quiz on macro economics
Microsoft Word - ECON2003_20170907_U6_v1.docx ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 84 UNIT 6 The Microeconomics Behind Macroeconomics: Money Supply and Money Demand Overview In this Unit, we will examine the microeconomic foundations of another important topic in macroeconomics. The supply and demand of money affects important variables such as the inflation rate, the money supply and the interest rate. We will first explore the money supply by learning about reserve banking, developing a model of the money supply, and then the tools which the central bank uses to influence the money supply. Next, we will examine portfolio and transaction theories of money demand to understand why individuals choose to hold money. ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 85 Learning Objectives By the end of this Unit you will be able to: 1. Apply the concept of reserve banking to real-life scenarios; 2. Analyse the efficacy of instruments of monetary policy in the Caribbean context; 3. Debate the merits of various theories of money demand; 4. Examine how financial innovations have changed money demand. This Unit is divided into two sessions as follows: Session 6.1: Money Supply Session 6.2: Money Demand ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 86 Readings and Resources Required Reading Mankiw, N. G. (2010). Chapter 19: Money Supply, Money Demand, and the Banking System. In Macroeconomics (7th ed.). New York: Worth Publishers. [Available via UWIlinC] Required Videos ACDC Leadership. (2014, November 13). How banks create money and the money multiplier. [Video File]. Available at https://www.youtube.com/watch?v=JG5c8nhR3LE Inspirare. (2016, April 28). The money market – money (5/6). [Video File]. Available at https://www.youtube.com/watch?v=mGdQKm_JGoM Simplifiedvideos. (2017, March 31). Classical and neoclassical approach to demand for money. [Video File]. Available at https://www.youtube.com/watch?v=y- NrtDpdfVY Welker, J. (2012, January 19). The tools of monetary policy. [Video File]. Available at https://www.youtube.com/watch?v=rcPEkmstDek Suggested Readings Baumol, W. J. (1952). The transactions demand for cash: An inventory theoretical approach. Quarterly Journal of Economics, 66(4), 545-556. [Available via UWIlinC]. Curtis, D., & Irvine, I. (2017). Chapter 9: Money, banking, and money supply. Macroeconomics: Theory, Markets, and Policy. Lyrlyx Learning. Available from https://lyryx.com/wp-content/uploads/2017/08/CI-Principles-of- Macroeconomics-2017-RevisionB.pdf Fisher, S. (1996). Why are central banks pursuing long-run price stability? In Proceedings – Economic Policy Symposium – Jackson Hole, Federal Reserve Bank of Kansas City, 7-34. Available from http://bit.ly/2wNHJyx Goodhart, C. A. E. (1994). What should central banks do? What macroeconomic objectives and operations? Economic Journal, 104(427), 1424-1436. [Available via UWIlinC]. Guru, S. (2016). Theories of demand of money: Tobin’s portfolio and Baumol’s inventory approaches. Available from http://www.yourarticlelibrary.com/economics/money/theories-of-demand- of-money-tobins-portfolio-and-baumols-inventory-approaches/37904/ Mishkin, F. S., & Serletis, A. (2011). Appendix 1 of Chapter 21. In The Economics of ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 87 Money, Banking, and Financial Markets. Boston: Pearson/Addison Wesley. Available at http://bit.ly/2xRmf0t Mishkin, F. S., & Serletis, A. (2011). Appendix 2 of Chapter 21. In The Economics of Money, Banking, and Financial Markets. Boston: Pearson/Addison Wesley. Available at http://bit.ly/2xRAked Tobin, J. (1956). The interest elasticity of transactions demand for cash. The Review of Economics and Statistics, 38(3), 241-247. [Available via UWIlinC]. Tobin, J. (1958). Liquidity preference as behavior towards risk. Review of Economic Studies, 25(2), 65-86. [Available via UWIlinC]. Williamson, S. (2008). Chapter 10: A Monetary Intertemporal Model: Money, Prices, and Monetary Policy. In Macroeconomics (3rd ed.). Boston: Pearson/Addison Wesley. [Available via UWIlinC]. Williamson, S. (2008). Chapter 15: Monetary, Inflation, and Banking. In Macroeconomics (3rd ed.). Boston: Pearson/Addison Wesley. [Available via UWIlinC]. ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 88 Session 6.1 Money Supply Introduction Thus far in the course we have been assuming that the money supply is determined only by the central bank’s actions. In practice, the central bank’s policies, the actions of depository institutions, and consumer behavior all affect the money supply. In this session, we will discuss the different ways in which financial intermediaries, the public, and central bankers interact to determine the money supply changes. The money supply, M, is money held by the public in the form of currency, C, and deposits in checking accounts at the bank, D. Reserve Banking (a) 100 Percent Reserve Banking In this system, banks are not allowed to make loans so all deposits are kept as reserves. Reserves are the amount of deposits that banks keep on hand and do not lend out. Because all deposits are reserves and there are no loans, the money supply, remains the same before and after the deposits are made as seen in Figure 6.1 below. Figure 6.1: How Deposits Affect Money Supply in 100 Percent Reserve Banking Deposits (moneysupply=monetarybase) Reserves(100%ofDeposits) MoneySupplyisunchanged ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 89 (b) Fractional Reserve Banking In this system, banks can make loans but are required to keep a fraction of deposits on hand as reserves. The amount that the banks are required to keep is determined by the reserve-deposit ratio that is set by the central bank. The action of making loans increases the money supply. To see how this works, consider a bank’s balance sheet. When the deposit is made at the bank, the bank’s total liabilities rise by the amount of the deposit because the bank owes this amount to the depositor. Of this amount, the bank is required to keep a portion but it can lend the rest. The bank’s assets therefore rise by the amount of new reserves and the amount it loans out. The loan adds to the amount of currency in the economy. Remember that M = C+D, so ∆M = ∆C + ∆D. Therefore, the money supply increases by the amount of the loan. Now suppose that the borrower of the loan deposits it into a checking account, then the bank’s total liabilities will rise again by the amount of the loan. On the asset side of the balance sheet, the bank keeps a fraction of the additional deposit as reserves and lends out the rest. The money supply increases again because the new loan adds to the amount of currency. To learn more on this topic, read page 549 in Mankiw (2010) where an example of this process is described. (c) Financial Intermediation The process whereby financial institutions connect savers who have funds to lend and borrowers who need funds to borrow is called financial intermediation. Many financial institutions have this function but only commercial banks use this process and add to the money supply. A Model of the Money Supply The money supply is influenced by the monetary base B which is the sum of currency C, bank reserves R, reserve-deposit ratio ?? which is the fraction of deposits that banks are required to keep as reserves, and currency-deposit ratio ?? which is the fraction of deposits that consumers hold as currency. Using the expressions for the money supply and the monetary base, we can write the money supply as a function of these three factors: ? = ?? + 1 ?? + ?? x? = ?x? Note that ? is the money multiplier because it allows the economy to create a money supply that is larger than the monetary base. The money multiplier is greater than 1 by definition. Since each unit of the monetary base allows for several units of the money supply, the monetary base is referred to as high powered money. An increase in the monetary base, a decrease in the reserve-deposit ratio, and a decrease in the currency to deposit ratio all lead to an increase in the money supply ECON 2003 Intermediate Macroeconomics II _Unit 6_20170907_v1 90 The Three Instruments of Monetary Policy The central bank or equivalent institution in a country can change the money supply indirectly by changing the monetary base or the required reserve ratio using the three instruments of monetary policy. These are open-market operations, reserve requirements, and the discount rate. (a) Open-Market Operations This is the most used tool of many central banks and involves the purchase or sale of assets to the public. Purchases increase the monetary base and the money supply while sales of assets decrease the money supply and the monetary base. (b) Reserve Requirements This is the least used monetary policy tool of many central banks. As alluded to in the discussion of fractional reserve banking, the required reserve ratio is the minimum proportion of deposits that banks are required to keep as reserves. If the central bank increases this ratio, the money supply falls but if the ratio is lowered, banks are required to keep less reserves on hand and so they can make more loans which increases the money supply. (c) The Discount Rate One of the functions of the central bank is to be a lender of last resort so that if commercial banks have insufficient reserves, they can borrow funds quickly. When banks borrow from the central bank, they are charged the discount rate. The cheaper the discount rate, the lower the cost of borrowing funds and the more likely that banks will lend to the public. A decrease in the discount rate encourages more borrowing from the central bank and increases the monetary base and the money supply. By contrast, an increase in the discount rate reduces banks’ willingness to lend and hence reduces the money supply. Bank Capital, Leverage, and Capital Requirements The discussion so far ignores the fact that banks need bank capital to begin operations, much of which is often borrowed. The banks use some of the borrowed money to finance investments which is