1. Foundation of Economic Analysis 3250:600
Instructor: Richard W. Stratton
Meets: Thursday 5:20 – 7:50 pm
CAS 134

2. The University of Akron
Administration
This Week’s Assignments
Farnham Chapter 13 (Role of Money)
Homework 08 (due before Thanksgiving)
Next week Thanksgiving
Weeks after break Assignments
Farnham Chapter 14 (AD/AS)
Homework 09 (review)
Essay 2
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The University of Akron
Decision Tree

3. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

4. The University of Akron
Introduction
Functions of Money
Medium of exchange
Unit of account
Store of value
Standard of deferred payment
We have used it primarily as unit of account and medium of exchange
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5. The University of Akron
Introduction
Many assets might be used as money
Money most liquid assets
Medium of exchange
M1 – in non-banking public’s hands
Currency,
Demand Deposits, and
Travelers’ checks
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6. The University of Akron
Introduction
M2 – M1 plus
Money market fund shares
Savings accounts
Small time deposits
Data sources
Monetary Aggregates
Official Definitions
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7. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

8. Financial Intermediaries
Financial Intermediaries channel savings to loans
From those who spend less than their income
To those who wish to spend more than their income
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9. Financial Intermediaries
Consumption
Product Markets
Revenues
Investment
House-holds
Firms
Borrowing
Borrowing
Saving
Financial Markets
Factor Markets
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Income
Expenses

10. Financial Intermediaries
Remember
S = Yd – C
So that
And that
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11. Financial IntermediariesPS
10% 8%
Real interest rate 3% Id
$12
$22
$40
Billions of dollars
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12. Financial Intermediaries
Some special institutions
Commercial banks
Thrift institutions
The Federal Reserve System
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13. Financial Intermediaries
These institutions accept short term deposits (demand deposits)
If they hold all funds – 100% reserves
But they earn no income
They learn that not all funds are requested each day, but that only a fraction of the funds are needed daily.
If they hold some – fractional reserves
They can loan the rest to earn an income
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14. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

15. The University of Akron
Nominal Money Stock
Banks create money by making loans
They convert assets that are NOT counted as money into assets that are counted as money
Fractional reserve system allows the creation of money
Click here to view exercise detailing how money is created using T-accounts
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16. The University of Akron
Nominal Money Stock
Money Supply (stock) is M1
Currency + Demand Deposits + Travelers’ Checks
Non-banking public
Monetary Base
Currency + Total Reserves
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The University of Akron

17. The University of Akron
Nominal Money Stock
Simple deposit multiplier (d)
1/rr or 1/FRR
If excess reserves increase by “E”, the maximum by which the money supply can increase is 1/rr * E
Money multiplier (mm)
Money Supply / Monetary Base
Takes into account currency drain
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18. The University of Akron
Nominal Money Stock
Money multiplier (mm)
Money Supply / Monetary Base
c = currency / deposit ratio
rr = reserve requirement
e = excess reserve ratio
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The University of Akron

19. The University of Akron
Nominal Money Stock
Money multiplier (mm)
Money Supply / Monetary Base
If excess reserves increase by “DER”, the money supply can increase by
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The University of Akron

20. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

21. The University of Akron
Central Bank
The Federal Reserve System
Board of Governors
Federal Open Market Committee
12 Regional banks
Functions
Bank for banks
Bank for federal government
Bank supervision
Monetary Policy
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22. The University of Akron
Central Bank
Monetary Policy Tools
Impact excess reserves and thus MS
Federal reserve requirement (rr)
Discount rate (primary and secondary)
Federal Funds Market and Federal Funds rate
Open Market Operations
Buying and selling of securities
Influences banks’ excess reserves
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23. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

24. The University of Akron
Money Market
Nominal and Real Money Supply
Nominal and Real Money Demand
Money Market Equilibrium
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25. The University of Akron
Money Market (supply)
The FED influences the Nominal Money Supply through monetary policy
Real Money Supply controls for changes in the price level, which we are holding constant at the moment
RLMS = MS / P
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26. The University of Akron
Money Market (supply)
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27. The University of Akron
Money Market (demand)
Why do we hold some of our assets as money?
Benefits of holding money
Comparative advantage for transactions
Transaction demand
Precautionary demand
Asset demand (part of portfolio)
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28. The University of Akron
Money Market (demand)
Transaction and Precautionary
Depends on planned spending
Depends primarily on
Real Income
Real Interest rates
Technology that changes the opportunity cost of holding money
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29. The University of Akron
Money Market (demand)
Asset demand (part of portfolio)
Depends on cost of holding money
Forgone income from interest earning assets
Depends primarily on
Nominal Interest rates
Real r = nominal r – inflation rate
If prices constant: real r = nominal r
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30. The University of Akron
Money Market (demand)
The Real Demand for money shows the relationship between
Quantity of money held
Real Interest rates (r)
Real income or output (Y)
Asset demand
Transaction demand
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31. The University of Akron
Money Market (demand)
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32. Money Market (equilibrium)
RLMD = RLMS
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33. Money Market (equilibrium)
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34. Money Market (equilibrium)
Increase the supply of money
Monetary policy
Equilibrium interest rate decreases
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35. Money Market (equilibrium)
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36. Money Market (equilibrium)
Increase the demand for money
Increase Y
Equilibrium interest rate increases
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37. Money Market (equilibrium)
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38. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

39. The University of Akron
LM Curve
The LM (Liquidity=Money) curve shows all combinations of the real interest rate (r) and Real Output (Y) for which:
The demand for money (MD) = Supply of money (MS)
Thus it is a relationship between the real interest rate (r) and equilibrium real output (Ye)
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40. The University of Akron
LM Curve
Thus it is the relationship between the real interest rate (r) and equilibrium real output (Ye)
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41. The University of Akron
LM Curve
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42. The University of Akron
LM Curve (shifters)
Any factor that shifts MD or MS (other than r) will shift the LM curve
Real income
Prices
Monetary policy
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The University of Akron

43. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs

44. The University of Akron
Money Market (demand)
Demand for money
Transaction demand
Asset demand (part of portfolio)
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45. The University of Akron
LM Curve
Ma = f(r)
Mt = k(Y)
Mt + Ma = Ms
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46. The University of Akron
LM Curve
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47. The University of Akron
LM Curve (increase Ms)
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48. The University of Akron
LM Curve (decrease Ms)
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The University of Akron

49. Decision Tree Graphs Introduction Financial Intermediaries
Nominal Money stock
Central Bank (The FED) and Monetary Policy
The Money Market (Md and Ms)
The LM curve
Graphs