1. Money in the Economy
Mmmmmmm,
money!
Lamar Van Dusen

2. Monetary Policy
• A tool of macroeconomic policy under the
control of the Federal Reserve that seeks to
attain stable prices and economic growth
through changes in the rate of growth of the
money supply.

3. The Money Supply
• M1: Currency + travelers checks + checkable
deposits
• M2: M1 + small time deposits + overnight
repurchase agreements + overnight
Eurodollars + money market mutual fund
balances
• M3: M2 + large denomination time deposits +
term repurchase agreements + term
Eurodollars + institutions only money
market fund balances

4. The Creators of Money
• The three major players whose decisions and
actions determine the rate of growth in the
money supply are:
– The Federal Reserve (Fed)
• Sets reserve requirements
• Operates the discount window
• Engages in open market operations
– The Commercial Banking System
• Accepts deposits and makes loans
• Sets excess reserves
– The Non-Bank Public
• Holds either deposits or cash

5. Money Creation
• Banks create money in their normal, day-to-
day profit seeking activities
• Banks do not try to create money
• Money creation occurs because we have a
fractional reserve commercial banking
system.
– Banks must hold a fraction of their deposits idle
as reserves. They may lend the remainder.
• As they make loans, new deposits are created,
causing the money supply to expand.

6. Bank Reserves
• Total Reserves = Required reserves plus
excess reserves
– Required reserves = Deposits X reserve
requirement
– Excess reserves = Total reserves - required
reserves

7. Money Creation: Assumptions
• Assumptions:
– Banks lend all their excess reserves
– The non-bank public does not use cash
– Only demand or checkable deposits exist
– The required reserve ratio is 10%

8. Money Creation: Step 1
• Assume the Federal Reserve injects $100
into the banking system
– Excess reserves increase by $100 in Bank #1
• Banks do not face reserve requirements on
injections of reserves by the Fed
• Bank #1, therefore, has $100 to lend

9. Money Creation: Step 2
• Let Bank #1 make a $100 loan to a member
of the non-bank public
– It does this by crediting the borrower’s
checking account with $100.
• Let the borrower spend the money.
• Let the recipient of the money bank at Bank
#2
• When Bank #1 honors the check, Bank #1’s
deposits and reserves fall by $100.

10. Money Creation: Step 3
• A second bank, Bank #2, has received a
new deposit of $100.
– Its total reserves increase by ?
• Its required reserves increase by ?
• Its excess reserves increase by ?
– Bank #2 may now make a loan of ?

11. Money Creation: Step 4
• Bank #2 makes a loan of $90 in the form of
a new demand deposit.
– When the money is spent and Bank #2 honors
the check, deposits and reserves at Bank #2 fall
by $90
• But Bank #3 now has a new deposit of $90
and may make a loan equal to ?

12. Money Creation: Summary
New Deposit Required Reserves Excess Reserves New Loan
$100 $100
$100 $10.00 $ 90 $ 90
$ 90 $ 9.00 $ 81 $ 81
$ 81 $ 8.10 $ 72.90 $ 72.90
$ 72.90 $ 7.29 $ 65.61 $ 65.61
$ 65.61 $ 6.51 $ 59.05 $ 59.05
$1,000 $100 $900 $900

13. Some Simple Formulas
• Note that in our simple example, demand
deposits are a multiple of required reserves
– Let R = required reserves
– Let r = % reserve requirement
– Let D = demand deposits
– R = r x D or
– D = 1/r x R
• A change in deposits will be a multiple of the
change in reserves
– /D = 1/r x /R

14. The Multiplier
• The simple deposit expansion multiplier is 1/r
or 1/reserve requirement
– r is a leakage out of the lending process
• if r gets bigger, expansion of deposits gets smaller
because banks have fewer excess reserves to lend
• if r gets smaller, expansion of deposits gets larger
because banks have more excess reserves to lend
• The real world multiplier is smaller than our
1/r because
– Banks hold idle excess reserves
– People hold and use cash

15. The Money Supply Model

16. The M1 Model: Derivation
• Definitions:
– M1 = D + C
– Base = R + C
– Total Deposits = D
• Assumptions:
– r = R/D = required reserve ratio for deposits
– e = E/D = the excess reserve ratio
– c = C/D = the ratio of currency to deposits

17. The M1 Model: Derivation
• Model:
– B = R + C
• R = rD + eD
– D = D
– C = cD
– E = eD
– B = rD + eD + cD
– B = D(r + e + c)
– D = (1/r + e + c)B

18. The M1 Model: Derivation
• Model:
– M1 = D + C
– M1 = D + cD
– M1 = D(1 + c) Factor out D
• M1 = 1 + c
r + e + c
B
• M1 = Multiplier x Base

19. Money Multiplier Terms
• Changes in r
– If r increases, the multiplier decreases
– If r decreases, the multiplier increases
• The money multiplier and M1 are
negatively related.

20. Money Multiplier Terms
• Changes in c
– If c increases, reserves drain from the banking
system.
• Fewer reserves mean less expansion of deposits.
– If c decreases, reserves in the banking system
increase.
• More reserves mean more expansion of deposits.
• The money multiplier and M1 are
negatively related.

21. Money Multiplier Terms
• Changes in e
– An increase in e means banks are holding more
excess reserves and lending less.
– A decrease in e means banks are holding fewer
excess reserves and lending more.
• The money multiplier and M1 are
negatively related.

22. M1 and Base
• Base is comprised of non-borrowed base,
discount loans, and currency.
– OMO purchases increase non-borrowed base.
– OMO sales decrease non-borrowed base.
• M1 is positively related to non-borrowed
base.

23. M1 and Base
• Base is comprised of non-borrowed base,
discount loans, and currency.
– Increases in discount loans increase base.
– Decreases in discount loans decrease base.
• M1 is positively related to the level of
discount loans.

24. The Money Supply
• The money supply equals the monetary base
times the money multiplier
– The monetary base (base) is defined as:
• Base = Reserves + Currency
– Base can be controlled by the Federal Reserve
– The multiplier reflects the ability of the banking
system to expand deposits
• The multiplier = 1 + c/(r + e + c)
– The value of the multiplier is determined by the Fed,
banks, and the members of the non-bank public.

25. Control of the Money Supply
• The Fed controls the money supply with...
– Open Market Operations
• Purchases and sales of government securities by the
Fed on the open market
– Discount Window
• Loans made by the Fed to banks
• The Fed influences the multiplier with
– Changes in the reserve requirement

26. Open Market Operations
Fed Bank
Presidents
Federal Open
Market Comm.
Fed Board of
Governors
Securities
Dealers
Federal Reserve
Bank of New York
Commercial
Banks
Change
in
Reserves
Change in
Money
Supply

27. Open Market Operations
• When the Fed buys Treasury bonds from a
bank, it pays for the bonds by crediting the
bank with an increase in reserves.
• When the Fed sells Treasury bonds to a
bank, it accepts payment for the bonds by
debiting the bank’s reserve position at the
Fed

28. Discount Loans
• When the Fed makes a discount loan to a
bank, the bank is credited with an increase
in reserves.
• When a bank repays the Fed, the bank’s
reserves are debited.

29. Reserve Requirements
• If the Fed increases reserve requirements,
banks have fewer excess reserves to lend,
causing the expansion of deposits to
decrease.
• If the Fed decreases or eliminates reserve
requirements, banks have more excess
reserves to lend, permitting the expansion of
deposits to increase.

30. Excess Reserves and Currency
Drains
• Banks determine the level of excess
reserves
– Increases in excess reserves diminish the
expansion of deposits.
– Decreases in excess reserves increase the
expansion of deposits

31. Excess Reserves and Currency
Drains
• Members of the non-bank public determine
currency in circulation
– Increases in currency drains from the banking
system, diminish the expansion of deposits
– Decreases in currency drains from the banking
system, increase the expansion of deposits

32. Central Bank Policy Channels
Policy
Tools
Level & Growth
Bank Reserves
Cost & Availability
of Credit
Size and Growth
Rate of Money
Supply
Market Value
of Securities
Volume
and
Growth
of
Borrowing
and
Spending
by the
Public
Full
Employment
Growth
Price
Stability

33. Monetary Policy
I see rates rising;
no, falling; no
rising; no --

34. Monetary Policy Transmission
Mechanism
• A monetary policy transmission mechanism
describes the chain of events that occur in
an economy as a result of a change in the
rate of growth in the money supply.
• Good monetary policy decisions depend on
understanding the different ways money can
cause changes in economic activity.

35. Interest Rate Channel
Change in Change in Short Change in
Money Supply Term Interest Rates GDP
Change in
Exchange
Rates
Change in
Long Term
Interest Rates

36. The Interest Rate Channel
• Traditional View
– A change in the money supply leads to a change
in interest rates which in turn changes the cost
of capital, causing a change in investment
spending, aggregate demand and GDP in the
short run.

37. The Interest Rate Channel
• Fact:
– A change in the money supply causes a change
in short term interest rates. Investment
spending is a function of long term interest
rates.
• Question:
– How can a change in short rates result in a
similar change in long rates?

38. Short Rates and Long Rates
• The expectations model of the term
structure is the key relationship between
short rates and long rates.
– The long rate is the expected average of future
short rates appropriate for the maturity of the
long bond.
• If the Fed acts to raise the short term rate and market
participants expect that the increase is the first of a
longer sequence, the long rate will rise as market
participants react to the Fed’s policy change.

39. Short Rates and Long Rates
• The expectations model of the term
structure is the key relationship between
short rates and long rates.
– The long rate is the expected average of future
short rates appropriate for the maturity of the
long bond.
• If the Fed acts to decrease the short term rate and
market participants expect that the decrease is the
first of a longer sequence, the long rate will fall as
market participants react to the Fed’s policy change.

40. Monetary Policy, Interest Rates
and GDP
• Let the Fed raise short-term interest rates
– As interest rates increase, the cost of
borrowing increases, causing investment
(I), consumer durables (C), and GDP to fall.
• Let the Fed decrease short-term interest
rates
–As interest rates decrease, the cost of
borrowing decreases, causing investment
(I), consumer durables (C), and GDP to
rise.

41. The Exchange Rate Channel
• Traditional View
–A decrease in the money supply leads to a
rise in interest rates which in turn raises the
exchange rate, causing a decline in net
exports, aggregate demand and GDP in the
short run.
• Question:
–How can a change in interest rates result in
a change in exchange rates?

42. • The exchange rate is the price of a currency
expressed in terms of another currency.
• The exchange rate and the interest rate are
positively related.
– The higher domestic real rates of interest are
relative to foreign real interest rates, the higher
will be the foreign exchange rate for the
domestic economy.
Explaining Exchange Rates with
Interest Rates

43. Interest Rate Parity
• Interest rate parity says that the interest rate
differential between any two countries is
equal to the expected rate of change in the
exchange rate between those two countries.

44. Interest Rate Parity: Example
• Assume that U.S. real interest rates are
higher than those in other countries.
–The high rates of return on U.S. assets will
attract foreign buyers, but in order to buy
U.S. financial assets, foreigners must first
buy dollars.
• The demand for dollars increases in the global
marketplace, causing the dollar to appreciate.
• The supply of the other currency increases in the
global marketplace, causing the other currency
to depreciate.

45. Monetary Policy, Exchange Rates
and GDP
• Let the Fed raise short-term interest rates
– As interest rates increase, exchange rates
increase, causing net exports (X - M) and GDP
to fall.
• GDP = C + I + G + (X - M)
– As the value of the dollar increases, we export fewer
goods and import more.

46. Monetary Policy, Exchange Rates
and GDP
• Let the Fed decrease short-term interest
rates
– As interest rates decrease, exchange rates
decrease, causing net exports (X - M) and GDP
to rise.
• GDP = C + I + G + (X - M)
– As the value of the dollar decreases, we export more
goods and import fewer.