A Primer on Macroeconomics, Volume II by Thomas M. Beveridge

Author:Thomas M. Beveridge
Language: eng
Format: epub
Publisher: Business Expert Press
Published: 2017-10-21T16:00:00+00:00

THINK IT THROUGH: Is the size of the deposit multiplier relatively stable? How might it vary in response to changing economic conditions?

Each time a member of the public deposits funds into his or her checking account the money supply increases and more reserves are received by banks to continue the process.

We should expect the deposit multiplier to vary with such factors as the business cycle and the degree of optimism in the economy. During “good times,” banks, eager to lend to the many creditworthy applicants they encounter, will reduce the amount of funds retained as excess reserves, and the deposit multiplier will move closer to its maximum value. However, during recessions, with greater risk of default, banks will become more cautious, holding back more funds as excess reserves, and the deposit multiplier will decline. Historically, banks have maintained low levels of excess reserves but, during the Great Recession, they accumulated significant excess reserves and this behavior made the deposit multiplier sink far below its theoretical value.

In this section, we have discovered that there is a “multiplier” relationship between commercial bank reserves and demand deposits, and that changes in bank reserves can fuel changes in the money supply.

The Market for Money: Money Supply, Money Demand, and the Interest Rate

In this section, we construct a model of the money market. In the money market, the interest rate can be thought of as the opportunity cost or the “price” of money. We will analyze the factors that influence the quantity of money demanded as the interest rate changes and the factors that affect the demand for money but, first, we will examine the supply side of the market.

The Supply of Money

We have already done the heavy lifting in understanding the behavior of the quantity of money supplied as the interest rate changes. In general, there is a positive relationship between the interest rate and the quantity of money supplied, as shown in Figure 7.2.

First, when the interest rate—the reward for lending—increases, banks will lend out more aggressively by reducing the amount of excess reserves they retain. As excess reserves are reduced and as more loans are generated, the quantity of money in circulation (in truth, the quantity of demand deposits) will increase. At the same time, when the interest rate increases, there will be a reduction in the currency drains that reduce the strength of the money creation process—members of the public will reduce their holdings of currency as the reward increases for holding funds in the form of bank deposits. Both of these factors combine to cause the financial sector to process reserves more actively as the “price” of money increases and, therefore, the money supply curve (M) is upward-sloping.

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