money and monetary policy spring 2003
TRANSCRIPT
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Money in the Economy
Mmmmmmm,
money!
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Monetary Policy A tool of macroeconomic policy under the
control of the Federal Reserve that seeks to
attain stable prices and economic growththrough changes in the rate of growth of the
money supply.
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The Money Supply
M1: Currency + travelers checks + checkable deposits
M2: M1 + small time deposits + overnight
repurchase agreements + overnight Eurodollars + money
market mutual fund balances M3: M2 + large denomination time deposits + term
repurchase agreements + term Eurodollars + institutions
only money market fund balances
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The Creators of Money
The three major players whose decisions and actionsdetermine the rate of growth in the money supply are:
The Federal Reserve (Fed)
Sets reserve requirements
Operates the discount window
Engages in open market operations
The Commercial Banking System
Accepts deposits and makes loans
Sets excess reserves
The Non-Bank Public Holds either deposits or cash
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Money Creation
Banks create money in their normal, day-to-day
profit seeking activities
Banks do not try to create money
Money creation occurs because we have a
fractional reserve commercial banking system.
Banks must hold a fraction of their deposits idle as
reserves. They may lend the remainder. As they make loans, new deposits are created, causing the
money supply to expand.
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Bank Reserves Total Reserves = Required reserves plus
excess reserves
Required reserves = Deposits X reserverequirement
Excess reserves = Total reserves - required
reserves
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Money Creation: Assumptions Assumptions:
Banks lend all their excess reserves
The non-bank public does not use cash
Only demand or checkable deposits exist
The required reserve ratio is 10%
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Money Creation: Step 2 Let Bank #1 make a $100 loan to a member of the
non-bank public
It does this by crediting the borrowers checkingaccount with $100.
Let the borrower spend the money.
Let the recipient of the money bank at Bank #2
When Bank #1 honors the check, Bank #1s
deposits and reserves fall by $100.
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Money Creation: Step 3 A second bank, Bank #2, has received a
new deposit of $100.
Its total reserves increase by ? Its required reserves increase by ?
Its excess reserves increase by ?
Bank #2 may now make a loan of ?
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Money Creation: Step 4 Bank #2 makes a loan of $90 in the form of
a new demand deposit.
When the money is spent and Bank #2 honorsthe check, deposits and reserves at Bank #2 fall
by $90
But Bank #3 now has a new deposit of $90and may make a loan equal to ?
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Money Creation: Summary New Deposit Required Reserves Excess Reserves New Loan
$100 $100$100 $10.00 $ 90 $ 90
$ 90 $ 9.00 $ 81 $ 81$ 81 $ 8.10 $ 72.90 $ 72.90
$ 72.90 $ 7.29 $ 65.61 $
65.61
$ 65.61 $ 6.51 $ 59.05 $
59.05
$1,000 $100 $900 $900
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Some Simple Formulas
Note that in our simple example, demand deposits are a
multiple of required reserves
Let R = required reserves
Let r = % reserve requirementLet D = demand deposits
R = r x D or
D = 1/r x R
A change in deposits will be a multiple of the change inreserves
/\D = 1/r x /\R
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The Multiplier
The simple deposit expansion multiplier is 1/r or 1/reserve
requirement
r is a leakage out of the lending process
if r gets bigger, expansion of deposits gets smaller because banks
have fewer excess reserves to lend
if r gets smaller, expansion of deposits gets larger because banks
have more excess reserves to lend
The real world multiplier is smaller than our 1/r because
Banks hold idle excess reservesPeople hold and use cash
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The Money Supply Model
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The M1 Model: Derivation
Definitions:
M1 = D + C
Base = R + C
Total Deposits = D
Assumptions:
r = R/D = required reserve ratio for depositse = E/D = the excess reserve ratio
c = C/D = the ratio of currency to deposits
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The M1 Model: Derivation
Model:B = R + C
R = rD + eD D = D
C = cD
E = eD
B = rD + eD + cD
B = D(r + e + c)
D = (1/r + e + c)B
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The M1 Model: Derivation
Model:
M1 = D + C
M1 = D + cD
M1 = D(1 + c) Factor out D
M1 = 1 + c
r + e + cB
M1 = Multiplier x Base
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Money Multiplier Terms
Changes in r
If r increases, the multiplier decreases
If r decreases, the multiplier increases
The money multiplier and M1 are
negatively related.
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Money Multiplier Terms
Changes in c
If c increases, reserves drain from the banking system.
Fewer reserves mean less expansion of deposits.
If c decreases, reserves in the banking system increase.
More reserves mean more expansion of deposits.
The money multiplier and M1 are negatively related.
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Money Multiplier Terms
Changes in e
An increase in e means banks are holding more
excess reserves and lending less.A decrease in e means banks are holding fewer
excess reserves and lending more.
The money multiplier and M1 arenegatively related.
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M1 and Base
Base is comprised of non-borrowed base,
discount loans, and currency.
OMO purchases increase non-borrowed base.
OMO sales decrease non-borrowed base.
M1 is positively related to non-borrowed
base.
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M1 and Base
Base is comprised of non-borrowed base,
discount loans, and currency.
Increases in discount loans increase base.
Decreases in discount loans decrease base.
M1 is positively related to the level of
discount loans.
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The Money Supply The money supply equals the monetary base
times the money multiplier
The monetary base (base) is defined as: Base = Reserves + Currency
Base can be controlled by the Federal Reserve
The multiplier reflects the ability of the banking
system to expand deposits The multiplier = 1 + c/(r + e + c)
The value of the multiplier is determined by the Fed, banks, and
the members of the non-bank public.
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Control of the Money Supply The Fed controls the money supply with...
Open Market Operations
Purchases and sales of government securities by theFed on the open market
Discount Window
Loans made by the Fed to banks
The Fed influences the multiplier with
Changes in the reserve requirement
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Open Market OperationsFed Bank
Presidents
Federal Open
Market Comm.
Fed Board of
Governors
Securities
Dealers
Federal Reserve
Bank of New York
Commercial
Banks
Change
in
Reserves
Change in
Money
Supply
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Open Market Operations When the Fed buys Treasury bonds from a
bank, it pays for the bonds by crediting the
bank with an increase in reserves. When the Fed sells Treasury bonds to a
bank, it accepts payment for the bonds by
debiting the banks reserve position at theFed
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Discount Loans When the Fed makes a discount loan to a
bank, the bank is credited with an increase
in reserves. When a bank repays the Fed, the banks
reserves are debited.
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Reserve Requirements If the Fed increases reserve requirements,
banks have fewer excess reserves to lend,
causing the expansion of deposits todecrease.
If the Fed decreases or eliminates reserve
requirements, banks have more excessreserves to lend, permitting the expansion
of deposits to increase.
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Excess Reserves and Currency
Drains Banks determine the level of excess
reserves
Increases in excess reserves diminish theexpansion of deposits.
Decreases in excess reserves increase the
expansion of deposits
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Excess Reserves and Currency
Drains Members of the non-bank public determine
currency in circulation
Increases in currency drains from the bankingsystem, diminish the expansion of deposits
Decreases in currency drains from the banking
system, increase the expansion of deposits
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Central Bank Policy ChannelsPolicy
Tools
Level & Growth
Bank Reserves
Cost & Availability
of Credit
Size and Growth
Rate of Money
Supply
Market Value
of Securities
Volume
and
Growthof
Borrowing
and
Spending
by thePublic
Full
Employment
Growth
Price
Stability
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Monetary PolicyI see rates rising;no, falling; no
rising; no --
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Monetary Policy Transmission
Mechanism A monetary policy transmission mechanism
describes the chain of events that occur in
an economy as a result of a change in therate of growth in the money supply.
Good monetary policy decisions depend on
understanding the different ways money cancause changes in economic activity.
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Interest Rate Channel
Change in Change in Short Change in
Money Supply Term Interest Rates GDP
Change in
Exchange
Rates
Change in
Long Term
Interest Rates
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The Interest Rate Channel
Traditional View
A change in the money supply leads to a
change in interest rates which in turn changesthe cost of capital, causing a change in
investment spending, aggregate demand and
GDP in the short run.
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The Interest Rate Channel
Fact:
A change in the money supply causes a change
in short term interest rates. Investmentspending is a function of long term interest
rates.
Question:How can a change in short rates result in a
similar change in long rates?
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Short Rates and Long Rates
The expectations model of the term structure is
the key relationship between short rates and
long rates.The long rate is the expected average of future short
rates appropriate for the maturity of the long bond.
If the Fed acts to raise the short term rate and market
participants expect that the increase is the first of a longersequence, the long rate will rise as market participants
react to the Feds policy change.
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Short Rates and Long Rates
The expectations model of the term structure is
the key relationship between short rates and
long rates.The long rate is the expected average of future short
rates appropriate for the maturity of the long bond.
If the Fed acts to decrease the short term rate and market
participants expect that the decrease is the first of a longersequence, the long rate will fall as market participants
react to the Feds policy change.
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Monetary Policy, Interest Ratesand GDP
Let the Fed raise short-term interestrates
As interest rates increase, the cost ofborrowing increases, causing investment(I), consumer durables (C), and GDP to fall.
Let the Fed decrease short-term interest
ratesAs interest rates decrease, the cost of
borrowing decreases, causing investment
(I), consumer durables (C), and GDP torise.
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The Exchange Rate Channel
Traditional View
A decrease in the money supply leads to arise in interest rates which in turn raises the
exchange rate, causing a decline in netexports, aggregate demand and GDP in theshort run.
Question:
How can a change in interest rates result ina change in exchange rates?
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The exchange rate is the price of a currencyexpressed in terms of another currency.
The exchange rate and the interest rate arepositively related.
The higher domestic real rates of interest arerelative to foreign real interest rates, the higher
will be the foreign exchange rate for thedomestic economy.
Explaining Exchange Rates withInterest Rates
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Interest Rate Parity
Interest rate parity says that the interest ratedifferential between any two countries is
equal to the expected rate of change in theexchange rate between those two countries.
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Interest Rate Parity: Example
Assume that U.S. real interest rates arehigher than those in other countries.
The high rates of return on U.S. assets will
attract foreign buyers, but in order to buyU.S. financial assets, foreigners must firstbuy dollars.
The demand for dollars increases in the globalmarketplace, causing the dollar to appreciate.
The supply of the other currency increases in theglobal marketplace, causing the other currencyto depreciate.
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Monetary Policy, Exchange
Rates and GDP Let the Fed raise short-term interest rates
As interest rates increase, exchange rates
increase, causing net exports (X - M) and GDPto fall.
GDP = C + I + G + (X - M)
As the value of the dollar increases, we export fewer
goods and import more.
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Monetary Policy, Exchange
Rates and GDP Let the Fed decrease short-term interest
rates
As interest rates decrease, exchange ratesdecrease, causing net exports (X - M) and GDP
to rise.
GDP = C + I + G + (X - M)
As the value of the dollar decreases, we export more
goods and import fewer.
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