Federal Funds Rate

July 13, 1990 Sept. 4, 1992: 8.00% - 3.00% (Includes 1990 1991
recession)
Feb. 1, 1995 Nov. 17, 1998: 6.00% - 4.75%
May 16, 2000 June 25, 2003: 6.50% - 1.00% (includes 2001
recession)
June 29, 2006 Oct. 29, 2008: 5.25% - 1.00%
Dec. 16, 2008: 0.00% - 0.25%
Dec. 16, 2015: 0.25% - 0.50%
Next raise?: 0.50% - 0.75%

Equilibrium in the Money Market

Supply of reserves ( )
= since = +
= Supply of central bank money Demand for currency by the public
Demand for reserves by banks:

Equilibrium condition:
Supply of reserves = Demand for reserves by banks
=
= + =

Supply & Demand for Money, and the Money Multiplier

From 4.19 , = + 1 $
4.20 :

1
+ 1

= $

Supply of Money = Demand for Money

Meaning: In equilibrium, the overall supply of money (currency +

checkable deposits) must equal the overall demand for money
(currency + checkable deposits).

 4.20 :

1
+ 1

Remarks on Eq. (4.20)

= $ . 4.2 : = $ .

Equation (4.2) characterizes the equilibrium in an economy without

banks.
=

1
+ 1

is called the money multiplier .

The overall supply of money equals to the money multiplier times

central bank money: = .
= money multiplier =

1
:

An increase in a dollar of

high-powered money leads to an increase of

supply.

dollars in the money

Remarks on Eq. (4.20)

The presence of a multiplier in equation (4.20) implies that a given
change in central bank money has a larger effect on the money
supply and in turn a larger effect on the interest rate in an economy
with banks than in an economy without banks.
Central bank money is sometimes called high-powered money or the
monetary base to reflect the fact the overall supply of money
depends in the end on the amount of central bank money.

Alternative Money Multiplier

The Fed directly controls the monetary base but doesnt directly
control the money supply: The Fed uses open market operations to
change the size of the monetary base.
Lets examine the relationship between the monetary base and the
money supply: 4.21 : = +

The monetary base has two uses: Some of the monetary base is held
as currency by the public, and the rest is held as reserves by banks.
4.22 : = +

Alternative Money Multiplier

To relate the money supply to the monetary base, divide (4.21) by
(4.22):

+
+

=
=

+


+

+1
+

4.23 : =

+1

+
+

Alternative Money Multiplier

4.23 : =

+1
+

The money multiplier will be greater than 1 as long as < (that is,
with fractional reserve banking).
Each additional dollar of monetary base will increase the money
supply by more than one dollar, which is why the monetary base is
known as high-powered money.
The money supply is proportional to the monetary base.
Thus, an increase in the monetary base increases the money supply
by the same percentage.

Alternative Money Multiplier

4.23 : =

+
+

An increase (or a decrease) in the reserve-deposit ratio causes

the money multiplier to fall (or to increase) and, if MB is unchanged,
it also causes the money supply to decline (or to increase).
Role of banks!
An increase (or a decrease) in the currency-deposit ratio causes
the money multiplier to fall (or to rise) and, if MB is unchanged, it
also causes the money supply to fall (or to rise).
Role of the public!

Example (4.7): Money Multiplier

An economy has a monetary base of 1,000 $1 bills. Calculate the
money supply in scenarios (a) (d) and then answer part (e).
(a) All money is held as currency.
(Ans.)
All the money is held as currency: = 0.
=

$1000
=
= and
0
+1
+1
=
= 1.
+
+0

0
0

= =0

Then M (the money supply) = MB (the monetary base).

The money supply will be $1,000.

Example (4.7): Money Multiplier

Method 2:
All the money is held as currency: = 0 = 1
=

1
+ 1

1
1+0

= 1.

Then = = $1,000.
(b) All money is held as demand deposits. Banks hold 100 percent of
deposits as reserves.
(Ans.)
=

0
=
= 0 and
1000
+1
0+1
=
=1
+
0+1

1000
1000

=1

Example (4.7): Money Multiplier

= 1 $1000 = $1,000 because 100 percent of money is held on
reserves and no loans are made.
Method 2:
All money is held as demand deposits; = 0 and = 1
=

1
+ 1

1
0+1

=1

= 1 $1000 = $1000.
(c) All money is held as demand deposits. Banks hold 20 percent of
deposits as reserves.
(Ans.)
=

0
1000

= 0 and =

200
1000

= 0.2

Example (4.7): Money Multiplier

=

+1
+

0+1
0+0.2

= 5.

= 5 $1000 = $5,000.
Method 2:
All money is held as demand deposits; = 0 and = 0.2
=

1
+ 1

1
0+0.2

=5

= 5 $1000 = $5000.
(d) People hold equal amount of currency and demand deposits. Banks
hold 20 percent of deposits as reserves.
(Ans.)
= 1 and =

= 0.2

Example (4.7): Money Multiplier

=

+1
+

1+1
1+0.2

= 1.67.

= 1.67 $1000 = $1,670.

Method 2:
People hold equal amount of currency and demand deposits; = 0.5
=

1
+ 1

1
0.5+0.2(10.5)

= 1.67

= 1.67 $1000 = $1,670.

Example (4.7): Money Multiplier

(e) The central bank decides to increase the money supply by 10
percent. In each of the above four scenarios, how much should it
increase the monetary base?
(Ans.)
Recall: = % = % b/c % = 0
= ; the money supply is proportional to the monetary
base.
Since m is a constant number, a 10% increase in the monetary base
(MB) leads to a 10% increase in the money supply (M).

Classical Economists View on Money

We saw how the money supply is determined by the banking system
together with the policy of the central bank, so can now start to
examine how the quantity of money is related to other economic
variables, such as the overall level of prices and incomes ().
The theory we would like to develop here, called the quantity theory
of money, has its root in the work of the early monetary theorists,
including the philosopher and economist David Hume.
It remains the leading explanation for how money affects the
economy in the long run.

Velocity and Quantity Theory of Money

The quantity theory of money allows us to make the connection
between money and inflation.
Quantity equation: . 4.24 = ,
where is the amount of money in circulation, is called the
velocity of money, denoted the price level, and denoted real GDP.
: nominal GDP the amount of goods and services purchased in
an economy, valued at current prices
: the effective amount of money used in purchases
Meaning: Nominal GDP is equal to the effective amount of
money used in purchases .

Velocity and Quantity Theory of Money

(Income) Velocity of Money, just called Velocity
The number of times the money stock (or money supply) is turned
over per year in financing the annual flow of income
The average number of times per year that each piece of paper
currency is used in a transaction
It measures how often the money stock turns over each period.
4.25 : =

nominal GDP
nominal money stock

Velocity and Quantity Theory of Money

Example: In 2009 nominal GDP was about $14,256 billion and the
money stock averaged $8,424 billion.
velocity =

nominal GDP

$,
$,

= . .

Meaning:
Each piece of is used, on average, in 1.7 transactions:
1.7 =
Each dollar of money balances financed on average $1.70 of
spending on final goods.
To put another way,

$8,424
$14,256

= 0.588 0.59; the public held an

average of 59 cents of per dollar of income.

Velocity and Quantity Theory of Money

The concept of velocity is important because it is a convenient way of
talking about money demand.

From 4.3
= , = + , the demand for real money
balances.
Substituting (4.3) into (4.25):
4.25 : =
since

= , = + in equilibrium.

Velocity and Quantity Theory of Money

Convenient assumption: money demand is proportional to income,
as is roughly true for long-run demand.

= , =

4.26

= ()

Real money demand is proportional to real income.

Plugging 4.26 into 4.25 :
=

4.27 :

1
=

1
=
()

Velocity and Quantity Theory of Money

4.27 : =

1
()

So, velocity is a quick way to summarize the effect of interest rate on

money demand high velocity means low demand for money:
at higher interest rates, holding money involves a higher opportunity
cost, and money therefore circulates fast.
Strong assumption: Velocity is a constant and does not depend on
income or interest rates: = .

Velocity and Quantity Theory of Money

From 4.25 : =
1

,=+

,=+

, = + =
4.28

where (a constant) tells how much money people want to hold for
every dollar of income.
4.28 says that the quantity demanded of real money balances is
proportional to real income.

Velocity and Quantity Theory of Money

This money demand function offers another way to view the quantity
equation:
In equilibrium,
From 4.28

= .

, =

= =

When people want to hold a lot of money for each dollar of income
( is large), money changes hands infrequently ( is small).
Conversely, when people want to hold a little money for each dollar
of income ( is small), money changes hands frequently ( is large).

Figure 4.8: Velocity of Money and Treasury Bill Rates

Question: Is velocity actually constant?

Velocity and Quantity Theory of Money

velocity is relatively stable between 1.5 and 2.2 over a 50-year
Period.
Velocity has a strong tendency to rise and fall with market interest
Rates.
Over the last decade velocity has become much less stable than
in the past
When the monetary aggregates all become relatively unstable,
the monetary authority should use the interest rate rather than the
money supply as the direct operating target.
velocity clearly is not constant.

Velocity and Quantity Theory of Money

=

% = % $ %
% < % $
% > 0 (velocity is rising)
% > % $
% < 0 (velocity is falling)

Figure 4.9: Growth Rates of , & NGDP, 1960 - 2012

Growth Rates of , , and Nominal GDP, 1960 - 2012

The growth rate of nominal was far higher in the early 1990s as a
result of increased demand for dollar by foreigners than that in
nominal GDP growth, so velocity fell substantially.
The growth rate of turned sharply negative in the mid-1990s as
new types of bank accounts encouraged consumers to reduce their
holdings of ; as a consequence, growth was lower than GDP
growth, so velocity grew during this period.
In the years since the financial crisis of 2008, the growth rate of
nominal was far higher than that in nominal GDP growth, so
velocity fell substantially.

Quantity Theory of Money

Since

= 4.24 : = ,

assuming that V is constant.

4.24 is the famous quantity equation, linking the price level and
the level of output to the money stock.
The quantity equation became the classical quantity theory of money
when it was argued that both and were fixed:
(i) Velocity was assumed not to change very much.
real output was taken to be fixed because the
(ii) = = ;
economy was at full employment level of output or potential output.

Quantity Theory of Money

4.29 : =

Endogenous variable:
Exogenous variable: , ,
The classical quantity theory is the proposition that the price level is
proportional to the money stock: If is constant, changes in the
money supply translate into proportional changes in nominal GDP.
=
% + % = % + %
4.30 : % = + %
=

Quantity Theory of Money

4.30 : =
The growth in the money supply determines the inflation rate.

In the classical case of (vertical) supply function - = = ,

changes in money translates into changes in the price level.
Milton Friedman says inflation is always and everywhere a
monetary phenomenon.
Conclusion: The quantity theory of money states that the central
bank, which controls the money supply, has ultimate control over the
rate of inflation. If the central bank keeps the money supply stable,
the price level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.

Financial Market Equilibrium in the Long Run

Both classical and Keynesian economists agree that the full employment assumption is reasonable for analyzing the long-term

behavior of the economy: = = .

Financial market equilibrium condition:

= , +

Exogenous variables:
, and
Endogenous variables:
r and

Financial Market Equilibrium in the Long Run

4.31 : =
, = +
The price level is proportional to the nominal money supply, given
that the real demand for money is fixed.
A doubling of the money supply would double the price level, with
other variables held constant.

Money Growth and Inflation

We want to show how inflation rate, or the growth rate of the price
level, is determined.
=

,+

4.32

,+
,+

The rate of inflation equals the growth rate of the nominal money minus
the growth rate of real money demand

To use (4.30) to predict the behavior of inflation we must also

know how quickly real money demand is growing.
Since in the long run equilibrium with a constant growth rate of money,
the nominal interest rate will be constant, growth in income will be
considered as a source of growth in real money demand.

Money Growth and Inflation

+
=

, +

=
=

,+

,+

4.33 : =

=
where is the income elasticity of money demand.

 4.33 : =

Example: =

2
.
3

Money Growth and Inflation

Meaning: The rate of inflation equals the growth rate of the nominal
money supply minus an adjustment for the growth rate of real money
demand arising from growth in real output.
(the income elasticity of money demand)
The percentage change in money demand resulting from a 1% increase
in real income

A 3% increase in real income will increase money demand

by = . An income elasticity of demand smaller than 1.0 implies

that money demand rises less than proportionally with income.

Money Growth and Inflation

Example: Suppose that nominal money growth is 10% per year, real
income is growing by 3% per year, and the income elasticity of money
demand is 2/3.
=

= .

The inflation rate will be 8% per year.

Figure 4.10: Linkages among , , and Interest Rates

Linkages among Money, Prices, and Interest Rates

As the quantity theory of money explains, money supply and

money demand together determine the equilibrium price

Changes in the price level are, by definition, the inflation rate

Inflation , in turn, affects the nominal interest rate through the

Fisher effect.

The nominal interest rate feeds back to affect the demand for
money , since the nominal interest rate is the cost of holding
money.

Linkages among Money, Prices, and Interest Rates

= , =

,=+

The quantity theory of money says that todays money supply

determines todays price level .
This conclusion remains partly true: if and are held constant,
the price level moves proportionately with the money supply.
Yet, the is not constant; it depends on , which in turn depends on
growth in the money supply % .
The presence of in the money demand function yield an additional
channel through which money supply affects the price level.

Linkages among Money, Prices, and Interest Rates

This general money demand equation implies that depends not

only on todays money supply but also on the money supply
expected in the future +1 .

The central bank announces that it will increase in the future, but it
does not change the money supply today.

This announcement causes people to expect higher money growth

and higher inflation.

This increase in expected inflation raises through the Fisher

effect.

Linkages among Money, Prices, and Interest Rates

The higher increases the cost of holding money and thus reduces
the demand for real money balances.

Because the central bank has not changed money stock

available today, the reduced demand for real money balances leads to
a higher price level today.
Conclusion: Expectations of higher money growth in the future lead
to a higher price level today.