Introduction to Money Supply
The market for money
 The Money Supply
 The relationship between the
quantity of money supplied
and nominal interest rate i.
Money

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.
MS
i0
M0
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
Money
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.
MS
i1
i0
MD
M1
M0
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
Money
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.
MS
i0
i1
MD
M0
M1
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
Money Supply and Banks
Banks as financial intermediaries
 Example: Balance for a bank
Assets
300 req’d reserves
50 excess reserves
900 US T-bonds
2000 car loans
3250

Liabilities
3000 deposits
250 net worth
3250
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
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
- MS does not change because currency held by the public and in checking
accounts are both part of the MS
- 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:
1000 + 900 + 810 + 729 + 656.1 + . . . . . = 10,000

D0
1,000
 10,000
r
0.1
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!
M 

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:
D 1, 000
M  0 
 10, 000
r
0.1

Withdrawals collapse the money in an economy via less bank lending even
though the actual number of bills in the economy has not changed!
Money Supply and the Fed
Demand for reserves
 Example: Suppose r = 0.1, D = 50 (billion $), and demand for excess reserves is
given by
D
i ff  25  QER
Derive reserves demand.
Federal Funds Market
iff
5
i ff  30  QRD
2
DR
DER
20
23
25
28
Q
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
QRS  RN  RB

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.
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:
Federal Funds Market
iff
RB + RN = 0 + 28 = 28
SR
3
Horizontal part:
id = 3
28
Q
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
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
D
i ff  25  QER
Graph the reserves supply and demand.
i ff  30  QRD
Federal Funds Market
iff
iff
(percent)
QRD
(Billions $)
2
28
5
25
5
SR
3
Vertical part: RN + RB = 28
Horizontal part: id = 3
Equilibrium
2
DR
25
28
Q
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.
The horizontal section
id = 4
The vertical section
no change
Starting on 1/1/03 the Fed
began setting the discount
rate 100 basis points (1%)
above its federal funds
rate target
Federal Funds Market
iff
4
SR
3
SR
2
DR
28
Q
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.
D
i ff  25  QER
i ff  32
30  QRD
Federal Funds Market
iff
i ff  32  28  4
4
The new equilibrium:
iff = 3
3
3  32  QRD
2
SR
QRD  32  3  29
DR
DR
28
29
Q
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.
Federal Funds Market
iff
SR
3
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.
DR
28
29
Q
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
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.
AD-AS-YFE
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.
AS
PL0
PL1
AD
The Fed has not changed the r
since 1992
AD’
Y1 YF Y0
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
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 = 28.5).
Show the effect of this policy change in the figure below.
Federal Funds Market
The horizontal section
no change
The vertical section
iff
SR
3
RN + RB = (28 + .5) + 0 = 28.5
2
New equilibrium
1.5
i ff  30  QRD
DR
i ff  30  28.5
i ff 1.5
28 28.5
Q
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
SR
3
2
1.5
DR
28 28.5
Q
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
SR
3
2.5
SR
So the Fed lowers the
discount rate to 2.5
1.5
DR
28 28.5
Q
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.
MS MS’
The money supply increases via
increased lending
i0
If inflation remains unchanged, r
will fall too, increasing I (and X).
i1
MD
M0
M1
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.
AD-AS-YFE
This results in higher GDP,
lower unemployment, and
higher prices
AS
PL1
AD’
PL0
AD
Y0
YF
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 = 28 - .5 = 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 27.5 (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.
Money Supply and the Financial Crisis
Interest on Reserves—the new tool
 The Fed’s rescue of the financial system in 2008-2009 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
iff
IOR
0
-iff
SR
Q
Money Supply and the Financial Crisis
Interest on Reserves—the new tool
 The Fed’s rescue of the financial system in 2008-2009 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
0
Q
Money Supply and the Financial Crisis
Interest on Reserves—the new tool
 The Fed’s rescue of the financial system in 2008-2009 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
0
Q
Money Supply and the Financial Crisis
Interest on Reserves—the new tool
 The Fed’s rescue of the financial system in 2008-2009 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
0
Q
Money Supply and the Financial Crisis
Interest on Reserves—the new tool
 The Fed’s rescue of the financial system in 2008-2009 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
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
This should hopefully return the
federal funds market to its precrisis state.
0
DR
SR
iff
Q
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
Money Supply Growth and Inflation
Hyperinflation in the Weimar Republic (Germany, post WWI)
Feb., 1920
March,1922
Nov.,1922
Feb., 1923
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%
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)
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
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 progrowth, free-market (not pro-business) polices.
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 progrowth, free-market (not pro-business) polices.
Watch the “Fear the boom and
bust” video on YouTube
AD-AS-YFE
PL
AS
14
12
10
8
6
AD
4
2009
2004
1998
1993
1987
1982
1976
Y