McConnell С., Campbell R. Macroeconomics: principles, problems, and policies, 17th ed
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CHAPTER 13
Money Creation
253
The answer is that reserves lost by a single bank are
not lost to the banking system as a whole. The reserves
lost by bank A are acquired by bank B. Those lost by B are
gained by C. C loses to D, D to E, E to F, and so forth.
Although reserves can be, and are, lost by individual banks
in the banking system, there is no loss of reserves for the
banking system as a whole.
An individual bank can safely lend only an amount
equal to its excess reserves, but the commercial banking
system can lend by a multiple of its excess reserves. This
contrast, incidentally, is an illustration of why it is impera-
tive that we keep the fallacy of composition (Last Word,
Chapter 1) firmly in mind. Commercial banks as a group
can create money by lending in a manner much different
from that of the individual banks in the group.
The Monetary Multiplier
The banking system magnifies any original excess reserves
into a larger amount of newly created checkable-deposit
money. The checkable-deposit multiplier, or monetary mul-
tiplier , is similar in concept to the spending-income mul-
tiplier in Chapter 8. That multiplier exists because the
expenditures of one household become some other house-
hold’s income; the multiplier magnifies a change in initial
spending into a larger change in GDP. The spending-
income multiplier is the reciprocal of the MPS (the leak-
age into saving that occurs at each round of spending).
Similarly, the monetary multiplier exists because the
reserves and deposits lost by one bank become reserves of
another bank. It magnifies excess reserves into a larger
creation of checkable-deposit money. The monetary
multiplier m is the reciprocal of the required reserve ratio
R (the leakage into required reserves that occurs at each
step in the lending process). In short,
Monetary multiplier
1
___________________
required reserve ratio
or, in symbols,
m
1
__
R
In this formula, m represents the maximum amount of
new checkable-deposit money that can be created by a
single dollar of excess reserves, given the value of R. By
multiplying the excess reserves E by m, we can find the
maximum amount of new checkable-deposit money, D ,
that can be created by the banking system. That is,
Maximum
checkable-deposit
excess
reserves
monetary
multiplier
creation
Bank
(1)
Acquired
Reserves and
Deposits
(2)
Required
Reserves
(Reserve
Ratio .2)
(3)
Excess
Reserves,
(1) (2)
(4)
Amount Bank Can
Lend; New Money
Created (3)
Bank A $ 100.00 (a
1
) $20.00 $80.00 $ 80.00 (a
2
)
Bank B 80.00 (a
3
, b
1
) 16.00 64.00 64.00 (b
2
)
Bank C 64.00 (b
3
, c
1
) 12.80 51.20 51.20 (c
2
)
Bank D 51.20 10.24 40.96 40.96
Bank E 40.96 8.19 32.77 32.77
Bank F 32.77 6.55 26.21 26.21
Bank G 26.21 5.24 20.97 20.97
Bank H 20.97 4.20 16.78 16.78
Bank I 16.78 3.36 13.42 13.42
Bank J 13.42 2.68 10.74 10.74
Bank K 10.74 2.15 8.59 8.59
Bank L 8.59 1.72 6.87 6.87
Bank M 6.87 1.37 5.50 5.50
Bank N 5.50 1.10 4.40 4.40
Other banks 21.99 4.40 17.59 17.59
Total amount of money created (sum of the amounts in column 4)
$400.00
TABLE 13.2 Expansion of the Money Supply by the Commercial Banking System
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or, more simply,
D E m
In our example in Table 13.2 , R is .20, so m is 5 ( 1兾.20).
Then
D $80 5 $400
Figure 13.1 depicts the final outcome of our example
of a multiple-deposit expansion of the money supply. The
initial deposit of $100 of currency into the bank (lower
right-hand box) creates new reserves of an equal amount
(upper box). With a 20 percent reserve ra-
tio, however, only $20 of reserves are
needed to “back up” this $100 checkable
deposit. The excess reserves of $80 permit
the creation of $400 of new checkable de-
posits via the making of loans, confirming
a monetary multiplier of 5. The $100 of
new reserves supports a total supply of
money of $500, consisting of the $100 initial checkable
deposit plus $400 of checkable deposits created through
lending.
Higher reserve ratios mean lower monetary multipli-
ers and therefore less creation of new checkable-deposit
money via loans; smaller reserve ratios mean higher mon-
etary multipliers and thus more creation of new checkable-
deposit money via loans. With a high reserve ratio, say,
50 percent, the monetary multiplier would be 2 ( 1兾.5),
and in our example the banking system could create only
$100 ( $50 of excess reserves 2) of new checkable de-
posits. With a low reserve ratio, say, 5 percent, the mone-
tary multiplier would be 20 ( 1兾.05), and the banking
system could create $1900 ( $95 of excess reserves 20)
of new checkable deposits.
You might experiment with the following two
brainteasers to test your understanding of multiple credit
expansion by the banking system:
• Rework the analysis in Table 13.2 (at least three
or four steps of it) assuming the reserve ratio is
10 percent. What is the maximum amount of money
the banking system can create upon acquiring $100 in
new reserves and deposits? (The answer is not $800!)
• Suppose the banking system is loaned up and faces a
20 percent reserve ratio. Explain how it might have
to reduce its outstanding loans by $400 when a $100
cash withdrawal from a checkable-deposit account
forces one bank to draw down its reserves by $100.
(Key Question 13)
Reversibility: The Multiple
Destruction of Money
The process we have described is reversible. Just as check-
able-deposit money is created when banks make loans,
checkable-deposit money is destroyed when loans are paid
off. Loan repayment, in effect, sets off a process of multi-
ple destruction of money the opposite of the multiple cre-
ation process. Because loans are both made and paid off in
any period, the direction of the loans, checkable deposits,
and money supply in a given period will depend on the
net effect of the two processes. If the dollar amount of
loans made in some period exceeds the dollar amount of
loans paid off, checkable deposits will expand and the
money supply will increase. But if the dollar amount of
loans is less than the dollar amount of loans paid off,
checkable deposits will contract and the money supply
will decline.
FIGURE 13.1 The outcome of the money expansion
process. A deposit of $100 of currency into a checking account creates
an initial checkable deposit of $100. If the reserve ratio is 20 percent, only
$20 of reserves is legally required to support the $100 checkable deposit.
The $80 of excess reserves allows the banking system to create $400 of
checkable deposits through making loans. The $100 of reserves supports a
total of $500 of money ($100 ⴙ $400).
New reserves
$100
$20
Required
reserves
Money created
$80
Excess
reserves
$100
Initial
deposit
$400
Bank system lending
QUICK REVIEW 13.3
• A single bank in a multibank system can safely lend (create
money) by an amount equal to its excess reserves; the
banking system can lend (create money) by a multiple of its
excess reserves.
• The monetary multiplier is the reciprocal of the required
reserve ratio; it is the multiple by which the banking system
can expand the money supply for each dollar of excess reserves.
• The monetary multiplier works in both directions; it applies
to money destruction from the payback of loans as well as
the money creation from the making of loans.
W 13.2
Money creation
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CHAPTER 13
Money Creation
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Last
Word
The Bank Panics of 1930 to 1933
A Series of Bank Panics in the Early 1930s Resulted
in a Multiple Contraction of the Money Supply.
In the early months of the Great Depression, before there was
deposit insurance, several financially weak banks went out of
business. As word spread that customers of those banks had lost
their deposits, a general concern arose that something similar
could happen at other banks. Depositors became frightened that
their banks did not, in fact, still have all the money they had
deposited. And, of course, in a
fractional reserve banking sys-
tem, that is the reality. Acting
on their fears, people en masse
tried to withdraw currency—
that is, to “cash out” their ac-
counts—from their banks.
They wanted to get their
money before it was all gone.
Economists liken this sort of
collective response to “herd”
or “flock” behavior. The sud-
den “run on the banks” caused
many previously financially
sound banks to declare bank-
ruptcy. More than 9000 banks
failed within 3 years.
The massive conversion of checkable deposits to currency
during 1930 to 1933 reduced the nation’s money supply. This
might seem strange, since a check written for “cash” reduces
checkable-deposit money and increases currency in the hands of
the public by the same amount. So how does the money supply
decline? Our discussion of the money-creation process provides
the answer, but now the story becomes one of money destruction.
Suppose that people collectively cash out $10 billion from
their checking accounts. As an immediate result, checkable-
deposit money declines by $10 billion, while currency held by
the public increases by $10 billion. But here is the catch: As-
suming a reserve ratio of 20 percent, the $10 billion of currency
in the banks had been supporting $50 billion of deposit money,
the $10 billion of deposits plus $40 billion created through
loans. The $10 billion withdrawal of currency forces banks to
reduce loans (and thus checkable-deposit money) by $40 billion
to continue to meet their reserve requirement. In short, a
$40 billion destruction of deposit money occurs. This is the
scenario that occurred in the early years of the 1930s.
Accompanying this multiple contraction of checkable
deposits was the banks’ “scramble for liquidity” to try to meet
further withdrawals of currency. To obtain more currency, they
sold many of their holdings of government securities to the
public. You know from this chapter that a bank’s sale of govern-
ment securities to the public,
like a reduction in loans, re-
duces the money supply. Peo-
ple write checks for the
securities, reducing their
checkable deposits, and the
bank uses the currency it ob-
tains to meet the ongoing bank
run. In short, the loss of re-
serves from the banking sys-
tem, in conjunction with the
scramble for security, reduced
the amount of checkable-de-
posit money by far more than
the increase in currency in the
hands of the public. Thus, the
money supply collapsed.
In 1933, President Franklin Roosevelt ended the bank pan-
ics by declaring a “national bank holiday,” which closed all na-
tional banks for 1 week and resulted in the federally insured
deposit program. Meanwhile, the nation’s money supply had
plummeted by 25 percent, the largest such drop in U.S. history.
This decline in the money supply contributed to the nation’s
deepest and longest depression.
Today, a multiple contraction of the money supply of the
1930–1933 magnitude is unthinkable. FDIC insurance has kept
individual bank failures from becoming general panics. Also,
while the Fed stood idly by during the bank panics of 1930 to
1933, today it would take immediate and dramatic actions to
maintain the banking system’s reserves and the nation’s money
supply. Those actions are the subject of Chapter 14.
255
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PART FOUR
Money, Banking, and Monetary Policy
256
1. Modern banking systems are fractional reserve systems:
Only a fraction of checkable deposits is backed by currency.
2. The operation of a commercial bank can be understood
through its balance sheet, where assets equal liabilities plus
net worth.
3. Commercial banks keep required reserves on deposit in a
Federal Reserve Bank or as vault cash. These required
reserves are equal to a specified percentage of the commer-
cial bank’s checkable-deposit liabilities. Excess reserves are
equal to actual reserves minus required reserves.
4. Banks lose both reserves and checkable deposits when
checks are drawn against them.
5. Commercial banks create money—checkable deposits, or
checkable-deposit money—when they make loans. The
creation of checkable deposits by bank lending is the most
important source of money in the U.S. economy. Money is
destroyed when lenders repay bank loans.
6. The ability of a single commercial bank to create money by
lending depends on the size of its excess reserves. Generally
speaking, a commercial bank can lend only an amount equal
to its excess reserves. Money creation is thus limited because,
in all likelihood, checks drawn by borrowers will be deposited
in other banks, causing a loss of reserves and deposits to the
lending bank equal to the amount of money that it has lent.
7. Rather than making loans, banks may decide to use excess re-
serves to buy bonds from the public. In doing so, banks merely
credit the checkable-deposit accounts of the bond sellers, thus
creating checkable-deposit money. Money vanishes when
banks sell bonds to the public, because bond buyers must draw
down their checkable-deposit balances to pay for the bonds.
8. Banks earn interest by making loans and by purchasing
bonds; they maintain liquidity by holding cash and excess
reserves. Banks having temporary excess reserves often lend
them overnight to banks that are short of required reserves.
The interest rate paid on loans in this Federal funds market
is called the Federal funds rate.
9. The commercial banking system as a whole can lend by a
multiple of its excess reserves because the system as a whole
cannot lose reserves. Individual banks, however, can lose
reserves to other banks in the system.
10. The multiple by which the banking system can lend on the
basis of each dollar of excess reserves is the reciprocal of the
reserve ratio. This multiple credit expansion process is re-
versible.
Terms and Concepts
fractional reserve banking system
balance sheet
vault cash
required reserves
reserve ratio
excess reserves
actual reserves
Federal funds rate
monetary multiplier
Study Questions
1. Why must a balance sheet always balance? What are the ma-
jor assets and claims on a commercial bank’s balance sheet?
2.
KEY QUESTION Why does the Federal Reserve require
commercial banks to have reserves? Explain why reserves
are an asset to commercial banks but a liability to the Fed-
eral Reserve Banks. What are excess reserves? How do you
calculate the amount of excess reserves held by a bank?
What is the significance of excess reserves?
3. “Whenever currency is deposited in a commercial bank,
cash goes out of circulation and, as a result, the supply of
money is reduced.” Do you agree? Explain why or why not.
4.
KEY QUESTION “When a commercial bank makes loans, it
creates money; when loans are repaid, money is destroyed.”
Explain.
5. Explain why a single commercial bank can safely lend only
an amount equal to its excess reserves but the commercial
banking system as a whole can lend by a multiple of its
excess reserves. What is the monetary multiplier, and how
does it relate to the reserve ratio?
6. Assume that Jones deposits $500 in currency into her
checkable-deposit account in First National Bank. A half-
hour later Smith obtains a loan for $750 at this bank. By how
256
Summary
Assets Liabilities and net worth
(1) (2) (1) ( 2)
Reserves $22,000 Checkable
Securities 38,000 deposits $100,000
Loans 40,000
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CHAPTER 13
Money Creation
257
much and in what direction has the money supply changed?
Explain.
7. Suppose the National Bank of Commerce has excess
reserves of $8000 and outstanding checkable deposits of
$150,000. If the reserve ratio is 20 percent, what is the size
of the bank’s actual reserves?
8.
KEY QUESTION Suppose that Continental Bank has the
simplified balance sheet shown on the previous page and that
the reserve ratio is 20 percent:
a. What is the maximum amount of new loans that this
bank can make? Show in column 1 how the bank’s bal-
ance sheet will appear after the bank has lent this addi-
tional amount.
b. By how much has the supply of money changed?
Explain.
c. How will the bank’s balance sheet appear after checks
drawn for the entire amount of the new loans have been
cleared against the bank? Show the new balance sheet in
column 2.
d. Answer questions a, b, and c on the assumption that the
reserve ratio is 15 percent.
9. The Third National Bank has reserves of $20,000 and
checkable deposits of $100,000. The reserve ratio is 20
percent. Households deposit $5000 in currency into the
bank that is added to reserves. What level of excess reserves
does the bank now have?
10. Suppose again that the Third National Bank has reserves of
$20,000 and checkable deposits of $100,000. The reserve
ratio is 20 percent. The bank now sells $5000 in securities
to the Federal Reserve Bank in its district, receiving a $5000
increase in reserves in return. What level of excess reserves
does the bank now have? Why does your answer differ (yes,
it does!) from the answer to question 9?
11. Suppose a bank discovers that its reserves will temporarily
fall slightly short of those legally required. How might it
remedy this situation through the Federal funds market?
Now assume the bank finds that its reserves will be substan-
tially and permanently deficient. What remedy is available
to this bank? (Hint: Recall your answer to question 4.)
12. Suppose that Bob withdraws $100 of cash from his checking
account at Security Bank and uses it to buy a camera from
Joe, who deposits the $100 in his checking account in
Serenity Bank. Assuming a reserve ratio of 10 percent and
no initial excess reserves, determine the extent to which (a)
Security Bank must reduce its loans and checkable deposits
because of the cash withdrawal, (b) Serenity Bank can safely
increase its loans and checkable deposits because of the cash
deposit, and (c) the entire banking system, including Seren-
ity, can increase loans and checkable deposits because of the
cash deposit. Have the cash withdrawal and deposit changed
the total money supply?
13.
KEY QUESTION Suppose the simplified consolidated balance
sheet shown below is for the entire commercial banking sys-
tem. All figures are in billions. The reserve ratio is 25 percent.
Web-Based Questions
net worth (assets less liabilities) of all commercial banks in
the United States increased, decreased, or remained
constant during the past year?
2.
RESERVE REQUIREMENTS—ANY CHANGES TO TAB LE
13.1? Go to the Fed’s Web site, www.federalreserve.gov/,
and select “Monetary Policy.” Then, in order, select Reserve
Requirements and find the link to “low-reserve amounts
and exemptions.” Does any part of Table 13.1 need updat-
ing? If so, prepare a new, updated table.
1. ASSETS AND LIABILITIES OF ALL COMMERCIAL BANKS
IN THE UNITED STATES The Federal Reserve, at www.
federalreserve.gov/releases/h8/Current/, provides an
aggregate balance sheet for commercial banks in the United
States. Check the current release, and look in the asset
column for “Loans and leases.” Rank the following compo-
nents of loans and leases in terms of size: commercial and
industrial, real estate, consumer, security, and other. Over
the past 12 months, which component has increased by the
largest percentage? By the largest absolute amount? Has the
Assets Liabilities and net worth
(1)
Reserves $ 52
Securities 48
Loans 100
(1)
Checkable
deposits $200
a. What amount of excess reserves does the commercial
banking system have? What is the maximum amount the
banking system might lend? Show in column 1 how the
consolidated balance sheet would look after this amount
has been lent. What is the monetary multiplier?
b. Answer the questions in part a assuming the reserve
ratio is 20 percent. Explain the resulting difference in
the lending ability of the commercial banking system.
14.
LAST WORD Explain how the bank panics of 1930 to 1933
produced a decline in the nation’s money supply. Why are
such panics highly unlikely today?
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Interest Rates and Monetary Policy
Some newspaper commentators have stated that the chairman of the Federal Reserve Board
(previously Alan Greenspan and now Ben Bernanke) is the second most powerful person in the United
States, after the U.S. president. That is undoubtedly an exaggeration because the chair has only a
single vote on the 7-person Federal Reserve Board and 12-person Federal Open Market Committee.
But there can be no doubt about the chair’s influence, the overall importance of the Federal Reserve,
and the monetary policy that it conducts. Such policy consists of deliberate changes in the money
supply to influence interest rates and thus the total level of spending in the economy. The goal is to
achieve and maintain price-level stability, full employment, and economic growth.
IN THIS CHAPTER YOU WILL LEARN:
• How the equilibrium interest rate is determined in
the market for money.
• The goals and tools of monetary policy.
• About the Federal funds rate and how the Fed
controls it.
• The mechanisms by which monetary policy affects
GDP and the price level.
• The effectiveness of monetary policy and its
shortcomings.
14
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CHAPTER 14
Interest Rates and Monetary Policy
259
Interest Rates
The Fed’s primary influence is on the money supply and
interest rates. So we initially need to better understand the
market in which interest rates are established. Interest is
the price paid for the use of money. It is the price that bor-
rowers need to pay lenders for transferring purchasing
power to the future. It can be thought of as the amount of
money that must be paid for the use of $1 for 1 year. Al-
though there is a full cluster of U.S. interest rates that vary
by purpose, size, risk, maturity, and taxability, we will sim-
ply speak of “the interest rate” unless stated otherwise.
Let’s see how the interest rate is determined. Because
it is a “price,” we again turn to demand and supply analysis
for the answer.
The Demand for Money
Why does the public want to hold some of its wealth as
money? There are two main reasons: to make purchases
with it and to hold it as an asset.
Transactions Demand, D
t
People hold money
because it is convenient for purchasing goods and services.
Households usually are paid once a week, every 2 weeks,
or monthly, whereas their expenditures are less predict-
able and typically more frequent. So households must have
enough money on hand to buy groceries and pay mort-
gage and utility bills. Nor are business revenues and
expenditures simultaneous. Businesses need to have money
available to pay for labor, materials, power, and other in-
puts. The demand for money as a medium of exchange is
called transactions demand for money.
The level of nominal GDP is the main determinant of
the amount of money demanded for transactions. The
larger the total money value of all goods and services ex-
changed in the economy, the larger the amount of money
needed to negotiate those transactions. The transactions
demand for money varies directly with nominal GDP. We
specify nominal GDP because households and firms will
want more money for transactions if prices rise or if real
output increases. In both instances a larger dollar volume
will be needed to accomplish the desired transactions.
In Figure 14.1 a we graph the quantity of money de-
manded for transactions against the interest rate. For sim-
plicity, let’s assume that the amount demanded depends
exclusively on the level of nominal GDP and is indepen-
dent of the interest rate. (In reality, higher interest rates
are associated with slightly lower volumes of money de-
manded for transactions.) Our simplifying assumption
allows us to graph the transactions demand, D
t
, as a vertical
line. This demand curve is positioned at $100 billion, on
the assumption that each dollar held for transactions pur-
poses is spent on an average of three times per year and
that nominal GDP is $300 billion. Thus the public needs
$100 billion ( $300 billion兾3) to purchase that GDP.
Asset Demand, D
a
The second reason for holding
money derives from money’s function as a store of value.
People may hold their financial assets in many forms, in-
cluding corporate stocks, corporate or government bonds,
or money. To the extent they want to hold money as an
asset, there is an asset demand for money.
People like to hold some of their financial assets as
money (apart from using it to buy goods and services)
because money is the most liquid of all financial assets; it is
immediately usable for purchasing other assets when oppor-
tunities arise. Money is also an attractive asset to hold when
the prices of other assets such as bonds are expected to de-
cline. For example, when the price of a bond falls, the bond-
holder who sells the bond prior to the payback date of the
full principal will suffer a loss (called a capital loss ). That loss
will partially or fully offset the interest received on the bond.
There is no such risk of capital loss in holding money.
The disadvantage of holding money as an asset is that
it earns no or very little interest. Checkable deposits pay
either no interest or lower interest rates than bonds. Idle
currency, of course, earns no interest at all.
Knowing these advantages and disadvantages, the
public must decide how much of its financial assets to hold
as money, rather than other assets such as bonds. The an-
swer depends primarily on the rate of interest. A house-
hold or a business incurs an opportunity cost when it holds
money; in both cases, interest income is forgone or sacri-
ficed. If a bond pays 6 percent interest, for example, hold-
ing $100 as cash or in a noninterest checkable account
costs $6 per year of forgone income.
The amount of money demanded as an asset therefore
varies inversely with the rate of interest (the opportunity
cost of holding money as an asset). When the interest rate
rises, being liquid and avoiding capital losses becomes more
costly. The public reacts by reducing its
holdings of money as an asset. When the in-
terest rate falls, the cost of being liquid and
avoiding capital losses also declines. The
public therefore increases the amount of
financial assets that it wants to hold as
money. This inverse relationship just de-
scribed is shown by D
a
in Figure 14.1 b.
Total Money Demand, D
m
As shown in
Figure 14.1 , we find the total demand for money D
m
, by
horizontally adding the asset demand to the transactions
O 14.1
Liquidity
preference
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260
key
graph
Rate of interest, i
(percent)
Rate of interest, i
(percent)
Rate of interest, i
(percent)
Amount of money demanded
(billions of dollars)
Amount of money demanded
(billions of dollars)
Amount of money demanded
and supplied
(billions of dollars)
(a)
Transactions demand
for money, D
t
(b)
Asset demand
for money, D
a
(c)
Total demand for money,
D
m
= D
t
+ D
a
, and supply
of mone
y
10
7.5
5
2.5
50 150
100 200
0
10
7.5
5
2.5
50 150
100 200
0
10
7.5
2.5
50 150
100 200
0 250
300
i
e
D
t
D
a
D
m
S
m
FIGURE 14.1 The demand for money, the supply of money, and the equilibrium interest rate. The total demand for
money D
m
is determined by horizontally adding the asset demand for money D
a
to the transactions demand D
t
. The transactions demand is vertical
because it is assumed to depend on nominal GDP rather than on the interest rate. The asset demand varies inversely with the interest rate because of
the opportunity cost involved in holding currency and checkable deposits that pay no interest or very low interest. Combining the money supply (stock)
S
m
with the total money demand D
m
portrays the market for money and determines the equilibrium interest rate i
e
.
QUICK QUIZ 14.1
1. In this graph, at the interest rate i
e
(5 percent):
a. the amount of money demanded as an asset is $50 billion.
b. the amount of money demanded for transactions is
$200 billion.
c. bond prices will decline.
d. $100 billion is demanded for transactions, $100 billion is
demanded as an asset, and the money supply is $200 billion.
2. In this graph, at an interest rate of 10 percent:
a. no money will be demanded as an asset.
b. total money demanded will be $200 billion.
c. the Federal Reserve will supply $100 billion of money.
d. there will be a $100 billion shortage of money.
3. Curve D
a
slopes downward because:
a. lower interest rates increase the opportunity cost of holding
money.
b. lower interest rates reduce the opportunity cost of holding
money.
c. the asset demand for money varies directly (positively) with
the interest rate.
d. the transactions-demand-for-money curve is perfectly vertical.
4. Suppose the supply of money declines to $100 billion. The
equilibrium interest rate would:
a. fall, the amount of money demanded for transactions would
rise, and the amount of money demanded as an asset would
decline.
b. rise, and the amounts of money demanded both for
transactions and as an asset would fall.
c. fall, and the amounts of money demanded both for
transactions and as an asset would increase.
d. rise, the amount of money demanded for transactions would
be unchanged, and the amount of money demanded as an
asset would decline.
Answers: 1. d; 2. a; 3. b; 4. d
demand. The resulting downward-sloping line in Figure 14.1 c
represents the total amount of money the public wants to
hold, both for transactions and as an asset, at each possible
interest rate.
Recall that the transactions demand for money depends
on the nominal GDP. A change in the nominal GDP—
working through the transactions demand for money—will
shift the total money demand curve. Specifically, an increase
in nominal GDP means that the public
wants to hold a larger amount of money for
transactions, and that extra demand will
shift the total money demand curve to the
right. In contrast, a decline in the nominal
GDP will shift the total money demand
curve to the left. As an example, suppose
nominal GDP increases from $300 billion
W 14.1
Demand for
money
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CHAPTER 14
Interest Rates and Monetary Policy
261
to $450 billion and the average dollar held for transactions
is still spent three times per year. Then the transactions
demand curve will shift from $100 billion ( $300 billion兾3)
to $150 billion ( $450 billion兾3). The total money de-
mand curve will then lie $50 billion farther to the right at
each possible inte rest rate.
The Equilibrium Interest Rate
We can combine the demand for money with the supply of
money to determine the equilibrium rate of interest. In
Figure 14.1 c the vertical line, S
m
, represents the money
supply. It is a vertical line because the monetary authorities
and financial institutions have provided the economy with
some particular stock of money. Here it is $200 billion.
Just as in a product market or a resource market, the
intersection of demand and supply determines the equilib-
rium price in the market for money. Here, the equilibrium
“price” is the interest rate ( i
e
)—the price that is paid for
the use of money over some time period.
Changes in the demand for money, the
supply of money, or both can change
the equilibrium interest rate. For reasons
that will soon become apparent, we are most
interested in changes in the supply of
money. The important generalization is
this: An increase in the supply of money will
lower the equilibrium interest rate; a de-
crease in the supply of money will raise the equilibrium in-
terest rate. (Key Questions 1 and 2)
Interest Rates and Bond Prices
Interest rates and bond prices are closely related. When
the interest rate increases, bond prices fall; when the
interest rate falls, bond prices rise. Why so? First under-
stand that bonds are bought and sold in financial markets,
and that the price of bonds is determined by bond demand
and bond supply.
Suppose that a bond with no expiration date pays a
fixed $50 annual interest and is selling for its face value of
$1000. The interest yield on this bond is 5 percent:
$50
______
$1000
5% interest yield
Now suppose the interest rate in the economy rises to
7
1
_
2
percent from 5 percent. Newly issued bonds will pay
$75 per $1000 lent. Older bonds paying only $50 will
not be salable at their $1000 face value. To compete with
the 7
1
_
2
percent bond, the price of this bond will need to
fall to $667 to remain competitive. The $50 fixed annual
G 14.1
Equilibrium
interest rate
interest payment will then yield 7
1
_
2
percent to whoever
buys the bond:
$50
_____
$667
7
1
_
2
%
Next suppose that the interest rate falls to 2
1
_
2
percent from
the original 5 percent. Newly issued bonds will pay $25 on
$1000 loaned. A bond paying $50 will be highly attractive.
Bond buyers will bid up its price to $2000, at which the
yield will equal 2
1
_
2
percent:
$50
______
$2000
2
1
_
2
%
The point is that bond prices fall when the
interest rate rises and rise when the inter-
est rate falls. There is an inverse relation-
ship between the interest rate and bond
prices. (Key Question 3)
QUICK REVIEW 14.1
• People demand money for transaction and asset purposes.
• The total demand for money is the sum of the transactions
and asset demands; it is graphed as an inverse relationship
(downward-sloping line) between the interest rate and the
quantity of money demanded.
• The equilibrium interest rate is determined by money
demand and supply; it occurs when people are willing to hold
the exact amount of money being supplied by the monetary
authorities.
• Interest rates and bond prices are inversely related.
The Consolidated Balance
Sheet of the Federal
Reserve Banks
With this basic understanding of interest rates we can turn
to monetary policy, which relies on changes in interest
rates to be effective. The 12 Federal Reserve Banks to-
gether constitute the U.S. “central bank,” nicknamed the
“Fed.” (Global Perspective 14.1 also lists some of the
other central banks in the world, along with their
nicknames.)
The Fed’s balance sheet helps us consider how the
Fed conducts monetary policy. Table 14.1 consolidates
the pertinent assets and liabilities of the 12 Federal Re-
serve Banks as of March 29, 2006. You will see that some
of the Fed’s assets and liabilities differ from those found
on the balance sheet of a commercial bank.
W 14.2
Bond prices and
interest rates
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PART FOUR
Money, Banking, and Monetary Policy
262
Assets
The two main assets of the Federal Reserve Banks are se-
curities and loans to commercial banks. (Again, we will
simplify by referring only to commercial banks, even though
the analysis also applies to thrifts —savings and loans, mu-
tual savings banks, and credit unions.)
Securities The securities shown in Table 14.1 are gov-
ernment bonds that have been purchased by the Federal
Reserve Banks. They consist largely of Treasury bills
(short-term securities), Treasury notes (mid-term securi-
ties), and Treasury bonds (long-term securities) issued by
the U.S. government to finance past budget deficits. These
securities are part of the public debt—the money borrowed
by the Federal government. The Federal Reserve Banks
bought these securities from commercial banks and the
public through open-market operations. Although they are
an important source of interest income to the Federal
Reserve Banks, they are mainly bought and sold to influ-
ence the size of commercial bank reserves and, therefore,
the ability of those banks to create money by lending.
Loans to Commercial Banks For reasons that
will soon become clear, commercial banks occasionally
borrow from Federal Reserve Banks. The IOUs that com-
mercial banks give these “bankers’ banks” in return for
loans are listed on the Federal Reserve balance sheet as
“Loans to commercial banks.” They are assets to the Fed
because they are claims against the commercial banks. To
commercial banks, of course, these loans are liabilities in
that they must be repaid. Through borrowing in this way,
commercial banks can increase their reserves.
Liabilities
On the liability side of the Fed’s consolidated balance
sheet, we find three items: reserves, Treasury deposits, and
Federal Reserve Notes.
Reserves of Commercial Banks The Fed
requires that the commercial banks hold reserves against
their checkable deposits. When held in the Federal Re-
serve Banks, these reserves are listed as a liability on the
Fed’s balance sheet. They are assets on the books of the
commercial banks, which still own them even though they
are deposited at the Federal Reserve Banks.
Treasury Deposits The U.S. Treasury keeps de-
posits in the Federal Reserve Banks and draws checks on
them to pay its obligations. To the Treasury these deposits
are assets; to the Federal Reserve Banks they are liabilities.
The Treasury creates and replenishes these deposits by de-
positing tax receipts and money borrowed from the public
or from the commercial banks through the sale of bonds.
Federal Reserve Notes Outstanding As we
have seen, the supply of paper money in the United States
consists of Federal Reserve Notes issued by the Federal
GLOBAL PERSPECTIVE 14.1
Central Banks, Selected Nations
The monetary policies of the world’s major central banks are
often in the international news. Here are some of their official
names, along with a few of their popular nicknames.
Australia: Reserve Bank of Australia (RBA)
Canada: Bank of Canada
Euro Zone: European Central Bank (ECB)
Japan: The Bank of Japan (“BOJ”)
Sweden: Sveriges Riksbank
United Kingdom: Bank of England
United States: Federal Reserve System
(the “Fed”) (12 regional Federal Reserve Banks)
Russia: Central Bank of Russia
Mexico: Banco de Mexico (Mex Bank)
Source: Federal Reserve Statistical Release, H.4.1, March 29, 2006, www.federalreserve.gov/.
TABLE 14.1 Consolidated Balance Sheet of the 12 Federal Reserve Banks, March 29, 2006 (in Millions)
Assets Liabilities and Net Worth
Securities $758,551 Reserves of commercial banks $ 14,923
Loans to commercial banks 19,250 Treasury deposits 4,663
All other assets 59,967 Federal Reserve Notes (outstanding) 754,567
All other liabilities and net worth 63,615
Total $837,768 Total $837,768
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