Money Supply Money Demand, and Inflation: Textbook: Mankiw Chapter 4
Money Supply Money Demand, and Inflation: Textbook: Mankiw Chapter 4
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WHAT IS MONEY?
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FUNCTIONS OF MONEY:
2. A Measure of Value
3. Store of Value:
‘repository of purchasing power over time’.
Helps to save purchasing power from the time income is
received until the time it is spent.
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TYPES OF MONEY
1. Fiat Money
has no intrinsic value
it is established as money by government decree, or fiat.
2. Commodity Money
gold.
can be used for various purposes—jewellry, dental fillings
Cigarettes are also a popular form of commodity money.
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THE DEMAND FOR MONEY
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WHAT IS PECULIAR ABOUT MONEY?
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MONEY IN FORMAL ECONOMIES
The money supply equals currency plus demand (bank account) deposits:
M = C + D
Since the money supply includes demand deposits, the banking system plays
an important role.
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Reserves (R ): the portion of deposits that banks have not
lent.
To a bank:
Liabilities include deposits,
Assets include reserves and outstanding loans
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.
What is it in India?
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BANKS’ ROLE IN THE MONEY SUPPLY
To understand the role of banks, we will consider three
scenarios:
1. No banks
3. Fractional-reserve banking
(banks hold a fraction of deposits as reserves, use the rest to make
loans)
With no banks,
D = 0 and M = C = $1000.
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SCENARIO 2: 100 PERCENT RESERVE BANKING
Thus, in a fractional-reserve
banking system, banks create money.
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SCENARIO 3: FRACTIONAL-RESERVE BANKING
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SCENARIO 3: FRACTIONAL-RESERVE BANKING
THIRDBANK’S
balance sheet
Assets Liabilities
reserves $128
$640 deposits $640
loans $0
$512
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FINDING THE TOTAL AMOUNT OF MONEY:
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MONEY CREATION IN THE BANKING SYSTEM
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A MODEL OF THE MONEY SUPPLY
exogenous variables
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SOLVING FOR THE MONEY SUPPLY
(NOT IN SYLLABUS):
C D
M C D B m B
B
where
C D
m
B
C D
C D D D
cr 1
C R C D R D cr rr
THE MONEY MULTIPLIER
cr 1
M m B , where m
cr rr
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QUESTION:
cr 1
M m B, where m
cr rr
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SOLUTION
1. An increase in rr reduces the possible loans that a bank can
give, and m reduces.
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INDIA’S BANKING SITUATION
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THREE INSTRUMENTS OF MONETARY POLICY
2. Reserve requirements
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1. OPEN MARKET OPERATIONS
Definition:
The purchase or sale of government bonds by the
Central Bank.
how it works:
If Central Bank buys bonds from the public, it pays with
new currency, increasing B and therefore M.
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2. RESERVE REQUIREMENTS
Definition:
Regulations that require banks to hold a minimum
reserve-deposit ratio.
how it works:
Reserve requirements affect rr and m:
If Central Bank reduces reserve requirements,
then banks can make more loans and “create”
more money from each deposit.
3. THE DISCOUNT RATE
Definition:
The interest rate that the Central Bank charges on loans it
makes to banks.
how it works:
When banks borrow from the Central Bank, their reserves
increase, allowing them to make more loans and “create”
more money.
The RBI can increase B by lowering the discount rate to
induce banks to borrow more reserves from the Fed.
WHICH INSTRUMENT IS USED MOST OFTEN?
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INDIA’S MONETARY POLICY INSTRUMENT
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WHY THE FED CAN’T PRECISELY CONTROL M
M m B,
cr 1
where m
cr rr
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FISCHER EQUATION
The Fisher equation is a concept in economics that describes the
relationship between nominal and real interest rates under the
effect of inflation. The equation states that the nominal interest
rate is equal to the sum of the real interest rate plus inflation.
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PRACTICE QUESTION:
Mark buys a one-year German government bond for $400.
He receives principal and interest totalling $436 one year later.
During the year the CPI rose from 150 to 162.
The nominal interest rate on the bond was ____ and the real interest
rate was ______:
A) 9%; 1%
B) 9%; -1%
C) 36%; 24%
D) 36%; 12%
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FISCHER’S QUANTITY THEORY OF MONEY:
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PRACTICE QUESTION ON QTM:
Nominal GDP of Winterfell was 3.2 million golden
dragons (the currency of Westeros) in 270 AC.
Corresponding real GDP based on 260 AC prices was 3
million golden dragons. If the velocity of money is 10,
what is the quantity of money that circulated in Winterfell?
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Money Supply * Velocity = Price * Average Cost per Transaction
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MONEY SUPPLY, MONEY DEMAND, AND MONETARY
EQUILIBRIUM
GDP, Capital stock, Real wage, Real interest rate - they measure a
physical (rather than a monetary) quantity.
Price level, the inflation rate, and the nominal wage – these are
nominal variables.
Economists call this theoretical separation of real and nominal
variables the classical dichotomy.
Changes in the money supply do not influence real variables.
This irrelevance of money for real variables is called money
neutrality.
Criticism: does not fully describe the world in which we live.
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