The Money Supply, Banking System, and Monetary Policy

1
The Money Supply, Banking System, and Monetary
Policy

• Chapters 17 18
• Macroeconomics Theories and Policies
• ECON 219
• S. Cunningham

2
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.

3
What is Money?

• Functions of Money
• 1) Medium of exchange
• 2) Unit of account
• 3) Store of value

4
M1 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.

5
What 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 accountsthese are checking accounts
  that can be drawn upon to make payments.

6
U.S. Money Supply M1
7
About 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.

8
What 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 M1
• Adds
• Savings deposits
• Small denomination time deposits (CDs)
• Retail money market mutual funds

9
U.S. Money Supply M2
10
U.S. Money Supply M3
11
The 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.

12
Structure of the Federal Reserve System

• The primary elements in the Federal Reserve
  System are
• The Board of Governors
• The Regional Federal Reserve District Banks
  (FRBs)
• The Federal Open Market Committee

13
The Federal Reserve Banks

• 12 District banks
• Nine directors
• The directors appoint the district president who
  is approved by the Board of Governors

14
The Federal Reserve System
15
The 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

16
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

17
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 banksit is the lender of last
  resort, the bankers 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.

18
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.

19
Money Supply Growth Rates
Source Monetary Trends Federal Reserve Bank of
St. Louis
20
Policy Goals of the Fed

• Ultimate GoalEconomic 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.

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Fed Policy Linkages
22
The Federal Reserve System

• The Feds Policy Tools
• The three main policy tools are
• 1) Open market operations
• 2) Discount rate
• 3) Reserve Requirements

23
Open 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.

24
Operating 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).

25
Discount 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.

26
Reserve 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.

27
How Banks Create Money

• Reserves Actual and Required
• The reserve ratio is the fraction of a banks
  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.

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How Banks Create Money
1
(Simple) Money Multiplier
Reserve Requirement (ratio)
29
The Multiple Creation of Bank Deposits
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Money Multiplier Extended Model

• Ms m x MB
• m m(rr, C/D, ER/D)
• where
• rr reserves ratio
• C/D currency to deposits ratio
• ER/D excess reserves to deposits
  ratio

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How Money Supply Changes affect GDP
32
Policymaking Process

• Independence from Political Process
• Congress could change things and weaken this
  independence
• Humphrey-Hawkins Reports
• FOMC Meetings
• 8 times a year (every 6 weeks)
• Issue directives

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Targeting Monetary Aggregates
Ms
r
r2
r1
Md2
Md1
M
34
Targeting Interest Rates
r
Md2
Md1
Ms
r
M1
M2
M
35
Targeting A Monetary AggregateIdeal Case
LM
r
r2
r1
IS2
IS1
Y
Y
36
Targeting A Monetary AggregateLess than Ideal
Case (I)
LM
r
IS2
IS1
Y
Y2
Y1
37
Targeting A Monetary AggregateLess than Ideal
Case (II)
LM
r
IS0
Y
Y2
Y1
Y3
38
Targeting the Interest Rate
r
r
LM
IS3
IS2
IS1
Y1
Y2
Y
Y3
39
Evolution of Policy

• 1970-79 Targeting Fed Funds Rate
• 1979-82 Targeting Monetary Aggregates
• 1982-2004 Mixed Approach
• Inflation Targeting?
• Time Inconsistency Problem