Chapter 4,Money Market
Analysis
Gang Gong
March 10,2002
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to
be used for presentation anywhere else
without the permission from the author.
Introduction
? The objective of this chapter is to study how
money and interest rate is determined in the
money and financial market.
? The money and financial market is the
market in which money and various
financial assets (such as,bonds and stocks)
are exchanged,
Introduction
? The Functions of Money
– Medium of Exchange
– Store of Value
– Unit of Account
Introduction
? Types of Money in Modern Economy with
Banking System:
– M1:
? Currency and Notes (issued by central bank),also
called high powered money or monetary base.
? checkable deposit.
– M2,Non-checkable saving deposit etc.
– M3,Large time deposit
Note,M1 is the most liquid money followed
by M2 and M3.
The Demand for Money
? Transaction Demand for Money,
— Money is an medium of transaction,The
transaction demand for money is those money
that is hold for transactionary purpose,It is
assumed to be related to nominal GDP,
The Demand for Money
Asset Demand for Money
– Money is also an asset,However,unlike the
other assets,such as bonds,stocks,etc.,money
(M1) does not generate interest rate (its only
advantage is the liquid),Therefore it can be
expected that when interest rate of other assets
increase,the demand for money will decline.
The Demand for Money
? The Total Demand for Money
– The total demand for money is the sum of
transaction demand for money and asset
demand for money,We thus can write the
demand function for money as
(see Figure presented in class)
hikYM d ??
The Supply of Money and Money
Market Equilibrium
? The supply of money is often assumed to be
controlled by the central bank,and therefore
it is exogenuous,
MM s ?
The Supply of Money and Money
Market Equilibrium
? The Money Market Equilibrium is the
condition at which
Therefore,given the money supply and
nominal GDP,it is the interest variation that
ensures the money market equilibrium,
ds MM ?
hikYM ??
The Supply of Money and Money
Market Equilibrium
? How Does the Interest Rate Variation
Ensure the Money Market Equilibrium
(mechanism analysis)
– Suppose the interest rate to be lower than the
equilibrium interest rate,In this case,there will
be an excess demand for money indicating
people will sell their bonds to exchange for
money,
The Supply of Money and Money
Market Equilibrium
? How Does the Interest Rate Variation
Ensure the Money Market Equilibrium
(mechanism analysis)
– (Continued from the last page) Therefore in the
bond market,there will be excess supply of
bond,This will reduce the bond price and hence
raise the rate of return on bond,which is a
measure of interest rate.
How Does the Federal Reserve
Create the Money Supply
? We shall now discuss how the central bank
control the money supply,In other words,
we will give you more detail analysis on the
mechanism of money supply,For this,we
need to discuss the modern banking system
such as the the Federal Reserve System in
U.S.
Federal Reserve System
(The Fed Structure)
V a ri o u s C o m m e rc ia l B a n k s
1 2 F e d e r a l R e s e r v e B a n k s The Commission of Open Market Operation
B o a r d o f G o v e r n o r s
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks,
The most important part of Federal Reserve
System is the commercial bank,We thus need to
discuss how commercial bank make their business
– Attracting deposit from the public at no or very
low interest rate;
– Using the public deposit to lend out at a higher
interest rate (own the profit from the interest
differential);
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks
(continued),
– However,they can not use all the deposit from
the public for lending,Some of them must be
kept as reserve (denoted as R);
– The Reserve Ratio (denoted as r)
r = R/D
where D is the deposit from the public
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks
(continued),
– Apparently,the reserve ratio is a very important
policy variable for a bank,Low reserve ratio
may cause the danger that the bank can not
meet a large deposit withdrawn from the public
(causing bankruptcy),Yet a high reserve ratio
may cause less loan and hence less profit,
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System
– Benefit,In the case of emergency needing cash,
the commercial bank can borrow the money
from the Federal Reserve Bank at its discount
window,This will efficiently avoid the
possibility of bankruptcy,
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System (continued)
– Responsibility,The commercial bank should
not abuse this benefit,They should regularly
maintain the required reserve according to the
required reserve ratio designed by the Federal
Reserve System
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System (continued),
The Required Reserve (Rr) =
Required Reserve Ratio (rr) ? Deposit (D)
Excess Reserve (Re) =
Actual Reserve (R) - Required Reserve (Rr)
How Does the Federal Reserve
Create the Money Supply
? The Multiplier Process of Money Creation
Previously,we have said that the central bank
can control the money supply,Yet what central
bank can directly control is the high powered
money,Even M1 also include the checkable
deposit,How central bank can control or influence
this part of money?
How Does the Federal Reserve
Create the Money Supply
? Consider an initial increase in high powered
money,say 100 millions dollars,This might
occur when the central bank buys bonds at
open market operation,What is the total
money creation for this activity of central
bank?
How Does the Federal Reserve
Create the Money Supply
? Assume
– the required reserve ratio is 20%
– all banks are exactly meeting their required
reserve
– this $100 millions is owned by a single person
called John who has an account in Bank A
Multiplier Process of Money Creation
The First Round,Bank A
Assets
Reserves +100
Loan +80
Reserve -80
Liabilities
Deposits +100
? In this case,the required reserve for this additional
100 million deposit is 20 million,The excess
reserve for Bank A is 100 - 20 = 80,This excess
reserve can be lend out,say,to Martin who open
an account in Bank B,
Multiplier Process of Money Creation
The Second Round,Bank B
Assets
Reserves +80
Loan +64
Reserve -64
Liabilities
Deposits + 80
? For bank B,the required reserve for this additional
80 million deposit is 16 million,The excess
reserve is 80 - 16 = 64,This excess reserve can be
lend out,say,to Smith who open an account in
Bank C.
Multiplier Process of Money Creation
? Now Bank C has excess reserve 64 - 0.2?64
= 51.2,This excess reserve can again be
lend out,
? What we have found for this initial creation
of high powered money is that it bring
the total deposit =
100 + 80 + 64 + 51.2 +,....
Multiplier Process of Money Creation
? Specifically,let the initial money from the
federal reserve denoted as H (H is the high
powered money) and the required reserve
ratio as rr,Then the total amount of money
created,denoted as M,due to H is given by
? Above 1/ rr is called the money multiplier.
H
r
M r1?
Analysis
Gang Gong
March 10,2002
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to
be used for presentation anywhere else
without the permission from the author.
Introduction
? The objective of this chapter is to study how
money and interest rate is determined in the
money and financial market.
? The money and financial market is the
market in which money and various
financial assets (such as,bonds and stocks)
are exchanged,
Introduction
? The Functions of Money
– Medium of Exchange
– Store of Value
– Unit of Account
Introduction
? Types of Money in Modern Economy with
Banking System:
– M1:
? Currency and Notes (issued by central bank),also
called high powered money or monetary base.
? checkable deposit.
– M2,Non-checkable saving deposit etc.
– M3,Large time deposit
Note,M1 is the most liquid money followed
by M2 and M3.
The Demand for Money
? Transaction Demand for Money,
— Money is an medium of transaction,The
transaction demand for money is those money
that is hold for transactionary purpose,It is
assumed to be related to nominal GDP,
The Demand for Money
Asset Demand for Money
– Money is also an asset,However,unlike the
other assets,such as bonds,stocks,etc.,money
(M1) does not generate interest rate (its only
advantage is the liquid),Therefore it can be
expected that when interest rate of other assets
increase,the demand for money will decline.
The Demand for Money
? The Total Demand for Money
– The total demand for money is the sum of
transaction demand for money and asset
demand for money,We thus can write the
demand function for money as
(see Figure presented in class)
hikYM d ??
The Supply of Money and Money
Market Equilibrium
? The supply of money is often assumed to be
controlled by the central bank,and therefore
it is exogenuous,
MM s ?
The Supply of Money and Money
Market Equilibrium
? The Money Market Equilibrium is the
condition at which
Therefore,given the money supply and
nominal GDP,it is the interest variation that
ensures the money market equilibrium,
ds MM ?
hikYM ??
The Supply of Money and Money
Market Equilibrium
? How Does the Interest Rate Variation
Ensure the Money Market Equilibrium
(mechanism analysis)
– Suppose the interest rate to be lower than the
equilibrium interest rate,In this case,there will
be an excess demand for money indicating
people will sell their bonds to exchange for
money,
The Supply of Money and Money
Market Equilibrium
? How Does the Interest Rate Variation
Ensure the Money Market Equilibrium
(mechanism analysis)
– (Continued from the last page) Therefore in the
bond market,there will be excess supply of
bond,This will reduce the bond price and hence
raise the rate of return on bond,which is a
measure of interest rate.
How Does the Federal Reserve
Create the Money Supply
? We shall now discuss how the central bank
control the money supply,In other words,
we will give you more detail analysis on the
mechanism of money supply,For this,we
need to discuss the modern banking system
such as the the Federal Reserve System in
U.S.
Federal Reserve System
(The Fed Structure)
V a ri o u s C o m m e rc ia l B a n k s
1 2 F e d e r a l R e s e r v e B a n k s The Commission of Open Market Operation
B o a r d o f G o v e r n o r s
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks,
The most important part of Federal Reserve
System is the commercial bank,We thus need to
discuss how commercial bank make their business
– Attracting deposit from the public at no or very
low interest rate;
– Using the public deposit to lend out at a higher
interest rate (own the profit from the interest
differential);
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks
(continued),
– However,they can not use all the deposit from
the public for lending,Some of them must be
kept as reserve (denoted as R);
– The Reserve Ratio (denoted as r)
r = R/D
where D is the deposit from the public
How Does the Federal Reserve
Create the Money Supply
? The Working of Commercial Banks
(continued),
– Apparently,the reserve ratio is a very important
policy variable for a bank,Low reserve ratio
may cause the danger that the bank can not
meet a large deposit withdrawn from the public
(causing bankruptcy),Yet a high reserve ratio
may cause less loan and hence less profit,
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System
– Benefit,In the case of emergency needing cash,
the commercial bank can borrow the money
from the Federal Reserve Bank at its discount
window,This will efficiently avoid the
possibility of bankruptcy,
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System (continued)
– Responsibility,The commercial bank should
not abuse this benefit,They should regularly
maintain the required reserve according to the
required reserve ratio designed by the Federal
Reserve System
How Does the Federal Reserve
Create the Money Supply
? The Benefit and the Responsibility of
Commercial Banks in the Federal Reserve
System (continued),
The Required Reserve (Rr) =
Required Reserve Ratio (rr) ? Deposit (D)
Excess Reserve (Re) =
Actual Reserve (R) - Required Reserve (Rr)
How Does the Federal Reserve
Create the Money Supply
? The Multiplier Process of Money Creation
Previously,we have said that the central bank
can control the money supply,Yet what central
bank can directly control is the high powered
money,Even M1 also include the checkable
deposit,How central bank can control or influence
this part of money?
How Does the Federal Reserve
Create the Money Supply
? Consider an initial increase in high powered
money,say 100 millions dollars,This might
occur when the central bank buys bonds at
open market operation,What is the total
money creation for this activity of central
bank?
How Does the Federal Reserve
Create the Money Supply
? Assume
– the required reserve ratio is 20%
– all banks are exactly meeting their required
reserve
– this $100 millions is owned by a single person
called John who has an account in Bank A
Multiplier Process of Money Creation
The First Round,Bank A
Assets
Reserves +100
Loan +80
Reserve -80
Liabilities
Deposits +100
? In this case,the required reserve for this additional
100 million deposit is 20 million,The excess
reserve for Bank A is 100 - 20 = 80,This excess
reserve can be lend out,say,to Martin who open
an account in Bank B,
Multiplier Process of Money Creation
The Second Round,Bank B
Assets
Reserves +80
Loan +64
Reserve -64
Liabilities
Deposits + 80
? For bank B,the required reserve for this additional
80 million deposit is 16 million,The excess
reserve is 80 - 16 = 64,This excess reserve can be
lend out,say,to Smith who open an account in
Bank C.
Multiplier Process of Money Creation
? Now Bank C has excess reserve 64 - 0.2?64
= 51.2,This excess reserve can again be
lend out,
? What we have found for this initial creation
of high powered money is that it bring
the total deposit =
100 + 80 + 64 + 51.2 +,....
Multiplier Process of Money Creation
? Specifically,let the initial money from the
federal reserve denoted as H (H is the high
powered money) and the required reserve
ratio as rr,Then the total amount of money
created,denoted as M,due to H is given by
? Above 1/ rr is called the money multiplier.
H
r
M r1?
