Trot PS 9
MONEY & BANKING
An economist is someone who knows more about money than the people who have it.
A. WHAT IS MONEY?
SA9-A1 PRICES & GOLD
No. If the supply of gold increases, the prices of all other goods and services will increase relative to a
given amount of gold. Hence, there will be inflation. E.g., Like the U.S. after gold was discovered at
Sutters Mill in 1848.
SA9-A2 What is Money in Fairdale?
n.b., If you are not sure how to proceed, see Section A on our home page. Taylor’s
Table 9.1 won’t be very helpful with this question.
a. M1 = Travelers' checks 100d
Demand Deposits 5,000
Other Checkables 9,000
M1 = 16,100d
b. M2 = M1 16,100
Small time deposits 3,500
Individual MMMF's 7,500
M2 = 27,100d
c. M3 = M2 27,100
Term Repos 2,000
Large time deposits 8,000
M3 = 37,100d
n.b., Vatican Bonds = Treasury Bonds. No? As the Notes relate, short-term
Treasuries are considered to be part of "L" (Why didn't they just call it M4? I
don’t know). And while they are certainly quite easily exchanged, it may not be at
low costs, so long-term Treasury bonds are not considered part of our money supply.
Presumably long-term Vaticans would not be part of Fairdale's money supply either.
Vatican Bank Deposits = Treasury Bank Deposits. Demand deposits which are part of
the money supply are those which belong to the "non-bank public". Thus, demand
deposits of banks in one another and the Government's deposits in banks are not
considered to be part of the money supply.
I was trying to be cute with this Fairdale money supply test question, but it
turned out to be a disaster. Students who knew the definitions of M1.M2,&M3
immediately made the connection between the US and Fairdale money supplies. But
those with a weak grasp of the definitions fell apart totally.
SA9-A3 What is Money in Econoville?
a. M1 = (Coin + Currency in circulation) + Demand Deposits held by the non-bank
Coin & Currency $300
Traveler’s Checks 40
Thrift Inst. NOW Accounts 175
Com. Bank Demand Deposits 330
b. M2 = M1 + Savings Deposits + Small Time Deposits + Overnight Repos & Euros
+ Private MMMF’s:
Savings Deposits 200
Small Time Deposits 60
Overnight Repos & Euros 250
Private MMMF’s 445
c. M3 = M2 + Large Time Deposits + Term Repos & Euros + Institutional MMMF’s:
Large Time Deposits (i.e., CD’s) 500
Term Euros 325
Institutional MMMF’s 500
What about the Picasso paintings? They certainly would be valuable assets, but they
are not liquid enough to be considered money.
*B. BANKING AS A BUSINESS
C. THE FEDERAL RESERVE SYSTEM
SA9-C1 STRUCTURE OF THE FED
No. Though the members of the Board of Governors are appointed by the president and confirmed by
the Senate, they are not the only decision-makers in the Federal Reserve system. There are also the bank
presidents of the district Federal Reserve banks. These presidents are not subject to government
approval. In fact, they are appointed by private financial businesses, namely, the banks that are members
of that district’s Federal Reserve bank.
D. THE BANKS A.K.A. THE MIRACLE OF MONEY
SA9-D1 RESERVES & BANK LOANS
a. Since Bank INF needs to keep 10 percent of the $100 million on reserve, the most Bank INF can lend
out is $90 million.
b. The maximum amount of deposits that will be created under these circumstances will be
F million I
= G 0.1 J
Since 10 percent of these deposits have to be kept for reserves, $900 million will be the maximum
amount of loans created.
SA9-D2 THE FED’s POWER OVER MONEY
Although the Fed can control the required reserve ratio as well as the monetary base, it cannot control
currency holdings, which are determined by the public’s behavior.
SA9-D3 MONETARY BASE
The monetary base is equal to currency plus reserves, while the money supply is equal to currency plus
deposits. The FED determines the monetary base. The FED in conjunction with the banking system and
the public determine the money supply.
SA9-D4 MONEY SUPPLY BASICS
a. Currency = MB BR = $425 billion $75 billion = $350 billion.
F .25 I 3.25
b. The money multiplier was G425 J
c. The amount of deposits in 1993 was $1,381.25 billion $350 billion = $1031.25 billion.
F 350 I 0.34
The currency-to-deposit ratio was G .25 J
d. The amount of deposits in 1993 was $1,381.25 billion $350 billion = $1031.25 billion.
F 75 I 00.73.
The reserve-to-deposit ratio was G .25J
E. HOW THE FED MAKES MONEY
SA9-E1 THE MONEY MULTILPLIER
Who (besides the FOMC) cares what the Fed Funds rate is. This is a question about the money generation
process. “k” is the desired currency to demand deposit ratio. To keep the calculations required here as
simple as possible, it is assumed that k = 0.
(a.) In this case the bank will lend out 85 percent of the $40,000 deposit or $34,000.
i.e., ∆DD = (1 – rrr)*Sarah’s deposit = (1 – 0.15)*40,000
n.b., The loan ratio = 1 – rrr. Here it is 85% of deposits
(b.) The automobile dealer will be able to lend out 85 percent of the $34,000 deposit or $28,900.
(c.) The total increase in deposits is = $266,667
i.e., Max ∆DD = ID/rrr
(d.) If people prefer to hold some of their money balances in the form of currency, the money multiplier
will decline, and the increase in deposits resulting from Sarah’s initial deposit will be smaller. This is
because, if people prefer to hold currency, there will be less money available for financial
intermediation. The money multiplier will fall from 6.67 to 2.89.
SA9-E2 MONEY SUPPLY CONCEPTS
k 1 .
a. The money multiplier, in this case, is 2.63
rr k 0.57
b. If the currency-to-deposit ratio (k) becomes equal to 0.3, the money multiplier
k 1 1.3
rr k 0.37
c. The money multiplier increases because the public is holding more money in the form of
checkable deposits; hence, there are more funds available for multiple deposit creation.
SA9-E3 TAYLOR’s MONEY MULTIPLIER
Given: CU/DD = k = 0.3,
rrr = is 0.2.
CU = $540 million ducats
Fairfield Funds Rate = 3.5%.
What is the value of M1 in Fairdale?
M1 = CU + DD
= 540 + ?
------ = 0.3
CU = 0.3*DD
Or DD = 540/0.3 = $1800 mil.
M1 = 540 + 1800 = $2,340 mil. Ducats.
SA9-E4 FESTIMATING THE MONEY SUPPLY II
Given: DD = $844.478 mil. Ducats.
n.b., This is simply a variation of the previous problem set. No?
M1 = CU + DD, so we would need to know “k” (the currency to deposit ratio) in order to estimate CU.
e.g., if k = 0.4
k = -------
CU = k * DD = 0.4 * 844.478 = $337.791 mil Ducats
M1 = 337.791 + 844.478 = 1,184.269 mil Ducats
F. MONEY GROWTH & INFLATION
SA9-F1 PRICES & INFLATION
a. Recall that MV = PT
Therefore, for 1973, we could estimate the price level as:
MV 861 156
b. Review equations F5, F6, & F7 from our home page notes.
% P % M % V % Y
12.67 percent b gb
4.35 percent 0.8 percent g
12.67 percent 4.35 percent 0.8 percent 9.12 percent
SA9-F2 PRICES & VELOCITY
Year Money Supply Velocity GDPR GDP Deflator
1997 1.066 Bil.$ 7.78 8.165 Bil. $ 1.0157
1998 1.078 8.13 8.516 1.0291
1999 1.101 8.40 8.859 1.044
a. Calculate the price index
Recall (from Ch.5?) that the GDP Deflator is our estimator of society’s price level..
If MV = Py, P = MV/y (1.066*7.78)/8.165 = 1.0157. Recall from our discussion of price
indexes that it is a convention to report the price indices by multiplying them by 100. Thus , in
a government publication, we would expect to see number reported as; 101.57
b. What might explain why velocity rose during these three years? i.e., What are the determinants
V = (technology (e.g., spread of ATM’s?) , habits, the state of society’s financial structure,
political conditions). Here, for the US, rapid tech changes in the banking system, probably
best explain the rise in velocity.
c. The 1998 inflation rate is the percent change in the price level between 1997 and 1998.
g(P) = 1.0291/1.0157 = 0.0132 or 1.3%
d. Assuming that in 1998 , the money supply grew at 5 percent per annum, what would inflation
have been assuming GDPR and Velocity provided in the table above?
g(P) = g(M) + g(V) - g (y)
given: g(M) = 5%
g(V) = 8.13/7.78 = 1.044987 or 4.5%
g(y) = 8.516/8.165 = 1.0429883 or 4.3%
Inflation Rate = g(P) = .05 + .045 - .043 = 0.052 or 5.2%