I. Introduction
A. Objectives
1. Understand the Structure of the US Central bank
2. Describe the tools used by central banks to influence the money supply and interest rates
3. Understand how open market operations work.
4. Understand how open market operations change the money supply.
5. Understand what determines the demand for money
6. Explain how financial innovations can affect the demand for money.
7. Understand how interest rates are determined.
8. Understand how central banks influence interest rates.
B. Outline of the Lecture
1. Descriptions of the central banks of the US and UK
2. Methods used by the central bank to control the money supply
3. The demand for money as a way of holding wealth
4. How the interest rate is determined.
II. The U.S. Federal Reserve System
A. A central bank is the public authority in charge of:
1 controlling and regulation the nation's money supply
2. and controlling the nation's financial markets.
B. The Federal Reserve or "Fed" is the central bank of the US.
1. It is generally called "the Fed"
2. It was created by Congress in 1913.
a. Much resistance to a central bank in US
b. Charters of first and second US central banks not renewed
c. Fed created in response to financial panic of 1907.
i. Created complex structure to disperse economic power
B. The Bank of England is the central bank in the UK
1. It is generally called "the Bank"
2. It was founded in 1694
3. Originally a private bank
a. Nationalized after WW II
C. The State Bank of Vietnam is the Central Bank of Vietnam
1. Supervises Banks
2. Provides interprovince check clearing services
3. Sets bank reserve requirements
B. The Fed is in charge of the US monetary policy,
1. Monetary policy is the attempt to control inflation and smooth the business cycle by:
a. changing the quantity of money (M) in circulation and
b. adjusting interest rates (r).
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A. There are three key elements in the Fed:
1. the Board of Governors,
2. the Regional Federal Reserve Banks, and
3. the Federal Open Market Committee.
B. The Board of Governors is the ruling body of the Fed.
1. It is comprised of seven members
a. appointed by the President and
b. confirmed by the Senate.
2. The terms are for 14 years
a. and they overlap so that
b. one position comes vacant every 2 years.
c. Purpose is to make Board of Governors independent of the President and Congress
i. Fed is almost a fully independent branch of government.
ii. Not elected - can't be reappointed.
3. One member is appointed by the President to a four year term as Chairman.
a. Can be reappointed
b. Gives president and congress some influence over the Fed.
4. Fed also has an independent source of income.
a. Does not depend on President or Congress for appropriations.
5. Result is that Fed is very independent of the government.
a. Independence limited by:
i. recognition that Congress could change structure of Fed.
ii. President could refuse to reappoint Chairman to an additional 4 year term.
b. Fed and government generally compromise with each other
c. rarely have open disagreements
C. There are 12 Federal Reserve Regional Banks
1. They participate in making monetary policy
2. They do research on regional economic problems.
D. The Federal Open Market Committee (FOMC) is the major policy making group in the Federal Reserve System.
1. The FOMC consists of:
a.The members of the Board of Governors,
b. The president of the Federal Reserve Bank of New York, and,
c. Four presidents of the other Federal Reserve Banks.
2. The FOMC meets monthly to formulate monetary policy.
a. results of meetings widely published
E. The Chairman of the Board of Governors
1. tends to dominate meetings of the FOMC
2. Controls research staff of Fed
3. Has great economic power of persuasion
1. With Board of Governors
2. with Congress
3. with the President
4. with financial market participants
5. With the general public
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A. Congress gave the Fed six explicit functions
1. Conducting monetary policy
2. Supervising the banks and other financial institutions
3. Serving as a lender of last resort to financial institutions
4. Providing banking services to the government
5. issuing currency (paper money)
6. Providing financial services to banks and other financial institutions.
C. The functions of the State Bank of Vietnam (SBV) include:
1. Supervise Banks
2. Provide interprovince check clearing services
3. Set bank reserve requirements
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(b 24-2)
A. The Fed has three policy tools to carry out its monetary policy:
1. required reserve ratios, (RRR)
2. the discount rate, and
3. open market operations (OMOs).
B. These are the same policy tools used by the Bank of England
C. The Fed sets required reserve ratios, (RRR)
1. Required reserve ratios (RRR) are:
a. the minimum percentages of deposits (DD)
b. that depository institutions must hold as required reserves (RR).
2. There is a different RRR for each type of deposit
a. The required reserve ratio (RRR) is actually a weighted average for the various types of deposits
3. By increasing the RRR, the Fed can create a shortage of reserves in the banking system.
a. The Fed can converts excess reserves (ER) into required reserves (RR) by increasing the RRR
4. This will force banks to call in loans and reduce the nominal money supply (M)
5. The required reserve ratio (RRR)
a. Determines the size of the simple money multiplier (SMM)
SMM = 1 / RRR
b. Influences the size of the actual money multiplier (AMM).
AMM = (CDR + 1) / (CDR + RRR)
5. The Fed does not change these ratios very often.
a. Too powerful a tool
b. Even small changes in RRR are quite disruptive
6. The reserve requirements act like a tax on the banks
a. It forces them to hold a higher fraction of their assets as reserves (RR) and thus
b. a smaller fraction of their assets as loans.
c. They are very unpopular with banks
7. The State bank of Vietnam (SBV) imposes a 10% reserve ratio on all deposits
a. State Bank of Vietnam (SBV) also recommends an additional 20% of deposits be held at SBV
b. This amounts to a high tax on the banks since they cannot lend out these reserves.
C. The discount rate (DR) is:
1. the interest rate the central bank charges commercial banks
2. when banks borrow reserves from it.
3. A higher discount rate (DR) would discourage banks from borrowing reserves from the Fed.
4. Increasing the discount rate (DR) makes it more costly to borrow reserves from the Fed
a. This encourages banks to keep larger reserves (AR)
b. and thereby reduces the money supply (M).
5. Banks in the US rarely borrow from the Fed
a. Fed discourages it
b. Banks borrow reserves from each other.
i. Federal Funds market
ii. Federal Funds interest rate is market determined by supply and demand
b. Changing the discount rate (DR) is symbolic.
c. It has an "announcement effect".
i. Businessmen tend to postpone investment if they think that the Fed is going to reduce the nominal money supply (M) and cut real GDP (Y).
ii. If bond traders think interest rates are going down, they will try to buy existing bonds.
iii. Bond prices will rise and the real rate of interest (r) on those bonds will fall.
B. Open market operations are:
1. the sale or purchase of government securities by the central bank.
2. the Fed buys and sells Treasury bonds and bills
a. Fed buys from commercial banks and
b. Private traders
2. When the Fed buys, it pays for them with reserves (AR).
a. Banks get an increase in their deposit at the Fed.
b. Private traders get checks drawn on the Federal Reserve Bank of New York.
3. If Fed buys government bonds from commercial banks, it will pay for them by increasing the banks deposit at the Fed.
a. This adds to banks' excess reserves (ER) and
b. allows them to make loans and thus
c. increase the nominal money supply (M)
3. When Fed sells government bonds to the banks, it collects by reducing the commercial bank's deposit at the Fed.
a. This reduces the banks' excess reserves (ER) and
b. The banks reduce their loans and thus
c. reduce the supply of nominal money (M).
4. When the Fed buys bonds from a private bond dealer.
a. The Fed pays with a check drawn on itself.
b. the bond dealer deposits the check in a commercial bank.
c. the commercial bank presents the check to the Fed for payment.
d. the Fed pays the commercial bank by increasing its deposit at the Fed.
i. This adds to banks' excess reserves (ER) and
ii. allows them to make loans and thus
iii. increase the nominal money supply (M)
5. The opposite process occurs if the Fed sells bonds to a private bond dealer.
a. The Fed receives a check drawn on a commercial bank.
b. Fed presents the check to the commercial bank for payment.
d. the Fed collects from the commercial bank by decreasing its deposit at the Fed.
i. This reduces the banks' excess reserves (ER) and
ii. forces them to call in loans and thus
iii. decrease the nominal money supply (M)
6. Open market operations are by far the most important tool of monetary control for:
a. The US Fed and
b. the Bank of England.
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A. The Fed's balance sheet can be shown as a T account
1. The assets on the left are what the Fed owns and
2. The liabilities on the right are what the fed owes.
B. the largest and most important asset is:
1. U.S. government securities.
2. Fed also has deposits in foreign central banks
i. Allows it to affect exchange rates
C. The most important liabilities are:
1. Federal Reserve notes in circulation (outside the Fed)
a. US paper money is nonconvertible fiat money
issued by the Fed.
i. Called "Federal Reserve Notes".
ii. Technically a debt of the Fed
b. Federal reserve note is like goldsmith's receipt
i. But this goldsmith will not give you gold.
ii. Just another receipt. (Federal Reserve note)
c. Federal reserve notes have no intrinsic value
i. They are not a promise to pay anything worthwhile.
2. Deposits at the Fed by commercial banks.
a. These are assets of the commercial banks
b. These are the most important liabilities
i. from the point of view of the nominal money supply (M)
c. They are the actual reserves (AR) of the commercial banks
3. Deposits of the US government
4. Deposits of foreign central banks
a. This allows central banks to trade currencies
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A. The monetary base (MB) is:
1. The actual of the banking system and
2. The potential reserves of the banking system.
B. In the US, the monetary base (MB) is defined as the sum of
1. bank deposits at the Fed plus
2. Federal Reserve notes outside the Fed and
3. coins issued by the US Treasury
C. In the UK, the monetary base is defined as:
1. the quantity of Bank of England notes and coins outside the Bank of England.
a. Includes notes and coins in circulation (outside the banks) and
b. The commercial banks cash reserves
B. The monetary base (MB) is the support of the nominal money supply (M).
C. The nominal money supply (M) is determined by:
1. The size of the monetary base (MB)
2. The size of the actual money multiplier (AMM)
D. By buying and selling securities, (Open market operations) the central bank can alter the size of the monetary base (MB).
1. By altering the size of the monetary base (M), the central bank can alter the size of the nominal money supply (M).
III. Controlling the money supply
A. In the US and the UK, the size of the nominal money supply (M) is determined by the actions of the central bank.
B. Those actions include:
1. Open Market Operations
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A. When the central bank conducts an open market operation by buying a government security,
1. It increases banks' reserves (AR).
a. Hence banks excess reserves (ER).
2. Banks loan the excess reserves (ER).
3. By making loans banks create nominal money (M).
B. When the central bank sells securities
1. It decreases the actual reserves (AR) and excess reserves (ER) of the banking system.
a. Banks are temporarily below the legally required reserve ratio (RRR).
2. Banks call in loans.
3. By calling in loans banks reduce the supply of nominal money (M).
a. Borrowers give checks to the banks
b. their demand deposits (DD) are reduced.
C. When the central bank buys securities, it may buy them from:
1. The commercial banks
2. Securities dealers
C. When the central bank buys from the commercial banks,
1. The central bank increases the commercial banks' deposits at the central bank.
2. The composition of the commercial bank's assets change
a. Securities decline
b. Deposits at central bank increase
2. This gives the commercial banks excess reserves (ER)
3. They lend out these excess reserves (ER)
a. thus increasing the nominal money supply (M).
b. usually in the form of increased demand deposits (DD) at the commercial banks
4. As demand deposits (DD) at commercial banks increase,
a. Excess reserves (ER) are converted into required reserves (RR).
DELTA RR = DELTA DD * RRR
D. When the central bank buys from securities dealers,
1. The Fed pays by giving checks drawn on itself to the securities dealers.
2. The securities dealers deposit the checks in the commercial banks.
3. The commercial banks deposit the checks in the central bank.
3. This increases their deposits at the central bank (AR) and (ER).
4. Commercial bank's liabilities change
a. Security dealer's deposits increase
5. Commercial bank's assets change
a. Deposits at central bank increase
6. This gives the commercial banks excess reserves (ER)
7. They lend out these reserves thus increasing the nominal money (M) supply.
8. As deposits (DD) at commercial banks increase, excess reserves (ER) are converted into required reserves (RR).
9. The money expansion process until:
a. all the new reserves are converted into currency outside the banks (CC) or
b. required reserves (RR)
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A. In the US, the monetary base is the sum of:
1. Federal reserve notes,
2. coins issued by the US Treasury and
3. commercial bank deposits at the Fed.
B. When the monetary base (MB) increases,
1. both actual reserves (AR) and
2. currency in circulation (CC) increase.
C. Only the increase in bank reserves (AR) can be used by the banks to create money.
D. The actual money multiplier (AMM) is:
1. the amount by which a change in the monetary base (MB) is multiplied to calculate
2. the final change in the money supply (M).
M = MB * AMM
DELTA M = DELTA MB * AMM
C. The "actual money multiplier" (AMM) differs from the "simple money multiplier" (SMM) because
1. The simple multiplier (SMM) shows:
a. how much a change in reserves (AR) affects:
b. the quantity of bank deposits (DD) while
2. The actual money multiplier (AMM) shows:
a. how much a change in the monetary base (MB)
b. affects the nominal money supply (M).
D. An increase in nominal money held outside the banks is called a "currency drain".
1. A currency drain occurs when people hold currency rather than depositing it in banks.
2. A currency drain reduces:
a. the amount of banks' reserves (AR),
b. Thus the amount banks can loan and
c. Thus the actual money multiplier (AMM).
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A. Assume central bank buys securities from the banks
1. The banks gain excess reserves (ER)
2. the banks lend the excess reserves (ER)
3. Borrowers use loans to make payments
4. Recipients of payments:
a. hold part as currency (CC)
b. Deposit part of receipts in a bank (DD)
5. Banks actual reserves (AR) increase by amount of the deposits.
DELTA AR = DELTA D
a. Required reserves (RR) increase by a fraction of the increase in deposits (deposit (DD) times required reserve ratio (RRR)
DELTA RR = DELTA DD * RRR
b. The RRR is less than one so:
i. the increase in required reserves (RR) is less than the increase in actual reserves (AR)
ii. hence excess reserves (ER) increase
DELTA RR = DELTA AR * (1 - RRR) < DELTA AR
DELTA ER = DELTA D - DELTA RR
= DELTA D - DELTA D * RRR
= DELTA D * (1 - RRR)
6 The quantity of nominal money (M) increases by:
a. the amount of the currency (CC) drain plus
b. the increase in bank deposits (DD)
DELTA M = DELTA CC + DELTA DD
7. The process continues until excess reserves (ER) are eliminated
ER = 0
a. All reserves are required reserves (RR)
AR = RR
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A. By Definition
AMM = DELTA M / DELTA MB
B. Also by definition:
M = DD + CC
MB = AR + CC
B. Hence
DELTA M = DELTA DD + DELTA CC
DELTA MB = DELTA AR + DELTA C
C. By substitution
AMM = DELTA M = DELTA D + DELTA C
DELTA MB DELTA AR + DELTA C
D. Divide numerator and denominator by DELTA D
AMM = DELTA D/ DELTA D + DELTA C/DELTA D
DELTA AR/ DELTA D + DELTA C/DELTA D
E. Let
RRR = DELTA AR / DELTA D
F. Define the Desired currency ratio = DCR = DELTA C/DELTA D
F. Hence:
AMM = 1 + DCR / RRR + DCR
G. The actual money multiplier (AMM) would be reduced by:
a. Increases in the required reserve ratio (RRR)
b. and the ratio of the public's currency holdings to bank deposits (DCR).
i. As the desired currency ratio (DCR) increases,
ii. the AMM falls toward 1.
H. AMM is less than SMM if RRR is less than 1. Which it is .
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ The above duplicates a part of lecture 9. Remove it from 9.
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A. The actual money multiplier (AMM) for M1 in the US was
1. 2.9 in 1991.
2. 2.5 on average between 1960 and 1991.
B. For the period 1960 - 1991
1. RRR averaged .10 or 10% of demand deposits
2. DCR averaged .50 or 50% of demand deposits
C. Substituting in actual money multiplier formula
AMM = (1 + DCR)/ (RRR + DCR)
= (1 + .5)/ (.1 + .5) = 1.5 / .6 = 2.5
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A. A change in the required reserve ratio (RRR) will:
1. alter excess reserves (ER) and
2. change the actual money multiplier (AMM)
AMM = (1 + DCR) / (RRR + DCR)
3. An increase in the RRR will:
a. lower excess reserves (ER) and
b. lower the money multiplier (AMM)
4. An decrease in the RRR will:
a. increase excess reserves (ER) and
b. increase the money multiplier (AMM)
B. A change in the discount rate (DR) has no direct effect on the nominal money supply (MN).
1. Theoretically an increase in the discount rate could discourage the banks from borrowing reserves from the central bank.
2. It could also encourage them to increase their reserve ratios (RRR)
a. So they would not be forced to borrow from the Fed.
b. thus reducing the actual money multiplier (AMM)
IV. The Demand for Money
(B 24-4)
A. The purpose of the central bank in controlling the nominal money supply (M) is:
1. to affect the rate of interest (r) in order to
2. affect output (Y), employment and prices (P)
B. The effect of changes in the nominal supply of money (M) will depend on
1. The price level (P) and
2. the nature of the demand for money (LL).
C. We will begin by assuming that the price level (P) is constant
1. There is a zero inflation rate (INFRTE)
INFRTE = 0
2. so that a change in the nominal money supply (M) is equal to a change in the real money supply (L)
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A. People have a choice in how they hold their wealth,
B. they could hold their wealth in the form of:
1. Goods (e.g. houses, gold) or
2. Interest bearing financial assets (e.g government bonds) or
3. Non-interest bearing financial assets (money)
B. Why do they chose to hold some of their wealth in the form of money?
1. Why do they demand liquidity?
C. There is no limit to the flow of income (Y) people want.
1. There is a limit to the stock of real money (L) that wish to keep on hand.
2. They want to hold their wealth in other kinds of assets as well.
D. People have three reasons for demanding money (L) (that is being willing to sacrifice interest earnings in order to hold some of their wealth in the form of money (L):
1. the transactions motive,
2. the precautionary motive,
3. and the speculative motive.
E. The transactions motive refers to the fact that:
1. people want money (L) to help consummate purchases and sales.
2. Money is very convenient for buying and selling things.
a. Most other assets not acceptable
b. Minimizes your time spent on sales of other assets to get money
i. Sometimes sales of other assets have high transactions costs.
(brokerage fees)
c. Firms need money to pay for inputs
i. In US, most of the nominal money supply (M) is held by firms for transactions purposes.
2. The transactions demand reflects the fact that payments and receipts are not perfectly synchronized.
3. The amount of nominal money (M) we keep for transactions purposes depends on:
a. the number of things we buy (Y) and
b. their average price (P).
4. So the transactions demand is a demand for real money balances (L)
a. real money balances (L) are:
i. nominal money balances (M)
ii. deflated by the price level (P).
L = (M / P).
c. If the price level (P) is constant,
i. a change in nominal money balances (M) is equivalent to
ii. a change in real money balances (L)
% DELTA L = % DELTA M
F. The precautionary motive for demanding money refers to:
1. the fact that money (L) is held as a reserve against unexpected events that require unplanned purchases;
2. The precautionary motive is due to uncertainty in the timing of payments and receipts.
3. Money is needed immediately if you:
a. see a bargain, or
b. have an emergency (eg car breakdown)
4. Often a line of credit (credit cards) will satisfy this motive
G. The speculative motive refers to the fact that:
1. Some people hold money to avoid losses from holding stocks and bonds that are expected to fall in price.
a. They are temporarily sitting on the sidelines
b. Waiting for bond prices to fall and
c. interest rates to rise.
2. If interest rates (r) are very low,
a. bond prices are very high
2. If bond prices are high
a. You may wish to sell your bonds or.
b. Hold on to money until bond prices come down (interest rates (r) rise)
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A. There are three important influences on the quantity of nominal money (M) people chose to hold. They are:
1. The price level (P),
2. The level of real GDP (Y),and
3. The interest rate (r)
B. The Price Level (P)
1. The nominal money supply (M) is the amount of money measured in current units e.g. (dong) (dollars).
a. The quantity of nominal money (M) demanded is proportional to the price level (P)
i. e.g. A 10 % increase in the price level (P) raises the quantity of nominal money (M) demanded by 10 %.
2. This implies that the amount of real money (L) does not change as price levels (P) change
3. The quantity of money measured in units of constant purchasing power (constant dong or dollars) is called "real money" (L)
a. The supply of real money (L) is equal to the supply of nominal money (M) divided by the price level (P).
L = M / P
2. The quantity of real money demanded (L) is independent of the price level (P).
3. For any given supply of nominal money (M):
a. A rising price level (P) reduces the supply of real money (L).
C. The real GDP (Y)
1. The higher real GDP (Y),
a. the more transactions take place.
2. Therefore, an increase in real GDP (Y)
b. raises the transactions demand for real money (L).
3. Real GDP (Y) is a good proxy for the total real value of the transactions that people undertake.
a. Thus the transactions demand for money will increase
i. if real GDP (Y) increases.
D. The interest rate
1. The nominal interest rate (rn) is the opportunity cost of:
a. holding wealth in the form of money (L) rather than
b. an interest-bearing asset.
i. e.g. a bond
2. Therefore, an increase in the nominal interest rate (rn)
a. increases the opportunity cost of holding wealth in the form of money (M) and
b. reduces the aggregate quantity of real money demanded (L).
3. As nominal interest rates (rn) rise,
a. interest earning assets (e.g. bonds) are substituted for money (L) in individual portfolios.
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(B pp. 414 - 416)
A. The demand for real money (LL) is "the relationship between:
1. the quantity of real money demanded (L) and
2. the nominal interest rate (rn),
3. holding constant all other influences."
LL = f (rn)
B. The demand for real money relationship (LL) can be shown as:
1. an equation,
2. a schedule or
3. a curve on a graph.
C. Note that the quantity of real money (L) demanded is determined by the nominal interest rate (rn),
1. not the real interest rate (rr) because
2. inflation reduces the real return on bonds at the same rate that it reduces the real return on money.
3. It does not effect the difference between the real rate of return on bonds and the real rate of return on money.
a. The real return on bonds is rn - INFRTE
b. The real return on money is 0 - INFRTE
c. The difference is rn - 0 or rn
3. Hence, the nominal rate of interest (rn) is the opportunity cost of holding wealth in the form of money instead of bonds.
4. For now we will assume that the real interest rate (r) and the nominal interest rate (rn) are the same.
r = rn
D. The demand for money curve (LL) will have a negative slope.
1. The negative slope of the demand curve (LL) reflects the role of the nominal interest rate (rn) as the opportunity cost of holding assets in the form of money (L).
a. The higher the nominal interest rate (rn),
i. the more expensive it is to hold your wealth in the form of money (L).
b. A change in the nominal interest rate (rn) causes a movement along the demand for real money balances curve (LL).
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A. The demand curve for real balances (LL) shifts if:
1. real GDP (Y) changes or
2. financial innovation occurs.
B. An increase in real GDP (Y) increase in the transactions and precautionary demands for real money balances (L)
1. and shifts the demand curve for real balances (LL) to the right.
C. Financial innovation reduces the cost of switching between money balances (L) and interest-bearing assets
1. This reduces the transactions and precautionary demand for real money (L)
2. and shifts the demand curve (LL) to the left.
3. An example is development of liquid non-money deposits
a. NOW and ATS deposits
i. Computers make it easy to calculate daily interest on NOW and ATS accounts,
ii. thus allowing checking on those deposits.
b. Computers make credit card purchases possible.
i. Charge through the month and pay at the end of the month.
i. Lowers transaction demand
ii. Lowers precautionary demand
a Automatic teller machines induce people to hold less cash (CC) and more demand deposits (DD).
i. Changes the form of money demanded, not the amount demanded.
ii. Can effect the supply of money (MN) by changing:
the desired currency ratio (DCR) and thus
the actual money multiplier (AMM)
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A. We can measure the sensitivity of the demand for real money (LL) to changes in nominal interest rates (rn) by looking at:
1. how changes in interest rates (rn) effect
2. velocity (V).
B. The velocity of circulation (V) is defined as:
1. the nominal GDP (P*Y) divided by
2. the nominal money supply (M)
V = P*Y / M
B. This is equivalent to defining velocity (V) as the real GDP (Y) divided by the real money supply (L = M/P)
V = Y / (M/P) = Y / L
C. So if an increase in the interest rate (rn) reduces the quantity of real money (L = M/P) demanded,
1. The Y / L ratio will increase and thus
2. Velocity (V) should increase.
D. Did this happen when interest rates increased in the US?
E. The econometric results depend on the measure of the money supply (M) used
1. Let V1 refer to the velocity of M1
2. Let V2 refer to the velocity of M2
E. V2 varies more closely with interest rates than V1
1. V1 was steadily increasing as financial innovation reduced the demand for a medium of exchange (C and D)
a. V1 is very loosely correlated with interest rates
b. The LL curve is constantly shifting
c. This means interest rates did not effect the demand for M1
2. V2 very closely tracks interest rates.
a. Very close relationship but
b. Very little variation in V2
c. This means that even very large percentage changes in interest rates (rn) result in
i. only small percentage changes in V2.
% DELTA rn > % DELTA V2
d. This means the demand curve for money (LL) is very insensitive to changes in interest rates.
i. it is "interest inelastic".
ii. (nearly vertical)
e. To restore equilibrium after a change in the demand for real balances (LL),
i. it will take a very large change in nominal interest rates (rn)
e. The demand for real money balance (LL) is interest inelastic because:
i. many items in M2 already pay interest.
ii. When interest rates on bonds increase, the interest rates on M2 accounts also increase.
V. Interest Rate Determination
A. An interest rate is the "percentage yield on a financial security such as a bond or a stock."
1. It will depend on the price of bonds
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A. There is an inverse relationship between:
1. the price of a bond and
2. the nominal interest rate (rn):
B. As the nominal interest rate (rn) rises,
1. the price of the bond decreases.
C. Take example of a perpetuity ,
1. A perpetuity is a bond that promises to pay a fixed amount every year forever.
a. (You never get the principal back.)
b. The fixed amount each year is called "the coupon"
2. In the case of the perpetuity
a. the nominal interest rate (rn) is:
i. the coupon divided by
ii. the price of the bond times 100.
rn = (coupon / price of the bond) * 100
3. There is an inverse relationship between the nominal interest rate (rn) and the price of the perpetuity.
a. As the price of the perpetuity rises,
i. its nominal interest rate (rn) falls.
ii. Though its coupon payment remains the same
D. As nominal interest rates (rn) fall,
1. the price of outstanding bonds rises.
2. Though their coupon payments remain the same
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A. The nominal interest rate (rn) is determined at each point in time by the equilibrium in the market for financial assets (the money market).
1. The real money supply (L) is a stock.
2. The supply can be graphed as a vertical line.
B. Equilibrium in the money market is a stock equilibrium,
1. that is, a situation where the entire stock of money (L) is willingly held.
1. The money market is in equilibrium when the quantity of real balances demanded (LL) equals the quantity supplied (L).
a. Where the demand for real money balances curve (LL) crosses the vertical supply of real money balances (L) curve.
2. Equilibrium in the goods market is a flow equilibrium,
a. that is, a situation where the quantity of goods or services supplied over some time period is willingly purchased.
C. At any given moment there is a price level (P) and a nominal money supply (M) determined by the central bank which produces a fixed level of the real money stock (L).
1. L supplied = a constant = L0
2. L demanded = (LL) = a function of the nominal interest rate (rn)
3. In equilibrium :
a. L supplied = L demanded = L0
b. The nominal interest rate (rn) must adjust to produce equality
D. If the nominal interest rate (rn) initially exceeds the equilibrium interest rate (rn0),
1. people demand less money than exists.
LL < L
1. Thus, they try to get rid of their "excess" money by buying bonds.
2. As the demand for bonds increases, the price of bonds increases.
3. This drives down the interest rate (rn) paid on bonds,
4. thereby restoring the nominal interest rate (rn) to its equilibrium level.
E. If the nominal interest rate (rn) initially is below the equilibrium interest rate, people demand more money than exists.
LL > L
1. Thus, they try to get more real money balances (L) by selling bonds.
2. As the supply of bonds increases, the price of bonds decreases.
3. This drives up the interest rate (rn) paid on bonds,
4. thereby restoring the interest rate (rn) to its equilibrium level.
F. When people try to hold more or less money,
1. They will not change the stock of real money (L),
2. They will change the opportunity cost of money, the nominal interest rate (rn) on bonds.
G. Since financial wealth is equal to the supply of bonds plus the supply of money (L)
1. S of Bonds + S of Money = D for Bonds + D for Money
2 S of Bonds - D for Bonds = D for Money - S for Money
3. Hence an excess supply of bonds is equal to the excess demand for money and vice versa.
4. The money market is in equilibrium, only when
a. the bond market is in equilibrium.
D of Bonds = S of Bonds
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A Interest rates (r) can change as a result of:
1. changes in the supply of money (L)
2. Changes in the demand for money (LL)
B. If the central bank reduces the supply of nominal money (M), and prices (P) do not change,
1. the money supply curve (L) shifts to the left.
2. As a result, the nominal interest rate (rn) rises.
3. The sequence of events is as follows:
a. People have an unsatisfied demand for real money balances (L).
D for money > S of money
i. They try to sell bonds.
ii. Bond prices fall.
iii. Nominal interest rates (rn) rise toward new equilibrium.
2. If the central bank increases the supply of nominal money (M),
a. People have an excess supply of money
b. the interest rate (rn) falls.
c. The sequence is the same as before
d. People have a excess supply of real money balances (L).
D for money < S of money
i. They try to buy bonds.
ii. Bond prices rise.
iii. Nominal interest rates (rn) fall toward new equilibrium.
C. If real GDP (Y) increased, that will increase:
1. the transactions and for money
2. the precautionary demand for money
3. The LL curve will shift to the right.
i. People will try to sell bonds to get more real money balances (L).
ii. Bond prices will fall
iii. Nominal interest rates (rn) will rise until the new equilibrium is reached.
C. Thus the nominal rate of interest (rn) can be determined by the money supply (L) and the demand for real balances (LL)
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A. On two occasions in the 1980s, the US Federal Reserve System dramatically altered nominal interest rates (rn)
1. by changing the nominal money supply (M)
B. In the early 1980s,
1. US was suffering high rate of inflation
2. The Fed slowed the growth rate of the nominal money supply (M)
3. Nominal interest rates (rn) rose dramatically.
C. In 1987 the prices of US Securities fell dramatically.
1. In effect, nominal interest rates (rn) had risen
2. The Fed increased the nominal money supply (M)
i. The public used some of the money (M) to try to buy securities.
ii. The demand for securities rose, so securities prices rose.
iii. The nominal interest rates (rn) returned to normal levels.
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A. Since central bank monetary policy changes nominal interest rates (rn), it changes bond prices:
1. People try to predict the central bank's actions because:
a. correct predictions allow profits to be made by burying or selling bonds.
2. If the central bank's actions can be predicted,
a. bond prices--and nominal interest rates (rn) -- will already have changed by the time the central bank carries out its actions.
3. If you think nominal interest rates (rn) will fall,
a. you think bond prices will rise.
i. So buy bonds
b. The increased demand for bonds will drive up bond prices
c. Hence nominal interest rates (rn) really will fall
i. ( A self-fulfilling prophecy).
X Summary of the lecture
Key Concepts
1. Central bank (Ngan Hang trung uong)
2. Currency drain
3. Demand for real money (LL)
4. Discount rate (DR) (Ti suat chiet khau)
5. Federal Open Market Committee
6. Flow equilibrium
7. Monetary base (MB)
8. Monetary policy
9. Actual Money multiplier (AMM)
10. Nominal money (M)
11. Nominal money balances (M) (Luong tien danh ngia)
11. Nominal interest rate (rn)
10. Nonconvertible note
11. Open market operations (OMO) (Nhung ngiep vu thi truong tu do)
12. Perpetuity
15. Real interest rates (r)
16. Real money supply (L)
17. Real money balances (Luong tien)
13. Stock equilibrium
Questions for review
1. What are the three main elements in the structure of the US Federal Reserve System?
2. What are the three main tools of monetary policy?
3. If the central bank wants to reduce the money supply, what actions should it take?
4. What will occur if banks have excess reserves?
5. What determines the size of the actual money multiplier((AMM)?
6. What determines the demand for real money (L)?
7. What happens to the interest rate on a bond, if its price falls?
8. Why do nominal interest rates (rn) fall if the real money supply (L) increases?