1. The Fed and Money Supply Lecture 16
Jennifer P. Wissink
©2017 Jennifer P. Wissink, all rights reserved.
October 19, 2017 1 1

2. The Federal Reserve System
The Federal Reserve System (a.k.a. The Fed) is the central bank of the United States.
It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system; over the years, its role in banking and the economy has expanded.
Today, The Fed’s duties fall into four general areas:
Conducting the nation’s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices.
Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation’s payments system.
Interesting Fed links:

3. The Federal Reserve System
Give Yellen Another Term
Janet Yellen - Chair

4. How The Fed Measures Money
M1, or transactions money is money that can be directly used for transactions.
M1 =
currency & coins held outside banks by the public
+ demand deposits (checking account balances)
+ travelers checks
+ other checkable deposits (e.g., NOW accounts)
From The Fed:
“M1 = A measure of the U.S. money stock that consists of currency held by the public, travelers checks, demand deposits and other checkable deposits including NOW (negotiable order of withdrawal) and ATS (automatic transfer service) account balances and share draft account balances at credit unions.”
“Demand Deposit = A deposit that may be withdrawn at any time without prior written notice to the depository institution. A checking account is the most common form of demand deposit.”
M1 is a stock measure—it is measured at a point in time—on a specific day.

5. How The Fed Measures Money
M2, or broad money, starts with M1 and adds to it near monies, or close substitutes for transactions money.
M2 = currency & coins held outside banks by the public
+ demand deposits (checking account balances)
+ travelers checks
+ other checkable deposits (e.g., NOW accounts) savings accounts money market deposit accounts small time deposits other near monies From The Fed: “M2=Measure of the U.S. money stock that consists of M1, certain overnight repurchase agreements and certain overnight Eurodollars, savings deposits (including money market deposit accounts), time deposits in amounts of less than $100,000 and balances in money market mutual funds (other than those restricted to institutional investors).”
The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.
There is even an M3!

6. i>clicker questions
M1 =
currency & coins held outside banks by the public
+ demand deposits (checking account balances)
+ travelers checks
+ other checkable deposits (e.g., NOW accounts)
M2 =
+savings accounts
+ money market deposit accounts
+ small time deposits
+ other near monies
Suppose Ben takes $1,000 out of his checking account and puts the money under his bed.
Will this transaction decrease M1?
A. Yes
B. No
Will this transaction decrease M2?
A. Yes
B. No
Suppose Ben takes $1,000 out of his checking account and puts the money into a savings account.
Will this transaction decrease M1?
A. Yes
B. No
Will this transaction decrease M2?
A. Yes
B. No

7. The Banking System Banks want to make profits.
A really brief review of some accounting:
Assets – Liabilities = Net Worth, or
Assets = Liabilities + Net Worth
Westley: I've always been a quick healer. What are our liabilities? Inigo Montoya: There is but one working castle gate, and... and it is guarded by 60 men. Westley: And our assets? Inigo Montoya: Your brains, Fezzik's strength, my steel.
Westley: I mean, if we only had a wheelbarrow, that would be something. Inigo Montoya: Where we did we put that wheelbarrow the albino had? Fezzik: Over the albino, I think. Westley: Well, why didn't you list that among our assets in the first place?
A bank’s most important assets are its loans.
Other assets include cash on hand (or vault cash), the bank’s deposits with The Fed and its securities.
A bank’s liabilities are its debts—what it owes.
Deposits are debts owed to the bank’s depositors.
Demand Deposits of the public (DDP) are checking accounts of the public.

8. The Banking System & Reserves
Total Reserves(TR):
balances that a bank has deposited at its Federal Reserve bank plus the bank’s cash on hand.
The required reserve ratio(rrr):
the percentage of total deposits at the bank that the bank must keep as reserves. (Let’s assume only demand deposits.)
Required Reserves(RR) = (rrr)* (DDP)
Recall DDP are the public’s demand deposits – deposits that may be withdrawn at any time without prior written notice to the depository institution.
Excess Reserves(ER) = TR – RR
Balances that a bank has over and above what is required.

9. T-Account for a Typical Bank
The balance sheet of a bank must always balance, so that the sum of assets (reserves + loans) equals the sum of liabilities (deposits) + net worth.
T-Account for a Typical Bank (millions of dollars)
ASSETS
LIABILITIES+Net Worth
Reserves 20
100
Deposits(DDP)
Loans 90 10
Net worth
Total
110

10. Liabilities+Net Worth
T-Account for The Fed – Not Your Typical Bank
TABLE Assets and Liabilities of the Federal Reserve System, June 30, 2010 (Billions of Dollars)
Assets
Liabilities+Net Worth
Gold
$ 11
$ 945
Currency in circulation
U.S. Treasury securities
777
970
Reserve balances
Federal agency debt securities
165
288
U.S. Treasury deposits
Mortgage-backed securities
1,118
170
All other liabilities and net worth
All other assets
302
$2,373
Total

11. The Creation of Money
To make the most profit they can, banks usually make loans up to the point where they can no longer do so because of their reserve requirement restriction.
If they are very confident and aggressive, they loan up to the point where their excess reserves are zero.
Note: in reality banks might hold on to some amount of excess reserves, it’s all about the tradeoff of risk and reward.
Recall:
Excess Reserves(ER) = Total Reserves(TR) - Required Reserves(RR)
Most banks want ER = zero!
(Or pretty near to it)
So they make loans by creating demand deposits, which in turn are spent and then turn into more demand deposits.
By this process money is created!

12. The Creation of Money w/only 1 Monopoly Bank
Suppose Abe has $100 in cash in his piggy bank on his book shelf.
So  M1=$100 + all the rest of everybody else’s stuff
Suppose Abe takes this $100 and deposits it into a checking account he opens at the one and only commercial bank in this economy – 1st Nat.
So… we now have DDA = $100 in Abe’s name at 1st Nat.
1st Nat deposits the $100 with its central bank.
1st Nat now has $100 in total reserves.
Suppose 1st Nat then makes money off those reserves by making loans to other people, who then spend the money and pay people who ALSO bank at 1st Nat – the “monopoly” bank.
When 1st Nat makes someone a loan that person gets a checking account in their name. They immediately spend that money and the person who sold them something puts the money they received in their checking account at 1st Nat.
i>clicker question: Assume the rrr=20%, how much in total DDP can Abe’s $100 in reserves (created by Abe’s initial deposit at 1st Nat) support?
A. $100
$200
$300
$400
$500

13. Balance Sheets of a Bank in a Single-Bank Economy with rrr=20%
Initially: Abe has $100 cash in his piggy bank. M1 = $100.
Then: Abe decides to deposit the $100 of cash into his 1st Nat bank as a demand deposit.
Balance Sheets of a Bank in a Single-Bank Economy with rrr=20%
1st Nat Panel 1
1st Nat Panel 2
1st Nat Panel 3
ASSETS
LIABILITIES
Reserves 0
0 Deposits
Reserves 100
100 Deposits
500 Deposits
Loans 400
Initially: before Abe puts his money in the bank. M1=$100
Right after Abe puts his money in the bank. M1=$100
Once the bank is “fully loaned up”. M1=$500
Panel 2 is right after Abe makes the deposit.
If the rrr = 20%, then the bank has excess reserves of $80.
With $80 of excess reserves, the bank can make $400 in loans which will be spent and then lead to $400 of additional deposits on top of Abe’s initial $100.
Panel 3 is after 1st Nat is “fully loaned up”.
1st Nat’s assets are $100 in reserves plus $400 in loans. Its liabilities are $500 in deposits (Abe’s $100 plus all the people who sold stuff to the borrowers).
RR on $500 of DDP equals (0.20)($500) = $100. Note: TR=RR ER=0 now! 1st Nat is fully loaned up.
So the $100 increase in total reserves allowed 1st Nat to increase demand deposits by $500.
A MONEY MULTIPLIER IS BORN.
Important Note: M1 was originally $100. Now M1 equals $500!
M1 = $400 and DDP = $500

14. 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.

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

16. 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.

17. 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
To see how these play out in the T-accounts see “hidden slides” in this PowerPoint.

18. 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.

19. 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.

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

21. 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.

22. 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.”
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)

23. 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.

24. 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)

25. 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

26. 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.

27. 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

28. 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?

29. 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

30. 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

31. 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 