The Money Creation Process

• The monetary base increases and banks have excess reserves. Banks lend the excess reserves and thereby create new deposits, that is, create new money.
• The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain.
• The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have excess reserves to loan. Banks lend these excess reserves and the process continues.
• Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves.
• The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes).

The Money Market

The Influences on Money Holding

The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money. The quantity of money that people plan to hold depends on:

• The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles.

· Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level. The quantity of real money demanded is independent of the price level.

• The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded.
• Real GDP: An increase in real GDP increases the quantity of money people plan to hold.
• Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts).

The Demand for Money Curve

The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal. As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

Date: 2015-12-11; view: 989