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Economics 302

Intermediate Macroeconomic

(Fall 2010)

Prof. Menzie Chinn

ec ures -October 20-25

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How the Fed controls the money supply

- old version- new version

The demand for money, currency andcheckin de osits

How the Fed traditionally conducts

Lags in the effect of monetary policy

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The money supply consists of currency

individuals and firms hold at banks. e money supp y s ere ore e ne

as:

M = CU + D Lets refer to balance sheets

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Fed Control of the Money Basere-

The Fed controls the mone su l b

selling bonds to, or by purchasing bondsfrom, the banks, and the public (openmarket operations, or OMOs

The monetary base (MB) is defined ascurrency plus reserves:

MB = CU + RE

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e e oes no ry o exerc se separa e

control of reserves and currency.

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Monetar Base/Mone Su l LinkReserve requirements.

Currency demand.

From the definition of the money supply:= = =

MB = CU + RE = cD + rD = (c+r)D

v ng y B, we ge m

slide 5cr

m

cr

B

+

+

= , .

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Excess and Borrowed Reserves In the US, the reserve requirement for banks

is10 percent. Banks always keep some excess reserves.

The amount of excess reserves has typically

been small because banks didnt use to receiven eres on e r reserve a ances a e e .

Banks can also increase their reserves by

w v . Bank reserves borrowed from the Fed are called

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.

The Fed has traditionally provided loans to troubledbanks.

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Excess Reserves and Borrowed

Reserves

The Fed usually makes loans to banks at

District Federal Reserve Banks.

The interest rate on the borrowin s is calledthe discount rate.

The discount rate used to be below Fed

un s ra e. ow a ove. Fed now pays interest on excess reserves.

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New M /Mone Su l LinkReserves now depend on RRES.

=

Currency demand.

CU = cD

From the definition of the money supply:M = CU + D = cD + D = (1+c)D

MB = CU + RE = cD + D = (c+)D

Dividing M by MB, we get a variable m

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B

cr +

=(

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Excess Reserves

slide 9Source: J. Hamilton, Econbrowser, Feb. 14, 2010.

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Relation of MB, M1 and M2

10Lehman

9

8

log M2, s.a.

6

log M1, s.a.

5

log moneybase, n.s.a.

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Distinguishing between Monetary

an sca o c es

Fiscal policy is defined as bond-financed

taxes. e mone ary ase an e money supp yremain unchanged, and bonds are issued if

reduced.

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Distinguishing between Monetary

an sca o c es

the monetary base matched by a change

direction.

open-market operation.

-

affect government purchases (G), transfersF , interest a ments Q , or taxes T .

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Hence, open-market operations do not affectfiscal policy.

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The Demand for Money Three motives in peoples demand for

money:

transactions motive,

precautionary motive,

.

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The Transactions Demand for Money:

An Inventory Theory

Families and businesses hold currenc

and keep funds in their checking accountsfor the same reason stores keeinventories of goods for sale.

expenditures occur every day, it is necessaryto hold a stock of currency and checking

deposits. This inventory theory of the demand for

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money falls into the category oftransactions

motive.

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M R20=

kW

M

2

=

0

MR2

=

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The Demand Function for Money We can summarize the demand for

currency and checking deposits in twodemand functions:

CU = CU(R, PY)

D = D(R, PY) The equations show that the demand for

currency and the demand for checking

deposits are functions of the market interestrate R and nominal income PY (the price level

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.

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14.4 HOW THE FED CONDUCTS

MONETARY POLICY

ow s ou e e use s power oachieve its objectives of keeping inflationow an econom c uc ua ons sma

Decisions about monetary policy in theUnited States are made by the FederalOpen Market Committee (FOMC).

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Setting Interest Rates or Money

Growth

FOMC alternatives for monetary policy: Set the growth rate of the money supply.

Set the short-term interest rate. Money supply setting is preferable if shifts

in the IS curve dominate.

Interest rate setting preferable if shifts inthe LM curve dominate.

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The Zero Bound on Nominal

Interest Rates

a are e mp ca ons or e con ucof monetary policy when nominal interestra es approac or equa zero

The constraint of a zero bound on thenominal interest rate limits the scope ofmonetary policy.

If the nominal interest rate is zero, itcannot be lowered any further to stimulate

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the economy.

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The Zero Bound on Nominal

Interest Rates

prices).,

produces a positive real interest rate.

s may e oo g o s mu a e eeconomy, and cannot be lowered any

ur er.

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20

16

12

8

4

UnitedStates

0Japan

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1980 1985 1990 1995 2000 2005 2010

Japanese and US money market rates. Source: IMF, IFS, and St. Louis Fed

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Zero Bound in America20

16

12

8

4

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70 75 80 85 90 95 00 05 10

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Lags in Conventional

Monetary policy affects real GDP and

prices with a lag.

effect of monetary policy on GDP occurs

Uncertainty about the future state of the

policy makers.

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Quantitative Easin

slide 27Source: Econbrowser (J. Hamilton, 11 August 2010)

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Impact on Longer Term Rates6

10 year

constant

Lehman Quantitative

Easing

4

5 maturity

Treasury

3

year

constant

maturity

Treasury

2

Fed Funds

1

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2005 2006 2007 2008 2009 2010

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So QE2 of $1 trillion would imply about a

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.

rate