I. Introduction
A. Objectives
1. Define money and its functions
2. Describe different forms of money
3. Understand how money is measured
4. Understand the balance sheets of financial intermediaries
5. Describe how banks create money
6. Understand the quantity theory of money
B. Outline of the lecture
1. What is money?
2. The role of financial intermediaries.
3. How banks create money
4. The links between the money supply, real GDP and the price level.
II. What Is Money?
(B 23-1)
A. Money is anything that is generally acceptable as a means of payment for goods and services.
******************************************************************
A. Money has four functions. It serves as a:
1. medium of exchange,
2. unit of account,
3. store of value, and
4. standard of deferred payment.
B. As a medium of exchange, money is accepted in exchange for goods and services.
1. In the absence of money, people would need to exchange goods and services directly, which is called barter.
2. Barter requires a double coincidence of wants, where each person has what the other person wants.
a. This is rare and so barter would be costly.
b. Money reduces transactions costs
c. Transactions costs include:
i. Finding a partner with a coincidence of wants
ii. Transporting and storing the trade goods.
c. Money guarantees that there will always be a double coincidence of wants.
i. Everyone is willing to accept money in a market society.
(In a command society or a traditional society, money may not be very useful.)
d. Money promotes exchange
i. by reducing transactions costs
e. Exchange promotes specialization
i. By guaranteeing a market
f. Specialization promotes economies of scale
i. Adam Smith and the pin makers
ii. Learning a simple skill
iii. less time setting up tools etc.
iv. increased possibility of mechanization
d. Money will remain acceptable as a means of exchange only if
i. people believe its quantity is being controlled
ii. Price is the rationing device to allocate scarce goods and services.
iii. It is available in convenient denominations.
e.g. 10,000 dong unit may be too small for many transactions. (inconvenient)
2. Money serves as a unit of account,
a. A Unit of account is a generally acceptable measure for stating the prices of goods and services.
i. Otherwise would have to post many price pairs
a. 2 goods = 1 price
b. 3 goods = 3 prices
c. 4 goods = 6 prices
d. 5 goods = 11 prices
ii. If you know the money price of two goods, you can calculate their trading ratio. (price)
a. Good A = $6
b. Good B = $2
c. Good A = 3 * Good B
ii. Unit of account need not be medium of exchange.
a. Beriozka shop in Moscow
b. Prices in rubles
c. had to pay in dollars
iii. Money will only be a good unit of account if its value doesn't change too rapidly.
3. Money is a store of value (wealth)
a. It can be held for a time and later exchanged for goods and services.
b. If money were not a store of value it could not serve as a medium of exchange.
c. It is generally cheaper and more convenient to store money than goods. (Can't store services)
i. Pigs (must feed them)
ii. gold (may be good store of value)
d. Problem is that the value of money fluctuates.
4. Money is a standard of deferred payment,
a. money is used in contracts as a measure for specifying future receipts and payments.
b. Contracts that call for a certain amount of money suffer from the risk of unanticipated inflation
c. If inflation is anticipated, then borrowers and lenders can adjust the interest rate.
d. Standard of deferred payment need not be the medium of exchange.
i. Contracts may be written in terms of a foreign currency (e.g. dollars)
e. The international debt of Viet Nam
i. Some in dollars
ii. some in transferrable rubles
II. Forms of Money
(B 23-2)
A. Money can take three forms:
1. commodity money,
2. token money and
3. private debt money.
*****************************************************************
A. Commodity money is:
1. anything that is valued for its own right and
2. also used as a means of payment.
B. An example is gold and silver
1. The advantages of precious metals are:
a. Because they are valued for their own sake, their value as money is easily known.
i. Gold quality easily verified
ii. Gold in limited supply -valuable -easily transported -easily divided
2. The disadvantages of precious metals are:
a. Value of gold coins was reduced by:
i. clipping from edges of coins
ii. "Debasing" or issuing coins with lower gold or silver content than existing coins
C. Gresham's Law states that bad money (debased coins) drives good money out of circulation.
1. People would save good coins and spend bad ones.
D. Commodity money has an opportunity cost because:
1. the commodity could be used for something else.
a. e.g. gold for:
i. jewelry
ii. dentistry
iii. electronic circuits
****************************************************************
A. Token money is:
1. a means of payment whose value as money greatly exceeds:
a. its cost of production or
b. its value in any other use except money
B. Among the types of token money are :
1. Convertible paper money and
2. Fiat money
C. Convertible paper money is circulating paper money that can be exchanged for or "converted into" a commodity.
1. example is goldsmith receipts
a. Receipt can be redeemed or transferred
b. Receipts are redeemable or "backed by gold"
c. "Fractional backing" refers to a situation where:
i. the amount of circulating paper money exceeds
ii. the stock of the commodity that backs it.
d. The goldsmiths:
i. lent out some of the gold on deposit
ii. gave gold receipts to borrowers
e. So goldsmiths could not have redeemed all outstanding receipts
i. They counted on fact that only a small fraction would redeem at one time.
f. The system was susceptible to panics
i. Some goldsmiths were hung as thieves.
2. Convertible paper money still ties up some of the commodity
3. Between 1879 and 1933, US had fractionally backed paper money system
a. US paper money was convertible into gold
i. Called gold certificates.
b. Until 1960s US $1 bills convertible into silver
i. Called silver certificates
D. Fiat money is:
1. an item used as money
2. that is intrinsically worthless.
3. It is acceptable because government declares it to be money.
a. In US paper money, and coins are fiat money.
4. Fiat money frees up commodity money for other uses.
5. There are no natural limitations on growth in stock of fiat money.
a. Value can change quickly.
******************************************************************
A. Private debt money is a "loan that the borrower promises to repay in currency on demand."
1. Checkable deposits are private debt money.
a. They are debts of the banks
2. A checkable deposit is a loan to a bank that the bank promises to pay back to the depositor:
i. in cash
ii. on demand.
3. The depositor thinks of his account as part of his money balances.
IV. Official Measures of the money supply in the US
(B 23-6)
A. There are three official measures of the money supply in the United States:
1. They are called M1, M2 and M3.
B. They correspond to differing degrees of liquidity:
1. M1 is the most liquid
2. M3 is the least liquid
B. Liquidity measures the ease with which an asset is converted into money at a known price.
*******************************************************************
A. M1 includes:
1. Currency outside banks,
2. traveler's checks,
3. demand deposits,
4. and other checkable deposits;
B. M1 clearly fits the definition as a medium of exchange
C. Currency held by banks is not part of M1.
1. That money is the banks' reserve
D. The composition of M1 is as follows
1. Currency in circulation is only about 30% of M1.
2. Largest component is demand deposits and other checkable deposits. (NOW and ATS)
3. Demand deposits are held in:
a. Commercial banks,
b. Savings and Loan Associations,
c. Savings banks and
d. Credit unions
****************************************************************
A. M2 includes
1. M1
2. Savings deposits,
3. Small time deposits,
4. Eurodollar deposits,
5. Money market mutual fund shares held by individuals
B. M2 includes items that are not a medium of exchange.
1. But they are a store of value and
2. can be quickly and costlessly exchanged for M1.
***********************************************************
A. M3 includes
1. M2 plus
2. large time deposits,
3. Eurodollar time deposits,
4. all other money market mutual fund shares
B. M3 includes items that are not a medium of exchange.
1. But they are a store of value and can be quickly exchange for M1.
2. But not as quickly or as costlessly as items in M2.
C. The items in M1 clearly meet the definition of money; the items in M2 and M3 are a little more distant, but are still quite liquid.
*****************************************************************
A. Checkable deposits are money but
1. Checks are not
a. It simply a means to transfer part of the deposit to someone else
2. Credit cards are not money
a. They simply give you the right to borrow money
***********************************************************
A. The following are definitions of the components of the US money supply:
1. Currency held outside banks:
a. Notes issued by the central bank (Federal Reserve System) and
b. coins issued by the US Treasury
2. Traveler's checks.
a. A check issued by a bank which is convertible into currency on demand.
3. Checkable deposits:
a. Deposit accounts on which a check can be written.
4. Demand deposit:
a. A checkable deposit convertible into currency on demand.
5. NOW Account: Negotiable Order of Withdrawal Account -
a. just another form of checkable deposit.
6. ATS Account: Automatic-Transfer Savings account:
a. A checkable deposit ,
b. the balance of which is kept at a certain level,
c. by transferring funds in and out of a savings account.
7. Savings deposit:
a. A deposit that technically cannot be withdrawn on demand.
b. in practice it can be instantly withdrawn.
8. Time deposit:
a. A deposit with a fixed term to maturity.
b. Small time deposits are below $100, 000.
c. Large time deposits are $100,000 or more.
9. Eurodollars:
a. US dollar accounts in banks in countries outside the US
a. Most Eurodollars in European banks
b. Can be in Asian, African and Latin American banks.
c. Dollar accounts in Vietnamese banks are Euro dollars.
10. Money market mutual fund:
a. A financial intermediary that obtains funds by issuing shares
b. on which checks can be drawn.
*****************************************************************
(B 23-6 p. 403)
A. The UK only publishes data on two measures of the money supply,
1. M0 and
2. M4.
B. M0 is the monetary base
1. It is the total quantity of notes and coins.
2. It includes notes and coins:
a. In circulation
b. In the banks
3. M0 measures the potential reserves of the UK banking system
a. If public held no currency or cash,
b. all of M0 would be in the vaults of the banks.
c. It makes no difference whether M0 is in the vaults of:
i. The central bank (The Bank of England) or
ii. The commercial banks
4. The US does not calculate M0,
i. but it does publish figures on the monetary base,
ii. which is the same thing as M0.
C. M4 is:
1. Cash in circulation
a. Not in the banks
2. Bank retail deposits
3. Building society deposits and shares
4. Wholesale deposits
***********************************************************
(WB p. 55)
A. In Vietnam there are two major measures of the money supply:
1. M2 or "total liquidity"
2. M2D or "Dong liquidity"
B. M2 contains:
1. Bank deposits - in Dong
2. Currency in circulation
3. Bank deposits in foreign currencies
C. Dong liquidity is equal to:
1. M2 less
2. Foreign currency deposits (Eurodollars)
D. The ratio of the money supply (M) to GDP (YN) has been changing:
1. YEAR M / YN V
1988 12% 8.3
1989 31% 3.2
1990 30% 3.3
1991 29% 3.4
1992 28% 3.6
2. M / YN is equal to 1 / V
a. M*V = P*Q = YN
M*V / YN = 1
M / YN = 1 / V
3. The increase of M2 as a fraction of nominal GDP (Y) is called "financial deepening"
D. Composition of M2 has been changing
1. Currency is about:
a. 1/2 of Dong liquidity (M2D)
b. 1/3 of Total liquidity (M2)
a. This has not changed
2. Foreign exchange deposits
a. Greatly increased as a percent of M2 after 1989
b. Now steady at about 1/3 of M2
3. Current (1992) composition of M2 is approximately:
a. 1/3 Dong deposits
b. 1/3 Currency
c. 1/3 Foreign exchange deposits
4. An important omission of M2 is:
a. Foreign currency used as money
b. Precious metals and stones used as money
IV. Financial Intermediaries in the US
A. A Financial intermediary is a firm that:
1. accepts deposits from households and other firms
2. and makes loans to other households and firms.
B. There are five major types of financial intermediaries in the US:
a. Commercial banks,
b. Savings and loan associations,
c. Savings banks,
d. Credit unions,
e. Money market mutual funds.
*****************************************************************
Commercial Banks
(B 23-3)
A. Commercial banks are private firms that receive deposits and make loans.
B. The best way to understand the operations of commercial banks is by examining the balance sheet of the commercial banking sector.
1. A balance sheet is a statement listing its assets and liabilities:
a. Assets are the things a firms owns and
b. Liabilities are what a firm owes.
C. The major liabilities of a commercial bank are:
1. checkable deposits,
2. savings deposits, and
3. time deposits.
D. The major assets of a bank are its:
1. reserves,
2. investment securities,
3. liquid assets (short-term loans),
4. and long term loans.
E. A bank's reserves consist of:
1. cash in the bank's vault and
2. deposits held at the Federal Reserve.
3. These assets do not earn any income for the bank
4. These assets give the bank liquidity
F. Short term bonds are called liquid assets
1. They pay a low rate of interest
2. They can be quickly and cheaply turned into cash
G. Investment securities are:
1. securities that can be sold quickly but
2. whose price fluctuates.
3. e.g. A US government bond
a. Pays higher interest than liquid assets but
b. Bank may have to sell at a loss
H. Long term loans are commitments where the bank lends:
1. a fixed amount of money
2. for a fixed time period.
3. Most loans are made to corporations:
a. To buy equipment or
b. to carry inventory
4. Long-term loans make up bulk of bank assets
5. They are the banks' least liquid assets
6. Earn the highest rate of return
*****************************************************************
(WB p. 55-57)
A. Assets of 4 State Owned Banks at the end of 1992
Bank Trillion Dong
(100 m $ approx)
1. Foreign Trade Bank (BFT) 17.0
2. Viet Nam Bank for Agriculture (VBA) 5.9
3. The Industrial and commercial bank (ICB) 5.0
4. Bank for Investment and Development (BID) 8.9
B. Except for BID, 85% of assets in short term loans
C. VBA has 90% of its loans in agriculture
D. BFT has majority of loans in foreign trade
E. All banks permitted to lend in any sector
F. Commercial banks allowed to own precious metals and stones
G. Trends in lending:
1. 1991 10% of new credit to private sector
2. 1992 35% of new credit to private sector
*****************************************************************
Other financial intermediaries in US
A. Savings and Loan Associations are companies that:
1. Traditionally obtained their funds from savings deposits and
2. made long term mortgage loans to home buyers.
3. Now they can act like commercial banks
B. Savings banks are banks owned by their depositors.
1. They made loans for mortgages
C. Credit unions were:
1. small cooperative lending institutions owned by their members
2. who are also their depositors
3. They take checkable deposits like banks
4. they make consumer loans
5. They are now growing very rapidly and taking depositors away from banks
a. Giving higher interest rate to depositors
b. Charging lower interest rates to lenders
c. Can operate with a smaller spread than banks because:
i. They are exempt from corporate profits taxes.
D. Money market mutual funds are financial institutions that:
1. obtain funds by selling shares.
2. They invest their money in highly liquid assets
e.g. US treasury bills. (90 day maturity - low interest)
2. They allow shareholders to write checks on their money market mutual fund accounts.
1. Mutual funds keep their accounts in commercial banks.
2. shareholder's check on his mutual fund account is really
a. a check drawn on the mutual fund's bank account.
**************************************************************
(WB p. 55-56)
A. Four state owned banks
BANKS Branches
1. Foreign Trade Bank (BFT) 14
2. Viet Nam Bank for Agriculture (VBA) 524
3. The Industrial and commercial bank (ICB) 96
4. Bank for Investment and Development (BID) 90
B. Five Branches of foreign-owned Banks
C. Two joint venture banks
1. Indovina Bank
2. VID public Bank
3. They are 50-50 partnerships between:
a. state owned banks and
b. foreign banks
D. 24 shareholding banks
1. Owners include:
a. private and public firms
b. Cooperatives
c. People's Committees
d. individuals
2. These banks have only one or two branches each
E. Several thousand small urban and rural cooperatives
G. One state run insurance company
H. Two very small finance companies
VII Economic Functions of Financial Intermediaries
A. Financial intermediaries make a profit from the difference between:
1. the interest rate paid on deposits and
2. the interest rate charged on loans.
B. The spread between the interest rates that financial intermediaries pay and the rate of interest they receive exists because intermediaries provide four services.
1. Minimizing the cost of obtaining funds
2. Minimizing the cost of monitoring borrowers
3. Pooling risk
4. Creating liquidity
C. Financial intermediaries minimize the cost of obtaining funds by:
1. pooling many people's relatively small deposits into a large sums
a. that can be loaned to many borrowers.
2. They can create organization to raise the funds
3. They can spread the cost over many borrowers
D. Financial intermediaries minimize the cost of monitoring borrowers by:
1. specializing in this activity.
2. spreading the costs over many borrowers
E. Financial intermediaries pool risk by:
1. Lending to a large number of borrowers
2. Lending to borrowers in different:
a. locations and
b. different industries
c. (diversification)
3. If one borrower is unable to pay back the loan,
a. The lender loses only a small fraction of his or her total deposit.
F. Financial intermediaries create liquidity by:
1. accepting deposits that can be instantly withdrawn (borrowing short) and
2. using these deposits to make long-lived loans (lending long).
A. The interest spread in Vietnam is controlled by government regulations.
1. Government sets
a. Minimum interest rates paid on deposits
1. For individuals 1.7% per month
b. Maximum interest rates charged on loans
1. 1 year loans = 2.3% per month
c. Spread is .6 % per month
d. Banks pay a 4% to 15% turnover tax on the spread
2. Banks also subject to a 50% profits tax
a. Banks cannot deduct reserve for bad loans
3. Banks make little profit on loans
a. Not very aggressive in taking riskier loans
b. Businesses must borrow elsewhere
i. Where interest rates are much higher
c. Not very aggressive in improving the check clearing system to get more depositors
i. Interbank clearing system improved since 1991
ii. 1/2 day within city
iii. 1 day within province
iv. between provinces 2 or 3 days
III. Financial Regulation, Deregulation, and Innovation
A. Financial intermediaries in the US face two types of restriction:
1. Deposit insurance and
2. Balance sheet rules.
*******************************************************************
B. In the US, deposits at banks (and at savings and loans) are insured by the Federal Deposit Insurance Corporation (FDIC).
1. FDIC guarantees that depositors are protected for up to $100,000 per depositor.
2. This gives financial intermediaries the incentive to make risky loans
a. since the depositors see their funds as perfectly safe;
b. because of this incentive, there are balance sheet regulations.
C. In the US, there are three main balance sheet regulations. They are:
1. capital requirements,
2. reserve requirements and
3. lending rules.
D. Capital requirements are:
1. regulations setting the minimum amount of the owners' financial wealth that must be at stake in the financial intermediary.
E. Reserve requirements are:
1. rules listing the minimum percentages of deposits that must be held as:
a. currency or
b. other safe assets.
F. Lending rules are:
1. restrictions on the type and size of loans that can be made by a financial intermediary.
******************************************************************
A. banks are supervised by:
1. the State Bank and
2. the Ministry of Finance
B. No regulations on ratio of secured to unsecured credit
C. No regulations as to asset distribution
D. There are no capital requirements
E. Banks have reserve requirements
1. Must keep 10% of deposit in non-interest bearing reserves at state Bank of Viet Nam (SBV)
2. Recommended by the State Bank of Viet Nam (SBV)
that:
a. banks keep an additional 20% of deposit in low- interest bearing reserves at state Bank of Viet Nam (SBV)
b. earns only .3% per month versus minimum interest on deposits of 1.7%
***************************************************************
A. In the US, the 1980s were marked by financial deregulation,
1. many of the restrictions on financial intermediaries were lifted.
B. The development of new financial products is called "financial innovation".
C. In the US, the 1980s were marked by rapid financial innovation,
D. The development of new financial products was aimed at
1. Lowering the administrative costs of making loans and
2. Raising the return on customer's deposits.
E. Financial innovation occurred for three reasons:
1. The economic environment,
2. technology and
3. regulation
F. The economic environment of the early 1980s featured:
1. high inflation rates (INFRTE) and
2. high nominal interest rates (nr),
3. which created high risks for intermediaries.
a. Some innovation, such as adjustable rate mortgages, was aimed at lowering this risk.
b. This fixed the real rate of interest on mortgages instead of:
i. The nominal rate
c. Banks would not take losses when nominal rates went up.
ii. Banks could now offer lower nominal rates (rn)
ii. They did not need to include inflation- risk premium.
G. Technological change, especially reductions in the cost of computing and long-distance communication, caused:
1. Spread of use of credit cards
2. Development of international financial markets
3. Increased use of Eurodollars
H. Some innovation was directed at avoiding regulation.
1. The development of NOW and ATS accounts allowed banks to pay interest on checking accounts
2. This encouraged people to hold their wealth in the form of deposits rather than bonds.
*****************************************************************
A. The effects of deregulation and innovation on US money supply was:
1. The composition of M1 changed -
a. demand deposits declined because
i. they paid low interest rates
b. other checkable deposits increased.
i. They paid higher interest rates
2. The composition of M2 changed -
a. Savings deposits declined
i. They paid low interest rates
b. Time deposits, money market and Eurodollar deposits increased
i. They paid higher interest rates
3. The composition of M3 changed -
a. Rapid growth in large time deposits
i. They paid high interest rates
E. Deregulation and innovation of US and UK financial institutions blurred the distinction between:
1. Commercial banks and
a. other financial intermediaries
2. Demand deposits and
a. other deposits
IV. How Banks Create Money
A. Money can be very broadly defined
1. Hence all financial institutions create some form of money.
B. I will use commercial banks as an example.
C. I will define money as:
1. bank deposits and
2. currency in circulation.
*************************************************************
Actual and Required Reserves
A. The actual reserve ratio (ARR) is:
1. the fraction of a bank's total deposits (D)
2. held as actual reserves (AR).
ARR = AR / D
3. The actual reserve ratio (ARR) is influenced by the actions of the bank's depositors.
B. The required reserve ratio (RRR) is:
1. the fraction of deposits (D)
2. that banks are required, by regulation, to keep as required reserves (RR).
RRR = RR / D
3. Required reserves (RR) are equal to:
a. the bank's deposits (D) times
b. its required reserve ratio (RRR).
RR = D * RRR
C. Excess reserves (ER) equal:
1. actual reserves (AR) minus
2. required reserves (RR).
ER = AR - RR
3. Whenever banks have excess reserves,
a. they are able to create money.
b. by making loans
***************************************************************
Creating Deposits by Making Loans
(B 23-4)
A. When a bank receives additional currency,
1. Its total reserves (AR) rise by the entire amount of the deposit
DEPOSIT 1 = DELTA AR
2. However, required reserves (RR) rise by only a fraction. (the required reserve ratio) (RRR).
DELTA RR = DEPOSIT * RRR
3. Hence, excess reserves (ER) increase.
DELTA ER = DELTA AR - DELTA RR
DELTA ER = DEPOSIT - DEPOSIT * RRR
DELTA ER = DEPOSIT * (1 - RRR)
a. The smaller the RRR, the larger the increase in excess reserves (ER)
4. The bank loans its excess reserves (ER).
LOAN = DELTA ER = DEPOSIT 1 * (1- RRR)
5. The bank has created money because:
a. the original deposit (DEPOSIT 1) is money and
i. Money was not destroyed when the bank accepted a cash deposit
ii. It just changed its form from currency to a demand deposit.
DELTA M = DELTA DD - DELTA CC
DELTA M = 0
b. so is the money loaned out by the bank
DELTA M = CC (or DD)
DELTA M = LOAN
B. This loan ends up as a deposit in another bank
LOAN = DEPOSIT 2
a. This deposit is smaller than the original deposit
DEPOSIT 2 = DEPOSIT 1 * (1 - RRR)
1. The new deposit boosts the second bank's total reserves (AR) by more than its required reserves (RR).
DELTA AR = DEPOSIT 2
DELTA RR = DEPOSIT 2 * (1 - RR)
2. The second bank acquires excess reserves (ER)
DELTA ER = DELTA AR - DELTA RR
DELTA ER = DEPOSIT 2 - DEPOSIT 2 * RRR
DELTA ER = DEPOSIT 2 * (1 - RR)
3. The second bank then loans its excess reserves (ER) and the process continues.
LOAN = DELTA ER
DELTA M = LOAN
C. Thus many banks wind up with extra deposits
D. After each round, the amount of excess reserves (ER) becomes smaller.
1. Excess reserves (ER) are being converted into required reserves (RR) as the amount of deposits (D) increases.
E. It is through this process that banks create money.
1. The amount of money created is a multiple of the original deposit.
*****************************************************************
The Simple Money Multiplier
A. The simple money multiplier (SMM) is:
1. the "amount by which an increase in bank reserves is multiplied to calculate the effect of:
a. the increase in actual reserves (AR) on
b. total bank deposits. (D)"
SMM = DELTA D / DELTA AR
B. The simple money multiplier equals
SMM = 1 / RRR
C. By making loans (or calling in loans), banks:
1. bring their required reserves (RR) into equality with
2. their actual reserves (AR).
RR = AR
D. Since in equilibrium, the banks are fully loaned out
ER = 0
1. Hence,
a. AR = RR = (RRR * D)
b. RRR * D = AR
2. If we divide by RRR, we get
a. D = AR * (1/RRR)
3. If we consider the change in AR, we get:
a. DELTA D = DELTA AR * (1/RRR)
4. Therefore, if we divide by DELTA AR, we get:
a. DELTA D / DELTA AR = (1/RRR) = SMM
E. The larger the RRR, the smaller the simple Money multiplier (SMM).
1. This is because less excess reserves are created during each round.
F. The smaller the Simple money multiplier (SMM), the smaller the money supply (M) that can be created from any given amount of actual reserves (AR).
**************************************************************
(B 23-Appendix)
A. The actual money multiplier (AMM) is smaller than the simple money multiplier (SMM) because:
1. not all loans made by banks end up as deposits in other banks.
2. Some is retained outside the banking system as cash.
SMM > AMM
B. The actual money multiplier (AMM) can be derived as follows:
LET AR = RRR * DD
1. Define the desired currency ratio (DCR) as the ratio between currency (CC) and demand deposits (DD) preferred by the public
DCR = CC / DD
Hence:
CC = DCR * DD
LET M = CC + DD
2. Define the monetary base (MB) as the actual reserves of the banks plus currency in the hands of the public
MB = CC + AR
DIVIDE M BY MB
M / MB = CC + DD / CC + AR
SUBSTITUTE FOR CC AND AR
M / MB = DCR * DD + DD / DCR * DD + RRR * DD
FACTOR OUT DD
M / MB = (DCR + 1) * DD / (DCR + RRR) * DD
CANCEL OUT THE DDs
M / MB = (DCR + 1) / (DCR + RRR)
MULTIPLY BY MB
M = (DCR + 1) / (DCR + RRR) * MB
DELTA M = (DCR + 1) / (DCR + RRR) * DELTA MB
DELTA M / DELTA MB = AMM = (DCR + 1) / (DCR + RRR)
C. The actual money multiplier (AMM) is:
AMM = (CDR + 1) / (CDR + RRR)
D. From the multiplier formula we can see that
1. The actual money multiplier is greater than 1 because
a. RRR is less than 1.
(CDR + 1) > (CDR + RRR)
2. Since an increase in CDR adds equally to the numerator and the denominator
a. as CDR increases AMM approaches 1.
UIII. Money in the AD-AS Model
A. An increase in the nominal money supply (M) will initially increase the stock of real money (L) and:
1. cause an increase in aggregate planned expenditures (APE) and
2. will shift the aggregate demand (AD) curve.
B. The effect of a change in the nominal money supply will not be the same:
1. in the short run and
2. in the long run
******************************************************************
(B 26-7)
A. Consider an increase in the nominal money supply (M) at less than full employment GDP (Y)
1. An increase in the nominal money supply (M) will cause an increase in aggregate planned expenditures (APE) by:
a. increasing real money balances (L) and
b. reducing interest rates (r).
c. This will increase autonomous consumption (CA) and investment (I)
d. This will increase the equilibrium level of real GDP (Y)
2. The increase in APE will shift the AD curve to the right.
B. In the short run, at a real GDP (Y) less than full employment GDP (YP):
Y < YP
1. The equilibrium will move up the SAS curve.
2. The price level will rise (P)
3. Real GDP (Y) will rise and
4. The economy will be closer to full employment GDP (YP).
*****************************************************************
(B 26-4)
DEH Note that Begg describes the effect of a decrease in the money supply.
A. In the long run, an increase in the nominal money supply (M) at full employment GDP (YP) will have the following effect.
1. An increase in the nominal money supply (M) will cause an increase in APE by:
a. increasing real balances (L) and
b. reducing interest rates (r).
2. This will shift the APE curve up because it will increase autonomous spending (A):
a. Autonomous consumption (CA)
b. Investment (I)
3. This will increase the equilibrium real GDP (Y) by a multiple of the increase in autonomous spending (A).
4. This will shift the AD curve to the right, (AD').
a. By an amount equal to the change in equilibrium GDP (Y)
3. The equilibrium point will move up the SAS curve.
4. The price level (P) will rise to (P')
a. This will partly offset the effects of the increase in the nominal money supply (M).
5. Real GDP (Y) will rise and the economy will be above full employment GDP (YP).
Y > YP
6. Wages will rise.
7. The short run Aggregate Supply Curve (SAS) will shift upward (to the left) to (SAS').
a. It rises due to rising capital and labor costs.
8. The economy will move along the new AD curve (AD')
9. Prices (P) will rise and (A) will fall somewhat
10. Real GDP (Y) will fall towards the full employment level (YP).
C. Between one full employment equilibrium and the next, an increase in the quantity of nominal money (M):
1. raises the price level (P) and
2. leaves Real GDP (Y) unchanged.
D. The dynamic time paths of prices (P) an output (Y) are as follows:
1. Prices
a. Constant until t0 when M increased
b. Started a slow upward climb to new equilibrium
2. Output
a. Constant at YP until t0
b. Increases to Y
c. Gradually falls back to YP
A Summary of the long run effect
A. An increase in the nominal money supply (M) shifts the AD curve to the right.
1. If unemployment exists,
a. the upward sloping SAS curve means that real GDP (Y) and the price level (P) both permanently rise.
B. An increase in the nominal money supply (M) when the economy is at full employment (YP)
1. shifts the AD curve to the right and
2. raises the price level (P) and
3. temporarily boosts real GDP (Y).
C. In the Long-run, the economy returns to full employment real GDP (YP).
1. real GDP (Y) does not change;
2 the only effect is a permanently higher price level (P).
V. The Quantity Theory
(B 28-1)
A. The quantity theory of money asserts that:
1. an increase in the nominal money supply (M) leads to
2. an equal percentage increase in the price level (P).
Growth rate of P = Growth rate of M
B. A corollary of the quantity theory is that changes in the nominal money supply (M) do not have any effect on output (Y) and employment.
*****************************************************************
A. The key to understanding the quantity theory is the equation of exchange (EOE),
(B Box 28-1 describes the EOE but calls it the quantity theory of money.
B. The Equation of Exchange (EOE) states that:
1. the nominal money supply (M) multiplied by the velocity of circulation (V) is equal to:
2. the price level (P) times real GDP (Y). or,
MN * V = P * Y
where
M = nominal money supply,
V = the velocity of circulation,
P = the price level,
Y = real GDP.
C. The velocity of circulation (V) is:
1. the average number of times in a year unit of money is used to purchase goods and services that make up real GDP (Y).
V = (P * Y) / M
1. This definition of V makes the equation of exchange true by definition
2. It is a truism , a tautology
3. It cannot be used for making predictions because
a. When M changes
b. Either V, Y or P could change
*************************************************************
A. If we reverse the order of the EOE,
M * V = P * Y
P * Y = M * V
1. and divide by real GDP (Y), we get
P = (M * V) / Y
or
P = M * (V / Y)
B. The quantity theory assumes that:
a. velocity (V) is constant and
b. that real GDP (Y) is not affected by the quantity of nominal money (M).
1. Hence (V/Y) is a constant
C. Looking at this in first differences,
P = (V/Y) * M, hence
DELTA P = (V\Y) * DELTA M
D. Divide this equation by the rearranged equation of exchange
DELTA P = (V/Y) * DELTA M
P (V/Y) * M
E. The V/Y ratio cancels out, therefore:
DELTA P/ P = DELTA M / M
% DELTA P = % DELTA M
F. If the assumptions of the quantity theory are correct:
1. The percentage change in the price level (P) (the rate of inflation = INFRTE) is equal to:
a. the percentage change in the nominal money supply (M).
INFRTE = % DELTA P = % DELTA M
2. Over time, percentage changes are rates of growth (RG)
3. Therefore the rate of growth of prices, (the inflation rate = INFRTE) will equal the rate of growth of the nominal money supply (M)
RG of P = RG of M
VIII. The Quantity Theory and the AD-AS Model
A. The aggregate demand curve expresses the price level (P) as a function of real GDP (Y).
B. The equation of exchange (EOE) can be rearranged to make the price level (P) a function of real GDP (Y).
P = M * V / Y
****************************************************************
A. The quantity theory assumes V is constant.
B. Thus for any value of M
a. (M * V) is constant.
C. This defines an AD curve which is a rectangular hyperbola.
P = a constant/ Y = (M * V) / Y
D. If the Quantity theory is correct:
1. An increase in the nominal money supply (M) would shift the AD curve up
a. by the same percentage as the percentage change in the nominal money supply (M).
2. The equilibrium would move along a vertical LAS curve.
3. There would be no change in real GDP (Y).
3. RG of P = RG of M
******************************************************************
A. The AD-AS model predicts that in the short run, a change in the nominal money supply (M) will cause:
1. A change in V and
2. In the short run, changes in real GDP (Y).
B. Hence, the inflation rate will be less than the rate of increase of the nominal money supply (M)
INFRTE = RG of P < Rg of M
C. To see which theory is correct, you must look at the data.
*****************************************************************
A. Historical evidence on the quantity theory of money gives four results:
1. On average, the growth rate of the money supply (M) exceeds the inflation rate.
RG of M > RG of P = INFRTE
a. This implies that the V/Y ratio is falling
b. Consistent with the long run growth of YP
c. Nominal Money (M) growth that matches real potential GDP (YP) growth
i. does not add to inflation
2. There is a correlation between inflation and the growth of the nominal money supply (M).
(RG of P/ RG on M) > 0
a. The correlation between the growth rate of the nominal money supply (M) and inflation rate (INFRTE) is most evident between 1915 to 1940;
b. The falling price levels (P) of the Great Depression were associated with a decrease in the nominal money supply (M).
c. after 1940, the correlation has been weaker.
d. But inflation of the 1970s was associated with rapid growth of the nominal money supply (M).
B. The responses of the price level (P) to massive increases in the nominal money supply (M) were not the same:
1. in WWI and
2. WWII
3. V was not constant
4. During WWI, a massive increase in the growth rate of the nominal money supply (M) was associated with:
a. a large increase in the inflation rate (INFRTE);
5. this was not as true during WWII.
C. Nominal Money supply (M) growth is more volatile than the inflation rate (INFRTE) .
V was not constant
1. This is not consistent with the quantity theory.
2. This is consistent with the AD-AS model which predicts
a. Some of the impact of a change in the nominal money supply (M) is on the price level (P) and
b. Some of the impact of a change in the nominal money supply (M) is on real GDP (Y).
******************************************************************
A. International evidence shows a strong tendency for high nominal money (M) growth rates to be associated with high inflation rates (INFRTEs).
a. International cross section of Nominal Money Supply (M) Growth plotted against Inflation Rates (INFRTE) shows:
i. Strong correlation for high inflation countries
ii. Weaker correlation for low inflation countries
b. Since correlation not perfect, it is more consistent with AD-AS model.
(B 28-3)
B. UK evidence (see Figure 28-5)
1. No close relation between rate of growth of M0 and rate of growth of price level (INFRTE)
2. Rates of inflation (INFRTE) seem to lag rates of growth of M4 by several years
a The lag indicates that in the short run changes in the nominal money supply (M) lead to
b. Changes in the real money supply (L)
c. Changes in real GDP (Y)
3. These results:
a. Contradict the quantity theory
b. Agree with the short run AS-AD model
*****************************************************************
(B 28-3)
A. Changes in the nominal money supply (M) may cause changes in the price level (P) or.
B. Changes in the price level (P) may cause changes in the nominal money supply (M) or
C. Changes in the nominal money supply (MN) and the price level (P) may be caused by a third variable.
1. (e. g. The government budget deficit)
D. In the US, the delayed post WWII inflation when price controls were lifted indicate that:
1. Nominal money supply (M) growth during WWII caused the post-war inflation
2. not vice versa.
X. Summary of lecture
Key concepts
1. Actual Money Multiplier (AMM)
2. Actual Reserves (AR)
3. Actual Reserve Ratio (ARR)
4. Asset
5. Balance sheet
6. Barter
7. Private sector cash deposit ratio (Ty so giua so tien mat va so tien gui cua khu vuc tu nhan)
8. Checkable deposit
9. Commercial bank
10. Commodity market
11. Convertible paper money
12. Credit Union
13. Currency
14. Debt money (Tien dua theo no)
15. Double coincidence of wants
16. Equation of exchange (EOE)
17. Excess reserves
18. Fiat money
19. Financial innovation
20. Financial intermediary (Trung gian tai chinh)
21. Gresham's law
22. Investment security
23. Legal tender (Phuong tien thaonh toan hop phap [luat dinh])
24. Liability
25. Liquid asset
26. Liquidity (Thah khoan)
27. Loan
28. M0 (Muc cung ung tien M0)
29. M1 (Muc cung ung tien M1)
30. M2 (Muc cung ung tien M2)
31. M3 (Muc cung ung tien M3)
32. M4 (Muc cung ung tien M4)
33. Medium of exchange (Phuong tien trao doi)
34. Money (Tien)
35. Money market mutual fund
36. Nominal Money supply (M) (Luong tien danh nghia)
37. Private debt money (IOU money) (Tien dua theo no)
38. Quantity theory of money
39. Real Money supply (L) (thuc te)
40. Required reserve ratio (RRR) (ti le du tru bat buoc)
41. Required reserves (RR)
42. Savings and Loan Association
43. Savings Bank
44. Simple Money Multiplier (SMM) (Thua so tien)
45. Standard of deferred payment
46. Store of value (Du tru gia tri)
47. Token money (Tien quy uoc)
48. Unit of account (Don vi ke toan)
49. Velocity of circulation (V)
50. Wholesale deposit market
Review Questions
1. What are the functions of money?
2. What are the different forms of money?
3. What are the three official measures of the money supply used in the US?
4. Why are checks and credit cards not money?
5. What are some types of financial intermediaries?
6. What are the main assets and liabilities of commercial banks?
7. What are the economic functions of intermediaries?
8. How do banks make a profit?
9. How do banks create money?
10. Why does the simple money multiplier (SMM) equal 1 divided by the required reserve ratio (RRR)?
11. Why is the actual money multiplier (AMM) smaller than the simple money multiplier (SMM)?
12. What does the AS-AD model predict will happen to the price level (P) and real GDP (Y) when the nominal money supply (MN) is increased?
13. What does the Quantity Theory of Money predict will happen to the price level (P) and real GDP (Y) when the nominal money supply (MN) is increased?
14. What assumptions must be made to transform the equation of exchange (EOE) into the quantity theory of money?
15. How well does the historical and international evidence support the quantity theory of money?