© 2008 Pearson Addison-Wesley. All rights reserved Chapter 14 Monetary Policy and the Federal Reserve System

© 2008 Pearson Addison-Wesley. All rights reserved 14-2 Chapter Outline Principles of Money Supply Determination –All currency –All reserve –Fractional reserve –Tools Monetary Control in the United States The Conduct of Monetary Policy: Rules Versus Discretion (skip)

© 2008 Pearson Addison-Wesley. All rights reserved 14-3 Principles of Money Supply Determination Three groups affect the money supply –The central bank is responsible for monetary policy –Depository institutions (banks) accept deposits and make loans –The public (people and firms) holds money as currency and coin or as bank deposits

© 2008 Pearson Addison-Wesley. All rights reserved 14-4 Principles of Money Supply Determination The money supply in an all-currency economy –A trading system based on barter is inconvenient –The creation of a central bank to print money can improve matters Central bank: buy (sell) assets to increase (decrease) money supply Public: use money as legal tender –In an all-currency economy, the money supply equals the monetary base Monetary base = currency (no bank deposit) in all-currency economy Monetary base: most liquid and can be used to “create” money

© 2008 Pearson Addison-Wesley. All rights reserved 14-5 Principles of Money Supply Determination The money supply under fractional reserve banking –The currency that banks hold is called bank reserves Bank reserves = vault cash + reserves at the central bank When bank reserves are equal to deposits, the system is called 100% reserve banking To make money, banks would have to charge fees for deposits, since they earn no interest on reserves (changed now!) –When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking Banks have incentive to lend out part of deposits. But face potential Bank runs. (a large scale, panicky withdrawal of deposits)

© 2008 Pearson Addison-Wesley. All rights reserved 14-6 Principles of Money Supply Determination The money supply under fractional reserve banking –When all the banks catch on to this idea, they will all make loans as the economy undergoes a multiple expansion of loans and deposits –How it works in a no-cash economy? Suppose monetary base increases by 1b through bank A Suppose reserve-deposit ratio is 25% and people don’t hold currency. The 1b increase can create 3b more money supply, altogether 4b money supply (deposits). 1+3/4+3/4*3/4+3/4*3/4*3/4+…=4 –Money supply = Monetary Base/(reserve-deposit ratio)

© 2008 Pearson Addison-Wesley. All rights reserved 14-7 Principles of Money Supply Determination The money supply under fractional reserve banking Notation: M  money supply, BASE  monetary base, high-powered money (M0) –Currency held by public (CU) and bank reserves (RES) DEP  bank deposits, RES  bank reserves, res  banks’ desired reserve-deposit ratio (RES/DEP) How much money can be created by monetary base? –Money multiplier

© 2008 Pearson Addison-Wesley. All rights reserved 14-8 Principles of Money Supply Determination The money supply with both public holdings of currency and fractional reserve banking –If there is both public holding of currency and fractional reserve banking, the picture gets more complicated –The money supply consists of currency held by the public and deposits, so M = CU + DEP (14.4) –The monetary base is held as currency by the public and as reserves by banks, so BASE  CU  RES (14.5)

© 2008 Pearson Addison-Wesley. All rights reserved 14-9 Principles of Money Supply Determination The money supply with both public holdings of currency and fractional reserve banking –Taking the ratio of these two equations gives M/BASE  (CU + DEP)/(CU + RES) (14.6) –This can be written as M/BASE  [(CU/DEP) + 1]/[(CU/DEP) + RES/DEP)] (14.7) –The currency-deposit ratio (CU/DEP, or cu) is determined by the public –The reserve-deposit ratio (RES/DEP, or res) is determined by banks

© 2008 Pearson Addison-Wesley. All rights reserved Principles of Money Supply Determination The money supply with both public holdings of currency and fractional reserve banking –Rewrite Eq. (14.7) as M  [(cu + 1)/(cu + res)]BASE (14.8) –The term (cu + 1)/(cu + res) is the money multiplier The money multiplier is greater than 1 for res less than 1 (that is, with fractional reserve banking) If cu  0, the multiplier is 1/res, as when all money is held as deposits The multiplier decreases when either cu or res rises Look at U.S. data to illustrate the multiplier (Table 14.1)

© 2008 Pearson Addison-Wesley. All rights reserved Table 14.1 The Monetary Base, the Money Multiplier, and the Money Supply in the United States

© 2008 Pearson Addison-Wesley. All rights reserved Principles of Money Supply Determination Three tools: –Open-market operations The most direct and frequently used way of changing the money supply is by raising or lowering the monetary base through open-market operations –Discount window lending –Reserve requirements

© 2008 Pearson Addison-Wesley. All rights reserved Principles of Money Supply Determination Application: The money multiplier during the Great Depression –The money multiplier is usually fairly stable, but it fell sharply in the Great Depression –The decline in the multiplier was due to bank panics, which affected the multiplier in two ways People became mistrustful of banks and increased the currency-deposit ratio (text Fig. 14.1) Banks held more reserves, in anticipation of bank runs, which raised the reserve-deposit ratio

© 2008 Pearson Addison-Wesley. All rights reserved Figure 14.1 The currency-deposit ratio and the reserve-deposit ratio in the Great Depression

© 2008 Pearson Addison-Wesley. All rights reserved Principles of Money Supply Determination Application: The money multiplier during the Great Depression –Even though the monetary base grew 20% from March 1930 to March 1933, the money supply fell 35% (text Fig. 14.2) –As a result, the price level fell sharply (nearly one-third) and there was a decline in output (though attributing the drop in output to the decline in the money supply is controversial)

© 2008 Pearson Addison-Wesley. All rights reserved Figure 14.2 Monetary variables in the Great Depression