The monetary base is defined as the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve) • M1 consists of: – ( 1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions – (2) traveler's checks of nonbank issuers – (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) – (4) other checkable deposits (OCDs) • M2 consists of M1 plus: – (1) savings deposits (including money market deposit accounts) – (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; – (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. • For the purposes of this class, money supply is M1 • For now, we will assume that the central bank sets the money supply at the level it desires
M1 and M2 Money Stock: M1 SA, Bil.$ 12 11 10 09 08 07 06 05 04 03 02 Source: Federal Reserve Board /Haver Analytics 2500 2250 2000 1750 1500 1250 1000 2500 2250 2000 1750 1500 1250 1000 Money Stock: M2 SA, Bil.$ 12 11 10 09 08 07 06 05 04 03 02 Source: Federal Reserve Board /Haver Analytics 11000 10000 9000 8000 7000 6000 5000 11000 10000 9000 8000 7000 6000 5000 • M2 is about 4x M1 • Demand deposits + other checkable deposits are more than 50% of M1 • Savings deposits are about 64% of M2
Money, interest rates, and exchange rates • Key question: what determines money demand for a household? • 1/ Expected return • Return relative to the return that can be expected on other assets – Assume interest paid on money is zero – So, holding money has a cost relative to other assets – All else equal, if interest rates rise, the demand for money falls • 2/ Liquidity of the asset – Liquidity is a key benefit of holding money – The need for liquidity rises with the average daily value of transactions – So, an increase in the average value of daily transactions for a household leads to an increase in money demand • Risk: riskiness of the expected return – Unimportant. Increase in riskiness of holding money (higher price of goods, for example) should also impact the riskiness of holding alternatives such as bonds
Money, interest rates, and exchange rates • Let’s translate this to an economy • What determines total demand for money in an economy? • 1/ Interest rate – All else equal, higher interest rate ↑ opportunity cost of holding money – Money demand ↓ • 2/ Price level – Price level is the price of a broad reference basket of goods and services in currency – If price level ↑, firms and households must spend more money to keep consumption same – So, ↑ price level means that money demand ↑ • 3/ Real national income – If national income rises, more goods and services are being sold in the economy – Increase in real value of transactions causes a rise in money demand
Money, interest rates, and exchange rates
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- Fall '16
- Exchange Rate, Foreign exchange market, United States dollar