Chapter 5

Money Demand
The demand and supply of money:
The affects of interest rate and income on the demand for money and supply of
money are significant, because the demand for money is viewed as a demand for
given quantity of purchasing power that is real value of money. The demand and
supply of a flow of funds per period of time, it is customary to say the demand and
supply of the stock of money at a given time, this is explained in the following
figure:

Sm
Dm

ib

Dm

M
P

Real money balance

The supply of money is assumed to be vertical line as it is fixed for short term. The
demand for money at each nominal interest rate is shown along

Dm Dm

quantity of money demanded equals the quantity supplied at an interest rate

.the

ib

is the same interest rate is the same interest rate that could be derived from the
demand and supply of loanable funds.
The velocity of money:
There is a relationship between money and income with real and nominal variables
which is called income velocity of money or velocity. Velocity can be defined as the
ratio of nominal income or national income(Y) divided by the average stock of
nominal money (M).

V=

Y
M .(1)

The average stock of money (M) is measured in the same period as nominal
income(Y). Definition can be re-arranged as,

MV =Y .(2)
The concept of velocity can be stated in equivalent real terms as real income Y/P or
simply y.
Divided by real money between M/P
Real income,

y=

Y
P

Y = yP

MV =Y
MV = yP

V=

yP
M
y
M
P

.(3)

(3) is identical to equation (1), except that the income and money variable in (1)
both have been divided by p , the value of velocity has not changed. Rearranging(3)

MV =Py .(4)
This equation says that expenditures (Money balances, times their turnover) are
equal to receipts (the average price times the quantity of goods and services in the
national income)
Dividing each side of(4) by P, we get

( MP )V = y
At each level of real income, an increase I demand for real balances is equivalent to
a decline in velocity.

Chapter Six:

The money supply can be divided into two parts:

Monetary base:
There is the part of money supply created by the central govt. it is called monetary
base. The monetary base B equals the currency and coin held by the public outside
the depository institutions- COB plus the cash reasons of the depository
institutions(R).

B=COB+ R

Money creation:
Depository institutions create money under the system of fractional reserve
banking. Fractional reserve banking is the practice of keeping only a fraction of the
deposits in the form of reserves. The bulk of deposits are invested in financial assets
other than reserves, from which depository institutions are most of their income.
Money creation in accounting form:
1. It is customary to show how banks and double entry book-keeping.
2. Each T account displays an identity that states that,
3. The sum of the value of all assets (which are commodities of value held by
bank) listed in the left hand column of each T account. Is exact equal to?
4. The sum of value of all liabilities (which are claims against the banks asset
by people or form) listed is the right hand column of each account.
Considering the T account there are two types of liabilities:
1. Equities
2. Claims of the owner of the bank.
3. Other liabilities: claim of persons or firms, who are not owner of the bank.

Mathematical problem: 1

Suppose Mr. John deposits $1000 inn a bank x, where the reserve requirement is
20%, Mr. Alvin takes an automobile loan amount of $800. Moreover Mrs. White
deposits the $800 to bank. After that bank management decides to loan to K
Corporation. Then how much money has created in bank X.

Solution:
Mr. John with a $1000 deposit, which is represented both as a $1000 liability, (1)
and a $1000 cash assets (2) in table -1.

Assets
2. $1000 cash

Liabilities
1. $ 1000 deposit by Mr. John
Table: 1: Initial deposit

The bank desires to maintain 20% reserve ratio. So that $800 is available for the
purchase of income earning asset. As Mr. Alvin takes a loan of $800 it causes a
reduction in cash $800. (3) and a new asset (4) which is shown in table-2:
Assets
Liabilities
2. $1000 cash
1. $ 1000 deposit by Mr. John
3. -$800 cash
4. $ 800 auto loan to Mr.Alvin
Table: 2: $800 money is created

In this step $800 is created, since Mr.Alvin has $800 that he didnt had. Mrs. White
the automobile dealer, deposits the $800, (5) Adding $800 to the banks cash asset,
(6) shown in table-3
Assets
2. $1000 cash
3. -$800 cash
4. $ 800 auto loan to Mr. Alvin

1.

Liabilities
$ 1000 deposit by Mr. John

5. $800 deposit by data dealer Mrs.

White

6. $800 cash
Table: 3: the redeposit of the new money
Now the bank has $1800 in deposit and $1000 in reserve. The management desires
to keep 20% of deposits $360 as reserve and to use the remainder of $640 for the
purchase of income earning asset. Therefor bank management decides to loan $640
to K Corporation. This loan reduces banks cash asset by $640 (7) to achieve the
new business loan asset (8) shown I table-4

Assets

Liabilities
1. $ 1000 deposit by Mr. John

2. $1000 cash
3. -$800 cash
4. $ 800 auto loan to Mr. Alvin

5. $800 deposit by data dealer Mrs.

White

6. $800 cash
7. -$640 cash
8.
$640
business
loan
to
K
corporation
Table: 4: the second money creation
K corporation has $640 it did not had before. In this stage $640 is created. K
corporation re-deposit $640 creative a new deposit(9) ad adding $64 t the bank
cash asset (10), As shown in table-5. Total cash reserve of the X bank are still
$1000. The total deposit are now $2040.
Assets

Liabilities
1. $ 1000 deposit by Mr. John

2. $1000 cash
3. -$800 cash
4. $ 800 auto loan to Mr.Alvin
6. $800 cash
7. -$640 cash
8.
$640
business
loan
to
corporation
1. $640 cash

5. $800 deposit by data dealer Mrs.White

K
9. $640 deposit of K corporation.

Table: 5:
Since the desired reserve ratio is 20 %( 2440*20%), the desired reserve level is
now 488 and the bank will desired to purchase $512 in additional income earning
assets.

The control of money supply:

Money supply can be control through the control bank in two different ways:
1. Open market operation
2. Change in reserve requirement
1. Open market operation: Open market operation applies to the central
bank special auction at which treasury securities are brought sold to the
private sector. When the central bank buy securities I pays private buyer
new money in the form of currency or bank reserve. This is an additional
to the monetary base in private conclusion. If the central bank sales
securities, it rests payment in the form of currency which reduces

monetary base thus open market operation can be used to control the
money supply.
(Open market operation only done by the central bank)
2. Change in reserve requirement: The central bank can also influence
the size of money supply by changing the proportion of deposit that
depository institution must sold at reserve. This is call a change in reserve
requirement.
Nominal
interest rates

I
Initial interest
rates

I
D

I1

M'
P'

M
P

M'
P

Real money
balance

Figure: change in real and nominal money supply.

Suppose the monetary base is increased, causing the nominal money supply M to
M as indicated in figure. The supply of real money balances may move from M/P to
M/P. Prices, however may start to rise so that the real money supply will become
smaller. That is, the amount of purchasing power contained in the money supply
may diminish. It is even possible that the real money supply will shift back to M/P
because the price level rises (from P to P) by more than the increase in nominal
money supply.

Although the government has capabilities for directly control the monetary base and
thereby influence the size of nominal money supply, it cant directly control the real
quantity of money M/P.

Financial intermediaries:
Financial intermediaries:
The saving and loan association may have the nearly complete trusts of its
customers the savings and loan association is one type of financial institutions
called financial intermediaries. The financial intermediary facilitates the exchange of
funds between borrowers and lenders by helping to bring borrowers and lenders
together. The word intermediary and the general name of the services supplied by
financial intermediaries imply the position of middleman.

Types of financial intermediaries:

Financial intermediaries can be divided into three groups:
1. Depository intermediaries
2. Contractual intermediaries
3. Investment intermediaries
1. Depository intermediaries: The depository intermediaries consist of
commercial banks and the thrifts, mutual saving banks, and loan association
and credit unions.
2. Contractual intermediaries: The contractual intermediaries consist of
insurance companies and pension funds. These intermediaries create credit
instruments that form a contractual relationship with the buyer, such as an
annuity or a pension. They hold portfolios that include bonds, common stocks
and real state.
3. Investment intermediaries: The investment intermediaries consist of
investment companies and finance companies. The investment companies
issue shares of ownership in their portfolio of assets. The investment
companies specialize in the purchase of different types of financial assets
such as gold or oil stocks.

Deposit and portfolios of commercial banks:

The view of the portfolio of assets shows how the intermediaries earn their income.
Most of the deposits of the commercial banks are financial assets of the non-bank
public which includes the concept of money such as M1, M2, thus the view of
deposits show the composition of most of the money supply.

What is extent of money or the extension of money.

Narrow money- m1 is called narrow money

And M1, M2, M3 is called broad money+ Sheet page

Bank deposits:
Commercial bank deposits are claims against commercial banks by depositors.
Estimates of these deposits must be adjusted to fit into the common concepts of
money. These concepts attempt to restrict the concept of money to holdings of the
non-bank public. Three aggregates must be deduced to obtain the deposits on the
books of the non-bank public.

1. Government deposits.
2. Interbank deposits.
3. Bank float.
1. Government deposits in private commercial banks are substantial. They
are mostly deposits of income tax withhold by employees.
2. Interbank deposits are deposits of one depository intermediary in another
depository intermediary.
3. Bank float arises when one bank is created with deposit but the deposits of
the bank on which the check was drawn have not yet been reduced.

Commercial bank deposits including demand deposits are subjected to

immediate withdrawal during regular banking hours at the request of the depositor.
Demand deposits of commercial banks can be transferred by bank check and are
sometimes called checking account, no money interest is paid on demand deposits.
Start to rise so that the real money supply will become smaller, that is, the amount
of purchasing power consider in the money supply may diminish. It is
possible
that that the real money supply will shift back to M/P, because the price level rises
(from P to P) by more than the increase the nominal money supply.
Although the government has capability for directly control the nonmonetary base
and thereby influence the size of nominal, money supply. It cannot directly control
the real quantity of money which is M/P.

Short Notes:
Bank reserve:

Bank reserves are the assets a bank holds that may be exchanged for depositors
withdrawal claims. The depositors expect currency or coins or a check that can be
deposited to another bank account in return for his/her claim. These expectations
are reinforced by government regulations for domestic bank deposits.
Vault cash:
The bank must be ready with cash assets to meet demands for withdrawals that
exceed deposits. Therefore bankers store money on their premises which is called
vault cash.
Reserve requirements:
Reserve requirements specify the type and amount of reserves that banks must
hold to fulfill government regulations. The types of reserves that may be used to
fulfill reserve requirements are called legal reserves. Legal reserves are equal to
reserves on deposit at the central bank and all vault cash.
Excess reserve:
Excess reserves are the total reserves a bank holds minus its required reserves.
Desired reserve:
Desired reserves are the amount of reserves that are preferred.
Total float:
Total float is composed of two parts mail float and bank float. Mail float occurs when
an individual or firm mails or delivers a check to another individual or firm before
the check is deposited in a bank.
+ (Bank Float) + bank float arises when one bank is credited with a deposit but the
deposits of the bank on which the check was drawn have not yet been received.
Saving deposits:
Can be at the commercial banks can usually be withdrawn at currency or coin, or as
a cashier check of the bank. They may be transferred into deposits differed deposits
account at the same bank, though technically the bank may referred to withdraw or
transferred a savings account for so days.
Certificates of deposits:
Corporations and private firms as well as some wealthy individuals have deposited
their money in special time deposits for which large denomination marketable
certificate of deposits with specified materials are given as evidence of their claim.

Fractional reserve banking is the practice of keeping only a fraction of deposits on

the form of reserve. Depository institutions are able to do this because only a small
formation up on any day or week to withdraw their deposits.
Correspondent banks:
Commercial bank that supply services to other commercial banks are called
correspondent banks it is paid indirectly in the form of income from depository
banks branches maintained by its bank customers.
Branch banking:
All the states have some form of branch banking which deposit banking creations
other than their main facilities.
Bank holding companies:
A bank holding company is a company that holds controlling stock in one or more
commercial banks.

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