The Fed, Money, and Credit Chapter #17

Money Stock Determination Money supply consists mainly of deposits at banks  Fed does not control directly –A key concept concerning money in the U.S. is the fractional reserve banking system: banks required to keep only a fraction of all deposits on hand or on reserve (not loaned out) High powered money (monetary base) consists of currency & banks’ deposits at Fed –The part of the currency held by the public forms part of the money supply –Currency in bank vaults & deposits at Fed are reserves backing individual & business deposits at banks –Fed’s control over monetary base is main route through which it determines money supply The Fed has direct control over high powered money (H) Money supply (M) is linked to H via the money multiplier, ratio of stock of money to stock of high powered money  mm > 1 –Top of figure 17-2 is the money stock –Bottom of figure is the stock of high-powered money = monetary base –The larger deposits are, as a fraction of M, the larger the multiplier

Money Stock Determination Money supply (M) consists of currency (CU) & deposits (D): M = CU + D High powered money (H) consists of currency & reserves: H = CU + reserves Behavior of public, banks & Fed in money supply process is summarized by: –Currency-deposit ratio: cu = CU / D –Reserve ratio:re = reserves / D –Stock of high powered money:H We can rewrite equations for M & H as: M = (1 + cu)D & H = (cu + re)D  This allows us to express money supply in terms of its principal determinants (re, cu & H): where mm is the money multiplier. Some observations of the money multiplier:  The money multiplier is larger the smaller the reserve ratio re  The money multiplier is larger the smaller the currency-deposit ratio cu  The smaller is cu, the smaller the proportion of H that is being used as currency AND the larger the proportion that is available to be reserves Payment habits of public determine how much currency is held relative to deposits ─ cu is affected by the cost & convenience of obtaining cash ─ cu falls with shoe leather costs (availability of cash machines lowers cu) ─ cu has a strong seasonal pattern (highest around Christmas)

The Instruments of Monetary Control The Federal Reserve has three instruments for controlling money supply 1.Open market operations Buying and selling of government bonds 2.Discount rate Interest rate Federal Reserve “charges” commercial banks for borrowing money Federal Reserve is often the lender of last resort for commercial banks 3.Required-reserve ratio Portion of deposits commercial banks are required to keep on hand, and not loan out

OMO & Fed’s Balance Sheet Impact of Fed buying $1M T-bonds with check on Fed’s balance sheet: 1) Fed’s ownership of securities ↑ by $1M 2) Seller deposits check with her bank, which deposits it with Fed  Bank deposits at Fed ↑ by $1M NOTE: Commercial banks reserves (initially held with Fed) ↑ by $1M NOTE: Fed create H at will by buying assets & paying with its own liabilities Two ways of looking at Fed’s balance sheets –Table 17-2 shows the principal assets and liabilities of the Fed  Government bonds  Currency –Table 17-3 shows the monetary base and two different ways of looking at reserves  Most reserves are required  Only a small fraction is borrowed at the discount window

Loans and Discounts Banks short on reserves can borrow (from Fed or other banks) to make up the ≠ The cost of borrowing from Fed is discount rate (also signals Fed’s intentions) The cost of borrowing from other banks is the federal funds rate An alternative way to describe money multiplier is to showing how adjustments by banks & public following an increase in H produce a multiple expansion of M –Fed’s open market purchase increases H & bank reserves –The bank in which Fed’s check was deposited has excess reserves & can increase lending –When bank makes loan, loan taker gets a bank deposit of the amount of the loan  money supply has increased by more than the amount of the open market operation –Expansion of loans (& money) continues until reserve-deposit ratio has fallen to the desired level and the public has achieved its desired currency-deposit ratio In Great Recession , Fed aggressively cut interest rates –Reduced to almost zero –Continued after official end of recession

The Reserve Ratio Bank reserves = deposits at the Fed and “vault cash” In the absence of regulation, banks would hold reserves to meet: 1.The demands of their customers for cash 2.Payments their customers make by checks that are deposited in other banks Fed specifies required reserves (portion of deposits kept on hand) Banks hold excess reserves (above required) for unexpected withdrawals Fed can ↑ money supply by reducing required reserves since RRR is not a policy tool of choice since Fed pays no interest on them, making them an interest free loan from banks to Fed –Changes in reserves have undesirable effects on bank profits During Great Recession ( ), excess reserves grew as Fed payed interest on both required & excess reserves & banks made fewer loans, which significantly impacted mm

Control of the Money Stock and Control of the Interest Rate Suppose money demand is LL & Fed wants to set interest % at i * & money stock at M * Fed cannot simultaneously set the interest % & the stock of money at any target level The Fed can move the money supply around, but not LL It can only set combinations of i and M that lie along LL At interest rate i *, can have M 0 /P At the target money supply, M * /P, can have interest rate of i 0 Cannot achieve BOTH targets

Money Stock and Interest Rate Targets William Poole’s article discusses choice between interest % & money stock targets –Assume Fed’s aim is a particular level of output  uses IS-LM model, in the short-run –LM(M) = LM curve that exists when Fed fixes money stock –LM(i) = LM curve that exists when Fed fixes the interest rate The problem: IS and LM curves shift unpredictably  When shift, output moves away from the target level In panel (a) Fed does not know in advance which of the two possible IS curves is the true one  Fed’s aim is to achieve Y *  Output closer to Y * when LM(M) is used In panel (b) IS curve is stable & uncertainty arises from shifts in the LM curve –If Fed sets M, LM shifts due to shifts in money demand –When setting money supply, Fed does not know what i will be  LM could be either LM 1 or LM 2 –Alternatively, Fed could set i at i * to ensure Y=Y *

Key Points for Fed’s Targets 1.Distinction between ultimate targets and intermediate targets. –Ultimate targets are variables (inflation & unemployment) behavior matters. –Fed aims at intermediate targets (interest %) to hit ultimate ones more accurately Intermediate targets give Fed something concrete & specific to aim for Enables Fed to focus on what it should be doing Help the private sector know what to expect Specifying targets allows holding Fed accountable for its actions Ideal target is a variable that: 1. Fed can control exactly 2. Has exact relationship with ultimate target –Fed uses instruments (discount rate, RRR & OMO) to hit the targets 2.It matters how often the intermediate targets are reset. –If Fed commits to a 5.5% money growth over several years, it would have to be sure that the velocity of money was not going to change unpredictably  else the actual level of GDP would be far different from the targeted level –As target is reset more often (as velocity changed) Fed is closer to hitting targets 3.The need for targeting arises from a lack of knowledge –If Fed had the right ultimate goals & knew exactly how the econ works, it could do what was needed to keep the economy as close to its ultimate targets as possible  but the Fed does not have a crystal ball or perfect foresight