1. Introduction to Money Supply
The market for money
The Money Supply
The relationship between the quantity of money supplied and nominal interest rate i.
On any given day, the quantity of money is fixed independent of interest rate i.
The quantity of money supplied is determined by bank lending and the Fed.
Money MS i0 M0

2. Introduction to Money Supply
The market for money
Equilibrium
Money supplied is fixed in the short-run.
i is determined by the intersection of MS and MD
Interest Rate Adjustment
When the interest rate is above its equilibrium level, the quantity of money supplied exceeds the quantity of money demanded (or needed).
People hold too much money, so they try to get rid of it by buying other financial assets.
The demand for financial assets increases, the prices of these assets rise, and the interest rate falls.
Money MS i1 i0 MD M1 M0

3. Introduction to Money Supply
The market for money
Equilibrium
Money supplied is fixed in the short-run.
i is determined by the intersection of MS and MD
Interest Rate Adjustment
When the interest rate is below its equilibrium level, the quantity of money demanded (or needed) exceeds the quantity of money supplied.
People are holding too little money, so they try to get more money by selling other financial assets.
The demand for financial assets decreases, the prices of these assets fall, and the interest rate rises.
Money MS i0 i1 MD M0 M1

4. Money Supply and Banks Banks as financial intermediaries
What role do banks play in the creation of the supply of money?
Commercial banks bring savers and investors together
Banks use checking and savings deposits to make loans
balance sheet for a bank
balance sheet has two sides:
Liabilities – the source of the funds for the bank
checking accounts
savings accounts
Assets (generate income for banks via interest payments)
Mortgages
car loans
US Treasury Bonds
required reserves
excess reserves (big withdrawal insurance)
Net worth = assets – liabilities

5. Money Supply and Banks Banks as financial intermediaries
Example: Balance for a bank
Assets Liabilities
300 req’d reserves deposits
50 excess reserves
900 US T-bonds
2000 car loans net worth
Reserves: assets not lent out by banks
Banks are Required to hold a fraction of Reserves (RR )
Reserves in Excess of RR are called excess reserves (RE )
If r = 10%, the bank holds RR = 3000 X 0.1 = 300,
R = RR + RE = $350

6. Money Supply and Banks The process of money creation
Example: banks role in determining the supple of money
You walk into Bank 1 and deposit $1000 into your checking account
MS does not change because currency held by the public and in checking accounts are both part of the MS
If the r = 10%, Bank 1 holds $100 of the $1000 deposit as RR & lends $900 to George.
George uses the $900 to buy a TV from BuyMart
BuyMart deposits the $900 into its account at Bank 2
Since the r = 10%, Bank 2 holds $90 of the $900 deposit as RR & lends $810 to Jill
Yada yada yada… The original deposit of $1000 is used to create money via lending:
= 10,000
Increases in bank deposits creates money in the economy via increased bank lending even though the actual number of bills in the economy has not changed!

7. Money Supply and Banks The process of money destruction
Example: banks role in determining the supple of money
You withdrawal $1000 from your checking account at Bank 1
MS does not change because currency held by the public and in checking accounts are both part of the MS
If the r = 10%, Bank 1 holds $100 less in RR and lends out $900 less.
Bank 1 cannot lend George the $900 he needs to buy a TV.
George does not spend the $900 at BuyMart
BuyMart deposits $900 less in its account at Bank 2.
Since the r = 10%, Bank 2 holds $90 less in RR and does lends out $810 less.
Yada yada yada.. Hence, the original withdrawal $1,000 destroys money via less lending:
Withdrawals collapse the money in an economy via less bank lending even though the actual number of bills in the economy has not changed!

8. Money Supply and the Fed
Demand for reserves
Example: Suppose r = 0.1, D = 50 (billion $), and demand for excess reserves is given by
Derive reserves demand.
Federal Funds Market
iff 5 2 DR
DER 20 23 25 28 Q

9. Money Supply and the Fed
Supply of reserves
A bank that can’t meet its reserve requirement (RR ) borrows from a bank that has excess reserves in the federal funds market and QS remains unchanged.
The vertical part of reserves supply curve is the amount of reserves the Fed supplies to the federal funds market.
When banks borrow from the Fed, discount loans rise, borrowed reserves (RB) increase, the quantity of reserves supplied increases.
When banks sell US Treasury securities to the Fed, non-borrowed reserves (RN) increase, which increases the quantity of reserves.
Hence, the supply of reserves is the sum
The horizontal part of the reserves supply curve is the discount rate (id )
If the federal funds rate is less than the discount rate (iff < id), banks will not borrow from the Fed because
“Insurance” purchased from the Fed is more expensive than from other banks
If the federal funds rate is more than the discount rate (iff > id), banks will want to borrow from the Fed instead of other banks
“Insurance” purchased from other banks is more expensive than from the Fed.

10. Money Supply and the Fed
Supply of reserves
Example: Suppose RB = 0 (billion $), RN = 28 (billion $) and id = 3 (percent). Graph the supply of reserves in the figure below.
Vertical part:
RB + RN = = 28
Horizontal part:
id = 3
Federal Funds Market
iff 3 SR 28 Q

11. Money Supply and the Fed
Federal funds market equilibrium
If demand for reserves intersects the vertical section of the supply of reserves, then
The federal funds interest rate is less than the discount interest rate (iff < id )
A bank would rather borrow from other banks
The quantity of reserves equals RN + RB
If demand for reserves intersects the horizontal section of the supply of reserves, the federal funds interest rate equals the discount interest rate (iff = id )
A bank is indifferent between borrowing from other banks or the Fed
However, the bank borrows from the Fed because something (a crisis) has dried up all of the excess reserves held by banks.
The equilibrium quantity of reserves exceeds RN + RB
The difference between equilibrium quantity of reserves and RN + RB is the quantity of discount loans made by the Fed

12. Money Supply and the Fed
Federal funds market equilibrium
Example: Suppose r = 0.1, D = 50, RB = 0, RN = 28, id = 3, and excess reserves demand is
Graph the reserves supply and demand.
Vertical part: RN + RB = 28
Horizontal part: id = 3
Federal Funds Market
iff
iff
(percent)
(Billions $) 2 28 5 25 5 3 SR
Equilibrium 2 DR 25 28 Q

13. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose the Fed increases the discount rate to 4 (percent). Show the effect of this policy change in the figure below.
Federal Funds Market
The horizontal section
id = 4
iff
The vertical section
no change 4 SR 3 SR
Starting on 1/1/03 the Fed
began setting the discount
rate 100 basis points (1%)
above its federal funds
rate target 2 DR 28 Q

14. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.
Federal Funds Market
iff 4
The new equilibrium:
iff = 3 3 SR 2 DR DR 28 29 Q

15. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.
In the past, the Fed has tried slowing the economy by increasing r.
Doing this creates a big collapse in bank lending to businesses and consumers.
In addition, the Fed has to make $1 billion in discount loans to banks because RE dried up.
So even though total reserves have increased via discount lending ($1 billion in the diagram above), this cash is sitting idle.
The effect is a reduction in money supply.
Federal Funds Market
iff 3 SR DR 28 29 Q

16. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.
Money
MS’ MS
This increases r provided inflation remains unchanged. i1 i0 MD M1 M0

17. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14 (percent). Show the effect of this policy change in the figure below.
Higher r decreases I, but also reduces net exports. These collapse AD.
This results in lower prices and real GDP.
In the past, small increases in r have put a “hot” economy (one that is growing too fast) into a recessionary gap.
The Fed has not changed the r since 1992
AD-AS-YFE AS
PL0
PL1 AD
AD’ Y1 YF Y0

18. Money Supply and the Fed
Open Market Operations
The Fed conducts an Open Market Purchase (OMP) by buying Treasury bonds from banks
Cash flows from the Fed to Banks
The quantity of reserves in the federal funds market rises
The federal funds interest rate declines
This is an exPansionary monetary policy
The Fed conducts an Open Market Sale (OMS) by selling Treasury bonds to banks
The Fed has bonds to sell because it purchased them directly from
Treasury in the primary market (this is called monetizing the debt)
Banks in the secondary market in a previous OMP
Banks give cash (reserves) to the Fed in exchange for Treasury bonds
The quantity of reserves in the federal funds market declines
The federal funds interest rate increases
This is a reStrictive monetary policy

19. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half of a billion dollars worth of bonds from banks (RN = = 28.5). Show the effect of this policy change in the figure below.
Federal Funds Market
The horizontal section
no change
iff
The vertical section
RN + RB = ( ) + 0 = 28.5 3 SR SR 2
New equilibrium
1.5 DR 28
28.5 Q

20. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.
Federal Funds Market
Starting on 1/1/03 the Fed
began setting the discount
rate 100 basis points (1%)
above its federal funds
rate target.
iff 3 SR SR 2
1.5 DR 28
28.5 Q

21. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.
Federal Funds Market
Starting on 1/1/03 the Fed
began setting the discount
rate 100 basis points (1%)
above its federal funds
rate target.
So the Fed lowers the discount rate to 2.5
iff 3 SR SR
2.5 SR
1.5 DR 28
28.5 Q

22. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.
Money
Increased RN means banks have more cash to lend to consumers and business.
The money supply increases via increased lending
If inflation remains unchanged, r will fall too, increasing I (and X). MS
MS’ i0 i1 MD M0 M1

23. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.
Lower r increases I, but also increases net exports. These increase AD.
This results in higher GDP, lower unemployment, and higher prices
AD-AS-YFE AS
PL1
PL0
AD’ AD Y0 YF

24. Money Supply and the Fed
Federal funds market equilibrium
Example (continued ): Suppose instead the Fed performs an OMS by selling a half of a billion dollars worth of bonds to banks (RN = = 27.5) . Explain how this policy change affects the economy.
An OMS is the opposite of an OMP.
If the Fed sells 0.5 (billion $) in US Treasury securities to banks, then 0.5 (billion $) in US Treasury securities leaves the Fed’s vault while 0.5 (billion $) in cash from member banks enters the Fed’s vault.
This decreases RN by 0.5 (billion $) and total reserves from 28 to (billion $), decreasing reserves supply.
The equilibrium federal funds interest rises while MS falls.
i rises, which raises r if inflation does not change.
Hence, I and X decline, decreasing AD
Lower AD results in less output and lower prices.

25. Money Supply and the Financial Crisis
Interest on Reserves—the new tool
The Fed’s rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative.
Federal Funds Market
iff DR
To prevent this in October of 2008, the Fed began paying Interest on Reserves (IOR), which is currently about 0.25%
Crisis mode id SR
iff
IOR Q
-iff

26. Money Supply and the Financial Crisis
Interest on Reserves—the new tool
The Fed’s rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative.
Federal Funds Market
iff DR
This allows the Fed to buy id SR
IOR Q

27. Money Supply and the Financial Crisis
Interest on Reserves—the new tool
The Fed’s rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative.
Federal Funds Market
iff DR
This allows the Fed to buy or sell as many securities as it wants without changing the federal funds rate. id SR
IOR Q

28. Money Supply and the Financial Crisis
Interest on Reserves—the new tool
The Fed’s rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative.
Federal Funds Market
iff DR
The federal reserve can also raise and lower the federal funds rate by simply raising IOR and id simultaneously. id SR
IOR Q

29. Money Supply and the Financial Crisis
Interest on Reserves—the new tool
The Fed’s rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative.
Federal Funds Market
iff DR
The Fed will need to conduct several controlled OMS while carefully raising IOR to reduce its $2-3 trillion balance while keeping a eye on inflation. id SR
iff
This should hopefully return the federal funds market to its pre-crisis state. Q

30. Money Supply Growth and Inflation
Money Supply growth is the percent change in the stock of money
Inflation is the percent change in the Price Level (PL) from one year to the next.
Hyperinflation is really high inflation
How high is really high?
It’s a judgment call
Usually we talk about ridiculously high examples.
Compounding is important to remember.
Examples of Hyperinflation
YouTube inflation video 1
YouTube inflation video 2

31. Money Supply Growth and Inflation
Hyperinflation in the Weimar Republic (Germany, post WWI)
Feb., 1920
March,1922
Nov.,1922
Feb., 1923

32. Money Supply Growth and Inflation
Hyperinflation in the Weimar Republic (Germany, post WWI)
July, 1923
Sept., 1923
Oct., 1923
Why did this happen?
In Nov. of 1918, there were 29,200,000,000 paper marks in circulation
A year later, 497,000,000,000,000,000,000 paper marks in circulation
That was a massive increase in the money supply, an increase of
1,702,054,794,421%

33. Money Supply Growth and Inflation
Yugoslavia had inflation problems in the 1980’s, but in 1993 things really got bad.
$1 = 900 Dinar (1/1/93)
$1 = 2,000,000 Dinar (11/12/93)
$1 = 13,000,000 Dinar (11/23/93)
$1 = 64,000,000 Dinar (11/31/93 )
$1 = 6,400,000,000 Dinar (12/15/93)
PRICES WERE DOUBLING EVERY DAY
$1 = 12,000,000,000,000,000,000,000 Dinar (1/24/94)

34. Keynes vs. Hayek Keynes: advocate of proactive government intervention
Budget deficits in recessions
Surpluses in economic expansions
Both can be used to manage AD, ensuring full employment
Hayek: advocate of economic freedom
Government intervention results in less economic freedom
Economic efficiency
"The problem was that under central planning, there was no economic calculation--no way to make a rational decision to put this resource here or buy that good there, because there was no price system to weigh the alternatives."
“Socialism told us that we had been looking for improvement in the wrong direction.“
The thesis in The Road to Serfdom is
Government intervention leads to more intervention
Each intervention has unintended consequences, which distort markets
Unintended consequences of well-intentioned policy generates the need for more interventions because consequences need to be corrected.
It is this dynamic that leads society down the road to serfdom.
The tree and western wild fire analogies

35. Keynes vs. Hayek
Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps.
Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices.

36. Watch the “Fear the boom and bust” video on YouTube
Keynes vs. Hayek
Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps.
Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices.
Watch the “Fear the boom and bust” video on YouTube PL
AD-AS-YFE
Hayek AD AS
Keynes Y