The Money Supply, Banking System, The Money Supply, Banking System, and Monetary Policyand Monetary Policy

Chapters 17 & 18Chapters 17 & 18Macroeconomics: Theories and PoliciesMacroeconomics: Theories and Policies

ECON 219ECON 219

S. CunninghamS. Cunningham

What is Money?What is Money?

Money is anything that is generally acceptable to sellers in exchange for goods and services.

A liquid asset is an asset that can easily (i.e., quickly, cheaply, conveniently) be exchanged for goods and services.

What is Money?What is Money?

Functions of Money

1) Medium of exchange

2) Unit of account

3) Store of value

M1 Money SupplyM1 Money Supply

Money in the United States Today consists of:– Currency is the bills and coins that we

use.– Deposits are also money because they

can be converted into currency and are used to settle debts.

What is Money?—M1What is Money?—M1

M1 is the narrowest and most liquid measure of the money supply.– It includes financial assets that are immediately available for

spending on goods and services. M1 includes:

– Currency– Travelers’ Checks– Demand Deposits (checking accounts)– Other Checkable Deposits (interest-bearing checking)

Demand Deposits and Checkable Deposits are called transactions accounts—these are checking accounts that can be drawn upon to make payments.

U.S. Money Supply: M1U.S. Money Supply: M1

About CurrencyAbout Currency

In 2003, currency was 52% of M1. U.S. currency today is not backed by gold

or silver.– It is backed only by the confidence and trust of

the public. – It is a fiduciary monetary system. (“Fiducia”

means “trust” in Latin.) Money backed by gold or silver (or

something else of value) is called commodity money.

What is Money?—M2What is Money?—M2

M2 adds to M1 less liquid assets that can be converted to M1 assets quickly and at low cost.

Includes everything in M1Adds:

– Savings deposits– Small denomination time deposits (CDs)– Retail money market mutual funds

U.S. Money Supply: M2U.S. Money Supply: M2

U.S. Money Supply: M3U.S. Money Supply: M3

The Federal Reserve SystemThe Federal Reserve System

The Federal Reserve System (“the Fed”) serves as the central bank for the United States.

A central bank typically has the following functions:– It is the bankers’ bank: it accepts deposits from

and makes loans to commercial banks.– It acts as banker for the federal government.– It controls the money supply.– Performs certain regulatory functions for the

financial industry.

Structure of the Structure of the Federal Reserve SystemFederal Reserve System

The primary elements in the Federal Reserve System are:

1. The Board of Governors

2. The Regional Federal Reserve District Banks (FRBs)

3. The Federal Open Market Committee

The Federal Reserve BanksThe Federal Reserve Banks

12 District banks Nine directorsThe directors appoint the district

president who is approved by the Board of Governors

The Federal Reserve SystemThe Federal Reserve System

The Board of GovernorsThe Board of Governors

Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes

vacant every two years President appoints a member as Chairman

to serve a four-year term

Federal Open Market Committee (FOMC)Federal Open Market Committee (FOMC)

Meets approximately every six weeks to review the economy

Made up of the following voting members:• 7 members of the Board of Governors• 5 of the FRB presidents (they rotate yearly)= 12 FOMC members

Functions of the Fed (1)Functions of the Fed (1)

Banking Services and Supervision– It supplies currency to banks through its 12 district

banks.– It holds the reserves of banks in the district bank of

each bank.– It processes and routes checks to banks through its

district banks and processing centers.– It makes loans to banks—it is the “lender of last resort”,

the “banker’s bank”.– It supervises and regulate banks, ensuring that they

operate in a sound and prudent manner.– It is the banker for the U.S. government. It sells

government securities for the U.S. Treasury.

Functions of the Fed (2)Functions of the Fed (2)

Controlling the Money Supply– The money supply is varied through the course

of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile.• Example: 4th quarter holiday season creates an

increased demand for money to buy gifts.

– The Fed also changes the money supply to achieve policy goals set by the FOMC.

Money Supply Growth RatesMoney Supply Growth Rates

Source: Monetary TrendsFederal Reserve Bank of St. Louis

Policy Goals of the FedPolicy Goals of the Fed

Ultimate Goal:Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation.

Intermediate Targets:– The Fed does not control output or the prices

directly. It does control the money supply.– The Fed establishes target growth rates for the

money supply, which it believes are consistent with its ultimate goals.

– The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.

Fed Policy LinkagesFed Policy Linkages

The Federal Reserve SystemThe Federal Reserve System

The Fed’s Policy Tools

The three main policy tools are:

1) Open market operations

2) Discount rate

3) Reserve Requirements

Open Market OperationsOpen Market Operations

Open Market Operations (OMOs): the buying and selling of government bonds by the Fed to control bank reserves, the fed funds rate, and the money supply.

For example, if the FOMC wants to increase the money supply, it gives a directive to the trading desk at the FRB-NY to buy bonds.

When the FRB-NY buys bonds, it writes checks on itself, injecting new reserves into the banks of the bond sellers.

The increase in reserves result in an increase in the money supply and a reduction in the fed funds rate.

Operating ProceduresOperating Procedures

FOMC Directive: The FOMC issues instructions to the Federal Reserve Bank of NY to implement monetary Policy for a six-week period.

The FOMC directs the bond traders at the FRB-NY to buy or sell government bonds to keep the federal funds rate at a specific level.– The federal funds rate (“fed funds rate”) is the interest

rate that banks charge when they lend excess reserves to each other.

– The buying and selling of government bonds by the fed to achieve policy objectives are called “open market operations (OMO)”.

Discount RateDiscount Rate

The discount rate (sometimes called the “bank rate”) is the rate of interest a Fed District Bank charges a bank in its district when such a bank borrows from the Fed.

When the Fed raises the discount rate, it raises the cost of borrowing reserves, reducing the amount of reserves borrowed.

Lower levels of reserves result in reduced lending, and reduced money supply.

Reserve RequirementReserve Requirement

Legal reserves: the cash a bank holds in its vault plus its deposits at the Fed.

Reserves held by banks in excess of their reserve requirements are called excess reserves.

If the Fed lowers reserve requirements, banks will hold excess reserves which they can then lend.

Such lending triggers the expansion multiplier, increasing the money supply.

Similarly, the Fed may decrease the money supply by raising reserve requirements.

How Banks Create MoneyHow Banks Create Money

Reserves: Actual and Required– The reserve ratio is the fraction of a bank’s

total deposits that are held in reserves.– The required reserves ratio is the ratio of

reserves to deposits that banks are required, by regulation, to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements.

– Excess reserves are the cash reserves beyond those required, which can be loaned.

How Banks Create MoneyHow Banks Create Money

(Simple) Money Multiplier =1

Reserve Requirement (ratio)

The The Multiple Creation of Bank DepositsMultiple Creation of Bank Deposits

Money Multiplier: Extended ModelMoney Multiplier: Extended Model

Ms = m x MBm = m(rr, C/D, ER/D)

whererr = reserves ratioC/D = currency to deposits ratioER/D = excess reserves to deposits

ratio

How Money Supply Changes How Money Supply Changes affect GDPaffect GDP

Policymaking ProcessPolicymaking Process

Independence from Political Process– Congress could change things and

weaken this independenceHumphrey-Hawkins ReportsFOMC Meetings

– 8 times a year (every 6 weeks)– Issue directives

Targeting Monetary AggregatesTargeting Monetary Aggregates

M

r

Md1

Md2

Ms

r1

r2

Targeting Interest RatesTargeting Interest Rates

M

r

Md1

Md2

Msr*

M1 M2

Targeting A Monetary AggregateTargeting A Monetary AggregateIdeal CaseIdeal Case

Y

r

IS1

IS2

LM

r1

r2

Y*

Targeting A Monetary AggregateTargeting A Monetary AggregateLess than Ideal Case (I)Less than Ideal Case (I)

Y

r

IS1

IS2

LM

Y1 Y2

Targeting A Monetary AggregateTargeting A Monetary AggregateLess than Ideal Case (II)Less than Ideal Case (II)

Y

r

IS0

LM

Y1 Y2 Y3

Targeting the Interest RateTargeting the Interest Rate

Y

r

IS1

LM

Y1 Y2 Y3

r*

IS2IS3

Evolution of PolicyEvolution of Policy

1970-79: Targeting Fed Funds Rate1979-82: Targeting Monetary

Aggregates1982-2004: Mixed Approach Inflation Targeting?

– Time Inconsistency Problem