Money Supply, Money Demand, and the Banking System

Money Supply

Quantity of money as the number of dollars held by the public, and we assumed that the Federal Reserve controls the supply of money by increasing or decreasing the number of dollars in circulation through openmarket operations. the money supply is determined not only by Fed policy but also by the behavior of households (which hold money) and banks (in which money is held). We begin by recalling that the money supply includes both currency in the hands of the public and deposits at banks that households can use on demand for transactions, such as checking account deposits. That is, letting M denote the money supply, C currency, and D demand deposits, we can write

Money Supply = Currency + Demand Deposits

100-Percent-Reserve Banking

We begin by imagining a world without banks. In such a world, all money takes the form of currency, and the quantity of money is simply the amount of currency that the public holds. For this discussion, suppose that there is $1,000 of currency in the economy. Now introduce banks. At first, suppose that banks accept deposits but do not make loans. The only purpose of the banks is to provide a safe place for depositors to keep their money. The deposits that banks have received but Have not lent out are called reserves. Some reserves are held in the vaults of local banks throughout the country, but most are held at a central bank, such as the Federal Reserve. In our hypothetical economy, all deposits are held as reserves: banks simply accept deposits, place the money in reserve,and leave the money there until the depositor makes a withdrawal or writes a check against the balance. This system is called 100-percent-reserve banking. Suppose that households deposit the economy’s entire $1,000 in Firstbank. Firstbank’s balance sheet—its accounting statement of assets and liabilities— looks like this:

 Firstbank’s Balance Sheet

Assets                                      Liabilities

Reserves $1,000                      Deposits $1,000

Fractional-Reserve Banking

Now imagine that banks start to use some of their deposits to make loans— for example, to families who are buying houses or to firms that are investing in new plants and equipment. The advantage to banks is that they can charge interest on the loans. The banks must keep some reserves on hand so that

reserves are available whenever depositors want to make withdrawals. But as long as the amount of new deposits approximately equals the amount of withdrawals, a bank need not keep all its deposits in reserve. Thus, bankers have an incentive to make loans. When they do so, we have fractional-reserve banking, a system under which banks keep only a fraction of their deposits in reserve.

Here is Firstbank’s balance sheet after it makes a loan:

Firstbank’s Balance Sheet

Assets                                                  Liabilities

Reserves $200                                     Deposits $1,000

Loans   $800

A Model of the Money Supply

Here we present a model of the money supply under fractional-reserve banking. The model has three exogenous variables:

1.      The monetary base B 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 Federal Reserve.

2.      The reserve–deposit ratio rr is the fraction of deposits that banks hold in reserve. It is determined by the business policies of banks and the laws regulating banks.

3.      The currency–deposit ratio cr is the amount of currency C people hold as a fraction of their holdings of demand deposits D. It reflects the preferences of households about the form of money they wish to hold.

The Three Instruments of Monetary Policy

1.        Open-market operations are the purchases and sales of government bonds by the Fed.

2.        Reserve requirements are Fed regulations that impose on banks a minimum reserve–deposit ratio.

3.        The discount rate is the interest rate that the Fed charges when it makes loans to banks.

Money Demand

The Demand for Money

The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives.

Transactions motive. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises.
Precautionary motive. People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money.
Speculative motive. Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset.
For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money.