money and monetary policy spring 2003

8/14/2019 Money and Monetary Policy Spring 2003

1/47

Money in the Economy

Mmmmmmm,

money!


2/47

Monetary Policy A tool of macroeconomic policy under the

control of the Federal Reserve that seeks to

attain stable prices and economic growththrough changes in the rate of growth of the

money supply.


3/47

The Money Supply

M1: Currency + travelers checks + checkable deposits

M2: M1 + small time deposits + overnight

repurchase agreements + overnight Eurodollars + money

market mutual fund balances M3: M2 + large denomination time deposits + term

repurchase agreements + term Eurodollars + institutions

only money market fund balances


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The Creators of Money

The three major players whose decisions and actionsdetermine the rate of growth in the money supply are:

The Federal Reserve (Fed)

Sets reserve requirements

Operates the discount window

Engages in open market operations

The Commercial Banking System

Accepts deposits and makes loans

Sets excess reserves

The Non-Bank Public Holds either deposits or cash


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Money Creation

Banks create money in their normal, day-to-day

profit seeking activities

Banks do not try to create money

Money creation occurs because we have a

fractional reserve commercial banking system.

Banks must hold a fraction of their deposits idle as

reserves. They may lend the remainder. As they make loans, new deposits are created, causing the

money supply to expand.


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Bank Reserves Total Reserves = Required reserves plus

excess reserves

Required reserves = Deposits X reserverequirement

Excess reserves = Total reserves - required

reserves


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Money Creation: Assumptions Assumptions:

Banks lend all their excess reserves

The non-bank public does not use cash

Only demand or checkable deposits exist

The required reserve ratio is 10%


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Money Creation: Step 2 Let Bank #1 make a $100 loan to a member of the

non-bank public

It does this by crediting the borrowers checkingaccount with $100.

Let the borrower spend the money.

Let the recipient of the money bank at Bank #2

When Bank #1 honors the check, Bank #1s

deposits and reserves fall by $100.


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Money Creation: Step 3 A second bank, Bank #2, has received a

new deposit of $100.

Its total reserves increase by ? Its required reserves increase by ?

Its excess reserves increase by ?

Bank #2 may now make a loan of ?


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Money Creation: Step 4 Bank #2 makes a loan of $90 in the form of

a new demand deposit.

When the money is spent and Bank #2 honorsthe check, deposits and reserves at Bank #2 fall

by $90

But Bank #3 now has a new deposit of $90and may make a loan equal to ?


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Money Creation: Summary New Deposit Required Reserves Excess Reserves New Loan

$100 $100$100 $10.00 $ 90 $ 90

$ 90 $ 9.00 $ 81 $ 81$ 81 $ 8.10 $ 72.90 $ 72.90

$ 72.90 $ 7.29 $ 65.61 $

65.61

$ 65.61 $ 6.51 $ 59.05 $

59.05

$1,000 $100 $900 $900


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Some Simple Formulas

Note that in our simple example, demand deposits are a

multiple of required reserves

Let R = required reserves

Let r = % reserve requirementLet D = demand deposits

R = r x D or

D = 1/r x R

A change in deposits will be a multiple of the change inreserves

/\D = 1/r x /\R


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The Multiplier

The simple deposit expansion multiplier is 1/r or 1/reserve

requirement

r is a leakage out of the lending process

if r gets bigger, expansion of deposits gets smaller because banks

have fewer excess reserves to lend

if r gets smaller, expansion of deposits gets larger because banks

have more excess reserves to lend

The real world multiplier is smaller than our 1/r because

Banks hold idle excess reservesPeople hold and use cash


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The Money Supply Model


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The M1 Model: Derivation

Definitions:

M1 = D + C

Base = R + C

Total Deposits = D

Assumptions:

r = R/D = required reserve ratio for depositse = E/D = the excess reserve ratio

c = C/D = the ratio of currency to deposits


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Model:B = R + C

R = rD + eD D = D

C = cD

E = eD

B = rD + eD + cD

B = D(r + e + c)

D = (1/r + e + c)B


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Model:

M1 = D + C

M1 = D + cD

M1 = D(1 + c) Factor out D

M1 = 1 + c

r + e + cB

M1 = Multiplier x Base


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Money Multiplier Terms

Changes in r

If r increases, the multiplier decreases

If r decreases, the multiplier increases

The money multiplier and M1 are

negatively related.


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Changes in c

If c increases, reserves drain from the banking system.

Fewer reserves mean less expansion of deposits.

If c decreases, reserves in the banking system increase.

More reserves mean more expansion of deposits.

The money multiplier and M1 are negatively related.


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Changes in e

An increase in e means banks are holding more

excess reserves and lending less.A decrease in e means banks are holding fewer

excess reserves and lending more.

The money multiplier and M1 arenegatively related.


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M1 and Base

Base is comprised of non-borrowed base,

discount loans, and currency.

OMO purchases increase non-borrowed base.

OMO sales decrease non-borrowed base.

M1 is positively related to non-borrowed

base.


23/47

M1 and Base

Base is comprised of non-borrowed base,

discount loans, and currency.

Increases in discount loans increase base.

Decreases in discount loans decrease base.

M1 is positively related to the level of

discount loans.


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The Money Supply The money supply equals the monetary base

times the money multiplier

The monetary base (base) is defined as: Base = Reserves + Currency

Base can be controlled by the Federal Reserve

The multiplier reflects the ability of the banking

system to expand deposits The multiplier = 1 + c/(r + e + c)

The value of the multiplier is determined by the Fed, banks, and

the members of the non-bank public.


25/47

Control of the Money Supply The Fed controls the money supply with...

Open Market Operations

Purchases and sales of government securities by theFed on the open market

Discount Window

Loans made by the Fed to banks

The Fed influences the multiplier with

Changes in the reserve requirement


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Open Market OperationsFed Bank

Presidents

Federal Open

Market Comm.

Fed Board of

Governors

Securities

Dealers

Federal Reserve

Bank of New York

Commercial

Banks

Change

in

Reserves

Change in

Money

Supply


27/47

Open Market Operations When the Fed buys Treasury bonds from a

bank, it pays for the bonds by crediting the

bank with an increase in reserves. When the Fed sells Treasury bonds to a

bank, it accepts payment for the bonds by

debiting the banks reserve position at theFed


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Discount Loans When the Fed makes a discount loan to a

bank, the bank is credited with an increase

in reserves. When a bank repays the Fed, the banks

reserves are debited.


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Reserve Requirements If the Fed increases reserve requirements,

banks have fewer excess reserves to lend,

causing the expansion of deposits todecrease.

If the Fed decreases or eliminates reserve

requirements, banks have more excessreserves to lend, permitting the expansion

of deposits to increase.


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Excess Reserves and Currency

Drains Banks determine the level of excess

reserves

Increases in excess reserves diminish theexpansion of deposits.

Decreases in excess reserves increase the

expansion of deposits


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Excess Reserves and Currency

Drains Members of the non-bank public determine

currency in circulation

Increases in currency drains from the bankingsystem, diminish the expansion of deposits

Decreases in currency drains from the banking

system, increase the expansion of deposits


32/47

Central Bank Policy ChannelsPolicy

Tools

Level & Growth

Bank Reserves

Cost & Availability

of Credit

Size and Growth

Rate of Money

Supply

Market Value

of Securities

Volume

and

Growthof

Borrowing

and

Spending

by thePublic

Full

Employment

Growth

Price

Stability


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Monetary PolicyI see rates rising;no, falling; no

rising; no --


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Monetary Policy Transmission

Mechanism A monetary policy transmission mechanism

describes the chain of events that occur in

an economy as a result of a change in therate of growth in the money supply.

Good monetary policy decisions depend on

understanding the different ways money cancause changes in economic activity.


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Interest Rate Channel

Change in Change in Short Change in

Money Supply Term Interest Rates GDP

Change in

Exchange

Rates

Change in

Long Term

Interest Rates


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The Interest Rate Channel

Traditional View

A change in the money supply leads to a

change in interest rates which in turn changesthe cost of capital, causing a change in

investment spending, aggregate demand and

GDP in the short run.


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The Interest Rate Channel

Fact:

A change in the money supply causes a change

in short term interest rates. Investmentspending is a function of long term interest

rates.

Question:How can a change in short rates result in a

similar change in long rates?


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Short Rates and Long Rates

The expectations model of the term structure is

the key relationship between short rates and

long rates.The long rate is the expected average of future short

rates appropriate for the maturity of the long bond.

If the Fed acts to raise the short term rate and market

participants expect that the increase is the first of a longersequence, the long rate will rise as market participants

react to the Feds policy change.


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Short Rates and Long Rates

The expectations model of the term structure is

the key relationship between short rates and

long rates.The long rate is the expected average of future short

rates appropriate for the maturity of the long bond.

If the Fed acts to decrease the short term rate and market

participants expect that the decrease is the first of a longersequence, the long rate will fall as market participants

react to the Feds policy change.


40/47

Monetary Policy, Interest Ratesand GDP

Let the Fed raise short-term interestrates

As interest rates increase, the cost ofborrowing increases, causing investment(I), consumer durables (C), and GDP to fall.

Let the Fed decrease short-term interest

ratesAs interest rates decrease, the cost of

borrowing decreases, causing investment

(I), consumer durables (C), and GDP torise.


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The Exchange Rate Channel

Traditional View

A decrease in the money supply leads to arise in interest rates which in turn raises the

exchange rate, causing a decline in netexports, aggregate demand and GDP in theshort run.

Question:

How can a change in interest rates result ina change in exchange rates?


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The exchange rate is the price of a currencyexpressed in terms of another currency.

The exchange rate and the interest rate arepositively related.

The higher domestic real rates of interest arerelative to foreign real interest rates, the higher

will be the foreign exchange rate for thedomestic economy.

Explaining Exchange Rates withInterest Rates


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Interest Rate Parity

Interest rate parity says that the interest ratedifferential between any two countries is

equal to the expected rate of change in theexchange rate between those two countries.


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Interest Rate Parity: Example

Assume that U.S. real interest rates arehigher than those in other countries.

The high rates of return on U.S. assets will

attract foreign buyers, but in order to buyU.S. financial assets, foreigners must firstbuy dollars.

The demand for dollars increases in the globalmarketplace, causing the dollar to appreciate.

The supply of the other currency increases in theglobal marketplace, causing the other currencyto depreciate.


45/47

Monetary Policy, Exchange

Rates and GDP Let the Fed raise short-term interest rates

As interest rates increase, exchange rates

increase, causing net exports (X - M) and GDPto fall.

GDP = C + I + G + (X - M)

As the value of the dollar increases, we export fewer

goods and import more.


46/47

Monetary Policy, Exchange

Rates and GDP Let the Fed decrease short-term interest

rates

As interest rates decrease, exchange ratesdecrease, causing net exports (X - M) and GDP

to rise.

GDP = C + I + G + (X - M)

As the value of the dollar decreases, we export more

goods and import fewer.


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money and monetary policy spring 2003

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