Chapter 14: Monetary Policy and the Federal Reserve System

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Chapter 14 Monetary Policy and the Federal
Reserve System
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Money supply and the central bank

• Government policy is the primary determinant the
  money supply
• Central bank--has the legal authority to issue
  money
• In general, central bank determines the supply of
  high-powered money Mh

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Definitions of money

• Mh currency bank reserves
• M1 demand deposits currency
• M2 M1 time deposits less than 100,000
• M3 M2 time deposits 100,000 or greater
• L debts

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Feds Balance Sheet
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Most important assets of the Fed

• US treasury securities bonds, notes, and bills
• foreign exchange reserves--short term liabilities
• used as a means to intervene to stabilize
  currencies
• loans to financial institutions
• gold reserves

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Tools of the Fed

• Open market operations
• discount window
• reserve requirements
• federal funds rate

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Open market operations

• Purchase and sale of financial instruments
• Expansion of the money supply
• Central bank purchases financial instruments ??Mh
  (highpowered money) ??M1
• Contraction of the money supply
• Central bank sells financial instruments ??Mh
  (highpowered money) ??M1

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OMO and the Money supply process

• Assume that the FED seeks to expand the money
  supply
• Fed buys a government security with a check.
• The individual deposits the check in his or her
  checking account.
• The bank holds a portion of the deposit in
  reserves, and loans out the rest

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Changes in the Individuals Balance sheet

• The individual deposits the check in his checking
  account

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Changes in the Commercial Banks Balance sheet
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Changes in the FEDs Balance sheet
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Discount window

• The name given to loans made to the private
  sector
• in the US, the FED loans only to financial
  institutions
• interest rate that the FED charges is called the
  discount rate
• discount rate is usually below the interest rate
  that banks charge customers

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• FED limits the number of the loans made to banks
  through the discount window
• Rediscounting--where the central bank purchases
  commercial paper (short term debt) of the private
  sector

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Foreign exchange operations

• purchase and sale of assets denominated in other
  currencies
• Assuming no capital controls
• (Mh-Mh-1)(Dcg - Dcg-1) E(Bc-Bc-1) (
  Lc-Lc-1)
• change in Mhchange in deficit change in
  foreign reserves change in net credit granted
  to commercial banks through the discount window

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Money multiplier and the money supply

• Mh CU R--highpowed money equals currency
  reserves
• R Dc VC--reserves equal deposits at the FED
  vault cash
• M1 CU D--currency demand deposits
• Reserve ratio R/Drd
• RrdD

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• M1/Mh (CU D)/(CU R) eq. 1 divided by eq
  2
• (CU/D 1)/(CU/D R/D) (cd
  1)/(cd rd) money multiplier

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• M1 (cd 1)/(cd rd)Mh ?Mh
• where ? (cd 1)/(cd rd) which equal the
  money multiplier

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ratio of reserves to deposits

• required reserve ratio is set by the FED
• banks may carry excess reserves, but they do not
  earn interest on reserves
• rd ratio total reserves to demand deposits

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Ratio of currency to deposits

• cd --if cd rises the money multiplier tends to
  fall
• cd--controlled by the public
• implies that the central bank can influence the
  money supply, but it cannot control it

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Debate over monetary policy

• for a long the FED target interest rates
• monetarists criticized this policy as
  inflationary
• in 1979 the FED began targeting the money supply
• more recently it has gone back to targeting
  interest rates