Money in the Economy

Mmmmmmm, money!

Monetary Policy

• A tool of macroeconomic policy under the control of the Federal Reserve that seeks to attain stable prices and economic growth through changes in the rate of growth of the money supply.

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

The Creators of Money• The three major players whose decisions and actions

determine 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

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.

Bank Reserves

• Total Reserves = Required reserves plus excess reserves– Required reserves = Deposits X reserve

requirement– Excess reserves = Total reserves - required

reserves

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%

Money Creation: Step 1

• Assume the Federal Reserve injects $100 into the banking system– Excess reserves increase by $100 in Bank #1

• Banks do not face reserve requirements on injections of reserves by the Fed

• Bank #1, therefore, has $100 to lend

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 borrower’s checking

account 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 #1’s deposits and reserves fall by $100.

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 ?

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 honors

the check, deposits and reserves at Bank #2 fall by $90

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

Money Creation: SummaryNew 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

Some Simple Formulas

• Note that in our simple example, demand deposits are a multiple of required reserves– Let R = required reserves– Let r = % reserve requirement– Let D = demand deposits– R = r x D or– D = 1/r x R

• A change in deposits will be a multiple of the change in reserves – /\D = 1/r x /\R

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 reserves

– People hold and use cash

The Money Supply Model

The M1 Model: Derivation

• Definitions:– M1 = D + C– Base = R + C– Total Deposits = D

• Assumptions:– r = R/D = required reserve ratio for deposits– e = E/D = the excess reserve ratio– c = C/D = the ratio of currency to deposits

The M1 Model: Derivation

• 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

The M1 Model: Derivation

• Model:– M1 = D + C– M1 = D + cD– M1 = D(1 + c) Factor out D

• M1 = 1 + c r + e + c

B

• M1 = Multiplier x Base

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.

Money Multiplier Terms

• 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.

Money Multiplier Terms

• 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 are negatively related.

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.

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.

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.

Control of the Money Supply

• The Fed controls the money supply with...– Open Market Operations

• Purchases and sales of government securities by the Fed on the open market

– Discount Window• Loans made by the Fed to banks

• The Fed influences the multiplier with– Changes in the reserve requirement

Open Market Operations Fed BankPresidents

Federal OpenMarket Comm.

Fed Board of Governors

Securities Dealers

Federal Reserve Bank of New York

Commercial Banks

Change inReserves

Change in Money Supply

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 bank’s reserve position at the Fed

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 bank’s reserves are debited.

Reserve Requirements

• If the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease.

• If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.

Excess Reserves and Currency Drains

• Banks determine the level of excess reserves– Increases in excess reserves diminish the

expansion of deposits.– Decreases in excess reserves increase the

expansion of deposits

Excess Reserves and Currency Drains

• Members of the non-bank public determine currency in circulation– Increases in currency drains from the banking

system, diminish the expansion of deposits– Decreases in currency drains from the banking

system, increase the expansion of deposits

Central Bank Policy Channels

PolicyTools

Level & GrowthBank Reserves

Cost & Availability of Credit

Size and Growth Rate of Money Supply

Market Value of Securities

Volume and Growth of Borrowing andSpending by the Public

FullEmployment

Growth

PriceStability

Monetary PolicyI see rates rising;no, falling; no rising; no --

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 the rate of growth in the money supply.

• Good monetary policy decisions depend on understanding the different ways money can cause changes in economic activity.

Interest Rate Channel

Change in Change in Short Change inMoney Supply Term Interest Rates GDP

Change inExchange Rates

Change in Long TermInterest Rates

The Interest Rate Channel

• Traditional View– A change in the money supply leads to a

change in interest rates which in turn changes the cost of capital, causing a change in investment spending, aggregate demand and GDP in the short run.

The Interest Rate Channel

• Fact:– A change in the money supply causes a change

in short term interest rates. Investment spending is a function of long term interest rates.

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

similar change in long rates?

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 longer sequence, the long rate will rise as market participants react to the Fed’s policy change.

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 longer sequence, the long rate will fall as market participants react to the Fed’s policy change.

Monetary Policy, Interest Rates and GDP

• Let the Fed raise short-term interest rates

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

• Let the Fed decrease short-term interest rates– As interest rates decrease, the cost of

borrowing decreases, causing investment (I), consumer durables (C), and GDP to rise.

The Exchange Rate Channel

• Traditional View– A decrease in the money supply leads to a

rise in interest rates which in turn raises the exchange rate, causing a decline in net exports, aggregate demand and GDP in the short run.

• Question:– How can a change in interest rates result in

a change in exchange rates?

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

• The exchange rate and the interest rate are positively related.

– The higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the foreign exchange rate for the domestic economy.

Explaining Exchange Rates with Interest Rates

Interest Rate Parity

• Interest rate parity says that the interest rate differential between any two countries is equal to the expected rate of change in the exchange rate between those two countries.

Interest Rate Parity: Example

• Assume that U.S. real interest rates are higher than those in other countries.– The high rates of return on U.S. assets will

attract foreign buyers, but in order to buy U.S. financial assets, foreigners must first buy dollars.

• The demand for dollars increases in the global marketplace, causing the dollar to appreciate.

• The supply of the other currency increases in the global marketplace, causing the other currency to depreciate.

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 GDP to fall.

• GDP = C + I + G + (X - M)– As the value of the dollar increases, we export fewer

goods and import more.

Monetary Policy, Exchange Rates and GDP

• Let the Fed decrease short-term interest rates– As interest rates decrease, exchange rates

decrease, 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.