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ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 84
UNIT 6
The Microeconomics Behind
Macroeconomics: Money Supply and
Money Demand
Overview
In this Unit, we will examine the microeconomic foundations of another important topic
in macroeconomics. The supply and demand of money affects important variables such
as the inflation rate, the money supply and the interest rate. We will first explore the
money supply by learning about reserve banking, developing a model of the money
supply, and then the tools which the central bank uses to influence the money supply.
Next, we will examine portfolio and transaction theories of money demand to
understand why individuals choose to hold money.
ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 85
Learning Objectives
By the end of this Unit you will be able to:
1. Apply the concept of reserve banking to real-life scenarios;
2. Analyse the efficacy of instruments of monetary policy in the Cari
ean
context;
3. Debate the merits of various theories of money demand;
4. Examine how financial innovations have changed money demand.
This Unit is divided into two sessions as follows:
Session 6.1: Money Supply
Session 6.2: Money Demand
ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 86
Readings and Resources
Required Reading
Mankiw, N. G XXXXXXXXXXChapter 19: Money Supply, Money Demand, and the
Banking System. In Macroeconomics (7th ed.). New York: Worth Publishers.
[Available via UWIlinC]
Required Videos
ACDC Leadership. (2014, November 13). How banks create money and the money
multiplier. [Video File]. Available at
https:
www.youtube.com/watch?v=JG5c8nhR3LE
Inspirare. (2016, April 28). The money market – money (5/6). [Video File]. Available at
https:
www.youtube.com/watch?v=mGdQKm_JGoM
Simplifiedvideos. (2017, March 31). Classical and neoclassical approach to demand for
money. [Video File]. Available at https:
www.youtube.com/watch?v=y-
NrtDpdfVY
Welker, J. (2012, January 19). The tools of monetary policy. [Video File]. Available at
https:
www.youtube.com/watch?v=rcPEkmstDek
Suggested Readings
Baumol, W. J XXXXXXXXXXThe transactions demand for cash: An inventory theoretical
approach. Quarterly Journal of Economics, 66(4), XXXXXXXXXX. [Available via
UWIlinC].
Curtis, D., & Irvine, I XXXXXXXXXXChapter 9: Money, banking, and money supply.
Macroeconomics: Theory, Markets, and Policy. Lyrlyx Learning. Available from
https:
lyryx.com/wp-content/uploads/2017/08/CI-Principles-of-
Macroeconomics-2017-RevisionB.pdf
Fisher, S XXXXXXXXXXWhy are central banks pursuing long-run price stability? In
Proceedings – Economic Policy Symposium – Jackson Hole,
Federal Reserve Bank of Kansas City, 7-34. Available from http:
it.ly/2wNHJyx
Goodhart, C. A. E XXXXXXXXXXWhat should central banks do? What macroeconomic
objectives and operations? Economic Journal, XXXXXXXXXX), XXXXXXXXXX. [Available
via UWIlinC].
Guru, S XXXXXXXXXXTheories of demand of money: Tobin’s portfolio and Baumol’s inventory
approaches. Available from
http:
www.yourarticleli
ary.com/economics/money/theories-of-demand-
of-money-tobins-portfolio-and-baumols-inventory-approaches/37904/
Mishkin, F. S., & Serletis, A XXXXXXXXXXAppendix 1 of Chapter 21. In The Economics of
ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 87
Money, Banking, and Financial Markets. Boston: Pearson/Addison Wesley.
Available at http:
it.ly/2xRmf0t
Mishkin, F. S., & Serletis, A XXXXXXXXXXAppendix 2 of Chapter 21. In The Economics of
Money, Banking, and Financial Markets. Boston: Pearson/Addison Wesley.
Available at http:
it.ly/2xRAked
Tobin, J XXXXXXXXXXThe interest elasticity of transactions demand for cash. The
Review of Economics and Statistics, 38(3), XXXXXXXXXX. [Available via UWIlinC].
Tobin, J XXXXXXXXXXLiquidity preference as behavior towards risk. Review of Economic
Studies, 25(2), 65-86. [Available via UWIlinC].
Williamson, S XXXXXXXXXXChapter 10: A Monetary Intertemporal Model: Money,
Prices, and Monetary Policy. In Macroeconomics (3rd ed.). Boston:
Pearson/Addison Wesley. [Available via UWIlinC].
Williamson, S XXXXXXXXXXChapter 15: Monetary, Inflation, and Banking. In
Macroeconomics (3rd ed.). Boston: Pearson/Addison Wesley. [Available via
UWIlinC].
ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 88
Session 6.1
Money Supply
Introduction
Thus far in the course we have been assuming that the money supply is determined only
y the central bank’s actions. In practice, the central bank’s policies, the actions of
depository institutions, and consumer behavior all affect the money supply. In this
session, we will discuss the different ways in which financial intermediaries, the public,
and central bankers interact to determine the money supply changes. The money supply,
M, is money held by the public in the form of cu
ency, C, and deposits in checking
accounts at the bank, D.
Reserve Banking
(a) 100 Percent Reserve Banking
In this system, banks are not allowed to make loans so all deposits are kept as reserves.
Reserves are the amount of deposits that banks keep on hand and do not lend out.
Because all deposits are reserves and there are no loans, the money supply, remains the
same before and after the deposits are made as seen in Figure 6.1 below.
Figure 6.1: How Deposits Affect Money Supply in 100 Percent Reserve Banking
Deposits
(money supply = monetary base)
Reserves (100% of Deposits)
Money Supply is unchanged
ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 89
(b) Fractional Reserve Banking
In this system, banks can make loans but are required to keep a fraction of deposits on
hand as reserves. The amount that the banks are required to keep is determined by the
eserve-deposit ratio that is set by the central bank. The action of making loans increases
the money supply. To see how this works, consider a bank’s balance sheet. When the
deposit is made at the bank, the bank’s total liabilities rise by the amount of the deposit
ecause the bank owes this amount to the depositor. Of this amount, the bank is
equired to keep a portion but it can lend the rest. The bank’s assets therefore rise by the
amount of new reserves and the amount it loans out. The loan adds to the amount of
cu
ency in the economy. Remember that M = C+D, so ∆M = ∆C + ∆D. Therefore, the
money supply increases by the amount of the loan.
Now suppose that the bo
ower of the loan deposits it into a checking account, then the
ank’s total liabilities will rise again by the amount of the loan. On the asset side of the
alance sheet, the bank keeps a fraction of the additional deposit as reserves and lends
out the rest. The money supply increases again because the new loan adds to the amount
of cu
ency. To learn more on this topic, read page 549 in Mankiw XXXXXXXXXXwhere an
example of this process is described.
(c) Financial Intermediation
The process whereby financial institutions connect savers who have funds to lend and
o
owers who need funds to bo
ow is called financial intermediation. Many financial
institutions have this function but only commercial banks use this process and add to
the money supply.
A Model of the Money Supply
The money supply is influenced by the monetary base B which is the sum of cu
ency C,
ank reserves R, reserve-deposit ratio ?? which is the fraction of deposits that banks are
equired to keep as reserves, and cu
ency-deposit ratio ?? which is the fraction of
deposits that consumers hold as cu
ency. Using the expressions for the money supply
and the monetary base, we can write the money supply as a function of these three
factors:
? =
?? + 1
?? + ??
x ? = ? x ?
Note that ? is the money multiplier because it allows the economy to create a money
supply that is larger than the monetary base. The money multiplier is greater than 1 by
definition. Since each unit of the monetary base allows for several units of the money
supply, the monetary base is refe
ed to as high powered money. An increase in the
monetary base, a decrease in the reserve-deposit ratio, and a decrease in the cu
ency to
deposit ratio all lead to an increase in the money supply
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The Three Instruments of Monetary Policy
The central bank or equivalent institution in a country can change the money supply
indirectly by changing the monetary base or the required reserve ratio using the three
instruments of monetary policy. These are open-market operations, reserve
equirements, and the discount rate.
(a) Open-Market Operations
This is the most used tool of many central banks and involves the purchase or sale of
assets to the public. Purchases increase the monetary base and the money supply
while sales of assets decrease the money supply and the monetary base.
(b) Reserve Requirements
This is the least used monetary policy tool of many central banks. As alluded to in
the discussion of fractional reserve banking, the required reserve ratio is the
minimum proportion of deposits that banks are required to keep as reserves. If the
central bank increases this ratio, the money supply falls but if the ratio is lowered,
anks are required to keep less reserves on hand and so they can make more loans
which increases the money supply.
(c) The Discount Rate
One of the functions of the central bank is to be a lender of last resort so that if
commercial banks have insufficient reserves, they can bo
ow funds quickly. When
anks bo
ow from the central bank, they are charged the discount rate. The cheaper
the discount rate, the lower the cost of bo
owing funds and the more likely that
anks will lend to the public. A decrease in the discount rate encourages more
o
owing from the central bank and increases the monetary base and the money
supply. By contrast, an increase in the discount rate reduces banks’ willingness to
lend and hence reduces the money supply.
Bank Capital, Leverage, and Capital Requirements
The discussion so far ignores the fact that banks need bank capital to begin operations,
much of which is often bo
owed. The banks use some of the bo
owed money to
finance investments which is