Introduction to Money Supply The Money Supply The relationship between the quantity of money supplied and nominal interest rate i. On any given day, the

Introduction to Money Supply

The Money Supply The relationship between the

quantity of money supplied and nominal interest rate i.

On any given day, the quantity of money is fixed independent of interest rate i.

The quantity of money supplied is determined by bank lending and the Fed.

The market for money

Money

M0

MS

i0

The market for money Equilibrium

Money supplied is fixed in the short-run.

i is determined by the intersection of MS and MD

Interest Rate Adjustment When the interest rate is above

its equilibrium level, the quantity of money supplied exceeds the quantity of money demanded (or needed).

People hold too much money, so they try to get rid of it by buying other financial assets.

The demand for financial assets increases, the prices of these assets rise, and the interest rate falls.

Money

M0

i0

MD

i1

M1

MS


The market for money Equilibrium

Money supplied is fixed in the short-run.

i is determined by the intersection of MS and MD

Interest Rate Adjustment When the interest rate is below

its equilibrium level, the quantity of money demanded (or needed) exceeds the quantity of money supplied.

People are holding too little money, so they try to get more money by selling other financial assets.

The demand for financial assets decreases, the prices of these assets fall, and the interest rate rises.

Money

M0

i0

MD

i1

M1

MS


Banks as financial intermediaries What role do banks play in the creation of the supply of money?

Commercial banks bring savers and investors together Banks use checking and savings deposits to make loans

balance sheet for a bank balance sheet has two sides:

Liabilities – the source of the funds for the bank• checking accounts• savings accounts

Assets (generate income for banks via interest payments)• Mortgages• car loans• US Treasury Bonds• required reserves• excess reserves (big withdrawal insurance)

Net worth = assets – liabilities

Money Supply and Banks

Banks as financial intermediaries Example: Balance for a bank

Assets Liabilities 300 req’d reserves 3000 deposits 50 excess reserves 900 US T-bonds 2000 car loans 250 net worth 3250 3250

Reserves: assets not lent out by banks Banks are Required to hold a fraction of Reserves (RR )

Reserves in Excess of RR are called excess reserves (RE )

If r = 10%, the bank holds RR = 3000 X 0.1 = 300,

R = RR + RE = $350


The process of money creation Example: banks role in determining the supple of money

You walk into Bank 1 and deposit $1000 into your checking account MS does not change because currency held by the public and in checking

accounts are both part of the MS If the r = 10%, Bank 1 holds $100 of the $1000 deposit as RR & lends $900

to George. George uses the $900 to buy a TV from BuyMart

BuyMart deposits the $900 into its account at Bank 2 MS does not change because currency held by the public and in checking

accounts are both part of the MS Since the r = 10%, Bank 2 holds $90 of the $900 deposit as RR & lends $810

to Jill Yada yada yada… The original deposit of $1000 is used to create money via

lending: 1000 + 900 + 810 + 729 + 656.1 + . . . . . = 10,000

Increases in bank deposits creates money in the economy via increased bank lending even though the actual number of bills in the economy has not changed!

000,101.0

000,10 D

M


The process of money destruction Example: banks role in determining the supple of money

You withdrawal $1000 from your checking account at Bank 1 MS does not change because currency held by the public and in checking

accounts are both part of the MS

If the r = 10%, Bank 1 holds $100 less in RR and lends out $900 less.

Bank 1 cannot lend George the $900 he needs to buy a TV. George does not spend the $900 at BuyMart BuyMart deposits $900 less in its account at Bank 2.

Since the r = 10%, Bank 2 holds $90 less in RR and does lends out $810 less.

Yada yada yada.. Hence, the original withdrawal $1,000 destroys money via less lending:

Withdrawals collapse the money in an economy via less bank lending even though the actual number of bills in the economy has not changed!

0 1,00010,000

0.1

DM


Demand for reserves Example: Suppose r = 0.1, D = 50 (billion $), and demand for excess reserves is

given by

Derive reserves demand.

20

Federal Funds Market

28 Q

DR

iff

5

Money Supply and the Fed

25 DERffi Q

DER

2523

2

30 DRffi Q

Supply of reserves A bank that can’t meet its reserve requirement (RR ) borrows from a bank that has excess

reserves in the federal funds market and QS remains unchanged. The vertical part of reserves supply curve is the amount of reserves the Fed supplies to

the federal funds market. When banks borrow from the Fed, discount loans rise, borrowed reserves (RB)

increase, the quantity of reserves supplied increases. When banks sell US Treasury securities to the Fed, non-borrowed reserves (RN)

increase, which increases the quantity of reserves. Hence, the supply of reserves is the sum

The horizontal part of the reserves supply curve is the discount rate (id )

If the federal funds rate is less than the discount rate (iff < id), banks will not borrow from the Fed because “Insurance” purchased from the Fed is more expensive than from other banks

If the federal funds rate is more than the discount rate (iff > id), banks will want to borrow from the Fed instead of other banks “Insurance” purchased from other banks is more expensive than from the Fed.

SR N BQ R R


Supply of reserves Example: Suppose RB = 0 (billion $), RN = 28 (billion $) and id = 3 (percent). Graph

the supply of reserves in the figure below.

Vertical part:

RB + RN = 0 + 28 = 28

Horizontal part:

id = 3


28 Q

SR

iff

3


Federal funds market equilibrium If demand for reserves intersects the vertical section of the supply of reserves, then

The federal funds interest rate is less than the discount interest rate (iff < id )

A bank would rather borrow from other banks The quantity of reserves equals RN + RB

If demand for reserves intersects the horizontal section of the supply of reserves, the federal funds interest rate equals the discount interest rate (iff = id )

A bank is indifferent between borrowing from other banks or the Fed However, the bank borrows from the Fed because something (a crisis) has dried

up all of the excess reserves held by banks. The equilibrium quantity of reserves exceeds RN + RB

The difference between equilibrium quantity of reserves and RN + RB is the quantity of discount loans made by the Fed


Federal funds market equilibrium Example: Suppose r = 0.1, D = 50, RB = 0, RN = 28, id = 3, and excess reserves

demand is

Graph the reserves supply and demand.

Vertical part: RN + RB = 28

Horizontal part: id = 3

30 DRffi Q

iff

(percent) (Billions $)

2 28

5 25

DRQ

25


28 Q

DR

iff

5

2

SR3

Equilibrium


25 DERffi Q

Federal funds market equilibrium Example (continued ): Suppose the Fed increases the discount rate to 4 (percent).

Show the effect of this policy change in the figure below.


28 Q

iff

2

SR3

DR

SR4

The horizontal section

id = 4

The vertical section

no change

Starting on 1/1/03 the Fedbegan setting the discountrate 100 basis points (1%)

above its federal funds rate target


30 DRffi Q

Federal funds market equilibrium Example (continued ): Suppose instead the Fed increases the required reserve ratio to

14%. Show the effect of this policy change in the figure below.


28 Q

iff

2

SR3

25 DERffi Q

32

DR

32 28 4ffi

DR

4

29

3 32 DRQ

32 3 29DRQ

The new equilibrium:

iff = 3





28 Q

iff

SR3

DR

29

In the past, the Fed has tried slowing the economy by increasing r.

Doing this creates a big collapse in bank lending to businesses and consumers.

In addition, the Fed has to make $1 billion in discount loans to banks because RE dried up.

So even though total reserves have increased via discount lending ($1 billion in the diagram above), this cash is sitting idle.

The effect is a reduction in money supply.




Money

M0

i0

MS

MD

This increases r provided inflation remains unchanged.

MS’

M1

i1



14 (percent). Show the effect of this policy change in the figure below.

Y0

PL1

YF

AD

Higher r decreases I, but also reduces net exports. These collapse AD.

This results in lower prices and real GDP.

In the past, small increases in r have put a “hot” economy (one that is growing too fast) into a recessionary gap.

The Fed has not changed the rsince 1992

AD’

Y1

PL0

AS

AD-AS-YFE


Open Market Operations The Fed conducts an Open Market Purchase (OMP) by buying Treasury bonds from

banks Cash flows from the Fed to Banks The quantity of reserves in the federal funds market rises The federal funds interest rate declines This is an exPansionary monetary policy

The Fed conducts an Open Market Sale (OMS) by selling Treasury bonds to banks The Fed has bonds to sell because it purchased them directly from

Treasury in the primary market (this is called monetizing the debt) Banks in the secondary market in a previous OMP

Banks give cash (reserves) to the Fed in exchange for Treasury bonds The quantity of reserves in the federal funds market declines The federal funds interest rate increases This is a reStrictive monetary policy


Federal funds market equilibrium Example (continued ): Suppose instead of changing id or r the Fed performs an OMP

by buying a half of a billion dollars worth of bonds from banks (RN = 28 + .5 = 28.5). Show the effect of this policy change in the figure below.


28 Q

iff

SR

2

DR

SR

1.5

28.5

3

The horizontal section

no change

The vertical section

RN + RB = (28 + .5) + 0 = 28.5

New equilibrium

30 DRffi Q

30 28.5ffi

1.5ffi


SR


by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.


28 Q

iff

SR

2

DR

1.5

28.5

3

Starting on 1/1/03 the Fedbegan setting the discountrate 100 basis points (1%)above its federal funds rate target.


SRSR

28

3




Q

iff

2.5

DR

1.5

28.5

Starting on 1/1/03 the Fedbegan setting the discountrate 100 basis points (1%)above its federal funds rate target.

So the Fed lowers the discount rate to 2.5

SR




Increased RN means banks have more cash to lend to consumers and business.

The money supply increases via increased lending

If inflation remains unchanged, r will fall too, increasing I (and X).

Money

M0

i0

MS

MD

MS’

M1

i1




Lower r increases I, but also increases net exports. These increase AD.

This results in higher GDP, lower unemployment, and higher prices

Y0

PL1

YF

AD

AD’PL0

AS

AD-AS-YFE


An OMS is the opposite of an OMP. If the Fed sells 0.5 (billion $) in US Treasury securities to banks, then 0.5 (billion

$) in US Treasury securities leaves the Fed’s vault while 0.5 (billion $) in cash from member banks enters the Fed’s vault.

This decreases RN by 0.5 (billion $) and total reserves from 28 to 27.5 (billion $), decreasing reserves supply.

The equilibrium federal funds interest rises while MS falls. i rises, which raises r if inflation does not change. Hence, I and X decline, decreasing AD Lower AD results in less output and lower prices.

Federal funds market equilibrium Example (continued ): Suppose instead the Fed performs an OMS by selling a half of a

billion dollars worth of bonds to banks (RN = 28 - .5 = 27.5) . Explain how this policy change affects the economy.


To prevent this in October of 2008, the Fed began paying Interest on Reserves (IOR), which is currently about 0.25% id

Money Supply and the Financial Crisis

Interest on Reserves—the new tool The Fed’s rescue of the financial system in 2008-2009 included purchasing enough

securities to increase the supply of reserves so much that it would drive the federal funds rate negative.


Q

iff

DR

-iff

0

SR

IOR

iff

Crisis mode

id




Q0

DR

This allows the Fed to buy

SR

IOR

iff


IOR

id




Q0

DR

This allows the Fed to buy or sell as many securities as it wants without changing the federal funds rate.

SR

iff





Q

iff

0

DR

The federal reserve can also raise and lower the federal funds rate by simply raising IOR and id simultaneously. id SR

IOR




Federal Funds Marketiff

0

DR

The Fed will need to conduct several controlled OMS while carefully raising IOR to reduce its $2-3 trillion balance while keeping a eye on inflation.

Q

iff

id SR

This should hopefully return the federal funds market to its pre-crisis state.


Money Supply growth is the percent change in the stock of money

Inflation is the percent change in the Price Level (PL) from one year to the next.

Hyperinflation is really high inflation How high is really high? It’s a judgment call Usually we talk about ridiculously high examples. Compounding is important to remember. Examples of Hyperinflation

YouTube inflation video 1 YouTube inflation video 2

Money Supply Growth and Inflation

http://www.youtube.com/watch?v=WI1i5yhwOz8

http://www.youtube.com/watch?v=WI1i5yhwOz8

http://www.youtube.com/watch?v=IoXCvwVO1J4

http://www.youtube.com/watch?v=IoXCvwVO1J4

March,1922

Feb., 1920

Nov.,1922

Feb., 1923

Hyperinflation in the Weimar Republic (Germany, post WWI)


July, 1923

Sept., 1923

Oct., 1923

Hyperinflation in the Weimar Republic (Germany, post WWI)

Why did this happen? In Nov. of 1918, there were 29,200,000,000 paper marks in circulation A year later, 497,000,000,000,000,000,000 paper marks in circulation That was a massive increase in the money supply, an increase of

1,702,054,794,421%


Yugoslavia had inflation problems in the 1980’s, but in 1993 things really got bad.

$1 = 900 Dinar (1/1/93)$1 = 2,000,000 Dinar (11/12/93)$1 = 13,000,000 Dinar (11/23/93)$1 = 64,000,000 Dinar (11/31/93 )$1 = 6,400,000,000 Dinar (12/15/93)

PRICES WERE DOUBLING EVERY DAY

$1 = 12,000,000,000,000,000,000,000 Dinar (1/24/94)


Keynes vs. HayekKeynes: advocate of proactive government intervention Budget deficits in recessions Surpluses in economic expansions Both can be used to manage AD, ensuring full employment

Hayek: advocate of economic freedom Government intervention results in less economic freedom Economic efficiency "The problem was that under central planning, there was no economic calculation--no

way to make a rational decision to put this resource here or buy that good there, because there was no price system to weigh the alternatives."

“Socialism told us that we had been looking for improvement in the wrong direction.“ The thesis in The Road to Serfdom is

Government intervention leads to more intervention Each intervention has unintended consequences, which distort markets Unintended consequences of well-intentioned policy generates the need for more

interventions because consequences need to be corrected. It is this dynamic that leads society down the road to serfdom.

The tree and western wild fire analogies

Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps.

Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices.

Keynes vs. Hayek

4

6

8

10

12

14

1976

1982

1987

1993

1998

2004

2009

AD-AS-YFE

AD

AS

Y

PL

Hay

ek

Keynes

Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps.

Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices.

Watch the “Fear the boom and bust”

video on YouTube

Keynes vs. Hayek

http://www.youtube.com/watch?v=d0nERTFo-Sk

Documents

Introduction to Money Supply The Money Supply The relationship between the quantity of money supplied and nominal interest rate i. On any given day, the