Money and Banking

Introduction to Money SupplyThe Money SupplyThe 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 moneyMoneyM0MSi0The market for moneyEquilibriumMoney supplied is fixed in the short-run.i is determined by the intersection of MS and MDInterest Rate AdjustmentWhen 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.MoneyM0i0MDi1M1MSIntroduction to Money SupplyThe market for moneyEquilibriumMoney supplied is fixed in the short-run.i is determined by the intersection of MS and MDInterest Rate AdjustmentWhen 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.MoneyM0i0MDi1M1MSIntroduction to Money SupplyBanks as financial intermediariesWhat role do banks play in the creation of the supply of money?Commercial banks bring savers and investors togetherBanks use checking and savings deposits to make loansbalance sheet for a bankbalance sheet has two sides:Liabilities the source of the funds for the bankchecking accountssavings accountsAssets (generate income for banks via interest payments)Mortgagescar loansUS Treasury Bondsrequired reservesexcess reserves (big withdrawal insurance)Net worth = assets liabilitiesMoney Supply and BanksBanks as financial intermediariesExample: Balance for a bank

Assets Liabilities300 reqd reserves3000 deposits50 excess reserves900 US T-bonds2000 car loans250 net worth32503250

Reserves: assets not lent out by banksBanks 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 = $350Money Supply and BanksThe process of money creationExample: banks role in determining the supple of moneyYou walk into Bank 1 and deposit $1000 into your checking accountMS does not change because currency held by the public and in checking accounts are both part of the MSIf 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 BuyMartBuyMart deposits the $900 into its account at Bank 2MS does not change because currency held by the public and in checking accounts are both part of the MSSince the r = 10%, Bank 2 holds $90 of the $900 deposit as RR & lends $810 to JillYada 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!

Money Supply and BanksThe process of money destructionExample: banks role in determining the supple of moneyYou withdrawal $1000 from your checking account at Bank 1MS does not change because currency held by the public and in checking accounts are both part of the MSIf 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 BuyMartBuyMart 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!

Money Supply and BanksDemand for reservesExample: Suppose r = 0.1, D = 50 (billion $), and demand for excess reserves is given by

Derive reserves demand.

20Federal Funds Market

28QDRiff5Money Supply and the Fed

DER25232

Supply of reservesA bank that cant 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 banksIf the federal funds rate is more than the discount rate (iff > id), banks will want to borrow from the Fed instead of other banksInsurance purchased from other banks is more expensive than from the Fed.

Money Supply and the FedSupply of reservesExample: 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 Federal Funds Market

28QSRiff3Money Supply and the FedFederal funds market equilibriumIf 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 banksThe 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 FedHowever, 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 + RBThe difference between equilibrium quantity of reserves and RN + RB is the quantity of discount loans made by the Fed

Money Supply and the FedFederal funds market equilibriumExample: 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 = 28Horizontal part: id = 3

iff(percent)(Billions $)228525

25Federal Funds Market

28QDRiff52SR3EquilibriumMoney Supply and the Fed

Federal funds market equilibriumExample (continued ): Suppose the Fed increases the discount rate to 4 (percent). Show the effect of this policy change in the figure below.Federal Funds Market

28Qiff2SR3DRSR4The horizontal section

id = 4The vertical section

no changeStarting on 1/1/03 the Fedbegan setting the discountrate 100 basis points (1%)above its federal funds rate targetMoney Supply and the Fed

Federal funds market equilibriumExample (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.Federal Funds Market

28Qiff2SR3

DR

DR429

The new equilibrium:

iff = 3Money Supply and the FedFederal funds market equilibriumExample (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.Federal Funds Market

28QiffSR3DR29In 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 Supply and the FedFederal funds market equilibriumExample (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below.MoneyM0i0MSMDThis increases r provided inflation remains unchanged. MSM1i1Money Supply and the FedFederal funds market equilibriumExample (continued ): Suppose instead the Fed increases the required reserve ratio to 14 (percent). Show the effect of this policy change in the figure below.

Y0PL1YFADHigher 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 r since 1992 ADY1PL0ASAD-AS-YFEMoney Supply and the FedOpen Market OperationsThe Fed conducts an Open Market Purchase (OMP) by buying Treasury bonds from banks Cash flows from the Fed to BanksThe quantity of reserves in the federal funds market risesThe federal funds interest rate declinesThis is an exPansionary monetary policyThe Fed conducts an Open Market Sale (OMS) by selling Treasury bonds to banks The Fed has bonds to sell because it purchased them directly fromTreasury in the primary market (this is called monetizing the debt)Banks in the secondary market in a previous OMPBanks give cash (reserves) to the Fed in exchange for Treasury bondsThe quantity of reserves in the federal funds market declinesThe federal funds interest rate increasesThis is a reStrictive monetary policyMoney Supply and the FedFederal funds market equilibriumExample (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.Federal Funds Market

28QiffSR2DRSR1.528.53The horizontal section

no changeThe vertical section

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

Money Supply and the FedSRFederal funds market equilibriumExample (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.Federal Funds Market

28QiffSR2DR1.528.53Starting on 1/1/03 the Fedbegan setting the discountrate 100 basis points (1%)above its federal funds rate target.Money Supply and the FedSRSR283Federal funds market equilibriumExample (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.Federal Funds Market

Qiff2.5DR1.528.5Starting 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 2.5SRMoney Supply and the FedFederal funds market equilibriumExample (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.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).

MoneyM0i0MSMDMSM1i1Money Supply and the FedFederal funds market equilibriumExample (continued ): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below.

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

This results in higher GDP, lower unemployment, and higher pricesY0PL1YFADADPL0ASAD-AS-YFEMoney Supply and the FedAn 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 Feds vault while 0.5 (billion $) in cash from member banks enters the Feds 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 ADLower AD results in less output and lower prices. Federal funds market equilibriumExample (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.Money Supply and the FedTo prevent this in October of 2008, the Fed began paying Interest on Reserves (IOR), which is currently about 0.25%idMoney Supply and the Financial CrisisInterest on Reservesthe new toolThe Feds 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.Federal Funds Market

QiffDR-iff0SR IORiffCrisis modeidInterest on Reservesthe new toolThe Feds 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.Federal Funds Market

Q0DRThis allows the Fed to buySR IORiffMoney Supply and the Financial Crisis IORidInterest on Reservesthe new toolThe Feds 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.Federal Funds Market

Q0DRThis allows the Fed to buy or sell as many securities as it wants without changing the federal funds rate.SRiffMoney Supply and the Financial CrisisInterest on Reservesthe new toolThe Feds 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.Federal Funds Market

Qiff0DRThe federal reserve can also raise and lower the federal funds rate by simply raising IOR and id simultaneously.idSR

IORMoney Supply and the Financial CrisisInterest on Reservesthe new toolThe Feds 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.Federal Funds Market

iff0DRThe 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. QiffidSRThis should hopefully return the federal funds market to its pre-crisis state.Money Supply and the Financial CrisisMoney 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 inflationHow high is really high? Its a judgment callUsually we talk about ridiculously high examples.Compounding is important to remember.Examples of HyperinflationYouTube inflation video 1YouTube inflation video 2Money Supply Growth and Inflation

March,1922Feb., 1920Nov.,1922

Feb., 1923

Hyperinflation in the Weimar Republic (Germany, post WWI)Money Supply Growth and InflationJuly, 1923

Sept., 1923Oct., 1923Hyperinflation in the Weimar Republic (Germany, post WWI)Why did this happen?In Nov. of 1918, there were 29,200,000,000 paper marks in circulationA year later, 497,000,000,000,000,000,000 paper marks in circulationThat was a massive increase in the money supply, an increase of 1,702,054,794,421%Money Supply Growth and Inflation

Yugoslavia had inflation problems in the 1980s, 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)

Money Supply Growth and InflationKeynes vs. HayekKeynes: advocate of proactive government intervention Budget deficits in recessionsSurpluses in economic expansionsBoth can be used to manage AD, ensuring full employment

Hayek: advocate of economic freedomGovernment 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 interventionEach intervention has unintended consequences, which distort marketsUnintended 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 analogiesKeynesians 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

AD-AS-YFEADAS Y PLHayekKeynesKeynesians 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 YouTubeKeynes vs. HayekChart195.19745.09075.23755.12895.27795.15415.31895.19155.36165.25185.40495.35615.44965.45195.49595.45085.54375.46945.59415.68465.64555.74035.69715.81625.74845.82595.79765.83145.84385.87335.88635.88955.92365.90855.95555.78745.98525.77666.01425.88356.04466.00576.07945.95786.11736.03026.15875.95516.20475.85736.25235.88916.30095.86646.34985.8716.39645.9446.44236.07766.48846.19756.53536.32566.58446.44836.63596.55966.68936.62336.74456.67736.80166.74036.85966.79736.91816.90356.97666.95597.03437.02287.09137.0517.1487.1197.20437.15347.26057.1937.31687.26957.37327.33267.42987.4587.48677.49667.54397.59297.60147.63217.65937.7347.71767.80667.77657.8657.83567.92747.89497.94477.95418.02778.01288.05968.07088.05958.12787.98898.18367.95028.2388.00388.29178.03758.34498.0698.3988.15768.45138.24438.50538.32948.56018.4178.61638.43258.67388.48648.73268.53118.79278.64388.85398.72798.91618.84738.97958.90439.0449.00329.10959.02539.17639.04479.24429.12079.31339.18439.38379.24729.45519.40719.52789.48899.60199.59259.67739.66629.75469.80969.83359.93279.914310.00899.997110.103410.081710.194310.167910.328810.255410.507610.34410.601210.433210.68410.523910.819910.616411.014310.710911.04310.808511.258510.908211.267911.009511.334511.112311.297211.214611.371311.316111.340111.416411.380111.51411.477911.610211.538811.704511.596411.796511.598811.886811.645811.974111.738712.058611.935512.140412.042812.219112.127612.295912.213812.371212.303512.445812.410312.520512.534112.595312.587512.670812.683212.747312.748712.82512.915912.904412.962512.985312.965913.067413.060713.150813.089313.234513.194113.318713.268513.402913.363513.486413.339213.5713.35913.651913.223513.73112.993713.806812.832613.877312.8113.943112.860814.004513.01914.06113.138814.114413.194914.166813.2774

Sheet1FRED Graph ObservationsFederal Reserve Economic DataLink: http://research.stlouisfed.org/fred2Help: http://research.stlouisfed.org/fred2/help-faqEconomic Research DivisionFederal Reserve Bank of St. LouisGDPPOTReal Potential Gross Domestic Product (GDPPOT), Billions of Chained 2005 Dollars, Quarterly, Not ApplicableGDPC1Real Gross Domestic Product, 1 Decimal (GDPC1), Billions of Chained 2005 Dollars, Quarterly, Seasonally Adjusted Annual RateFrequency: Quarterlyobservation_dateGDPPOTGDPC11976-01-015197.45090.75.19745.09071976-04-015237.55128.95.23755.12891976-07-015277.95154.15.27795.15411976-10-015318.95191.55.31895.19151977-01-015361.65251.85.36165.25181977-04-015404.95356.15.40495.35611977-07-015449.65451.95.44965.45191977-10-015495.95450.85.49595.45081978-01-015543.75469.45.54375.46941978-04-015594.15684.65.59415.68461978-07-015645.55740.35.64555.74031978-10-015697.15816.25.69715.81621979-01-015748.45825.95.74845.82591979-04-015797.65831.45.79765.83141979-07-015843.85873.35.84385.87331979-10-015886.35889.55.88635.88951980-01-015923.65908.55.92365.90851980-04-015955.55787.45.95555.78741980-07-015985.25776.65.98525.77661980-10-016014.25883.56.01425.88351981-01-016044.66005.76.04466.00571981-04-016079.45957.86.07945.95781981-07-016117.36030.26.11736.03021981-10-016158.75955.16.15875.95511982-01-016204.75857.36.20475.85731982-04-016252.35889.16.25235.88911982-07-016300.95866.46.30095.86641982-10-016349.85871.06.34985.8711983-01-016396.45944.06.39645.9441983-04-016442.36077.66.44236.07761983-07-016488.46197.56.48846.19751983-10-016535.36325.66.53536.32561984-01-016584.46448.36.58446.44831984-04-016635.96559.66.63596.55961984-07-016689.36623.36.68936.62331984-10-016744.56677.36.74456.67731985-01-016801.66740.36.80166.74031985-04-016859.66797.36.85966.79731985-07-016918.16903.56.91816.90351985-10-016976.66955.96.97666.95591986-01-017034.37022.87.03437.02281986-04-017091.37051.07.09137.0511986-07-017148.07119.07.1487.1191986-10-017204.37153.47.20437.15341987-01-017260.57193.07.26057.1931987-04-017316.87269.57.31687.26951987-07-017373.27332.67.37327.33261987-10-017429.87458.07.42987.4581988-01-017486.77496.67.48677.49661988-04-017543.97592.97.54397.59291988-07-017601.47632.17.60147.63211988-10-017659.37734.07.65937.7341989-01-017717.67806.67.71767.80661989-04-017776.57865.07.77657.8651989-07-017835.67927.47.83567.92741989-10-017894.97944.77.89497.94471990-01-017954.18027.77.95418.02771990-04-018012.88059.68.01288.05961990-07-018070.88059.58.07088.05951990-10-018127.87988.98.12787.98891991-01-018183.67950.28.18367.95021991-04-018238.08003.88.2388.00381991-07-018291.78037.58.29178.03751991-10-018344.98069.08.34498.0691992-01-018398.08157.68.3988.15761992-04-018451.38244.38.45138.24431992-07-018505.38329.48.50538.32941992-10-018560.18417.08.56018.4171993-01-018616.38432.58.61638.43251993-04-018673.88486.48.67388.48641993-07-018732.68531.18.73268.53111993-10-018792.78643.88.79278.64381994-01-018853.98727.98.85398.72791994-04-018916.18847.38.91618.84731994-07-018979.58904.38.97958.90431994-10-019044.09003.29.0449.00321995-01-019109.59025.39.10959.02531995-04-019176.39044.79.17639.04471995-07-019244.29120.79.24429.12071995-10-019313.39184.39.31339.18431996-01-019383.79247.29.38379.24721996-04-019455.19407.19.45519.40711996-07-019527.89488.99.52789.48891996-10-019601.99592.59.60199.59251997-01-019677.39666.29.67739.66621997-04-019754.69809.69.75469.80961997-07-019833.59932.79.83359.93271997-10-019914.310008.99.914310.00891998-01-019997.110103.49.997110.10341998-04-0110081.710194.310.081710.19431998-07-0110167.910328.810.167910.32881998-10-0110255.410507.610.255410.50761999-01-0110344.010601.210.34410.60121999-04-0110433.210684.010.433210.6841999-07-0110523.910819.910.523910.81991999-10-0110616.411014.310.616411.01432000-01-0110710.911043.010.710911.0432000-04-0110808.511258.510.808511.25852000-07-0110908.211267.910.908211.26792000-10-0111009.511334.511.009511.33452001-01-0111112.311297.211.112311.29722001-04-0111214.611371.311.214611.37132001-07-0111316.111340.111.316111.34012001-10-0111416.411380.111.416411.38012002-01-0111514.011477.911.51411.47792002-04-0111610.211538.811.610211.53882002-07-0111704.511596.411.704511.59642002-10-0111796.511598.811.796511.59882003-01-0111886.811645.811.886811.64582003-04-0111974.111738.711.974111.73872003-07-0112058.611935.512.058611.93552003-10-0112140.412042.812.140412.04282004-01-0112219.112127.612.219112.12762004-04-0112295.912213.812.295912.21382004-07-0112371.212303.512.371212.30352004-10-0112445.812410.312.445812.41032005-01-0112520.512534.112.520512.53412005-04-0112595.312587.512.595312.58752005-07-0112670.812683.212.670812.68322005-10-0112747.312748.712.747312.74872006-01-0112825.012915.912.82512.91592006-04-0112904.412962.512.904412.96252006-07-0112985.312965.912.985312.96592006-10-0113067.413060.713.067413.06072007-01-0113150.813089.313.150813.08932007-04-0113234.513194.113.234513.19412007-07-0113318.713268.513.318713.26852007-10-0113402.913363.513.402913.36352008-01-0113486.413339.213.486413.33922008-04-0113570.013359.013.5713.3592008-07-0113651.913223.513.651913.22352008-10-0113731.012993.713.73112.99372009-01-0113806.812832.613.806812.83262009-04-0113877.312810.013.877312.812009-07-0113943.112860.813.943112.86082009-10-0114004.513019.014.004513.0192010-01-0114061.013138.814.06113.13882010-04-0114114.413194.914.114413.19492010-07-0114166.813277.414.166813.2774

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