MONEY

Monetary History,

Theory, and Policy

What is Money?

• Many definitions

• At the end of the day, money is anything that functions as money

• What are the functions of money?

functions of money

1. Unit of account – means of measuring the comparable worth of goods and services; standard of value

2. Medium of exchange – a. means of purchase (money exchanges directly for goods and services); b. means of payment (means of settling debt)

3. Store of value – means of accumulating wealth; money as an end-in-itself

fractional reserve banking

• In a fractional reserve banking system, banks keep some fraction of total deposits on reserve to meet the normal demand of depositors

• The fraction of deposits kept on reserve are required reserves, the remaining portion of deposits are excess reserves and are available for lending and investing

characteristics of fractional reserve banking system

1. Banks are private, profit-seeking enterprises;

2. Through lending, spending, and redepositing, banks affect the money supply;

3. Banks are susceptible to a run on the bank

Tension between #1 and #3: banks want to earn profits, and so want to lend reserves, but don’t want to be vulnerable to a run, so don’t want to lend too much

Central banks

• In U.S., the Federal Reserve, or “Fed”

• A central bank is like a bank for private banks:

1. lend reserves to private banks – they charge interest on loans, called the discount rate

2. hold private banks’ reserves

demand for money

• Transactions demand – stable, determined by mpc and convention

• Precautionary demand - stable, determined by mpc and convention

• Speculative demand – determined by relation between two rates of interest:– 1. current actual rate (ic)

– 2. expected future rate (ie)

speculative demand

• To understand how the speculative demand for cash is determined by the relation of the two rates of interest, must understand:

• 1. investor motto: buy low and sell high

• 2. inverse relation between bond prices and interest rates

speculative demand

• If ic < ie then people think that interest rates are going to go up, so they think that bond prices are going to go down, so they sell bonds and hold cash (speculative demand for cash is high)

• If ic > ie then people think that interest rates are going to go down, so they think that bond prices are going to go up, so they buy bonds with all available cash (speculative demand for cash is low)

Money DemandInterest Rate

Quantity of Money

MD

i

0

three ways central bank can attempt to affect the money supply

1. Set reserve requirement ratio - % of deposits banks must keep on reserve (least used method; money supply is too sensitive to changes in rrr)

2. Set discount rate – rate of interest charged for borrowing reserves (intermediate method – 5-7 times per year)

3. Open market operations – buying and selling bonds (used most often; daily)

methods of attempting to control the money supply

• To try to increase the money supply:– decrease rrr; decrease d.r.; buy bonds

• To try to decrease the money supply:– increase rrr; increase d.r.; sell bonds

money supply

• If the central bank is able to control the money supply, the money supply is “exogenous,” and the money supply curve is vertical.

Exogenous Money Supply

Money Supply (Ms)Interest Rate

Quantity of Money

i

M10

Shift inward of Money Supply (Exogenous Money Supply)

Ms1

Interest Rate

Quantity of Money

Ms2

M1M20

Shift outward of Money Supply (Exogenous Money Supply)

Ms1

Interest Rate

Quantity of Money

Ms2

M1 M20

money supply

• Since the mid-1980s, it has become widely argued that the central bank cannot control the money supply, and that the money supply is “endogenous,” so that the money supply curve is horizontal. In this case, the money supply is determined by market forces, in particular the demand for money or the demand for credit. In this case, it is the short-term interest rate that central banks control directly.

Endogenous Money Supply

Ms1

Interest Rate

Quantity of Money

i

0

endogenous money supply

• In this view, when households and firms increase their demand for loans, the Fed and private banks are said to accommodate the demand for credit. Credit is extended and investment increases, increasing output and income. Higher income means higher savings, and these savings are redeposited in the banking system.

endogenous money supply

• This depiction of the money supply process fits in very nicely with Keynes’s view of the investment-savings relationship and capitalism as a demand-led system. Just as Keynes turned the investment-savings relation on its head, likewise, in this view loans create deposits rather than the other way round.

Incorporating endogenous money into the Keynesian view of the

investment-savings relation

Demand for credit↑ Fed and private banks accommodate the demand for credit credit is extended I↑ Y↑ S↑ savings are redeposited into banks, replenishing reserves depleted initially by the loans and even increasing reserves

Institutional mechanisms banks can use to try to extend their lending

capacity1. Fed Funds – member banks of the

Federal Reserve system can borrow reserves from one another. These reserves are called “Fed Funds” and the rate of interest they pay is the Federal Funds rate, the inter-bank lending rate set by the Fed.

Institutional mechanisms banks can use to try to extend their lending

capacity2. Foreign banks – U.S. banks can borrow dollars

from foreign banks, that are not regulated by the Fed and so have no reserve requirements in dollars. These reserves used to be called “Eurodollars” but it is no longer only European banks that lend and the creation of the “Euro” currency makes the terminology confusing (what would we call the Euros European banks borrow from abroad, “Euroeuros”?

Institutional mechanisms banks can use to try to extend their lending

capacity3. certificates of deposit (CDs) – these are

savings accounts that must keep a minimum balance for a minimum length of time. The key to understanding how they are used to extend lending capacity is that the rrr on CDs is lower than on other types of accounts. Banks can use CDs to extend lending capacity in two ways:

Using CDs to Extend Lending Capacity

• i. offer new, attractive CDs to attract new customers, increasing reserves;

• ii. change current customers over from regular deposits, e.g., checking accounts, to CDs, decreasing the average rrr.

Institutional mechanisms banks can use to try to extend their lending

capacity4. Repos (repurchasing agreements) – a repo is, in

general, an agreement between a buyer and a seller to reverse a transaction at a specified time in the future (often the next day) at a specified price. So a bank will sell $1 million worth of bonds today and agree to buy them back tomorrow for $1.01 mil. The first bank will get to “hold” $1 mil. Overnight, increasing its average reserve holdings over that period (banks do not have to meet their reserve requirements at every moment in time, just on average over a two-week period). The second bank will get to earn something on its excess reserves.

Institutional mechanisms banks can use to try to extend their lending

capacity5. open market operations – selling bonds to

obtain reserves, with or without repos attached.

Institutional mechanisms banks can use to try to extend their lending

capacity6. Fed as “Lender of Last Resort” (LLR) – borrow

reserves from the Fed, at the discount rate (rate of interest Fed charges banks to borrow reserves). This is called going to the “discount window”. Fed is LLR in the sense that it is the ultimate lender of dollars, and in the sense that banks use it as the last resort, because there can be penalties for repeatedly failing to meet reserve requirements.

money supply and demand, and the equilibrium rate of interest

• The equilibrium rate of interest in Keynes is determined by the intersection of money supply and money demand curves.

• Assume an exogenous money supply for the time being.

Exogenous Money Supply

Money Supply (Ms)Interest Rate

Quantity of Money

Money Demand (MD)

M*

i*

0

Keynesian Monetary Policy

• Monetary policy is the attempt to affect macroeconomic variables such as aggregate output, income, employment and the price level through changes in the money supply and interest rates.

• Expansionary policy seeks to expand output and employment; anti-inflationary policy seeks to control inflation.

• Assume exogenous money supply for now.

Keynesian Expansionary Monetary Policy (KEMP)

The Fed increases the money supply through its available mechanisms (rrr, dr, omo). This causes interest rates to fall, increasing investment, causing output, income, and employment to expand.

Ms↑ i↓ I↑ Y↑

Keynesian Expansionary Monetary Policy (KEMP)

Ms1

Interest Rate

Quantity of Money

MD

Ms2

i*1

i*2

M1 M20

Limits of KEMP

Keynesian Expansionary Monetary Policy has three limits.

1. Interest rates may be insensitive to changes in the money supply (liquidity trap)

Liquidity Trap – horizontal portion of the money demand function. When interest rates get so low that no one thinks they can get any lower, so no matter how much money the Fed throws into the system, people just hold onto it, waiting for interest rates to rise and bond prices to fall.

Liquidity TrapInterest Rate

Quantity of Money

MD

Ms2

iLT

M2 M3

Ms3

0

Liquidity Trap

Limits of KEMP

Keynesian Expansionary Monetary Policy has three limits.

2. Investment may be insensitive to changes in interest rates (recall all of Keynes’s’ warnings about inverse, mechanistic relation between interest rates and investment).

Limits of KEMP

Keynesian Expansionary Monetary Policy has three limits.

3. Output may be insensitive to changes in investment. (either if the economy is at full employment—in which case why pursue expansionary monetary policy—or, if the mpc is falling faster than investment is increasing.

Keynesian Anti-Inflationary Monetary Policy (KAIMP)

Fed decreases money supply, causing interest rates to rise, causing investment to slow, decreasing inflation.

Ms↓ i↑ I↓ P↓

(here P↓ is usually a slowing of inflation rather than deflation)

Keynesian Anti-Inflationary Monetary Policy (KAIMP)

Ms1

Interest Rate

Quantity of Money

MD

Ms2

i*1

i*2

M1 M20

Limits of KAIMP

• Keynesian Anti-Inflationary Monetary Policy has two limits.

1. It is only effective for “demand-pull” inflation—inflation due to excess demand. If there is “cost-push” (or supply-side) inflation, it may not be effective and could even exacerbate it (though higher finance costs, for example).

Limits of KAIMP

• Keynesian Anti-Inflationary Monetary Policy has two limits.

2. The Fed can overshoot its mark and the fall in investment may cause output and employment to fall, which can even cause a recession.

Keynesian Fiscal and Monetary Policies

• In general, fiscal policy is seen as more direct, stronger, and more effective, and monetary policy is seen as more indirect, weaker, and less effective.

• In the Post-War “golden age” of U.S. capitalism (approximately 1946-1971), a combination of fiscal and monetary policies were used, called “fine-tuning” the macroeconomy.