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Money Supply Money Demand, and Inflation: Textbook: Mankiw Chapter 4

The money multiplier, m, captures the idea that changes in the monetary base (cash plus bank reserves) are amplified into larger changes in the money supply (cash plus bank deposits) through the banking system. When the central bank increases the monetary base, banks can use those added reserves to increase lending and create new deposits. Each new dollar of reserves allows banks to create many more dollars of new deposits (given fractional reserve requirements). The money multiplier formula shows how high reserve requirements (high rr) reduce money creation by banks, while a preference for currency (high cr) also limits money creation by draining deposits that could otherwise be lent out. So in summary, the money multiplier concept demonstrates how the banking system expands the money

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0% found this document useful (0 votes)
45 views43 pages

Money Supply Money Demand, and Inflation: Textbook: Mankiw Chapter 4

The money multiplier, m, captures the idea that changes in the monetary base (cash plus bank reserves) are amplified into larger changes in the money supply (cash plus bank deposits) through the banking system. When the central bank increases the monetary base, banks can use those added reserves to increase lending and create new deposits. Each new dollar of reserves allows banks to create many more dollars of new deposits (given fractional reserve requirements). The money multiplier formula shows how high reserve requirements (high rr) reduce money creation by banks, while a preference for currency (high cr) also limits money creation by draining deposits that could otherwise be lent out. So in summary, the money multiplier concept demonstrates how the banking system expands the money

Uploaded by

Priyanka
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
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Money Supply

Money Demand, and


Inflation

Textbook: Mankiw Chapter 4


CLASSIC VS KEYNES RE-VISITED
-Classical Economists are of the opinion that prices are flexible.
Recall Supply and Demand from Economics-1
- Keynesians believed that prices are ‘sticky’.
takes time and effort to renegotiate.

- Money markets ‘clear’, and are most efficient.

slide 2
WHAT IS MONEY?

Money has 4 purposes:


1.Medium of Exchange:
-facilitates both buying and selling of goods and services.
- helps economy based on specialization and division of labour
- difficult to ensure “double coincidence of wants”.
 all people will have to find someone who has a good that they want and who
want to get the service or good they have to offer.

- money should have general acceptability, portability, divisibility,


durability, stability of value, homogeneity.

slide 3
FUNCTIONS OF MONEY:
2. A Measure of Value

•Money is a common denominator, through which the exchange


value of all goods and services can be expressed without any
difficulty.
•Otherwise, assuming existence of ‘n’ commodities in an economy,
we will have to find n (n – 1)/2 rates.
•Allows one to compare the values of commodities. Suppose, the
price of commodity X is Rs. 5 while that of Y is Rs. 10. Thus, Y is
twice as expensive as X.
•Money also enables dissimilar things such as a person’s car or real
estate to be added up.
•National income is also expressed in terms of money. slide 4
FUNCTIONS OF MONEY:

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.

4. Money as the Standard of Deferred Payment

slide 5
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.

slide 6
slide 7
THE DEMAND FOR MONEY

 Demand for money is closely related to the properties of


money.

Everyone has individual Liquidity vs. Return preferences

Other variables: Price level, Real income, Interest rates

 Payment technologies: Credit cards, ATMs, and other financial


innovations reduce money demand

slide 8
WHAT IS PECULIAR ABOUT MONEY?

 Consider Apples, Bananas and Mangos


 Everyone wants variety.
 What if apples and bananas can be traded for mangoes but not
directly with each other
 With any other good or asset, when people want more they must
buy it
 If you want more money, however, you should simply refrain from
buying other things.
 Excessive Money demand causes depression.

slide 9
MONEY IN FORMAL ECONOMIES

The quantity of money available in an economy is called the money


supply.
The government controls the supply of money
Just as the level of taxation (T) and level of government purchases
(G) are policy instruments of the government, so is the quantity of
money.
The government’s control over the money supply is called monetary
policy.
 Direct or Indirect?

Partially independent institution: Central Bank


slide 10
BANKS’ ROLE IN THE MONEY SUPPLY

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.

slide
11
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?

slide
12
BANKS’ ROLE IN THE MONEY SUPPLY
To understand the role of banks, we will consider three
scenarios:
1. No banks

2. 100-percent reserve banking


(banks hold all deposits as reserves)

3. Fractional-reserve banking
(banks hold a fraction of deposits as reserves, use the rest to make
loans)

In each scenario, we assume C = Rs1000.


SCENARIO 1: NO BANKS

With no banks,
D = 0 and M = C = $1000.

slide
14
SCENARIO 2: 100 PERCENT RESERVE BANKING

 Initially C = $1000, D = $0, M = $1000.


 Now suppose households deposit the $1000 at
“Firstbank.”

FIRSTBANK’S After the deposit,


C = $0,
balance sheet D = $1000,
Assets Liabilities M = $1000.

reserves $1000 deposits $1000 100% Reserve Banking


has no impact on size of
money supply.
slide
15
SCENARIO 3: FRACTIONAL-RESERVE BANKING

 Suppose banks hold 20% of deposits in reserve,


making loans with the rest.
 Firstbank will make $800 in loans.

FIRSTBANK’S The money supply now


equals $1800:
balance sheet
Assets Liabilities The depositor still has
$1000 in demand
reserves $200 deposits,
loans $800 deposits $1000 but now the borrower
holds $800 in currency.
slide
16
SCENARIO 3: FRACTIONAL-RESERVE BANKING

Thus, in a fractional-reserve
banking system, banks create money.

The money supply now


FIRSTBANK’S equals $1800:
balance sheet The depositor still has
Assets Liabilities $1000 in demand
deposits,
reserves $200
deposits $1000 but now the borrower
loans $800 holds $800 in currency.

slide
17
SCENARIO 3: FRACTIONAL-RESERVE BANKING

 Suppose the borrower deposits the $800 in


Secondbank.
 Initially, Secondbank’s balance sheet is:
But then Secondbank will
SECONDBANK’S loan 80% of this deposit
balance sheet
and its balance sheet will
Assets Liabilities look like this:
reserves $160
$800 deposits $800
loans $0
$640

slide
18
SCENARIO 3: FRACTIONAL-RESERVE BANKING

 If this $640 is eventually deposited in Thirdbank,


 then Thirdbank will keep 20% of it in reserve, and
loan the rest out:

THIRDBANK’S
balance sheet
Assets Liabilities
reserves $128
$640 deposits $640
loans $0
$512

slide
19
FINDING THE TOTAL AMOUNT OF MONEY:

Original deposit = $1000


+ Firstbank lending = $ 800
+ Secondbank lending = $ 640
+ Thirdbank lending = $ 512
+ other lending…

Total money supply = (1/rr )  $1000


where rr = ratio of reserves to deposits
In our example, rr = 0.2, so M = $5000

slide
20
MONEY CREATION IN THE BANKING SYSTEM

A fractional reserve banking system creates money,


but it doesn’t create wealth:
bank loans give borrowers
some new money
and an equal amount of new debt.

slide
21
A MODEL OF THE MONEY SUPPLY
exogenous variables

the monetary base, B = C + R


controlled by the central bank

the reserve-deposit ratio, rr = R/D


depends on regulations & bank policies

the currency-deposit ratio, cr = C/D


depends on households’ preferences

slide
22
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

If rr < 1, then m > 1


If monetary base changes by B,
then M = m  B
m is called the money multiplier.

slide
24
QUESTION:
cr  1
M  m B, where m 
cr  rr

Case 1: Suppose the central bank increases rr.


Case 2: Households decide to hold more of their money as
currency and less in the form of demand deposits.

Determine impact on money supply in both cases and explain the


intuition for your result.

slide
25
SOLUTION
1. An increase in rr reduces the possible loans that a bank can
give, and m reduces.

2. If households deposit less of their money, then banks can’t


make as many loans, so the banking system won’t be able to
“create” as much money.

slide
26
INDIA’S BANKING SITUATION

slide 27
THREE INSTRUMENTS OF MONETARY POLICY

1. Open market operations

2. Reserve requirements

3. The discount rate

slide
28
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.

slide
29
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?

Open market operations:


Used to be frequently used.
Changes in reserve requirements:
Least frequently used.
Changes in the discount rate:
Very frequently used in India.

slide
32
INDIA’S MONETARY POLICY INSTRUMENT

Repo rate is of prime importance


Before the launch of repo, the most important monetary policy
instrument used was the CRR.
The repo rate now acts as ‘the policy rate’ for the RBI that
signals short term interest rate in the economy.
As per the new inflation targeting monetary policy framework
there is only one objective-price stability, one target- inflation
and one instrument – repo rate.

slide 33
WHY THE FED CAN’T PRECISELY CONTROL M

M  m B,
cr  1
where m 
cr  rr

Households can change cr,


causing m and M to change.
Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves,
then rr, m and M change.

slide
34
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.

Nominal Interest Rate = Real Interest Rate + Inflation Rate

slide 35
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%

slide 36
FISCHER’S QUANTITY THEORY OF MONEY:

Let P be the price and Y be the real GDP/output.


Then nominal GDP= P x Y
Let M be money supply in the economy and V the velocity i.e. the
average number of times each dollar changes hands. Then, the
total value of all transactions that occur in the economy is:
Transactions = M x V
The total dollar value of transactions that occur in an economy
must equal the nominal value of total output. We can write this as
follows:
Sum of Transactions = Nominal Output
MV=PY
slide 37
IMPLICATIONS OF QTM:
The quantity theory of money states that the price level in an
economy is the direct consequence of the money supply (M).
If the velocity of money is constant, any increase in money
supply causes a proportionate increase in price level.
The quantity theory of money is the classical interpretation of
what causes inflation. It states that if the number of times a
dollar is used for a transaction, i.e. the money’s velocity is
constant, any increase in quantity of money changes only
price and not the real output.

slide 38
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?

If the money supply increases by 10% next year but the


real GDP remains the same, what would be the nominal
GDP and what’s the percentage increase in price?

slide 39
Money Supply * Velocity = Price * Average Cost per Transaction

slide 40
MONEY SUPPLY, MONEY DEMAND, AND MONETARY
EQUILIBRIUM

The money supply is a policy variable that is controlled by the


Central Bank.
 Through instruments such as open-market operations, the Central Bank directly
controls the quantity of money supplied.

Money demand has several determinants, including interest rates


and the average level of prices in the economy.

People hold money because it is the medium of exchange.


 The amount of money people choose to hold depends on the prices of goods
and services.
MONEY SUPPLY, MONEY DEMAND, AND MONETARY
EQUILIBRIUM
In the long run, the overall level of prices adjusts to the
level at which the demand for money equals the supply.
THE CLASSICAL DICHOTOMY

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.

slide 43

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