Chap18

Editor's Notes

1. This chapter is particularly good for students with interests in money and banking and finance. The first half of this chapter covers money supply, including money creation in the banking system, and how the central bank controls the money supply. Much of this material is review for most students who took a macro principles course. However, this chapter presents a model of the money multiplier that is more realistic than the models found in most principles texts. The second half of the chapter presents several theories of money demand.
2. It might be worthwhile at this point to explain why deposits are liabilities and why reserves and loans are assets.
3. In this and the following examples, we assume there is $1000 in currency circulating in the economy. We then compare the size of the money supply in different scenarios about the banking system: no banks, 100% reserve banking, and fractional reserve banking.
4. Maybe the borrower deposits the $800 in the bank. Or maybe the borrower uses the money to buy something from someone else, who then deposits it in the bank. In either case, the $800 finds its way back into the banking system.
5. Again, the person who borrowed the $640 will either deposit it in his own checking account, or will use it to buy something from somebody who, in turn, deposits it in her checking account. In either case, the $640 winds up in a bank somewhere, and that bank can then use it to make new loans.
6. The point of all this algebra is to express the money supply in terms of the three exogenous variables described on the preceding slide.
7. Note: An increase in cr raises both the numerator and denominator of the expression for m . But since rr < 1, the denominator is smaller than the numerator, so a given increase in cr will increase the denominator proportionally more than the numerator, causing a decrease in m . If your students know calculus, they can use the quotient rule to see that (d m /d cr ) < 0.
8. Why it’s called “open market operations”: The “operations” are the buying and selling. The market in which U.S. Treasury bonds are traded is “open” in the sense that anyone---you, me, your Aunt Zelda, the Fed---can buy or sell in this market.
9. Why not reserve requirements? Making them too low creates a risk of bank runs. Making them too high makes banking unprofitable. In addition, banking would be difficult if the Fed changed reserve requirements frequently.
10. Table 18-1, p.517. Source: Adapted from Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960 (Princeton, NJ: Princeton University Press, 1963), Appendix A. To the table, I have added an extra column with the percent changes. I have animated the table so that the rows appear in three groups. First group: M , C , and D , because M = C + D Second group: B , C , and R , because B = C + R Third group: m and its components, rr and cr The base rises, yet the money multiplier falls so much that the money supply falls.
11. Why portfolio theories are not relevant for M1: As a store of value, M1 is dominated by other assets: other assets serve the store of value function as well as M1, but offer a better risk/return profile, so there is no reason why anybody would hold M1 for a store of value.
12. Intuition for the signs: Stocks and bonds are alternatives to money. An increase in their expected returns makes money less attractive, and thus reduces desired money holdings. The real return to holding money is -  e . An increase in  e is a decrease in the real return to holding money, which would cause a decrease in desired money balances. And finally, an increase in wealth causes an increase in the demand for all assets.
13. In the Baumol-Tobin model, we assume for simplicity that the consumer’s wealth is divided between cash on hand and savings account deposits. The savings account pays interest rate i , while cash pays no nominal interest. Alternatively, we can think of “money” in the Baumol-Tobin model as representing all monetary assets, including some that pay interest. Then, i in the model would be the interest rate on non-monetary assets (e.g. stocks & bonds) minus the interest rate on monetary assets (interest-bearing checking & money market deposit accounts). F would be the cost of converting non-monetary assets into monetary ones, such as a brokerage fee. The decision about how often to pay the brokerage fee is analogous to the decision about how often to make a trip to the bank.
14. Figure 18-1 on p.521. Our first step: compute average money holdings as a function of N. (Then, we will find the optimal value of N.) If N=1, then the consumer withdraws $Y from her savings account at the beginning of the year. As she spends it gradually throughout the year, her money holdings fall.
15. Figure 18-1 on p.521. If N = 2, consumer makes one trip at the beginning of the year, withdraws half of the money she will spend throughout the year. She spends it gradually over the first half of the year until it runs out. Then she makes another trip, withdrawing enough money to last her the second half of the year, and spends it down gradually.
16. Figure 18-1 on p.521.
17. Figure 18-2 on p.523. (For any value of N, the height of the red line equals the height of the blue line plus the height of the green line at that N.) This slide shows the graphical derivation of N*. The following slide uses basic calculus to derive an expression for N*. It is “hidden” and can be omitted without loss of continuity. If you display it, then before leaving this slide you might point out that the slope of the cost function (red line) equals zero at N*.
18. This slide uses calculus to derive N*. Since a calculus background is not assumed, I have “hidden” this slide. If you wish to include it in your presentation, click on the Slide Show drop-down menu, and unselect “Hide Slide”.
19. If you did not show your students the slide with the calculus derivation of the expression for N*, then you can just say “it turns out that N* is equal to this expression….”
20. Page 523 of the text contains a very nice paragraph discussing things that alter F , and hence money demand: automatic teller machines internet banking wages (higher wages increase the opportunity cost of time spent visiting the bank) bank or brokerage fees
21. Answer: (From p.523) “The spread of automatic teller machines reduces F by reducing the time it takes to withdraw money.” Lower F increases N* and decreases money demand - you can see this from the expressions N* and money demand. A decrease in the cost of withdrawing money allows consumers to hold lower real money balances relative to their spending, so they can keep more of their money in interest-bearing bank accounts. Of course, they will need to make more trips to the bank now, but doing so is less costly.