Maclachlan, Money & Banking Fall The Money Supply Process and Monetary Policy Tools Week 9

Maclachlan, Money & Banking Fall Consider the narrowest definition of money: M1. Consists of … currency checkable deposits travelers checks

Maclachlan, Money & Banking Fall How do banks create new deposits? They must have excess reserves. When they make a loan with the excess reserves, a new deposit is created.

Maclachlan, Money & Banking Fall Bank reserves consist of …. Vault cash (includes cash in ATM’s). Deposits at the Fed.

Maclachlan, Money & Banking Fall Government securities Discount loans Fed notes in circulation Deposits of member banks Fed AssetsFed Liabilities

Maclachlan, Money & Banking Fall Monetary Base (aka High Powered Money) Currency in circulation + Bank Reserves = Fed notes and coins in circulation + vault cash + bank deposits at Fed

Maclachlan, Money & Banking Fall Money Supply Process: Simple Model Assumptions: 10% required reserve ratio. Banks hold no excess reserves. No currency. What happens to the money supply when the Fed purchases $100 of Treasury securities?

Maclachlan, Money & Banking Fall Deposit Creation

Maclachlan, Money & Banking Fall Deposits at Failed Banks: 1929–33

Maclachlan, Money & Banking Fall e, c: 1929–33

Maclachlan, Money & Banking Fall Money Supply and Monetary Base: 1929–33

Maclachlan, Money & Banking Fall Monetary Policy

Maclachlan, Money & Banking Fall Three Tools of Monetary Policy Open market operations Discount rate Reserve requirements

Maclachlan, Money & Banking Fall Open Market Operations 2 Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly

Maclachlan, Money & Banking Fall Discount Loans 3 Types 1.Primary Credit 2.Secondary Credit 3.Seasonal Credit Lender of Last Resort Function 1.To prevent banking panics FDIC fund not big enough Example: Continental Illinois 2.To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident

Maclachlan, Money & Banking Fall How Primary Credit Facility Puts Ceiling on i ff Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2

Maclachlan, Money & Banking Fall Discount Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting discount rate changes 2.Fluctuations in discount loans cause unintended fluctuations in money supply 3.Not fully controlled by Fed

Maclachlan, Money & Banking Fall Reserve Requirements Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks

Maclachlan, Money & Banking Fall Goals of Monetary Policy Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict

Maclachlan, Money & Banking Fall Money Supply Target 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i''

Maclachlan, Money & Banking Fall Interest Rate Target 1.M d fluctuates between M d' and M d'' 2.To set i-target at i* M s fluctuates between M' and M''

Maclachlan, Money & Banking Fall Criteria for Choosing Targets 1.Measurability 2.Controllability 3.Ability to predictably affect goals Interest rates aren’t clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates