Topic_7_-_Money_Supply_and_Money_Demand

Topic_7_-_Money_Supply_and_Money_Demand - macro Chapter...

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macro Money Supply and Money Demand Topic 7 Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 1 Chapter objectives Chapter objectives ± Money supply – how the banking system “creates” money – three ways the central bank can control the money supply – why the central bank can’t control it precisely ± Theories of money demand – a portfolio theory – a transactions theory: the Baumol-Tobin model Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 2 Banks ’ role in the money supply role in the money supply ± The money supply equals currency plus demand (chequing account) deposits: M = C + D ± Since the money supply includes demand deposits, the banking system plays an important role. Topic 7 Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 3 A few preliminaries A few preliminaries ± Reserves ( R ): the portion of deposits that banks have not lent. ± To a bank, liabilities include deposits, assets include reserves and outstanding loans ± 100-percent-reserve banking : a system in which banks hold all deposits as reserves. ± Fractional-reserve banking : a system in which banks hold a fraction of their deposits as reserves. Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 4 SCENARIO 1: No Banks No Banks With no banks, = 0 and = = $1000. Topic 7 Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 5 SCENARIO 2: 100 Percent Reserve Banking 100 Percent Reserve Banking ± After the deposit, C = $0, D = $1000, M = $1000. ± 100% Reserve Banking has no impact on size of money supply. UWI BANK’S balance sheet Assets Liabilities reserves $1000 deposits $1000 ± Initially C = $1000, D = $0, M = $1000. ± Now suppose households deposit the $1000 at “UWI Bank.”
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Topic 7 Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 6 SCENARIO 3: SCENARIO 3: Fractional Fractional -Reserve Banking Reserve Banking The money supply now equals $1800: The depositor still has $1000 in demand deposits, but now the borrower holds $800 in currency. UWI BANK’S balance sheet Assets Liabilities deposits $1000 ± Suppose banks hold 20% of deposits in reserve, making loans with the rest. ± UWI Bank will make $800 in loans. reserves $1000 reserves $200 loans $800 Topic 7 Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 7 SCENARIO 3: SCENARIO 3: Fractional Fractional -Reserve Banking Reserve Banking The money supply now equals $1800: The depositor still has $1000 in demand deposits, but now the borrower holds $800 in currency. UWI BANK’S balance sheet Assets Liabilities reserves $200 loans $800 deposits $1000 Thus, in a fractional-reserve banking system, banks create money . Topic 7 – Money Supply and Money Demand Money Supply and Money Demand slide 8 SCENARIO 3: Fractional -Reserve Banking Reserve Banking ± But then Guild Bank will loan 80% of this deposit ± and its balance sheet will look like this: GUILD BANK’S balance sheet Assets Liabilities deposits $800 ± Suppose the borrower deposits the $800 in Guild Bank.
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This note was uploaded on 11/12/2011 for the course ECON 2003 taught by Professor Macoeconomics2 during the Spring '10 term at University of the West Indies at Mona.

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Topic_7_-_Money_Supply_and_Money_Demand - macro Chapter...

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