Chapter - 2

Supply and Demand for Money

 Money supply includes the currency in the hands of the
public and the deposits at banks that households can use
on demand for transactions, such as checking accounts.
 That is, letting M denote the money supply, C currency

and D demand deposits;

 Money supply = Currency + Demand deposits

M=C+D
 To understand the money supply, we must understand

the interaction between currency and demand deposits

and how the Central bank policy influences these two
components of the money supply.
 Supply and Demand for Money…..
Imagine a world without banks, where all money
takes the form of currency M=C
 Now introduce banks and at first assume that banks

accept deposits but do not make loans.

 The only purpose of the banks is to provide a safe place for
deposits to keep their money.
 A dollar deposited in a bank reduces currency by one
dollar and raises deposits by one dollar, so the money
supply remains the same.
 The banks must keep some reserves on hand so that
reserves are available whenever depositors want to make
withdrawals.
 Supply and Demand for Money…..
 .

 Each $1 of reserve generates $(1/rr) of money supply.

In our above example rr = 0.2, so the original $1000
generates $5000 of money.
 Supply and Demand for Money…..
 The banking systems ability to create money is the primary
difference between banks and other financial institutions.
 Note that although the system of fractional–reserve

banking creates money, it does not create wealth.

 When a bank loans out some of its reserves, it gives

borrowers the ability to make transactions and therefore

increases the supply of money.
 The borrowers are also undertaking a debt obligation to

the bank, however, so the loan does not make them

wealthier.
 In other words, the creation of money by the banking

system increases the economy’s liquidity, not its wealth.

 2.1.1 A Model of the Money Supply
 The model has the following three exogenous variables.
i. Monetary base (B): It is the total number of dollars held
by the public as currency (C) and by the banks as reserves
(R). It is directly controlled by the Central bank.
ii. Reserve-deposit ratio (rr): It is the fraction of deposits
that banks hold in reserve. It is determined by the business
policies of banks and the laws regulating banks.
 Currency-deposit ratio (cr): It expresses the preferences

of the public about how much money to hold in the form

of currency (C) and how much to hold in the form of
demand deposits (D).
 2.1.1 A Model of the Money Supply
 The present model shows how the money supply
depends on the monetary base, the reserve deposit ratio,
and the currency-deposit ratio.
 It examines how Central bank polices and the choices of

banks and households influence the money supply.

 The model begins with the definition of money supply

and monetary base.

 M = C + D ------------ (1)

 B = C + R ------------- (2)

 The first equation states that the money supply is the sum

of currency and demand deposits.

 2.1.1 A Model of the Money Supply….

 The
  second equation states that the monetary base is the
sum of currency and bank reserves. If we
 divide the first equation by the second, we get:
 M/B = C+D/ C+R ------------- (3)
 If we divide both the top and bottom of the expression on
the right by D: C/D is the currency-deposit ratio (cr),
 …………(4) R/D is the reserve-deposit ratio (rr).
 Making these substitutions, and bringing the B from the
left to the right side of the equation, we obtain:
 2.1.1 A Model of the Money Supply….

  X B…………(5) This equation shows how the money
supply depends on the three exogenous variables.
 Money supply is proportional to the monetary base.
 The factor of proportionality [(cr+1)/(cr+rr)] is denoted
by m and is called the ‘money multiplier.’
 That is, M = m x B -------------- (6)
 Each dollar of the monetary base produces m dollars of money.
 Since the monetary base has a multiplier effect on the
money supply, the monetary base is sometimes called
‘high-powered money.’
 2.1.1 A Model of the Money Supply….

  X B…………(5) This equation shows how the money
supply depends on the three exogenous variables.
 Money supply is proportional to the monetary base.
 The factor of proportionality [(cr+1)/(cr+rr)] is denoted
by m and is called the ‘money multiplier.’
 That is, M = m x B -------------- (6)
 Each dollar of the monetary base produces m dollars of money.
 Since the monetary base has a multiplier effect on the
money supply, the monetary base is sometimes called
‘high-powered money.’
 Numerical Example:
 If the monetary base is $300 billion, the reserve deposit
ratio is 0.1 and currency-deposit ratio is 0.4; calculate the
money multiplier and the money supply.
 Answer:
 m = 0.4 +1 = 2.8
 0.4+0.1 Money supply (M) = 2.8 x 300 = 840
 Each dollar of the monetary base generates 2.8 dollars of
money, so the total money supply is $840 billion.
 Numerical Example: 2

To get a feel for what the money multiplier means, let
us again construct a numerical example with realistic
numbers for the following variables:
rr = required reserve ratio = 0.10
C = currency in circulation = $400 billion
D = checkable deposits = $800 billion
Calculate money multiplier and money supply based on
the above given information
 Summary of exogenous(rr, cr and B) variable
effect on money supply and multiplier
 The money supply is proportional to the monetary base ,
when m=1.
 ii. The lower the reserve-deposit ratio, the more loan
banks make, and the more money create from every
dollar of reserves.
 Thus, a decrease in the reserve-deposit ratio raises the
money multiplier and the money supply.
 iii. The lower the currency-deposit ratio, the fewer dollars
of the monetary base the holds as currency, the more base
dollars banks hold as reserves, and the more money banks
can create.
 Thus, a decrease in the currency-deposit ratio raises M
 2.1.2 Instruments of Monetary Policy
 The Central bank controls the money supply indirectly by
altering either the monetary base or the reserve-deposit
ratio.
 To do this the Central Bank has at its disposal three
instruments of monetary policy:
 Open market Operations: These are the purchases and
sales of government bonds by the Central bank.
 OMS –reduce B - then reduce money supply
 OMP increase B - then increase money supply.
 2.1.2 Instruments of Monetary Policy….
 Reserve requirements: These are Central bank
regulations that impose on banks a minimum reserve-
deposit ratio. An increase in reserve requirements raises
the reserve-deposit ratio and thus lowers the money
multiplier and the money supply.
 iii. Discount rate: It is the interest rate that the Central
bank charges when it makes loan to banks.
 Banks borrow from the Central bank when they find
themselves with too few reserves to meet reserve
requirements.
 Hence, reductions in the discount rate raise the monetary
base and the money supply.
 2.2 Demand for Money
 The demand for money arises from the important
functions performed by money, such as units of account,
store of value and medium of exchange
 The demand for money as explained by the famous
quantity theory assumes that the demand for real balances
is proportional to income. That is:
 (M/P)d = kY --------------- (7)
 Where, k is a constant. However, more general and
realistic money demand function assumes that the
demand for real balances depends on both the interest rate
and income;
 (M/P)d = L(i,Y) --------------- (8)
 2.2.1 Portfolio Theories of Money Demand

 Theories of money demand that emphasizes the role of

money as a store of value are called ‘portfolio theories.’
 These theories stress that people hold money as part of
their portfolio of assets.
 The key insight is that money offers a different
combination of risk and return than other assets.
 In particular, money offers a safe (nominal) return,
whereas the prices of stocks and bonds may rise or fall.
 Portfolio theories predict that the demand for money
should depend on the risk and return offered by money
and by the various assets households can hold instead of
money.
 2.2.1 Portfolio Theories of Money Demand….

 Money demand should depend on total wealth, because

wealth measures the size of the portfolio to be allocated
among money and the alternative assets.
For example, we might write the money demand function as:
 (M/P)d = L(rs, rb, πe , W) ----------- (9)

 Where rs is the expected real return on stock,

 rb, is the expected real return on bonds,

 πe is the expected inflation rate, and

 W is real wealth. An increase in rs is the expected inflation

rate, and W is real wealth.

 2.2.1 Portfolio Theories of Money Demand….

 An increase in rs or rb reduces money demand, because

other assets become more attractive.
 An increase in πe also reduces money demand, because
money becomes less attractive.
 An increase in W raises money demand, because higher
wealth implies a larger portfolio.
 2.2.2 Transactions Theories of Money Demand

 Theories of money demand that emphasizes the role of

money as a medium of exchange are called ‘transactions
theories.’
 People decide how much money to hold by trading off
these costs and benefits.
 A prominent model of this type is the ‘Baumol- Tobin
Model’, developed in 1950s by economists William
Baumol and James Tobin, and it remains a leading theory
of money demand.
 2.2.2.1 The Baumol-Tobin Model of Cash
Management
 The Baumol-Tobin model analyses the costs and benefits
of holding money.
 The benefit of holding money is convenience; people
hold money to avoid making a trip to the bank every time
they wish to buy something.
 The cost of this convenience is the forgone interest they
would have received had they left the money deposited in
a savings account that paid interest.
 Consider a person who plans to spend Y dollars
gradually over the course of year (For simplicity, assume
that the price level is constant, so real spending is
constant over the year).
 2.2.2.1 The Baumol-Tobin Model of Cash
Management…..
 Figure 2.1 shows the money holding over the course of
the year under this plan.
 The money holding begin the year at Y and end the year
at zero, averaging Y/2 over the year.

 2.2.2.1 The Baumol-Tobin Model of Cash
Management……
 A second possible plan is to make two trips to the bank.
 In this case, the person withdraws Y/2 dollars at the
beginning of the year, gradually spends this amount over
first half of the year, and then makes another trip to
withdraw Y/2 for the second half of the year.
 Figure-2.2 shows that money holdings over the year vary
between Y/2 and zero, averaging Y/4.
 This plan has the advantage that less money is held on
average, so less interest is forgone, but it has the
disadvantage of requiring two trips to the bank rather
than one.
 2.2.2.1 The Baumol-Tobin Model of Cash
Management……

 2.2.2.1 The Baumol-Tobin Model of Cash
Management……
 Generally, suppose the individual makes N trips to the
bank over the course of the year.
 On each trip, he/she withdraws Y/N dollars; then spends
the money gradually over the following 1/Nth of the year.
 Figure-2.3 shows that money holdings vary between Y/N
and zero, averaging Y/2N.
 2.2.2.1 The Baumol-Tobin Model of Cash
Management……
 The optimal choice of N is determined by different factors.
 The greater N is, the less money is held on average and
the less interest is forgone.
 But as N increases, so does the inconvenience of making
frequent trips to the bank.
 For any N, the average amount of money held is Y/(2N),
so the forgone interest is iY/(2N).
 Because F is the cost per trip to the bank, the total cost of
making trips to the bank is FN.
 The total cost the individual bears is the sum of forgone
interest and the cost of trips to the banks.
 Total cost = Forgone interest + Cost of trips
 2.2.2.1 The Baumol-Tobin Model of Cash
Management……

 Total cost = iY/(2N) + FN ---------- (10)

 The larger the number of trips N, the smaller the forgone
interest, and the larger the cost ofgoing to the bank.
 Figure-2.4 shows how total cost depends on N.
 There is one value of N that minimizes total cost. The
optimal value of N denoted by N* is:
 N* =  iY/2F ------------ (11)
 Average money holding = Y/(2N*) = YF/2i
 This explanation shows that the individual holds more
money if the fixed cost of going to the bank F is higher, if
expenditure Y is higher, or if the interest rate i is lower.
 2.2.2.1 The Baumol-Tobin Model of Cash
Management……


 2.2.3 Financial Innovation and the Rise of Near
Money

 Traditional macroeconomic analysis groups assets into

two categories: those used as medium of exchange as
well as store of value (currency, checking accounts) and
those used only as a store of value (stocks, bonds, savings
accounts).
 The existence of near money complicates monetary
policy by making the demand for money unstable.
 Since money and near money are close substitutes,
households can easily switch their assets from one form
to the other forms. Such changes can occur for minor
reasons and do not necessarily reflect changes in
spending.
 2.2.3 Financial Innovation and the Rise of Near
Money

 Thus, the velocity of money becomes unstable, and the

quantity of money gives faulty signals about aggregate
demand.
 End of the session

Thank for
your attention
 Chapter – 3
The Labour market