Title: Chapter 14: Monetary Policy and the Federal Reserve System
1Chapter 14 Monetary Policy and the Federal
Reserve System
2Money supply and the central bank
- Government policy is the primary determinant the
money supply - Central bank--has the legal authority to issue
money - In general, central bank determines the supply of
high-powered money Mh
3Definitions of money
- Mh currency bank reserves
- M1 demand deposits currency
- M2 M1 time deposits less than 100,000
- M3 M2 time deposits 100,000 or greater
- L debts
4Feds Balance Sheet
5Most important assets of the Fed
- US treasury securities bonds, notes, and bills
- foreign exchange reserves--short term liabilities
- used as a means to intervene to stabilize
currencies - loans to financial institutions
- gold reserves
6Tools of the Fed
- Open market operations
- discount window
- reserve requirements
- federal funds rate
7Open market operations
- Purchase and sale of financial instruments
- Expansion of the money supply
- Central bank purchases financial instruments ??Mh
(highpowered money) ??M1 - Contraction of the money supply
- Central bank sells financial instruments ??Mh
(highpowered money) ??M1
8OMO and the Money supply process
- Assume that the FED seeks to expand the money
supply - Fed buys a government security with a check.
- The individual deposits the check in his or her
checking account. - The bank holds a portion of the deposit in
reserves, and loans out the rest
9Changes in the Individuals Balance sheet
- The individual deposits the check in his checking
account
10Changes in the Commercial Banks Balance sheet
11Changes in the FEDs Balance sheet
12Discount window
- The name given to loans made to the private
sector - in the US, the FED loans only to financial
institutions - interest rate that the FED charges is called the
discount rate - discount rate is usually below the interest rate
that banks charge customers
13- FED limits the number of the loans made to banks
through the discount window - Rediscounting--where the central bank purchases
commercial paper (short term debt) of the private
sector
14Foreign exchange operations
- purchase and sale of assets denominated in other
currencies - Assuming no capital controls
- (Mh-Mh-1)(Dcg - Dcg-1) E(Bc-Bc-1) (
Lc-Lc-1) - change in Mhchange in deficit change in
foreign reserves change in net credit granted
to commercial banks through the discount window
15Money multiplier and the money supply
- Mh CU R--highpowed money equals currency
reserves - R Dc VC--reserves equal deposits at the FED
vault cash - M1 CU D--currency demand deposits
- Reserve ratio R/Drd
- RrdD
16 - M1/Mh (CU D)/(CU R) eq. 1 divided by eq
2 - (CU/D 1)/(CU/D R/D) (cd
1)/(cd rd) money multiplier
17- M1 (cd 1)/(cd rd)Mh ?Mh
- where ? (cd 1)/(cd rd) which equal the
money multiplier
18ratio of reserves to deposits
- required reserve ratio is set by the FED
- banks may carry excess reserves, but they do not
earn interest on reserves - rd ratio total reserves to demand deposits
19Ratio of currency to deposits
- cd --if cd rises the money multiplier tends to
fall - cd--controlled by the public
- implies that the central bank can influence the
money supply, but it cannot control it
20Debate over monetary policy
- for a long the FED target interest rates
- monetarists criticized this policy as
inflationary - in 1979 the FED began targeting the money supply
- more recently it has gone back to targeting
interest rates