Austrian Macroeconomics

Lecture 4

The Fed’s Tools of Monetary Control

• Earlier, we learned

money supply = money multiplier × bank reserves

• The Fed can change the money supply by changing bank reserves or changing the money multiplier.

How the Fed Influences Reserves

• Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.

– If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account.

With more reserves, the bank can make more loans, increasing the money supply.

– To decrease bank reserves and the money supply, the Fed sells government bonds.

How the Fed Influences Reserves • The Fed makes loans to banks, increasing their

reserves.

– Traditional method: adjusting the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow

– New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans.

• The more banks borrow, the more reserves they have for funding new loans and increasing the money supply.

How the Fed Influences the Reserve Ratio

• Recall: reserve ratio = reserves/deposits, which inversely affects the money multiplier.

• The Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits.

Reducing reserve requirements would lower the reserve ratio and increase the money multiplier.

• Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. Raising this interest rate would increase the reserve ratio and lower the money multiplier.

Problems Controlling the Money Supply

• If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.

• If banks hold more reserves than required, they make fewer loans, and money supply falls.

• Yet, the Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

Bank Runs and the Money Supply • A run on banks:

When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.

• Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.

• Also, banks may make fewer loans and hold more reserves to satisfy depositors.

• These events increase R, reverse the process of money creation, cause money supply to fall.

How Well Has the Fed Performed?

The Fed Dollar Vs the Gold Dollar 1

• $22.57 in the year 2012 has the same "purchasing power" as $1 in the year 1914 (the year the Fed began operating)

• $17.23 in the year 2012 has the same "purchasing power" as

$1 in the year 1933 (the year the U.S. abandoned the domestic gold standard)

• $5.67 in the year 2012 has the same "purchasing power" as $1 in the year 1971 (the year that the U.S. closed the “gold window” on foreign governments and central banks)

• $2.23 in the year 2012 has the same "purchasing power" as $1 in the year 1984 (the year the enlightenment of central banks and the “Great Moderation” began).

The Fed Dollar Vs the Gold Dollar 2

• $0.80 in the year 1914 had the same "purchasing power" as $1 in the year 1800.

• $0.67 in the year 1896 (the year of new gold discoveries in South Africa) had the same "purchasing power" as $1 in the year 1800.

• $0.82 in the year 1896 had the same "purchasing power" as

$1 in the year 1880 (period of greatest rate of growth in U.S. history).

• $1.19 in the year 1914 had the same "purchasing power" as $1 in the year 1896 (the year of new gold discoveries and period of “Great Inflation”).

Capital and the Structure of Production

Production and Time Preference

• Production takes time and takes place in stages

• Law of Time Preference:

– Time is scarce and so individuals prefer to achieve their goals sooner rather than later, all other things equal.

– Everyone values a good (or satisfaction or sum of money) available in the present to the same good available in the future.

The Nature of a Loan Transaction

Borrower’s value scale Lender’s value scale

$10,000 present $11,000 future

$11,000 future $10,000 present

Worker Payday Lender

$244 present $280 future

$280 future $244 present

Time Preference Defined

• An individual’s time preference (t.p.) is expressed in his or her consumption/saving ratio: C/S

• Example:

Assume persons A and B both earn income of $1,000 per month.

A: C/S = $800/$200 = 4/1

B: C/S = $500/$500 = 1/1

• A higher C/S ratio indicates a relatively higher t.p. because a greater proportion of income is spent on present consumption. A lower C/S ratio indicates a relatively lower t.p. because a lower proportion of income is spent on present consumption and a relatively larger proportion is saved for spending on future consumption.

Changes in Time Preference

• A person’s t.p. is not constant. It varies with income, age and other circumstances. Different people will have different t.p. even in the same circumstances.

• Examples:

– Typical t.p. life cycle: children; young adults; middle age; old age

– Criminals; lottery winners; undeveloped countries; immigrants versus playboys; preventive medical care

– Announcements: a) a new drug will double the average human lifespan; b) a meteor will crash into Earth in a year.

Laws of Human Action

1. All people prefer a greater quantity of goods to a smaller quantity of goods, all other things equal. (Law of Total Utility)

3 DVDs > 2 DVDs > 1 DVD

2. All people value a quantity of goods available sooner more highly than an equal quantity of goods available later, all other things equal. (Law of Time Preference)

IPhone (today) > IPhone (in 2 yrs.) > IPhone (in 5 yrs.)

3. Some longer processes of production are more productive than shorter processes of production.

Law of Human Action cont’d

3. Example: You can catch more fish per day with the same number of workers by first building a boat and a net than by making fishing poles and having the laborers fish off the dock.

4. Some highly valued goods can only be produced with longer processes of production, e. g, automobiles, laptops, MRI machines, etc. Therefore:

5. People will only use longer processes of production if they are sufficiently more productive (that is, yield either a greater quantity of the same goods or new goods that cannot be produced with shorter processes) to overcome their t.p. in waiting a longer time for the goods.

Choosing Production Processes

More Productive Less Productive

Shorter All Some

Longer Some None

Choosing Production Processes

• People will always chose the shorter and most productive processes first, because of the laws of time preference and maximizing utility.

• No one will choose the longer less productive processes of production when they can get an equal or greater quantity of goods from the shorter processes.

• People will only choose longer more productive processes if there are sufficient savings available to produce the necessary capital goods.