The Fed and Money Supply Lecture 16 Jennifer P. Wissink ©2017 Jennifer P. Wissink, all rights reserved. March 29, 2017 1 1

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The Creation of Money – Many banks, Many People Start with 3 banks HSBC Wells Fargo CitiBank Each bank wants to end the process with zero excess reserves.  Total Reserves = Required Reserves A bunch of people People with odd numbers put money in their bank. Abe is Mr. 1. He is odd. People with even numbers borrow money from their bank and buy stuff from odd people who immediately put that money in their checking accounts. Each person is “used” only once.

The Creation of Money with Many Banks (rrr=20%) & Many People Odd People Save via Banks, Even People Borrow & Immediately Spend Assets Liabilities Liabilites

The Creation of Money – Many banks The Creation of Money When There Are Many Banks Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 100 100 Deposits Reserves 100 Loans 80 180 Deposits Reserves 20 Loans 80 Reserves 80 80 Deposits Reserves 80 Loans 64 144 Deposits Reserves 16 Loans 64 Reserves 64 64 Deposits 115.20 Deposits Reserves 12.80 .00 500 Total . . . .20 51 Bank 4 64 Bank 3 80 Bank 2 100 Bank 1 Deposits Summary:

The Money Multiplier So: The money multiplier is the multiple by which demand deposits can increase for every dollar increase in reserves. In our examples the required reserve ratio is 20%. Each dollar increase in reserves caused an increase in deposits of $5. An additional $100 of reserves resulted in additional demand deposits of $500. Note: We assumed there were no leakages out of the system. What if there were leakages? So: Remember: demand deposits increased by $500. But in this example, M1 only increased by $400.

How the Fed Controls the Money Supply Via actions that change banks’ reserves – particularly excess reserves - which in turn change demand deposits, which in turn change the money supply. Three tools are available to the Fed for changing the money supply: changing the required reserve ratio changing the discount rate engaging in open market operations

The Required Reserve Ratio The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create. If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans. So:  rrr  MSupply  rrr  Msupply To see how this plays out in the T-accounts see “hidden slide” in this PowerPoint.

The Required Reserve Ratio A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) PANEL 1: REQUIRED RESERVE RATIO = 20% Federal Reserve Commercial Banks Assets Liabilities Government $200 $100 Reserves $500 Deposits securities Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% $800 Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900.

The Discount Rate What is the discount rate? The discount rate is the interest rate that an eligible depository institution is charged to borrow funds, typically for a very short period of time, directly from a Federal Reserve Bank. Banks borrow from the Fed to meet required reserve levels when they are short on reserves. So, the lower the discount rate, the cheaper it is to borrow from the Fed, the smaller the amount of reserves banks will keep on hand, so the more demand deposits they will create by making loans. On the flip side, the higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do. So…  discount rate  MSupply  discount rate  Msupply On January 9, 2003, the Fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis. Moral suasion is pressure that was exerted in the past by the Fed on member banks to discourage them from having to borrow heavily to meet reserve requirements. To see how this plays out in the T-accounts see “hidden slide” in this PowerPoint.

The Discount Rate The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED Federal Reserve Commercial Banks Assets Liabilities Securities $160 $80 Reserves $400 Deposits Currency Loans $320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED $100 Reserves (+ $20) $500 Deposits (+ $300) $20 Loans (+ $100) $420 Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580.

Open Market Operations Open market operations are when the Fed purchases(buys) or sells government securities in the open market. Open market operations are used to expand or contract the amount of reserves in the system and thus alter the money supply. Open market operations are by far and away the most significant tool of the Fed for controlling the supply of money.

The Federal Funds Rate & OMO The Federal Reserve Act specifies that the FOMC should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." At each meeting, the FOMC closely examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter the federal funds rate. By trading government securities, the New York Fed affects the money supply and federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market. A decrease in the federal funds interest rate stimulates economic growth. An increase in the federal funds interest rate will curb economic growth.

source: https://research.stlouisfed.org/fred2/

source: https://research.stlouisfed.org/fred2/

Open Market Operations An open market purchase(buy) of securities from the public by The Fed results in an increase in reserves and an increase in the money supply by an amount equal to the money multiplier times the change in reserves. An open market sale of securities to the public by The Fed results in a decrease in reserves and a decrease in the money supply by an amount equal to the money multiplier times the change in reserves. Open market operations are the Fed’s preferred means of controlling the money supply because: they can be used with some precision are extremely flexible are fairly predictable.

An OMO Sale to Ms Suppose the rrr = 20% The Fed's Next Move Is A Delicate One(NPR) “One of the Federal Reserve's main jobs is creating money. And the central bank has created a lot of it since the financial crisis — more than $3 trillion. One of the next jobs for the Fed is to make that money disappear.” http://www.npr.org/2015/03/18/393748257/the-feds-next-move-is-a-delicate-one Federal Reserve Decides To Keep Interest Rates Low A While Longer http://www.npr.org/sections/thetwo-way/2016/03/16/470698819/federal-reserve-decides-to-keep-interest-rates-low-a-while-longer Suppose the rrr = 20% Suppose The Fed sells $5 in securities to the public, namely to Jane Q. Public. a loss of reserves of $5 (since Jane pays for them w/DD) so Reserves = -$5 Note: with rrr = 20% the K$ = 5 An OMO sale of $5 in securities to the public leads to a decrease in the money supply of $25. In this case, Ms = DD = (K$)(Reserves) Plugging in you get: -$25 = (5)( -$5)

An OMO Sale to Ms , with rrr=20% Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1: the initial situation Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities $100 $20 Reserves Deposits $5 $0 Debts $80 Currency Loans Net Worth Note: Money supply (M1) = Currency + Deposits = $180. PANEL 2: right after The Fed sells $5 of securities to Jane Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities (- $5) $95 $15 Reserves (- $5) Deposits (- $5) $0 Debts $80 Currency Loans Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. PANEL 3: after the Commercial Banks get “right” again Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities (- $5) $95 $15 Reserves (- $5) $75 Deposits (- $25) Deposits (- $5) $0 Debts $80 Currency Loans (- $20) $60 Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155.

An OMO Purchase and the K$  Ms Suppose rrr=20%  K$ = 5 Suppose The Fed buys $70 in securities from Fred Z. Public. The money supply will increase by $350. Note: Ms= DDp=(K$)(Reserves) The $70 purchase increases reserves by $70 Plugging into Ms  $350 = (5)($70)

Can You Do An OMO Purchase To Ms? PANEL 1 Federal Reserve Commercial Banks Fred Z. Public Assets Liabilities Securities $100 $20 Reserves Deposits $5 $70 Debts $80 Currency Loans $75 $10 Net Worth PANEL 2 PANEL 3

Two Great Videos On The Crisis Of Fall 2008 The Financial Crisis: Implications for Washington, Wall Street, and Main Street Wednesday, October 1, 2008, 5:00 PM - 6:30 PM Hollis Auditorium, 132 Goldwin-Smith Hall http://www.johnson.cornell.edu/news/financialCrisis.html Market Chaos Unraveled Sept. 24, 2008, 4:30 PM - 5:30 PM Professors Bob Jarrow and Maureen O'Hara and Senior Lecturer Rich Marin presented their interpretation of the current, unprecedented turmoil in the financial markets in a panel discussion moderated by Associate Dean Doug Stayman. Addressing a standing-room-only crowd in Sage Hall B09, plus an overflow audience in B08 via video, Jarrow set the stage by discussing the framework that led up to the crisis, O'Hara explained what's happening with credit markets and liquidity, and Marin addressed Wall Street as a model - what's broken and what's not. http://www.johnson.cornell.edu/news/jspanel_marketChaos.html

The Money Market Money Supply (MS) Money Demand (MD) Totally determined by The Fed. So… a vertical line in our graphs. What we were calling M1. Now it’s MS. Money Demand (MD) Will make more interesting. Determined by households’ desires to hold assets as money rather than interest bearing bonds. Look at motives for holding money, rather than bonds.

The Demand Function for Money Simple model that asks: What determines how much of a person’s assets/wealth will be held as non-interest earning balances, i.e., money? Note, a households assets include: money balances 0 interest and perfectly liquid bonds/securities + interest and imperfectly liquid claims on real capital (physical assets) most of the time we will ignore this 3rd category

Bond Price and Interest Rate Suppose I, Jennifer P. Wissink, offer to sell you a bond/security/promissory note where I promise to give you $1,000 in exactly two years from today. No inflation. No risk! What would you be willing to pay me (ok, loan me) for this promise? What “price” would you pay?

Bond Price and Interest Rate What is $1,000 in T=2 years from today worth today, if r = 4%=.04? Ask, how much would you have to put in the bank today, $PV, to have a balance or Face/Future Value, $FV, of $1,000 two years from today, at r = 4%=.04 in each year? So, after one year: $PV + $PV·r And after two years: ($PV + $PV·r) + ($PV + $PV·r) ·r So, $FV = $PV + $PV·r + $PV·r + $PV·r2 So, $FV = $PV(1+2r+r2) So, $FV = $PV(1+r)2 So, solving for the present value you then get $PV = $FV/(1+r)2 So, the present value of $1,000 in 2 years at r=4%=.04 is $PV = $1,000/(1.04)2 = $924.56 General Formula: The $PV of $X in T periods from now at interest rate r is $PV = $X/(1+r)T

Bond Price and Interest Rate What is $1,000 in T=2 years from today worth today, if r = 4%=.04? Ask, how much would you have to put in the bank today, $PV, to have a balance or Face/Future Value, $FV, of $1,000 two years from today, at r = 4%=.04 in each year? So, after one year: $PV + $PV·r And after two years: ($PV + $PV·r) + ($PV + $PV·r) ·r So, $FV = $PV + $PV·r + $PV·r + $PV·r2 So, $FV = $PV(1+2r+r2) So, $FV = $PV(1+r)2 So, solving for the present value you then get $PV = $FV/(1+r)2 So, the present value of $1,000 in 2 years at r=4%=.04 is $PV = $1,000/(1.04)2 = $924.56 General Formula: The $PV of $X in T periods at interest rate r is  

i>clicker questions Suppose the interest rate increased to r=5%=.05, holding everything else the same. The $PV of the promise to get $1,000 in two years would Increase. Decrease Stay the same Suppose the interest rate stayed at 4%=.04 but now you had to wait until 4 years to get the $1,000, holding everything else the same. The $PV of the promise would Increase. Decrease Stay the same

Bond Price and Interest Rate So there is an inverse relationship between bond prices ($PB) and the market interest rate (r). If r , then $PB  If r , then $PB 