Macro Project 2 Important Final Assignment $ Any Takers?

Handout #17P

Money

The Root of All Reserves

Money is any good that is widely accepted in trade and for repayment of debt. People can use money for trade rather than having to barter. People accept money because they know other people will accept it. Money makes the economy more efficient, frees up resources and makes everyone better off. Money serves three functions:

· Medium of exchange—people can use money for trade rather than having to barter.

· Unit of account—provides a common measure for values.

· Store of value—can maintain its value over time to some satisfactory degree.

The money supply is measured in two ways.

· M1 is the narrow definition and includes only currency outside of banks, checkable deposits and traveler’s checks. These are totally liquid assets. Liquid asset are asset that are easily and cheaply turned into cash.

· M2 is the broader definition and includes M1 plus savings deposits, money market deposit accounts or non-institutional mutual funds, small denomination time deposits like CDs, These financial assets are just slightly less liquid than M1.

The Federal Reserve System (the Fed) is the central bank of the U.S. The Federal Reserve System has a number of functions, including:

· Controlling the money supply

· Providing paper money to the economy

· Providing check clearing services

· Holding banks reserves

· Supervising member banks

· Serving as the government’s banker

· Serving as the lender of last resort

· Handling the sales of US Treasury securities

These functions control the money supply through the nation’s banking system. It works through the required reserve ratio for banks. Banks only hold part of their deposits on hand as reserves. The required percentage banks must hold is set by the Fed.

In a simplified banking system with only one bank, suppose the bank receives a brand new $1000 bill as a deposit from customer 1. Though customer 1 could require his/her $1000 at any time, the bank is only required to hold part as reserves. Suppose the required reserve ratio set by the Fed is 10%. That means that the bank only has to hold onto $100 as require reserves out of the $1000 deposit and it can loan the rest out, charging interest on the loan, and earning income that way. So the bank loans out $900 to a borrower, customer 2, and he/she puts that $900 in his/her checking account at the bank. The bank has to keep $90 as required reserves and is free to loan out $810. So it does, to customer 3, who then deposits the $810 loan proceeds into his/her checking account. The bank has to keep $81 of this deposit as reserves, and has $729 to loan out to customer 4. And so on, and so on, and so on. . . . . .

Here’s the bank’s activities:

Total Reserves (	Required Reserves (10%) (	Loans (	New Deposits
			$1000.00
$1000.00	$100.00	$900.00	$900.00
$900.00	$90.00	$810.00	$810.00
$810.00	$81.00	$729.00	$729.00
$729.00	$72.90	$656.10	$656.10
$656.10	$65.61	$590.49	$590.49
$590.49	$59.05	$531.44	$531.44
$531.44	$53.14	$478.30	$478.30
$478.30	$47.83	$430.47	$430.47
$430.47	$43.05	$387.42	$387.42
$387.42	$38.74	$348.68	$348.68
$348.68	$34.87	$313.81	$313.81
And so on	And so on	And so on	And so on

By the time the process is all the way done, the money supply will have increased by $10,000 with $1000 from the initial new $1000 bill and $9000 from the banking system. The total change in the money supply can be calculated by the simple deposit multiplier which is

1 divided by the required reserve ratio (r). The multiplier would calculate the maximum total change in money supply as

∆M1 or M2 = 1 * ∆Bank reserves from original deposit of funds

r

In our example, this would be 1/.10 * $1000 or $10,000.

The process works in reverse to decrease the money supply—banks have to hold onto repaid loan funds to meet their reserves, rather than loan them out again. That shrinks the money supply through the simple deposit multiplier operating on the required reserve ratio, r.

When calculating the maximum change in the money supply, it matters whether the initial deposit into the banking system is new to the money supply or was already part of the money supply, just not in the banking system. If the money is new to the money supply, the maximum is calculated using the full multiplication: initial deposit in the bank * 1/r. However, if the deposit was already part of the money supply, you have to subtract it out at the end: (initial deposit * 1/r)-initial deposit.

Two things have to happen to reach the maximum change in the money supply. First, there can’t be any cash leakages. All the loans have to be re-deposited in the bank—if not, a smaller amount will be multiplied at every level afterward and the change in the money supply cannot reach the maximum. Second, the bank has to loan all its excess reserves. If the bank keeps part of the reserves it could otherwise loan, a smaller amount will be multiplied at every level afterward and the change in the money supply cannot reach the maximum.

The Fed can change the money supply through reserves in several ways:

· Open market operations—if the Fed purchases securities from banks, it deposits money to pay for the securities in the bank’s reserve account. This increase in reserves can then be loaned, and through the simple deposit multiplier, expand M1 or M2. If the Fed sells securities to a bank, it removes reserves from the bank’s reserve account which reduces reserves and in turn the amount that the bank can now loan. Open market purchases by the Fed expand the money supply and open market sales by the Fed contract the money supply.

· The required reserve ratio—the Fed can raise of lower the percentage of deposits that a bank is required to hold as reserves. If the Fed lowers the required reserve ratio, some of the bank’s required reserves will suddenly become excess reserves and the money supply will expand. If the Fed increases the required reserve ratio, banks will have to increase required reserves which means there will be less to loan out and the money supply will contract.

· The discount rate—this is the interest rate that the Fed charges to banks to borrow funds from the Fed. If the Fed lowers the discount rate, more banks will borrow funds from the Fed, which increases their reserves, and expands the money supply. If the Fed increases the discount rate, fewer banks will borrow funds from the Fed, and banks reserves will decrease, contracting the money supply.

The main point to remember—anything that increases reserves in the banking system will increase the money supply. Anything that reduces reserves will contract it.

Quantity Theory of Money

Changes in the money supply change the price level. This effect is analyzed through the equation of exchange. This equation states that

Money supply (M) * Velocity of money (V) = Price level (P) * Real GDP (Y) or (Q)

or MV = PQ

The velocity of money is simply the number of times annually that the money supply is spent on final goods and services in the economy. Suppose the economy has a money supply of $100 and during the year $700 of final goods and services was purchased. That means that each dollar of the money supply was spent an average of 7 times on final goods and services.

V = PQ or V = $700 so V = 7

M $100

MV measures total expenditures, also known as aggregate demand, and PQ measures nominal GDP. If MV measures total expenditures, then MV = C + I + G + NX.

The equation of exchange leads to the simple quantity theory of money. If you assume that velocity and real GDP are constant (in the short-run), then changes in the money supply will make a proportional change in the price level, or $∆M = %∆P. Or, increases in the money supply lead to inflation.

The equation of exchange results in the statement

P = MV

Q

If real GDP is assumed to change also, then you have three influences on the price level

· Inflationary influences—increases in money supply, increases in velocity (numerator) or decrease in real GDP (denominator)

· Deflationary influences—decreases in money supply, decreases in velocity (numerator) or increase in real GDP (denominator)

Looking at growth rates, the equation of exchange is:

(Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). You can rearrange this equation by subtracting the (Real GDP growth rate) from both sides,

That gives you:

(Inflation rate) = (Money growth rate) + (Growth rate of velocity) ( (Real GDP growth rate).

If velocity is assumed to remain constant, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP. In periods of hyperinflation, or rapidly increasing price levels in excess of 50% per month, velocity will not remain constant but will be rapidly increasing also.

The Market for Money

There is a market for money, which is different from the market for loanable funds.

People like to hold some of their wealth in the form of money, creating a demand for money.

The quantity of money that people plan to hold depends on:

· The Price Level: The higher the price level, the more money people will want to hold.

· The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded.

· Real GDP: An increase in real GDP increases the quantity of money people plan to hold.

· Financial Innovation: Any financial innovation that enables people to more easily access their financial accounts, like ATMs and debit cards, or increases the opportunity cost of holding money (interest paid on checking accounts) affects the demand for money.

The demand curve for money shows the relationship between the quantity of real money demanded and the interest rate, which is the cost for holding money. By holding money, people are foregoing the opportunity to make income through interest earnings. When interest rates are high, you are giving up the chance to earn more income, so you become less willing to hold your wealth in cash or non-interest earning deposit accounts. The negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

The supply of money is fixed at whatever level the Fed has set it at. The supply curve will be a vertical line at that quantity.

If the Fed increases the money supply by:

a) open market purchase, or

b) decreasing the required reserve ratio, or

c) decreasing the discount rate,

the money supply curve will move out to the right because all of these methods will increase bank excess reserves that can be loaned. At the current nominal interest rate, this causes a surplus of money and people will buy more of everything, including bonds. The demand for bonds will increase which drives the price of bonds up. When bond prices increase, real interest rates decrease (PBONDS and ireal always move in opposite directions). Since nominal interest rate = real interest rate + expected inflation, nominal interest rates decrease also down to inom1.

If the Fed decreases the money supply by:

a) open market sale, or

b) increasing the required reserve ratio, or

c) increasing the discount rate,

the money supply curve will move in to the left because all of these methods will decrease bank excess reserves that can be loaned. At the current nominal interest rate, this causes a shortage of money and people will sell bonds to turn their bonds into money. The supply of bonds will increase which drives the price of bonds down. When bond prices decrease, real interest rates increase (PBONDS and Ireal always move in opposite directions). Since nominal interest rate = real interest rate + expected inflation, nominal interest rates increase also up to inom1.

A change in real GDP or financial innovation changes the demand for money and shifts the money demand curve. An increase in real GDP increases the demand for money and shifts the money demand curve to the right, ultimately increasing the short-run nominal interest rate.

A new financial innovation or a decrease in real GDP will decrease the demand for money and shifts the demand for money curve leftward, ultimately decreasing the short-run nominal interest rate.

In the long run, the real interest rate is determined by supply and demand in the loanable funds market. Since the nominal interest rate equals the real interest rate plus the expected inflation rate, the nominal interest rate cannot adjust to balance the demand and supply in the market for money. Instead the price level adjusts to create that balance. When the Fed changes the quantity of money, the price level changes (in the long run) by a percentage equal to the percentage change in the quantity of money (remember the equation of exchange). So the % change in M will equal the % change in P in the long run.

When the price level changes, the expected rate of inflation will change too. That will in turn change the nominal interest rate. The change in the nominal interest rate changes the opportunity cost or price of holding money, so the quantity demanded of money will increase or decrease, shown as a movement along the demand curve for money.

Quantity of Real Money

inom

MS (M1 or M2, set by the Fed)

MD

Nominal Interest Rate

Quantity of Real Money

inom

MS1

MD

Nominal Interest Rate

inom1

AFTER ireal (

MS

MONEY SURPLUS

Buy bonds (DBONDS

(PBONDS ((ireal ((inom

(Money Supply

Quantity of Real Money

inom

MS1

MD

Nominal Interest Rate

inom1

AFTER ireal (

MS

MONEY SHORTAGE

Sell bonds (SBONDS

(PBONDS ((ireal ((inom

(Money Supply

Quantity of Real Money

inom1

MS

MD1

Nominal Interest Rate

( Real GDP(

(Money Demand

MD

inom

MONEY SHORTAGE

Sell bonds (SBONDS

(PBONDS ((ireal ((inom

Quantity of Real Money

inom

MS

MD

Nominal Interest Rate

(Financial Innovation or (Real GDP(

(Money Demand

MD1

inom1

MONEY SURPLUS

Buy bonds (DBONDS

(PBONDS ((ireal ((inom