topic 11 - monetary theory

PSCI 1500: Introduction to

Economics

Monetary Theory

MONEY SUPPLY & ECONOMIC ACTIVITY

REVIEW

Summary of Key Lessons from previous topics:

1. Total, or aggregate spending drives the economy’s levels of production, employment, and income.

2. Total spending is found by adding together the spending of all four major macroeconomic sectors.

3. Increases in total spending lead to increases in production, employment, and income unless the economy is at full employment.


REVIEW

Summary of Key Lessons from previous topics

4. At (or near) full employment, increases in spending lead to overall price increases (demand-pull inflation)

5. Decreases in total spending result in a decline in production, employment, and income, and may dampen inflation.

6. Money is created when financial depository institutions make loans, destroyed as it is repaid.

Equation of Exchange (MV = PQ)• Also known as the “Quantity Theory of Money”• Illustrates how changes in the supply of money

(M) influence the level of prices (P) and/or the total output of goods and services (Q).

• Velocity of money (V) is the number of times each dollar is spent for new goods and services in a year, or how often the money supply turns over each year.

• The theory proposed that money supply has a direct, proportional relationship with price level.

• Thus, increase in the currency in circulation would lead to a proportional increase in price of goods.


Changing Money Supply (M) based on MV = PQ

Increase in money supply (M)• If the overall economy is not at full

employment and production, it will lead to total output (Q) to increases more than the increase in price (P).

• Whereas if the economy is at full employment, it will lead to the price (P) increases to be more than total output (Q) increases.

Decrease in money supply (M)• Typically results in a decrease in total

output (Q), but price (P) usually does not decrease.


MONEY CREATION

Components of bank reserves:

1. Actual Reserves (AR) - Financial institutions’ reserve account plus its vault cash.

2. Reserve Requirement (%) - Specific percentage of deposits that a financial institution must keep as actual reserves.

3. Required Reserves (RR) - Amount of actual reserves that a financial institution must keep to back its deposits.

MONEY CREATION

Components of bank reserves (cont’d):

4. Excess Reserves (ER)• Reserves of a financial depository

institution over the amount it is required to maintain in actual reserves.

• Actual reserves minus required reserves.• ER = AR - RR

MONEY CREATION

Process of Money Creation (cont’d.) Excess Reserves & Loan Making

Financial depository institutions can make new loans up to the value of their excess reserves.

MONEY CREATION

Multiple Expansion of Money

Money Multiplier Effect - initial change in excess reserves in the financial depository institutions system causes a larger change in the money supply.

Money Multiplier = 1/RR (RR – reserve requirement)

For example, if 10%, money multiplier is 10

MONEY CREATION

EXCESS RESERVE (ER)

EXCESS RESERVE - the foundation for loan making

Loan can be created up to the value of excess reserve

The supply of money can be controlled through controlling the amount of excess reserve.

Let say, Actual Reserve = $ 10,000Required Reserve = $ 6,000Excess Reserve = AR - RR = $ 4,000

If total loan demanded is greater than ER, how will the monetary policy react?...................

The Central Bank puts $50,000,000 in new excess reserves into the system when the reserve requirement is 8%. What is the money multiplier and the maximum amount by which the money supply can increase because of these new reserves?

Money multiplier = 1/0.08 = 12.5Money supply increase = $625,000,000

TEST YOUR UNDERSTANDING

The Central Bank decides to raise the reserve requirement from 10% to 11%. By how much will excess reserves decrease at ABC Bank if it has $33,500,000 in deposits and $5,750,000 in actual reserves?

Decrease in excess reserves = 1% x $33,500,000

= $ 335,000


MONEY SUPPLY & SPENDING LEVELS

Relationship between Loan Making, the Money Supply, Spending, and the Level of Economic Activity

INTEREST RATES

What is interest Rate?Price paid to borrow money - cost of borrowing

Percentage of the amount borrowed.Can be used to control the money supply.

INTEREST RATES & SPENDING LEVELS

• Interest Rates on Loans

Interest rates for loans are determined by the demand for, and supply of funds for loans.

Decreases in excess reserves will cause interest rates to rise, and amount of loans made to fall.

Increases in the excess reserves will cause interest rates to fall, and amount of loans made rise.

Effect of Changes in Excess Reserves on the Interest Rate and the Quantity of Loans


Relationship among Excess Reserves, the Interest Rate, Loan Making, and the Level of Economic Activity



Explain why financial institutions are required to keep reserves.

Reserves are required in order to limit the amount of bank lending (money creation) that can occur.

Without required reserves, theoretically banks would have unlimited power to lend and thus, expand the money supply without any limit.

Describe on how a change in the reserve required ratio affects the money supply.

An increase in the ratio will decrease the size of the excess reserves held by commercial banks, thus causing the money supply to decrease.

A decrease in the ratio will increase the size of the excess reserves held by commercial banks, thus causing the money supply to increase.


topic 11 - monetary theory

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