1、Money Supply, Money Demand, and the Banking System,19,In this chapter, you will learn:,how the banking system “creates” money three ways the Fed can control the money supply, and why the Fed cant control it precisely leading theories of money demand a portfolio theory a transactions theory: the Baum
2、ol-Tobin model,Banks role in the money supply,The money supply equals currency plus demand (checking account) deposits:M = C + D Since the money supply includes demand deposits, the banking system plays an important role.,A few preliminaries,Reserves (R ): the portion of deposits that banks have not
3、 lent. A banks 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.,Banks role in the money su
4、pply,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 = $1000.,SC
5、ENARIO 1: No banks,With no banks, D = 0 and M = C = $1000.,SCENARIO 2: 100-percent reserve banking,After the deposit: C = $0, D = $1,000, M = $1,000 LESSON: 100%-reserve banking has no impact on size of money supply.,reserves $1,000,deposits $1,000,Initially C = $1000, D = $0, M = $1,000. Now suppos
6、e households deposit the $1,000 at “Firstbank.”,reserves $1,000,reserves $200 loans $800,SCENARIO 3: Fractional-reserve banking,The money supply now equals $1,800: Depositor has $1,000 in demand deposits. Borrower holds $800 in currency.,deposits $1,000,Suppose banks hold 20% of deposits in reserve,
7、 making loans with the rest. Firstbank will make $800 in loans.,LESSON: in a fractional-reserve banking system, banks create money.,reserves $800 loans $0,reserves $160 loans $640,SCENARIO 3: Fractional-reserve banking,Secondbank will loan 80% of this deposit.,deposits $800,Suppose the borrower depo
8、sits the $800 in Secondbank. Initially, Secondbanks balance sheet is:,SCENARIO 3: Fractional-reserve banking,deposits $640,If this $640 is eventually deposited in Thirdbank,then Thirdbank will keep 20% of it in reserve, and loan the rest out:,reserves $640 loans $0,reserves $128 loans $512,Finding t
9、he total amount of money:,Original deposit = $1000+ Firstbank lending = $ 800+ Secondbank lending = $ 640+ Thirdbank lending = $ 512+ other lending,Total money supply = (1/rr ) $1,000 where rr = ratio of reserves to deposits In our example, rr = 0.2, so M = $5,000,Money creation in the banking syste
10、m,A fractional reserve banking system creates money, but it doesnt create wealth: Bank loans give borrowers some new money and an equal amount of new debt.,A model of the money supply,Monetary base, B = C + R controlled by the central bank Reserve-deposit ratio, rr = R/D depends on regulations & ban
11、k policies Currency-deposit ratio, cr = C/D depends on households preferences,exogenous variables,Solving for the money supply:,where,The money multiplier,If rr 1 If monetary base changes by B, then M = m B m is the money multiplier, the increase in the money supply resulting from a one-dollar incre
12、ase in the monetary base.,where,NOW YOU TRY: The Money Multiplier,Suppose households decide to hold more of their money as currency and less in the form of demand deposits.Determine impact on money supply. Explain the intuition for your result.,where,SOLUTION:,Impact of an increase in the currency-d
13、eposit ratio cr 0. An increase in cr increases the denominator of m proportionally more than the numerator. So m falls, causing M to fall. If households deposit less of their money, then banks cant make as many loans, so the banking system wont be able to “create” as much money.,Three instruments of
14、 monetary policy,1. Open-market operations 2. Reserve requirements 3. The discount rate,Open-market operations,definition: The purchase or sale of government bonds by the Federal Reserve. how it works: If Fed buys bonds from the public, it pays with new dollars, increasing B and therefore M.,Reserve
15、 requirements,definition: Fed regulations that require banks to hold a minimum reserve-deposit ratio. how it works: Reserve requirements affect rr and m: If Fed reduces reserve requirements, then banks can make more loans and “create” more money from each deposit.,The discount rate,definition: The i
16、nterest rate that the Fed charges on loans it makes to banks. how it works: When banks borrow from the Fed, their reserves increase, allowing them to make more loans and “create” more money. The Fed can increase B by lowering the discount rate to induce banks to borrow more reserves from the Fed.,Wh
17、ich instrument is used most often?,Open-market operations: most frequently used. Changes in reserve requirements: least frequently used. Changes in the discount rate: largely symbolic. The Fed is a “lender of last resort,” does not usually make loans to banks on demand.,Why the Fed cant precisely co
18、ntrol M,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.,where,CASE STUDY: Bank failures in the 1930s,From 1929 to 1933: over 9,000 banks closed money suppl
19、y fell 28% This drop in the money supply may have caused the Great Depression, but certainly contributed to its severity.,CASE STUDY: Bank failures in the 1930s,Loss of confidence in banks cr m Banks became more cautious rr m,where,CASE STUDY: Bank failures in the 1930s,March 1933,% change,August 19
20、29,Could this happen again?,Many policies have been implemented since the 1930s to prevent such widespread bank failures. E.g., Federal Deposit Insurance, to prevent bank runs and large swings in the currency-deposit ratio.,Bank capital, leverage, and capital requirements,Bank capital: the resources
21、 a banks owners have put into the bank A more realistic balance sheet:,Bank capital, leverage, and capital requirements,Leverage: the use of borrowed money to supplement existing funds for purposes of investment Leverage ratio = assets/capital= ($200+500+300)/$50 = 20,Bank capital, leverage, and cap
22、ital requirements,Being highly leveraged makes banks vulnerable. Example: Suppose a recession causes our banks assets to fall by 5%, to $950. Then, capital = assets liabilities = 950 950 = 0,Bank capital, leverage, and capital requirements,Capital requirement: minimum amount of capital mandated by r
23、egulators intended to insure that banks will be able to pay off depositors higher for banks that hold more risky assets 2008-2009 financial crisis: Losses on mortgages shrunk bank capital, slowed lending, exacerbated the recession. Govt injected $ billions of capital into banks to ease crisis and en
24、courage more lending.,Money Demand,Two types of theories Portfolio theories emphasize “store of value” function relevant for M2, M3 not relevant for M1. (As a store of value, M1 is dominated by other assets.) Transactions theories emphasize “medium of exchange” function also relevant for M1,A simple
25、 portfolio theory,where rs = expected real return on stocks rb = expected real return on bonds e = expected inflation rate W = real wealth,The Baumol-Tobin Model,a transactions theory of money demand notation: Y = total spending, done gradually over the year i = interest rate on savings account N =
26、number of trips consumer makes to the bank to withdraw money from savings account F = cost of a trip to the bank (e.g., if a trip takes 15 minutes and consumers wage = $12/hour, then F = $3),Money holdings over the year,N = 1,Average = Y/ 2,Money holdings over the year,Average = Y/ 4,Y/ 2,Y,N = 2,Mo
27、ney holdings over the year,Average = Y/ 6,Y/ 3,Y,N = 3,The cost of holding money,In general, average money holdings = Y/2N Foregone interest = i (Y/2N ) Cost of N trips to bank = F N Thus,Given Y, i, and F, consumer chooses N to minimize total cost,Finding the cost-minimizing N,Finding the cost-mini
28、mizing N,Take the derivative of total cost with respect to N, set it equal to zero:,Solve for the cost-minimizing N*,The money demand function,The cost-minimizing value of N :,To obtain the money demand function, plug N* into the expression for average money holdings:,Money demand depends positively
29、 on Y and F, and negatively on i.,The money demand function,The Baumol-Tobin money demand function:,How this money demand function differs from previous chapters: B-T shows how F affects money demand. B-T implies: income elasticity of money demand = 0.5, interest rate elasticity of money demand = 0.
30、5,NOW YOU TRY: The impact of ATMs on money demand,During the 1980s, automatic teller machines became widely available. How do you think this affected N* and money demand? Explain.,Financial Innovation, Near Money, and the Demise of the Monetary Aggregates,Examples of financial innovation: many check
31、ing accounts now pay interest very easy to buy and sell assets mutual funds are baskets of stocks that are easy to redeem - just write a check Non-monetary assets having some of the liquidity of money are called near money. Money & near money are close substitutes, and switching from one to the othe
32、r is easy.,Financial Innovation, Near Money, and the Demise of the Monetary Aggregates,The rise of near money makes money demand less stable and complicates monetary policy. 1993: the Fed switched from targeting monetary aggregates to targeting the Federal Funds rate. This change may help explain wh
33、y the U.S. economy was so stable during the rest of the 1990s.,Chapter Summary,1. Fractional reserve banking creates money because each dollar of reserves generates many dollars of demand deposits. 2. The money supply depends on the: monetary base currency-deposit ratio reserve ratio 3. The Fed can
34、control the money supply with: open market operations the reserve requirement the discount rate,Chapter Summary,4. Bank capital, leverage, capital requirements Bank capital is the owners equity in the bank. Because banks are highly leveraged, a small decline in the value of bank assets can have a hu
35、ge impact on bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid.,Chapter Summary,5. Portfolio theories of money demand stress the store of value function posit that money demand depends on risk/return of money & alternative assets 6. The Baumol-Tobin model a transactions theory of money demand, stresses “medium of exchange” function money demand depends positively on spending, negatively on the interest rate, and positively on the cost of converting non-monetary assets to money,
