Monetary Policy Money, Interest & Money Supply. History of The Federal Bank First Bank of the United...

Monetary PolicyMonetary Policy

Money, Interest & Money Supply

History of The Federal BankHistory of The Federal Bank

• First Bank of the United States (1BUS)– Alexander Hamilton– Objective was to create stability & provide young

nation with ability to deal with foreign entities.– Charter was for 20 years (1791 - 1811)

• Second Bank of the United States (2BUS)– Result on inflation during War of 1812– Privately owned with public obligations.– 20 year charter (1816 - 1836)– President Jackson ended bank in 1833.

History of Federal BanksHistory of Federal Banks

• No National bank until 20th Century

• Panic of 1907– Money supply got tight– Pressure on banks– Pyramid reserves

• Small banks reserves at larger banks

• Federal Reserve Act of 1913• Created the “Fed”

The Federal ReserveThe Federal Reserve

• Responsibilities include– Supervising member banks

• Interesting point that member banks technically own & control Federal Reserve.

• Creates a political buffer.• Reports to Congress

– Cash Reserves– Money Supply

• Moves money in & out of circulation.

The Federal ReserveThe Federal Reserve

• What does the Fed do?– Check Clearing– Loans for banks

• Maintains reserves through S-T loans & loans to banks in trouble.

– Federal Government’s Bank (The Treasury)

– Supervises Member Banks• Reserves, Charters &

Mergers.

– Regulates the Money Supply• Replaces old money &

monitors supply

What is Money?What is Money?

• 3 Components

– Medium of exchange• Usable for buying and selling of goods & services

– Unit of account• Allows for easy accounting of value & comparisons

– Store of Value• Retains value over time

What is the Money Supply?What is the Money Supply?

• Money supply (MS)

– Measures amount of money in circulation

– 4 different Kinds• M1 – Most liquid• M2• M3• L – Least liquid

Federal ReserveFederal Reserve

• Types of Monetary Measures• M1

– Currency in circulation + Checking accounts + travellers checks

• M2– M1 + Money Market accounts & mutual funds + other S-T

saving deposits

• M3 – M2 + L-T savings deposits

• L – M3 + Savings bonds + S-T treasuries

Money Supply & Interest RatesMoney Supply & Interest Rates

Interest rate

r1

r2

re

Md2Md

1 Mde

Money supply

Money demand

Quantityof money

Quantity (supply)set by the Fed


Interest rate

r1

r2

Mde

Money supply

MD1

Quantityof money

Increases in demand:MD shifts, MS constant so results in r increases

MD2


Interest rate

r1

r2

Mde

Money supply

MD1

Quantityof money

Higher r leads to Higher price levels & lower outputs

MD2

AD

Quantity of output

Y1Y2

P2

P1


Interest rate

r1

r2

Mde1

Money supply

MD1

Quantityof money

Increased MS leads to increase AD & higher output

MS2

AD1

Quantity of output

Y1 Y2

P1

Mde2

AD2

How the Fed Can Change MSHow the Fed Can Change MS

• Fed Tools

1. Open Market Operations

2. Fed Funds Rate & Discount Rate

3. Reserve Requirements for investors

4. Regulation of consumer credit

5. Moral suasion

1. Open Market Transactions1. Open Market Transactions

• To Increase the money supply– Fed buys US securities on the market

• Money exchanged for bonds which increases the Money Supply. Money used by Fed to buy bonds was not in circulation but now it is.

• Increasing supply known as Easy-money policy• Consequences include

– Easier credit– Lower interest rates initially– Higher aggregate demand– Leads to inflation– Tool for fighting recessionary times


• To Decrease the money supply– Fed sells US securities on the market

• Bonds exchanged for money which decreases the Money Supply. Money used to purchase bonds in the hands of Government so out of circulation.

• Decreasing supply known as Tight-money policy• Consequences include

– Tighter credit– Higher interest rates initially– Lower aggregate demand– Fights inflation– Greenspan used policy to manage growth


• Effects of decreasing the money supply– Fed sells bonds for dollars– More bonds in market, fewer dollars– Fewer dollars = less loanable funds– Less $ available for loans = higher interest rates– Higher r = Lower C & I in GDP– Result is a shift in GDP results

• Khan video on increasing MS through open market– http://www.khanacademy.org/humanities---other/finance/

core-finance/v/fed-open-market-operations

2. Fed Funds Rate & 2. Fed Funds Rate & Discount RateDiscount Rate

• Fed Funds Rate– Rate member banks charge each other– Lower than Discount rate

• Discount rate – Rate Fed Charges member banks

• Prime rate– Rate commercial banks charge their best customers.

• Effects– Lowering discount rate

• Encourages borrowing because the price of money or cost of borrowing decreases

• Increases loans, investments & money supply.

– Raising discount rate• Decreases amount of loans, investments & MS.

2. Effects of Rate Changes2. Effects of Rate Changes

• Effects– Lowering Fed Funds Rate & Discount Rate

• Encourages borrowing because the price of money or cost of borrowing decreases

• Increases loans, investments & money supply.

– Raising Fed Funds Rate & Discount Rate• Decreases amount of loans, investments & MS.

• Khan Academy – Discount Rate– http://www.khanacademy.org/humanities---other/

finance/banking-and-money/v/the-discount-rate

2. Taylor Rule2. Taylor Rule

• Economist John Taylor rules for the Fed’s target Fed Funds Rate

• (assumes target of 2% inflation

• GDPreal = GDPpot + Inflation

• If GDPreal up 1%, then Fed Funds up ½ %.

• If Inflation 1% > target, then Fed Funds up ½ %.

3. Reserve Requirements3. Reserve Requirements

• Amount of money banks must keep on hand.

• If reserve requirement changes, amount available for loans change with it.

• Example – if a bank has 10,000,000 in deposits & reserve ratio is 10%, then bank must have $1,000,000 in the bank.

– Rest can be used for loans. In this case $9,000,000.


• Lowering reserve requirement – Increases amount available for loans– Increases MS– Reduces rates because of greater supply– Increases investments

• Raising reserve requirement– Decreases amount available for loans– Decreases MS


• Reserve ratio = (Bank’s Required Reserves) . (Bank’s Liabilities {deposits})

• Monetary Multiplier = 1 / (required reserve ratio)

Effects of multipierEffects of multipier

• Beleagured State Bank (BSB)– . 10% RR 25% RR– Deposits $100M $100M– RR 10% 25%– Reserves $10M $25M

– Funds – Loans $90M $75M

– Effects of raising RR in this case is reduction in funds available for loans of $15M for BSB alone.

• Multipler 1/.1 = 10X 1/.25 = 4X

Other ControlsOther Controls

• 4. Credit Card rates– Revoked in 1952– Set rates on consumer credit cards

• 5. Moral Suasion– Unofficial pressures placed on banks– “you don’t have to do this but …”

LimitationsLimitations

• Forecasts• If forecast is wrong, then so is the policy

• Timing• Time lags with implementing changes in policy

• Trade-offs• Monetary policy a tool to fight inflation or recession

Trade-OffsTrade-Offs

• Growth – Good.• Inflation – Bad.

• Easy Money– Increases growth (good)– Increases inflation (bad)

• Tight Money– Decreases growth (bad)– Decreases inflation (good)

Easy Money

Tight Money

Summary – Expansionary MPSummary – Expansionary MP

• Problem: unemployment & recession– Fed buys bonds, lowers RR, lowers DR– Money supply– Excess reserves up– Fed Funds rate falls– Interest rates falls– Investment spending up– Aggregate Demand up– Real GDP up

• Opposite is true for restrictive MP

Expansionary PolicyExpansionary Policy

GDPR up

Imports down

Price Level

up

Exports up Unemploy

-ment down

GDPN up

Exchange rates down

Invest-ments

up

AD up

InterestRatesdown

MoneySupply

up

Inflation up

Determining Nominal Interest RatesDetermining Nominal Interest Rates

MS

MD

Rate of interest, i

Quantity Money

ie

Me

Determining Real Interest RatesDetermining Real Interest Rates

S

D

Rate of interest, r

Quantity of funds

re

Qe

If Quantity of fundsrepresents all funds,Govt. debt affects demand. If only private funds, Govt.debt affects supply

PhillipPhillip’’s Curves CurveA

nnua

l rat

e of

infla

tion,

%

Unemployment rate, %

PCsr

PClr

Trade-off between inflation & unemployment. As economy heats up, unemployment drops & inflation goes up

Long-run unemploymentSet by LRAS & potentialGDP, therefore long-runPhillip’s curve is vertical

Investment DemandInvestment Demand

ID

Rate of interest, r

Investment

i

I

Relationship betweenNominal interest rates& Investment (GDP)

Graph RelationshipsGraph Relationships

iMoney Market

M

MD

MS

Investment Demandi

I

I

GDPR

i i

I

I

Y

MS

M M

i i

Y

I

I

Contraction of MS leads to higher i, which reduces I, causing GDP to fall

Graph reversed so GDP is falling

Laffer CurveLaffer CurveT

ax r

ate,

%

0

100

Tax revenue, $

MaximumTax Revenue

Shape of curvesubject of debate

Inflation & the EconomyInflation & the Economy

• Khan Videos on Inflation & Economy• Moderate inflation in a good economy

– Good visual presentation of relationships (3 minutes)–

http://www.khanacademy.org/humanities---other/finance/microeconomics-macroeconomics/v/moderate-inflation-in-a-good-economy

• Stagflation– Low growth with high inflation– Short video (3 minutes) built on prior video– http://www.khanacademy.org/humanities---other/

finance/microeconomics-macroeconomics/v/stagflation

Inflation & Deflation TutorialsInflation & Deflation Tutorials

• Khan Academy– Inflation, Deflation & Capacity Utilization, part 1 (12:32)

• http://www.khanacademy.org/humanities---other/finance/current-economics/v/inflation--deflation---capacity-utilization

– Inflation, Deflation & Capacity, part 2 (11:49)• http://www.khanacademy.org/humanities---other/finance/current-

economics/v/inflation--deflation---capacity-utilization-2

– Effects of Obama’s stimulus bill (13:20)• http://www.khanacademy.org/humanities---other/finance/current-

economics/v/inflation---deflation-3--obama-stimulus-plan

Monetary Policy Money, Interest & Money Supply. History of The Federal Bank First Bank of the United...

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