MACROECONOMICS 2010 Worth Publishers, all rights reserved 2010 Worth Publishers, all rights reservedS E V E N T H E D I T I O NPowerPoint Slides by Ron CronovichN. Gregory MankiwC H A P T E RMoney Supply, Money Demand, and the Banking System19In this chapter, you will learn:how the banking system “creates” moneythree ways the Fed can control the money supply, and why the Fed cant control it preciselyleading theories of money demanda portfolio theorya transactions theory: the Baumol-Tobin model2CHAPTER 19 Money Supply, Money Demand, Banking SystemBanks role in the money supplyThe 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. 3CHAPTER 19 Money Supply, Money Demand, Banking SystemA few preliminariesReserves (R ): the portion of deposits that banks have not 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. 4CHAPTER 19 Money Supply, Money Demand, Banking SystemBanks role in the money supplyTo understand the role of banks, we will consider three scenarios:1.No banks2.100-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. 5CHAPTER 19 Money Supply, Money Demand, Banking SystemSCENARIO 1: No banksWith no banks, D = 0 and M = C = $1000.6CHAPTER 19 Money Supply, Money Demand, Banking SystemSCENARIO 2: 100-percent reserve bankingAfter the deposit: C = $0, D = $1,000, M = $1,000 LESSON:100%-reserve banking has no impact on size of money supply. FIRSTBANKS balance sheetAssetsLiabilitiesreserves $1,000 deposits $1,000Initially C = $1000, D = $0, M = $1,000. Now suppose households deposit the $1,000 at “Firstbank.”7CHAPTER 19 Money Supply, Money Demand, Banking SystemFIRSTBANKS balance sheetAssetsLiabilitiesreserves $1,000reserves $200loans $800SCENARIO 3: Fractional-reserve bankingThe money supply now equals $1,800:Depositor has $1,000 in demand deposits.Borrower holds $800 in currency.deposits $1,000Suppose banks hold 20% of deposits in reserve, making loans with the rest.Firstbank will make $800 in loans. LESSON: in a fractional-reserve banking system, banks create money.8CHAPTER 19 Money Supply, Money Demand, Banking SystemSECONDBANKS balance sheetAssetsLiabilitiesreserves $800loans $0reserves $160loans $640SCENARIO 3: Fractional-reserve bankingSecondbank will loan 80% of this deposit.deposits $800Suppose the borrower deposits the $800 in Secondbank. Initially, Secondbanks balance sheet is:9CHAPTER 19 Money Supply, Money Demand, Banking SystemSCENARIO 3: Fractional-reserve bankingTHIRDBANKS balance sheetAssetsLiabilitiesdeposits $640If this $640 is eventually deposited in Thirdbank,then Thirdbank will keep 20% of it in reserve, and loan the rest out: reserves $640loans $0reserves $128loans $51210CHAPTER 19 Money Supply, Money Demand, Banking SystemFinding the total amount of money:Original deposit = $1000+ Firstbank lending= $ 800+ Secondbank lending = $ 640+ Thirdbank lending= $ 512+ other lendingTotal money supply = (1/rr ) $1,000 where rr = ratio of reserves to depositsIn our example, rr = 0.2, so M = $5,00011CHAPTER 19 Money Supply, Money Demand, Banking SystemMoney creation in the banking systemA 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. 12CHAPTER 19 Money Supply, Money Demand, Banking SystemA model of the money supplyMonetary base, B = C + Rcontrolled by the central bankReserve-deposit ratio, rr = R/Ddepends on regulations & bank policiesCurrency-deposit ratio, cr = C/Ddepends on households preferencesexogenous variables13CHAPTER 19 Money Supply, Money Demand, Banking SystemSolving for the money supply:where14CHAPTER 19 Money Supply, Money Demand, Banking SystemThe money multiplierIf rr 1If 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 increase in the monetary base. whereNOW YOU TRY: The Money MultiplierSuppose households decide to hold more of their money as currency and less in the form of demand deposits.1. Determine impact on money supply. 2. Explain the intuition for your result. whereSOLUTION: Impact of an increase in the currency-deposit ratio cr 0. 1.An increase in cr increases the denominator of m proportionally more than the numerator. So m falls, causing M to fall. 2.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.17CHAPTER 19 Money Supply, Money Demand, Banking SystemThree instruments of monetary policy1.Open-market operations2.Reserve requirements3.The discount rate18CHAPTER 19 Money Supply, Money Demand, Banking SystemOpen-market operationsdefinition: 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. 19CHAPTER 19 Money Supply, Money Demand, Banking SystemReserve requirementsdefinition: 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. 20CHAPTER 19 Money Supply, Money Demand, Banking SystemThe discount ratedefinition: The interest 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. 21CHAPTER 19 Money Supply, Money Demand, Banking SystemWhich 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.22CHAPTER 19 Money Supply, Money Demand, Banking SystemWhy the Fed cant precisely control MHouseholds 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. where23CHAPTER 19 Money Supply, Money Demand, Banking SystemCASE STUDY: Bank failures in the 1930s From 1929 to 1933: over 9,000 banks closedmoney supply fell 28%This drop in the money supply may have caused the Great Depression, but certainly contributed to its severity. 24CHAPTER 19 Money Supply, Money Demand, Banking SystemCASE STUDY: Bank failures in the 1930s Loss of confidence in banks cr mBanks became more cautious rr mwhereCASE STUDY: Bank failures in the 1930s March 1933% change0.410.212.3141.250.037.80.17cr0.14rr3.7m2.95.58.49.441.018.33.2R3.9C7.1B13.55.519.040.341.028.3%22.6D3.9C26.5MAugust 192926CHAPTER 19 Money Supply, Money Demand, Banking SystemCould 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. 27CHAPTER 19 Money Supply, Money Demand, Banking SystemBank capital, leverage, and capital requirementsBank capital: the resources a banks owners have put into the bankA more realistic balance sheet:AssetsLiabilities and Owners EquityReserves$200Deposits$750Loans$500Debt$200Securities$300Capital (owners equity)$5028CHAPTER 19 Money Supply, Money Demand, Banking SystemBank capital, leverage, and capital requirementsLeverage: the use of borrowed money to supplement existing funds for purposes of investmentLeverage ratio = assets/capital= ($200+500+300)/$50 = 20AssetsLiabilities and Owners EquityReserves$200Deposits$750Loans$500Debt$200Securities$300Capital (owners equity)$5029CHAPTER 19 Money Supply, Money Demand, Banking SystemBank capital, leverage, and capital requirementsBeing 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 AssetsLiabilities and Owners EquityReserves$200Deposits$750Loans$500Debt$200Securities$300Capital (owners equity)$5030CHAPTER 19 Money Supply, Money Demand, Banking SystemBank capital, leverage, and capital requirementsCapital requirement: minimum amount of capital mandated by regulatorsintended to insure that banks will be able to pay off depositorshigher for banks that hold more risky assets2008-2009 financial crisis: Losses on mortgages shrunk bank capital, slowed lending, exacerbated the recession.Govt injected $ billions of capital into banks to ease crisis and encourage more lending.31CHAPTER 19 Money Supply, Money Demand, Banking SystemMoney DemandTwo types of theoriesPortfolio theoriesemphasize “store of value” functionrelevant for M2, M3not relevant for M1. (As a store of value, M1 is dominated by other assets.)Transactions theoriesemphasize “medium of exchange” functionalso relevant for M132CHAPTER 19 Money Supply, Money Demand, Banking SystemA simple portfolio theorywherers = expected real return on stocksrb = expected real return on bonds e = expected inflation rateW = real wealth33CHAPTER 19 Money Supply, Money Demand, Banking SystemThe Baumol-Tobin Modela transactions theory of money demandnotation:Y = total spending, done gradually over the yeari = interest rate on savings account N = number of trips consumer makes to the bank to withdraw money from savings accountF = cost of a trip to the bank (e.g., if a trip takes 15 minutes and consumers wage = $12/hour, then F = $3)34CHAPTER 19 Money Supply, Money Demand, Banking SystemMoney holdings over the yearN = 1Money holdings TimeAverage = Y/ 2Y135CHAPTER 19 Money Supply, Money Demand, Banking SystemMoney holdings over the yearMoney holdings Time11/2Average = Y/ 4Y/ 2YN = 236CHAPTER 19 Money Supply, Money Demand, Banking SystemMoney holdings over the yearAverage = Y/ 61/32/3Money holdings Time1Y/ 3YN = 337CHAPTER 19 Money Supply, Money Demand, Banking SystemThe cost of holding moneyIn general, average money holdings = Y/2NForegone interest = i (Y/2N )Cost of N trips to bank = F N Thus,Given Y, i, and F, consumer chooses N to minimize total cost38CHAPTER 19 Money Supply, Money Demand, Banking SystemFinding the cost-minimizing NN*40CHAPTER 19 Money Supply, Money Demand, Banking SystemThe money demand functionThe cost-minimizing value of N :To obtain the money demand function, plug N* into the expression for average money holdings:Money demand depends positively on Y and F, and negatively on i.41CHAPTER 19 Money Supply, Money Demand, Banking SystemThe money demand functionThe 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 = 0.5NOW YOU TRY: The impact of ATMs on money demandDuring the 1980s, automatic teller machines became widely available. How do you think this affected N* and money demand? Explain.43CHAPTER 19 Money Supply, Money Demand, Banking SystemFinancial Innovation, Near Money, and the Demise of the Monetary AggregatesExamples of financial innovation:many checking accounts now pay interestvery easy to buy and sell assetsmutual funds are baskets of stocks that are easy to redeem - just write a checkNon-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 other is easy. 44CHAPTER 19 Money Supply, Money Demand, Banking SystemFinancial Innovation, Near Money, and the Demise of the Monetary AggregatesThe 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 why the U.S. economy was so stable during the rest of the 1990s. Chapter Summary1. Fractional reserve banking creates money because each dollar of reserves generates many dollars of demand deposits. 2. The money supply depends on the:monetary basecurrency-deposit ratioreserve ratio3. The Fed can control the money supply with:open market operationsthe reserve requirementthe discount rateChapter Summary4. Bank capital, leverage, capital requirementsBank 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 huge impact on bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid. Chapter Summary5. Portfolio theories of money demandstress the store of value functionposit that money demand depends on risk/return of money & alternative assets6. The Baumol-Tobin modela transactions theory of money demand, stresses “medium of exchange” functionmoney demand depends positively on spending, negatively on the interest rate, and positively on the cost of converting non-monetary assets to money