Modern macroeconomics: monetary policy

1
"Money
is whatever is generally
accepted in exchange for goods and services
accepted not as an object to be consumed but
as an object that represents a temporary abode
of purchasing power to be used for buying
still other goods and services. Milton
Friedman (1992)
2
What is Money?

• A medium of exchangeUsed to buy and sell goods
  and services.
• Avoids barter
• 2. A store of value Allows transfer of
  purchasing power from one period to another.
• A measure of valueConverts worth to a monetary
  value.

3
The Value of Money

• Fiat Money
• just because
• Intrinsic value
• Not worth the paper its printed on.
• Trusted
• legal tender
• Scarce
• determines its value

4

• Two basic measurements of the money supply are M1
  and M2
• The components of M1 are
• Currency
• Checking Deposits (including demand deposits and
  interest-earning checking deposits)
• Traveler's checks
• M2 (a broader measure of money) includes
• M1,
• Savings,
• Time deposits under 100,000, and,
• Money mutual funds

The Supply of Money
5

• The third measurement of the money supply is M3
• The components of M3 are
• M2
• Time deposits, over 100,000 and,
• Foreign currency holdings in US banks overseas

6
The Composition of Money in the U.S.
The M1 and M2 Money Supply of the U.S
(as of May 2009)
Money Supply, M1 (in billions)
Currency (in circulation)
850
Demand deposits
407
Other checkable deposits
334
Travelers checks
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Total M1
1,596
Money Supply, M2 (in billions)
M1
1,596
Savings deposits a
4,445
Small time deposits
1,308
Money market mutual funds
979
Total M2
8,328
a Including money market deposit accounts.
Source http//www.federalreserve.gov.

• The size and composition of the two most widely
  used measures of U.S. money supply (M1 M2) are
  shown above.

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M1, M2, or not?
b
b
a
a
a
a
c
c
c
c
1. __ A 100 bill
2. __ A 6-month certificate of deposit
3.__ A 10,000 retirement account invested in
stocks
4. __ A 50 travelers check
5. __ A 5,000 American Express credit line
6. __ A quarter
7. __ A 1 off coupon clipped from the paper
8. __ A 100 balance in a checking account
9. __ A 200 balance in a savings account
10. __ A 10,000 treasury bill
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The Changing Nature of M1
Billions of
Total 1,293
1,350
1,200
1,050
900
750
600
450
300
150
1970
1975
1980
1985
1990
1995
2000
2003

• In the 1980s, interest-earning checking accounts
  M1?

• In the 1990s, money market mutual funds
  M1?

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The Changing Nature of M1
Billions of
M1
Total 1,388
900
750
600
450
761
318
300
150
1970
1975
1980
1985
1990
1995
2000
2005

• In the 1980s, interest-earning checking accounts
  M1?

• In the 1990s, money market mutual funds
  M1?

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Financial
Depository
Institutions

• Function
• accept and maintain deposits.
• make loans.

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Financial
Depository
Institutions

• Types.
• Commercial Banks.
• Savings and Loans
• Credit Unions
• Savings Banks.

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The Functions of Commercial Banking Institutions

• Banks provide services and pay interest to
  attract checking, savings, and time deposits
  (liabilities).
• Most of these deposits are invested and loaned
  out, providing interest income for the bank.
• Banks hold a portion of their assets as reserves
  (either as cash or deposits with the Fed) to
  meet their daily obligations toward their
  depositors.

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Fractional Reserves

• Banks maintain only a fraction of their assets
  (deposits) as reserves to meet the requirements
  of depositors.
• an decrease in required reserves lets banks make
  more loans, expand the money supply

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Creating Money

• Printing Money
• Making Loans
• a. Key Ingredients
• Deposits Household savings
• Required Reserves money held at the bank or at
  the FRS (around 10)
• Excess Reserves loan able funds
  Deposits Required Reserves

A depository institution can make loans up to the
value of its excess reserves
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Loan Making
Main Street Bank Situation Demand deposits
50,000 Reserve requirement 10
Actual reserves at bank 10,000
How much can they lend?
Excess Reserves Demand deposits
50,000 Reserve requirement 10 Actual
reserves 10,000 - Required
reserves 5,000 Excess reserves
5,000
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Loan Making
Excess Reserves (5,000) can be loaned
By making a loan, the bank has created money.
The original deposits are still in Main Street
Bank, but now there is an additional 5,000 out
floating around.
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Creating Money
If the Excess Reserves are loaned
The borrowed money is spent and deposited at
another bank.
The second banks reserves are now up 5,000 -
it must keep 10 or 500 - it can then loan out
4,500 (5,000 500)
This process can be repeated at each step. 10
of the money is lost at each step
The more that is required to be held in reserve,
the less money can be created
The lower the reserve requirement, the greater
the amount of money that can be created
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Creating Money from New Reserves
New cash depositsActual Reserves
Potential demand deposits created byextending
new loans
NewRequired Reserves
Bank
Initial deposit (bank A)
1,000.00
200.00
800.00
Second stage (bank B)
160.00
800.00
640.00
Third stage (bank C)
128.00
640.00
512.00
Fourth stage (bank D)
102.40
512.00
409.60
Fifth stage (bank E)
81.92
409.60
327.68
Sixth stage (bank F)
65.54
327.68
262.14
Seventh stage (bank G)
52.43
262.14
209.71
All others (other banks)
1,048.58
209.71
838.87
Total
5,000.00
1,000.00
4,000.00

• When banks are required to maintain 20 reserves
  against demand deposits, the creation of 1,000
  of new reserves will potentially increase the
  supply of money by 5,000.

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The Money Multiplier
From the table a deposit of 1000, with a 20
reserve requirement led to a 4000 expansion of
the money supply
Is there a pattern here?
Yes!!!
It just takes 3 easy steps
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The Steps
1. Find the reciprocal of the required
reserve 1/20 1/1/5 5
2. Multiply the initial change in the excess
reserves by the money multiplier 1000 5
5000

• Subtract out the initial change
• 5000 - 1000 4000

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Problem 1

• Deposit of 10,000

• ________
• ________
• ________

• Required reserve 10

• Increase in the money supply?

• 10,000 c. 100,000
• 9,000 d. 90,000

• ________
• ________
• ________

How about if the reserve requirement was 20?

• 200,000 c. 100,000
• 40,000 d. 50,000

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Problem 2

• Deposit of 16,000

• ________
• ________
• ________

• Required reserve 25

• Increase in the money supply?

• 144,000 c. 80,000
• 48,000 d. 64,000

• ________
• ________
• ________

How about if the reserve requirement was 20?

• ________
• ________
• ________

How about if the reserve requirement was 10?
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The Effect of Loaning Money
1. Loan making changes the money supply
2. Increases in loans leads to increased
spending which increases the money supply.
3. BUT, decreases in loan making, or even paying
back a loan decreases the money supply.
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Reserve Requirements (Reserve Ratios) for Banks
and Thrifts, 2003
Type of Deposit Current Requirement
Limits
Checkable Deposits
0 - 6 million 0
3
6 - 42.1 million 3
3
Over 42.1 million 10
8-14
Non-checkable non-personal
savings and time deposits 0
0-9
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The Federal Reserve System
FRS
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The Federal Reserve System

• Created in 1913
• Responsible for
• a. overseeing the money supply
• b. coordinating commercial bank operations
• c. regulating depository institutions

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The FRS Organization

• The Board of Governors is at the center of the
  banking system in the U.S.

• The seven members of the Board of Governors also
  serve on the Federal Open Market Committee

• The FOMC is a 12-member board that establishes
  Fed policy regarding the buying and selling of
  government securities.

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• Board of Governors
• 7 members appointed by President
• - 14 yr terms at 2 yr intervals for
  continuity independence
• -not more than one from each district

2010
2000
2014
2012
2008
2006
2004
2002
Staggered 14 Year Terms
http//www.federalreserve.gov/
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The FRS Districts

• Each district bank monitors the commercial banks
  in their region and assists them with the
  clearing of checks.
• The Board of Governors of the Federal Reserve
  System is located in Washington D.C.

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The FRS Regions and Branches

• ____________________
• ____________________, ____________________
• ____________________
• _________________, _________________,
  _________________
• ________________, _________________,
  _________________,
• _________________, ________________,
  _________________, _________________,
  _________________, _________________
• _________________, _________________
• _________________, ________________,
  _________________, _________________
• _________________, _________________
• _________________, ________________,
  ________________, __________________
• _________________, _________________,
  _______________,
• _________________, ________________,
  _________________, _________________,
  _________________, _________________

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The FRS Regions and Branches
1 Boston 2 New York City, Buffalo 3
Philadelphia 4 Cleveland, Pittsburgh,
Cincinnati 5 Richmond, Baltimore, Charlotte 6
Atlanta, Nashville, Birmingham, Miami,
Jacksonville, New Orleans 7 Chicago, Detroit 8
St. Louis, Louisville, Memphis, Little Rock 9
Minneapolis, Helena 10 KC, Denver, Omaha,
Oklahoma City 11 Dallas, San Antonio, El Paso 12
SF, Salt Lake City, LA, Port., Seattle, Honolulu
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2. Federal Open Market Committee -12 members
7 Governors (for majority) plus 5 Pres or
VP from 1 NY 2 Bost, Phila, or Richmond, 3 Atl,
Dallas, or StL 4 Minn, KC, or SF, LA 5 Clev, or
Chicago set policy on buying selling bonds on
open mkt
3. Federal Advisory Council outsiders 12
members - 1 each selected by Board of each Region
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The Federal Reserve and Monetary policy
1. Monetary Policy Tools
a. The Reserve Requirement
-reducing it encourages loans and increases the
money supply
-increasing it discourages loans and decreases
the money supply
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Current Requirements
Type of Deposit Current Legal Range Checkable
0-5.5 mil 0 0-3 5.5-42.8
mil 3 0-3 over 42.8 mil 10 8-14 Savings
0 0-9
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b. The Discount Rate
3 rates 1. Discount Rate 2. Federal Funds
Rate 3. Prime Rate
federal reserve to member banks
bank to bank
banks to best customers
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b. The Discount Rate
Raising Discount Rate discourages bank
borrowing decreases money supply
Lowering Discount Rate encourages bank
borrowing increases money supply
Current Favorite
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The Federal Reserve and Monetary policy
c. Open Market Operations
Buying and Selling Securities (Bonds)
-selling bonds puts bonds out and take money out
of circulation
What effect will this have on the economy??
-buying bonds puts money back in circulation and
takes bonds in
What effect will this have on the economy??
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Easy Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
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Tight Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
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The Functions of the US Treasury
1. Controls the Federal Budget
2. Borrows money for deficits
3. Issues Securities
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The Functions of the Fed
1. Supervise and Examine Member Banks
Make sure they are following the rules
2. Maintain Reserve Accounts
Makes clearing check easier
3. Control Currency Circulation
Replace money or increase or decrease money in
circulation
4. Clear Checks
Moves checks from region to region
5. Act as Fiscal agent for the US Government
Borrows, writes checks, takes deposits
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Three Factors that have Changed the Nature of
Money

• Widespread use of the dollar abroad One-half
  to as much as two-thirds of U.S. dollar currency
  is held abroad, and these holdings appear to be
  increasing.
• These dollars are included in the M1 money supply
  even though they are not circulating in the U.S.

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2. Increasing availability of low-fee stock and
bond mutual funds Stock and bond mutual funds
are not included in M1 or M2, so movement of
funds from M1 or M2 distorts both the M1 and M2
figures. 3. Debit cards and electronic money
Increased use of these will reduce the demand
for currency. These innovations will reduce the
reliability of the money supply figures as an
indicator of monetary policy.
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The Changing Nature of Money Around the World

• Twelve European nations (Austria, Belgium,
  Finland, France, Germany, Greece, Ireland, Italy,
  Luxembourg, Netherlands, Portugal, and Spain)
  now use the euro. Monetary policy for this
  currency is conducted by the European central
  bank.
• Several countries (Panama and Ecuador for
  example) either directly use the dollar or tie
  their domestic currency to the dollar.
• As international trade expands and people around
  the world search for access to sound money, the
  number of currencies is likely to decline in the
  future.