. 2  ) ' #     # 
  )   # )        $  & 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.
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!  2  '   ˜ 
uccording to the quantity theory of money, " %   /, where  is a constant
measuring how much people want to hold for every dollar of income.
Ñ  2  '   ˜ 
Later we adopted a more realistic money demand function, where the demand for
real money balances depends on  and : " %     

 ' 2  '   ˜ 


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. Roney offers a safe nominal return, while other investments may
fall in both real and nominal terms. " %   "„ „  `å >% where „ is the
expected return in the stock market, „ is the expected return on bonds, å is the
expected inflation rate, and > is real wealth.
2     2  '   ˜ 
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.
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Total Cost = Forgone Interest + Cost of Trips
Total Cost = '/(2) + 
interest # of trips # of trips
income travel
cost
There is only one value of  that minimizes total cost.
The optimal value of  is denoted *.

* =  /2

uverage Roney Holding is = /2(*)


|   = 'F/2

The cost of money holding: forgone interest, the cost of trips to the
bank, and total cost depend on the number of trips  One value of
 denoted *, minimizes total cost.
Cost

Total cost =  /(2) + 

Cost of trips to bank ()


Forgone interest ( /(2))

*
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  alters the money demand
function²that is, it changes the quantity of money demanded for a
given interest rate and income.
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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.

In reality, however, most people have income elasticities that are


larger than ½ and interest elasticities smaller than ½.

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  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.
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ussets are grouped into two categories:
% 012/( ussets used as a medium of exchange as well as a store
of currency (currency, checking accounts)
-% 12u 012/( ussets used a store of value (stocks, bonds, and
savings accounts).

 „  a consists of assets that have acquired the liquidity of money


(e.g., checks that can be written against mutual fund accounts).

 „  a causes instability in money demand and can give faulty


signals about aggregate demand.

One response to this problem is to use a broad definition of money that


includes near money, but it¶s hard to choose what kinds of assets
should be grouped together.
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The instability of money demand has been a political issue for
The Federal Reserve. In 1993, Fed chairman ulan Greenspan said
that the aggregates ³do not appear to be giving reliable indications of
economic developments and price pressures.´

Over the previous year, R1 had grown at 12 percent, while R2 had


grown 0.5 percent. Depending on the weight given to each measure,
monetary policy was either very loose, very tight, or somewhere in
the middle.

Since then, the Fed has set a target for the


 „

a „ , 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.
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Reserves Open-market operations
100-percent-reserve banking Reserve requirements
Balance sheet Discount rate
Fractional-reserve banking Excess reserves
Financial intermediation Bank capital
Ronetary base Leverage
Reserve-deposit ratio Capital requirement
Currency-deposit ratio Portfolio theories
Roney multiplier Dominated asset
High-powered money Transactions theories
Baumol-Tobin model
Near money
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