The Government, the Central Bank and Money

Money is a just a tool that does three things

• Serve as a unit of account

• Serve as a medium of exchange

• Serve as a store of value.

Lot’s of things could do these jobs, some better than others

• Cash is really good at most of these things (but is it better at some things than others)

• Demand deposits (checking accounts) are also obvious kinds of money

• Other liabilities might also work (but how well and where should the line be drawn separating “money” from other kinds of debt?)

Does Money Matter? The Quantity Theory of Money

• Let V stand for the “velocity of money” that is the total number of times the money supply is spent in a given year. In symbols

MxV = PxQ

• Where

– M is the money supply

– P is the price level

– Q is the quantity of goods transacted

Does Money Matter? The Quantity Theory of Money (Continued)

• Now suppose that

– V is determined by things other than prices or the aggregate level of economic activity such as the sophistication of the financial system.

– Q is determined by real economic factors such as the availability and productivity of labor and other resources.

• In such an environment, the price level would depend entirely on the money supply.

Since, as we will see, banks play a critical role in the process of supplying money, let’s start with brief history of US

banking

• First Bank of the United States (1811-1831)

• Banking in the Jacksonian Era: The Second National Bank (1816-1836)

• State Banking (1836-1863)

• National Bank Act (1863)

• The Federal Reserve (1913)

Functions of the Fed

• Create money and control money supply

• Regulate and supervise financial institutions

• Provide banking services to the Federal Government

• Provide banking services to private financial institutions (for example, check clearing and wire transfers).

• Monitor economic conditions and provide advice to private and public sector

The Feds Control of the Money Supply: Basic Definitions.

• C= the total stock of cash in the hands of the public

• D=the total amount of demand deposit liabilities (money in checking accounts)

• M=C+D (the money supply)

• R=the amount of reserves the banks choose to hold in Fed

• Rr=required reserve ratio—the amount of reserves the banks are required to hold as proportion of demand deposits. That is, the required reserves are Rr x D

The Feds Control of the Money Supply: A Slightly Simplified Model

• C = c x D, (where c is just some number indicating what proportion of their total D people want in the form of cash. For example, demand deposit liabilities might be $)

• R = Rr x D (the banks don’t hold excess reserves.

• Put it all together and it means that

– M = (1+c)R/Rr

– In other words, the amount of money is controlled by the reserves in the Fed

So, how can the Fed control reserves?

• Most importantly by “Open Market Operations”, which just means the buying and selling of financial assets, mostly Treasury Bonds, Bills and Notes.

Example (assume c=.05 and Rr=.10)

• If total bank reserves were $300, calculate the money supply

– M = 1.05x300/.1 = $3,150

• If the fed bought $100 M worth of bonds, what happens to M?

– When the Fed buys the bonds, the money ends up as part of bank reserves. Thus the money supply goes up by 1.05x100/.1 = $1,050 million.

– Similarly if the Fed were to sell $100 M worth of bonds, the money it is paid for the bonds comes out of reserves and so M would fall by $1,050 million.

How does the monetary policy influence interest rates? Demand and Supply Again.

• Clearly, the Fed supplies money but it might seem unusual to talk about the “demand” for money.

• But in fact it makes perfectly good sense. Money is different than income or wealth. Bill Gates, for example, has lots of income and wealth, but maybe doesn’t have much more money than you or I.

• In a simple world, the rate of interest is just the opportunity cost of holding money—as interest rates go down, people are willing to hold more money (that is, they “demand” more money).

The Picture

Interest rate

M

Demand for Money

Money Supply (Set by Fed)

Equilibrium interest rate

The Fed reflects US political and ideological history, which can be caricatured as

• Distrust of centralized political institutions

• Distrust of large private economic institutions

• This means the Fed isn’t exactly one thing but a collection of 13 (interelated things)

– The 12 District Banks

– The Board of Governors

Federal Reserve Districts

                                                                                                                              

What Do The District Banks Do

• Regulate banking within their district

• Clear checks (in competition with private check clearing agencies)

• Issue and withdraw currency

• Make loans to banks within the district

• Approve in-district bank mergers

• Examine certain banks (note that who examines a bank will depend on a variety of factors)

Do District Banks Influence Monetary Policy?

• Small tool: regulating credit to member banks

• Big tool: participating in “open market committee”

Who Controls District Banks? (The Structure of the Board of Directors)

Nine Board Members

• 3 Category A: Bankers appointed by member banks (who actually own stock in the Fed)

• 3 Category B: Non-bankers appointed by member banks

• 3 Category C: Directors appointed by members of the Board of Governors

• Note: This system diffuses the power of any one constituency

“Member Banks”: Who “Owns” the Fed?

• Banks chartered by the National Government (officially the Comptroller of the Currency

• State banks who choose to become members

• Interesting question: why would a bank want to be a member?

Are All Districts Equal?

• No. The New York District actually buys and sells enormous quantities of Treasury Securities in response to Fed attempts to influence money supply.

• No. Different banks develop reputations and “personalities” that reflect their region, the interests of the officers and the research staff. For example Dallas has a long-standing interest in Mexco and Latin America. The current President, Richard Fisher, was deeply involved in trade negotiations over NAFTA.

The Board of Governors FAQ’s

• Who are they?: The board that runs the Federal Reserve (but remember, not the District Banks)

• How Many Are There?: Seven

• Who Appoints Them?: The President (with advice and consent of the Senate)

• How long do they serve?: 14-years without renewal (with staggered terms to keep any one President from appointing all of them)t runs the Federal Reserve (but remember, not the District Banks)

The Board of Governors: Centralization and Autonomy

• The structure might seem wildly complex, but it actually is designed to create an agency that has some accountability without being directly controlled by the currently elected political establishment.

• To see this, compare the structure of the Fed with the organization of, say, the Justice Department of the Department of Housing and Urban Development.

The Chairman of the Board of Governors

• Appointed from among the Governors for a 4-year term and can be reappointed (if he or she resigns as chairman, it is expected that they will also resign from the Board).

• Unwritten but generally honored rule: the Chairman is a Wiseman, and while maybe not technically able to walk on water or raise the dead, is someone above the political fray. (It would be bad form for a President to appoint his recently paroled brother-in-law or his leading contributor.)

• The Chairman is not the first among equals, he is the spokeperson for the Fed and cultivates an almost mystical air of authority.

The Federal Open Market Committee (FOMC) FAQ’s

• What is it? The committee in charge of setting monetary and credit policy for the Federal Reserve Districts.

• Who’s on it? The 7 members of the BOG, the President of the NY Fed and 4 district bank presidents chosen on a rotating basis (all the District Bank Presidents attend, but only 5 vote).

• When do they meet? At least 8 times a year.

Question: Is The Fed too Independent?• Yes:

– Monetary policy is at least as important to peoples lives as tax policy, judicial policy and foreign policy. We trust the democratic process to regulate these activities, we should trust democracy to handle monetary policy as well.

• No: Monetary policy is different than these other things.

– First, it is technical (for example, the relationship between monetary growth and inflation) and doesn’t involve the same kinds of value judgements inherent I these other issues. We don’t allow politicians to vote on how much fuel to carry on the Space Shuttle. We shouldn’t allow them to set monetary policy.

– Second, monetary policy provides the foundation for all economic activity. Short term political tinkering could (and has) harmed the entire economy.