Ch 3: Money Demand and Money Supply

Introduction
The supply and demand for money are crucial to many issues
in macroeconomics.

In the first part, we see that the banking system plays a key
role in determining the money supply.
We discuss various policy instruments that the central bank
can use to influence the banking system and alter the money
supply.

In the second part, we consider the motives behind money

demand,
and we analyze the individual household’s decision about how
much money to hold.
1. Money Supply
The quantity of money is defined as the amount of
money held by the public,

and we assume that the central bank controls the supply of

money by increasing or decreasing the amount of money in
circulation through open market operations.

This explanation is a good starting point for understanding

what determines the supply of money,
but it is incomplete, because it omits the role of the
banking system in this process.
In this section we see that the money supply is determined

not only by the Central bank 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

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.
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 br1,000 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
br1,000 in First bank.

First bank’s balance sheet—its accounting statement

of assets and liabilities—looks like this:
The bank’s assets are the b1,000 it holds as reserves; the
bank’s liabilities are the br1,000 it owes to depositors.

Unlike banks in our economy, this bank is not making

loans, so it will not earn profit from its assets.

The bank presumably charges depositors a small fee to

cover its costs.
What is the money supply in this economy?
Before the creation of First bank, the money supply was
the br1,000 of currency.

After the creation of First bank, the money supply is the

br1,000 of demand deposits.
A birr deposited in a bank reduces currency by one birr and
raises deposits by one birr, so the money supply remains the
same.

If banks hold 100 percent of deposits in reserve, the

banking system does not affect the supply of money.
Now imagine that banks start to use some of their
deposits to make loans—
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 if 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 First bank’s balance sheet after it makes a loan:

This balance sheet assumes that the reserve–deposit

ratio—the fraction of deposits kept in reserve—is 20
percent.
First bank keeps $200 of the $1,000 in deposits in reserve
and lends out the remaining $800.

Notice that First bank increases the supply of money

by $800 when it makes this loan.
Before the loan is made, the money supply is $1,000,
equaling the deposits in First bank.
After the loan is made, the money supply is $1,800: the
depositor still has a demand deposit of $1,000, but now the
borrower holds $800 in currency.
Thus, in a system of fractional-reserve banking, banks
create money.
The creation of money does not stop with First bank.
If the borrower deposits the $800 in another bank
(or if the borrower uses the $800 to pay someone who
then deposits it),
the process of money creation continues.
Here is the balance sheet of Second bank:
Second bank receives the $800 in deposits, keeps 20
percent, or $160, in reserve, and then loans out $640.

Thus, Second bank creates $640 of money. If this $640

is eventually deposited in Third bank, this bank keeps
20 percent, or $128, in reserve and loans out $512,
resulting in this balance sheet:
The process goes on and on. With each deposit and loan,
more money is created.

Although this process of money creation can continue

forever, it does not create an infinite amount of
money.
Letting rr denote the reserve–deposit ratio, the amount of
money that the original $1,000 creates is

Total Money Supply = [1 + (1 - rr) + (1 - rr)2 +

(1 – rr)3 + ... ] × $1,000
= (1/rr) × $1,000.
Each $1 of reserves generates $(1/rr) of money.
In our example, rr = 0.2, so the original $1,000 generates $5,000 of
money.

The banking system’s ability to create money is the primary

difference between banks and other financial institutions.

Financial markets have the important function of transferring the

economy’s resources from those households that wish to save some
of their income for the future to those households and firms that
wish to borrow to buy investment goods to be used in future
production.

The process of transferring funds from savers to borrowers is called

financial intermediation.
Many institutions in the economy act as financial
intermediaries.
The most prominent examples are:
the stock market, the bond market, and the banking
system.

Yet, of these financial institutions, only banks have the

legal authority to create assets
(such as checking accounts) that are part of the money
supply.

Therefore, banks are the only financial institutions

that directly influence the money supply.
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.
***A Model of the Money Supply

Now that we have seen how banks create money, let’s

examine in more detail what determines the money supply.

Here we present a model of the money supply under

fractional-reserve banking. The model has three exogenous
variables:

vThe monetary base (B) is the amount of money held by the

public as currency C and by the banks as reserves R.

It is directly controlled by the Central bank.

vThe 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.

v 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 model shows how the money supply depends on
the monetary base (B),
the reserve–deposit ratio (rr), and
the currency–deposit ratio (cr).

It allows us to examine how the Central bank’s policy

and the choices of banks and households influence the
money supply.

We begin with the definitions of the money supply and

the monetary base:
M = C + D,
B = C + R.




We can now see how changes in the three exogenous
variables,
B, rr, and cr
cause the money supply to change.

1. The money supply is proportional to the

monetary base.

Thus, an increase in the monetary base increases

the money supply by the same percentage.

The Three Instruments of Monetary Policy

The Central bank controls the money supply indirectly

by altering either the monetary base (B) or the
reserve–deposit ratio(rr).

To do this, the central bank has at its disposal three

instruments of monetary policy:

1. Open-market operations,
2. Reserve requirements, and
3. The discount rate.
1. Open-market operations are the purchases and sales of
government bonds by the central bank.

When the central bank buys bonds from the public, the money
it pays for the bonds increase the monetary base (B = C + R)
and thereby increase the money supply (M = m x B).

When the central bank sells bonds to the public, the money it
receives reduce the monetary base (B) and thus decrease the
money supply (M).

Open-market operations are the policy instrument that the

central bank uses most often.

3. The discount rate is the interest rate that the central
bank charges when it makes loans to banks.

Banks borrow from the central bank when they find

themselves with too few reserves to meet reserve
requirements.

The lower the discount rate, the cheaper are borrowed

reserves, and the more banks borrow at the central bank ’s
discount window.

Hence, a reduction in the discount rate raises the monetary

base (B = C + R) and the money supply (M).
Although these three instruments
—open-market operations, reserve requirements, and
the discount rate—
give the central bank substantial power to influence the
money supply,
the central bank cannot control the money supply
perfectly.

Bank discretion in conducting business can cause the

money supply to change,
in ways the central bank did not anticipate.
For example, banks may choose to hold excess reserves
—that is, reserves above the reserve requirement.
The higher the amount of excess reserves, the higher the
reserve–deposit ratio, and the lower the money supply.

As another example, the central bank cannot

precisely control the amount banks borrow from the
discount window.
The less banks borrow, the smaller the monetary base; and
the smaller the money supply.
Hence, the money supply sometimes moves in ways the
central bank does not intend.


Just as studies of the consumption function rely on
microeconomic models of the consumption decision,

studies of the money demand function rely on

microeconomic models of the money demand decision.

In this section we first discuss in broad terms the different

ways to model money demand. We then develop one
prominent model.
Recall that money serves three functions: it is
ü a unit of account,
ü a store of value, and
ü a medium of exchange
• The first function —money as a unit of account —
does not by itself generate any demand for money,
because one can quote prices in dollars without holding
any.

• By contrast, money can serve its other two functions

only if people hold it.

• Theories of money demand thus emphasize the role of

money,
either as a store of value
or as a medium of exchange.
Portfolio Theories of Money Demand

Theories of money demand that emphasize the role of

money as a store of value are called portfolio theories.

According to these theories, people hold money as part of

their portfolio of assets.

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.

v An increase in rs reduces money demand, because
other assets become more attractive.

v An increase in Eπ also reduces money demand,

because money becomes less attractive.
(Recall that Eπ affects the expected real return to holding
money).

v An increase in W raises money demand, because

greater wealth means a larger portfolio.
From the standpoint of portfolio theories, we can view our
money demand function, L(i, Y), as a useful simplification.

First, it uses real income Y as a proxy for real wealth W.

Second, the only return variable it includes is the nominal
interest rate,
which is the sum of the real return on bonds and
expected inflation
(that is, i = rb+ Eπ).
According to portfolio theories, however, the money
demand function should include the expected returns
on other assets as well.
Cambridge version (cash-balance approach)

A version of quantity theory which concentrate on

the factors that determine the demand for money,
was developed by economists at the University of
Cambridge.

These economists agreed that an individual’s

demand for cash balances (or nominal money) is
proportional to the individual’s money income.
If this were true of all individuals, then the aggregate
demand for money (MD) could be written as proportional
to money national income (Y):
MD = kY ,
where
k is a constant.
Since Y is money national income, it can be divided into
its price and quantity components, so that
MD = kPQ
where
P is the general price level,
and Q is real income (or output).
Notice that k is the reciprocal of the income velocity of
circulation of money, v ,

which can be defined as the average number of times

the money supply changes hands in financing the
national income.

This demand for money arises

to enable people to fulfill its planned expenditure,
during the intervening periods between receipts of wages,
salaries or other forms of income.
If we continue to assume that the money supply (M) is
under the control of the monetary authorities we can
write that in equilibrium,

M = MD

Substituting from above, we have

M = kPQ

with k constant and Q fixed because the economy is

assumed to remain at full employment,
an increase in M will create an excess supply of money.
This leads people to increase their spending
directly on goods and services so that the general
price level is pulled upwards.

As this happens,
the demand for money increases and eventually
becomes equal to the money supply again.
The Keynesian theory of Money Demand
(Income-Expenditure Approach)

Keynes divides the demand for money into three types:

(a) The transactions demand, which is the demand by

firms and households for holdings of money to finance
day-to-day transactions.

(b) Precautionary demand, which arises out of

uncertainty and the desire not to be caught short of
ready cash.
(c) The speculative demand, which is the demand
for money as a financial asset and therefore part
of a wealth portfolio.

In (a) and (b) money is clearly held mainly for its role
as a medium of exchange.
In (c) it is held mainly for its role as a store of wealth.

What factors influence these three demands for money?.

Transactions Theories of Money Demand

Theories of money demand that emphasize the role of

money as a medium of exchange are called
transactions theories.

These theories acknowledge that money is a

dominated asset and stress that people hold money,
unlike other assets, to make purchases.
Transactions’ theories of money demand take many
forms,
depending on how one models the process of obtaining
money and making transactions.

All these theories assume that money has

- the cost of earning a low rate of return,
- and the benefit of making transactions using
money is more convenient.

People decide how much money to hold by trading

off these costs and benefits.
To see how transactions theories explain the money
demand function,
let’s develop one prominent model of this type.

The Baumol–Tobin model was developed in the 1950s

by economists William Baumol and James Tobin, and
it remains a leading theory of money demand.
The Baumol–Tobin Model of Cash Management

The Baumol–Tobin model analyzes 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.
To see how people trade off these benefits and costs,
consider a person who plans to spend Y birr gradually
over the course of a year.

(For simplicity, assume that the price level is constant,

so real spending is constant over the year.)

How much money should the person hold in the process

of spending this amount?

That is, what is the optimal size of average cash

balances?
Consider the possibilities.

vHe could withdraw the Y birr at the beginning of

the year and gradually spend the money.

Panel (a) of the graph below shows his money holdings

over the course of the year under this plan.

His money holdings begin the year at Y and end the

year at zero, averaging Y/2 over the year.
vA second possible plan is to make two trips to the bank.
In this case, he withdraws Y/2 birr at the beginning of the
year, gradually spends this amount over the first half of the
year,

and then makes another trip to withdraw Y/2 for the second
half of the year.

Panel (b) of the graph 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 the individual forgoes less interest,
but it has the disadvantage of requiring two trips to the
bank rather than one.
v More generally, suppose the individual makes N trips
to the bank over the course of the year.

On each trip, he withdraws Y/N birr he then spends the

money gradually over the following 1/Nth of the year.

Panel (c) of the graph shows that money holdings vary

between Y/N and zero, averaging Y/(2N).

v The question is, what is the optimal choice of N?

The greater N is, the less money the individual holds
on average and the less interest the person forgoes.
But as N increases, so does the inconvenience of
making frequent trips to the bank.

Suppose that the cost of going to the bank is some

fixed amount F.

We can view F as representing the value of the time

spent traveling to and from the bank and waiting in
line to make the withdrawal.

Also, let i denote the interest rate.

Because money does not bear interest, i measures the
opportunity cost of holding money.



So far, we have been interpreting the Baumol–Tobin
model as a model of the demand for currency.

That is, we have used it to explain the amount of money

held outside of banks. Yet one can interpret the model
more broadly.

Imagine a person who holds a portfolio of

monetary assets (currency and checking accounts)
and nonmonetary assets (stocks and bonds).

Monetary assets are used for transactions but offer a

low rate of return.
Let i be the difference in the return between monetary
and nonmonetary assets, and

let F be the cost of transforming nonmonetary assets

into monetary assets, such as a brokerage fee.

The decision about how often to pay the brokerage fee is

analogous to the decision about how often to make a
trip to the bank.

Therefore,
the Baumol–Tobin model describes this person’s
demand for monetary assets.
By showing that money demand depends
positively on expenditure Y
and negatively on the interest rate i,

the model provides a microeconomic justification for the

money demand function, L(i, Y).

One implication of the Baumol–Tobin model is that any

change in the fixed cost of going to the bank F alters the
money demand function—

that is, it changes the quantity of money demanded

for any given interest rate and income.
Ø The precautionary demand for money arises out of
consumers’ desires to provide for unexpected, and therefore
unplanned, expenditures.

For example, a sales representative on a business trip may

carry some extra cash,
not for expected transactions, but to guard against any
unforeseen contingencies, such as a car breakdown, or a
possibility of coming across a cash bargain.

This demand for money is likely to depend on national income:

the higher the total value of transactions, the more money will
be needed to guard against unexpected transactions.
It can be argued that rates of interest may also influence
the precautionary demand.

The rate of interest is the opportunity cost of holding

money

Thus, if interest rates rise, consumers and firms may be

tempted to reduce their precautionary holdings and
hold interest bearing assets instead.

For simplicity, however, it is convenient to assume that

the precautionary demand does not respond to changes
in interest rates (that is, it is completely interest
inelastic).
This enables to combine the precautionary demand
with the transactions demand, and to suppose that,

the total transactions and precautionary demand for

money is a function of money national income.

Indeed, wherever the transaction demand, Lt, is referred,

it is understood that this includes the precautionary
demand.

It was in his analysis of the speculative demand for

money that Keynes differed fundamentally from his
predecessors.
Before examining the nature of this demand for money, the
relationship between the price of a bond and the rate of
interest should be clear.

A bond is an asset that earns a fixed sum of money for its

owner each year.

There is an inverse relationship between the price of a

bond and the rate of interest.

An increase in the rate of interest, reduces the saleable

value of a bond,
which is a potential capital loss for an investor who
purchased the bond at a higher price
Similarly, a fall in the rate of interest means a
potential capital gain for investor.

Since a fall in the rate of interest implies capital

gains for bond-holders,
the theory predicts that an abnormally high interest
rate will lead to,
a large demand for bonds and, consequently,
a small demand for speculative money balances.
If the prevailing interest rate is low, the theory
predicts a low demand for bonds,
and, consequently, a high demand for speculative
money balances.

In this way,
Keynes derived an inverse relationship between the
rate of interest and the speculative demand for
money.
Total demand for money

The total demand for money (or total liquidity

preference) is found by adding together

the transactions, precautionary and speculative

demands.