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Macroeconomics: Money- Supply and Demand-


Different "types" of money:

  • M1: the money held in coins and bank notes, and in checking account deposits. This is the most liquid form of money.
  • M2: M1 plus savings accounts and small time deposits that cannot be used within a certain period of time. Note that M2 is bigger than M1 but slightly less liquid.
  • M3: M1 and M2 plus larger time deposits. This is bigger and less liquid than M2.

Money supply:
  • It measures the amount of money available to households and firms at some point in time (usually represented by either the M1, M2, or M3).
  • The money supply is mainly determined by the central bank (also known as the Federal Reserve, or the Fed, in the US). The central bank influences the interest rate through monetary policies aimed at changing the money supply.
  • Note that the money supply curve is perfectly inelastic, since the Fed makes decisions that are not influenced by the nominal interest rate.
    • The y-axis is the nominal interest rate, which can be think of it as the price of money, or the opportunity cost of holding money.


Role of commercial banks:
  • Accepting checking and saving deposits, which the bank pays interest.
    • Checking and saving accounts are liabilities for the bank, since the bank owes the amount deposited plus interest.
  • Loans to borrowers, either households or firms. 
    • A loan is an asset to the bank, since the bank is owed the amount loaned plus interests.
  • The profit for a commercial bank comes from the difference between the interest rates charged on its assets and the the interests rates it pays on its liabilities.
Required reserves:
  • A commercial bank is required to keep a certain amount of its deposits on reserve (i.e it cannot loan it out) 
    • The Federal reserve determines the percentage of total deposits that banks must keep on reserve via the required reserve ratio (RRR). 
  • The Fed only pays a low interest rate on the required reserve. As a result, commercial banks usually prefer to loan the excess reserve out.
    • An increase in excess reserve shifts the money supply to the right (and vice versa). The level of excess reserves depends on the RRR.
Creation of money by commercial banks:
  • By making the following assumption that most people have access to a bank account and that there is a RRR and banks are willing to loan out their excess reserves, then following happens:
    • Money multiplier: the ultimate amount by which an increase in the checkable deposits in the banking system  which is the sum of a converging geometric series:
    • If the bank's reverse increase because the Fed has purchased government bonds, then the total amount of money created is simply x times the money multiplier.
    • If a person deposits a sum of cash into their bank account, say y dollars, then the total amount of money created is y times the money multiplier minus y since y is already existing money in the system.
Money demand:
  • Money is demanded for two main reasons: it is an asset to keep wealth in liquid form, or to use in transaction.
  • Asset demand: inverse relationship between the amount of money demanded and the interest rate. Thus, the asset demand curve is downward sloping.

  • Transaction demand: often denoted by the letter M, refers to the demand for liquidity in order to purchase a good or service. M depends on the level of output in the economy (Y), the velocity of money (V), and the average price level (P) in the economy. 
  • You can assume that P and V are stable, therefore the transaction demand is dependent only on the level of output in the economy. Therefore the transaction demand of money is inelastic since it is not influenced by the level of interest rate.

  • Total demand for money: combine both the asset and transaction demands, the result is a downward sloping curve (Dm) inversely related to the nominal interest rate and dependent on the level of national output (Y) (i.e if Y goes up, Dm shifts to the right).
    • Note that the total demand is just the horizontal summation the two types of demand discussed above.

References:
  1. Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 153-162.
  2. Fed St Louis for the first graph

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