Two Alternative Ways to Think about the Equilibrium

Equation (4.5), which equates supply and demand for central bank money, describes money market equilibrium in an economy with banks. There are two ways to think about this equation.

First, consider equilibrium in the market for reserves. Supply of reserves is central bank money minus currency. Demand for them is R^d. Equating supply and demand for reserves gives

H-CU^d=R^d, (4.6)

which is clearly identical to the equilibrium condition in equation (4.4). The advantage to thinking about equilibrium in this way is that it facilitates discussion of the federal funds market—the market for bank reserves—and the federal funds rate—the interest rate that adjusts to clear this market. In the federal funds market, banks that need reserves at the end of the day borrow them from banks that have excess reserves.

Second, consider equilibrium in terms of the overall supply and the overall demand for money (currency and checkable deposits). Reorganize equation (4.5) to read

H/[c+q(1-c)]=$YL(i). (4.7)

The quantity 1/[c+q(1-c)] is called the money multiplier. The money supply equals central bank money times the multiplier. Since c and q are assumed to be fixed, the central bank can control the money supply by controlling H. For this reason, central bank money is often called high powered money or the monetary base.

Note that 0<c<1 and 0<q <1 together imply that the money multiplier is greater than one. Thus, a given increase in central bank money leads to a larger increase in the overall money supply. The source of the money multiplier is fractional reserve banking. A given increase in currency deposits creates only a fractional increase in bank reserves. The remainder of the deposit increase is used to purchase bank assets (e.g., bonds). The purchase puts more money in the hands of the nonbank public and hence creates more checkable deposits, and so on. Thus, the money multiplier can be described as the limit of a geometric series, in much the same way as the output multiplier was explained in Chapter 3.

Date: 2015-02-16; view: 1248