Chapter Sixteen Monetary Control Monetary Control The Fed

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Chapter Sixteen Monetary Control

Chapter Sixteen Monetary Control

Monetary Control • The Fed does not control the money supply directly, but indirectly

Monetary Control • The Fed does not control the money supply directly, but indirectly through adjustments to its monetary base • This base supports a larger money supply through the money-multiplier process • The money supply is a measure of the amount of money held in the economy, such as M 1 or M 2 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 2

The Money Supply • Money supply = Money multiplier × Monetary base • Money

The Money Supply • Money supply = Money multiplier × Monetary base • Money supply: M 1 or M 2 or M 3 • Monetary base: determined by Federal Reserve; equal to reserves + currency held by nonbank public • Money multiplier: depends on decisions by people, banks, and the Fed Copyright © Houghton Mifflin Company. All rights reserved. 16 | 3

Money Creation and Destruction • Fed influences money supply by affecting banks’ reserves, mainly

Money Creation and Destruction • Fed influences money supply by affecting banks’ reserves, mainly through open-market operations • The Fed’s main asset is its portfolio of securities • Banks create and destroy money by changing amount of outstanding loans – Money is “created” when more loans are made available through banks, and destroyed when fewer loans are given Copyright © Houghton Mifflin Company. All rights reserved. 16 | 4

Federal Reserve Balance Sheet, 12/31/2004 ($ billions) Assets Liabilities + Capital Securities 750. 86

Federal Reserve Balance Sheet, 12/31/2004 ($ billions) Assets Liabilities + Capital Securities 750. 86 781. 55 64. 05 Monetary Base Other Liabilities Capital Discount Loans Other 0. 04 Total 814. 95 Copyright © Houghton Mifflin Company. All rights reserved. 9. 86 23. 54 16 | 5

Open-Market Operations • Open-market purchase: Fed buys securities from government securities dealers, adds reserves

Open-Market Operations • Open-market purchase: Fed buys securities from government securities dealers, adds reserves to bank • Fed’s assets (securities) increase; monetary base (bank reserves) increase • Open-market sale: Fed sell securities; gets reserves from banks; Fed assets decline; monetary base declines Copyright © Houghton Mifflin Company. All rights reserved. 16 | 6

How Banks Create Money 1. Fed buys securities in open market 2. First Bank

How Banks Create Money 1. Fed buys securities in open market 2. First Bank gets reserves and now has excess reserves 3. First Bank makes additional loans 4. Funds go to Second Bank, which now has excess reserves 5. Second Bank makes additional loans 6. Third Bank has excess reserves. . . Copyright © Houghton Mifflin Company. All rights reserved. 16 | 7

Effect of $4 Million Open-Market Purchase Bank New Deposits Additional Reserves First 4. 00

Effect of $4 Million Open-Market Purchase Bank New Deposits Additional Reserves First 4. 00 0. 400 Loans Made 3. 60 Second 3. 60 0. 360 3. 24 Third 3. 24 0. 324 2. 92 Fourth 2. 92 0. 292 2. 63 . . 40. 00 4. 000 36. 00 Total Copyright © Houghton Mifflin Company. All rights reserved. 16 | 8

The Money Multiplier • The money multiplier is the ratio of the money supply

The Money Multiplier • The money multiplier is the ratio of the money supply to the monetary base. mm = M ÷ MB Copyright © Houghton Mifflin Company. All rights reserved. 16 | 9

Money Multiplier (cont’d) • The multiple amount by which the money supply increases from

Money Multiplier (cont’d) • The multiple amount by which the money supply increases from an open-market purchase of $4 million equals: 1/q = 1/0. 1 = 10 (q = reserve requirement) ΔM = mm × ΔMB if mm is constant Ex: ΔM = mm × ΔMB = 10 × 4 = 40 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 10

Realistic Money Multipliers • Simple examples thus far…i. e. , money created by banks

Realistic Money Multipliers • Simple examples thus far…i. e. , money created by banks and deposited in banks stays in banks • For a more realistic example examine – How the monetary base is split into reserves and currency held – How different measures of money are split into their components – How banks split between required & excess reserves and required clearing balances. – How people split holdings into different assets Copyright © Houghton Mifflin Company. All rights reserved. 16 | 11

Realistic Money Multipliers (cont’d) • Monetary base is equal to the amount of reserves

Realistic Money Multipliers (cont’d) • Monetary base is equal to the amount of reserves held by banks plus the amount of currency held by the nonbank public MB = R + C • Different measures of the money supply will have different multipliers. M 1 = D + C Copyright © Houghton Mifflin Company. All rights reserved. 16 | 12

Realistic Money Multipliers (cont’d) • Different measures of the money supply will have different

Realistic Money Multipliers (cont’d) • Different measures of the money supply will have different multipliers M 2 = D + C + N + MMF (MMF signifies money market mutual funds. ) • The M 2 multiplier is the ratio of M 2 to the monetary base: Mm 2 = M 2 / MB Copyright © Houghton Mifflin Company. All rights reserved. 16 | 13

Bank Reserves • Banks hold reserves both because of reserve requirements and because they

Bank Reserves • Banks hold reserves both because of reserve requirements and because they may have agreed to hold required clearing balances (RCB) at the Fed • Required clearing balances help to ensure that banks have plenty of funds at the Fed to cover daily transactions and help check-clearing process run smoothly Reserves = Required reserves + Excess reserves + Required clearing balances R = RR + ER + RCB Copyright © Houghton Mifflin Company. All rights reserved. 16 | 14

Deriving the Multipliers Copyright © Houghton Mifflin Company. All rights reserved. 16 | 15

Deriving the Multipliers Copyright © Houghton Mifflin Company. All rights reserved. 16 | 15

How People & Banks Affect the Money Supply • Changes in the multiplier affect

How People & Banks Affect the Money Supply • Changes in the multiplier affect the money supply simultaneously • Who determines multipliers? – People: C/D (the ratio of currency to deposits), N/D (ration of non-transactions deposits to transaction deposits), MMF/D (money market mutual funds to transaction deposits) – Banks: ER/D (excess reserves to deposits), RCB/D (required clearing balances to deposits) – The Fed: RR/D (required reserves to deposits) Copyright © Houghton Mifflin Company. All rights reserved. 16 | 16

How People & Banks Affect the Money Supply (cont’d) Please insert Table 16. 3

How People & Banks Affect the Money Supply (cont’d) Please insert Table 16. 3 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 17

How People & Banks Affect the Money Supply (cont’d) Figure 16. 1 Money Multipliers

How People & Banks Affect the Money Supply (cont’d) Figure 16. 1 Money Multipliers The rate of decline in the M 1 multiplier increased in the 1990 s with the advent of sweep accounts Copyright © Houghton Mifflin Company. All rights reserved. 16 | 18

How People & Banks Affect the Money Supply (cont’d) Figure 16. 2 a Components

How People & Banks Affect the Money Supply (cont’d) Figure 16. 2 a Components of the Numerator of the M 1 Money Multiplier Both components of the M 1 multiplier rose rapidly beginning in 1995 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 19

How People & Banks Affect the Money Supply (cont’d) Figure 16. 2 b Components

How People & Banks Affect the Money Supply (cont’d) Figure 16. 2 b Components of the Numerator of the M 2 Money Multiplier The components of the M 2 numerator also rose sharply after 1995 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 20

How People & Banks Affect the Money Supply (cont’d) Figure 16. 3 a Components

How People & Banks Affect the Money Supply (cont’d) Figure 16. 3 a Components of the Denominator of the Money Multipliers (Other Than C/D) The components of the denominator of the multipliers Copyright © Houghton Mifflin Company. All rights reserved. 16 | 21

How People & Banks Affect the Money Supply (cont’d) Figure 16. 3 b Components

How People & Banks Affect the Money Supply (cont’d) Figure 16. 3 b Components of the Denominator of the Money Multipliers Movements in the denominator are dominated by movements in the ratio of currency to transactions deposits over time Copyright © Houghton Mifflin Company. All rights reserved. 16 | 22

The Tools of Monetary Policy 1. 2. 3. • Open-market operations Changes in the

The Tools of Monetary Policy 1. 2. 3. • Open-market operations Changes in the discount rate Changes in reserve requirements Bank’s reserves can be broken down into those borrowed from the Fed: Monetary base = reserves + currency Copyright © Houghton Mifflin Company. All rights reserved. 16 | 23

Open-Market Operations • The most commonly used tool • Example: People demand more money

Open-Market Operations • The most commonly used tool • Example: People demand more money during the holidays, so the Fed increases the monetary base to prevent the decline in the multiplier from affecting M 1 • Defensive open-market operations are undertaken because of seasonal effects or temporary changes in market demand • Dynamic open-market operations are undertaken when the Fed wants to actively change monetary policy Copyright © Houghton Mifflin Company. All rights reserved. 16 | 24

Discount Lending M = mm × (DL + NBR + C) • • •

Discount Lending M = mm × (DL + NBR + C) • • • The discount rate is the interest rate banks pay when they borrow from the Fed at the discount window When the discount rate is higher, fewer loans are made The Fed takes a haircut on loan’s collateral (requires collateral valued at more than the amount of the loan) Copyright © Houghton Mifflin Company. All rights reserved. 16 | 25

Discount Lending (cont’d) • Primary credit discount loan – – – • requires CAMELS

Discount Lending (cont’d) • Primary credit discount loan – – – • requires CAMELS rating of 1, 2, or 3 no questions asked primary credit discount rate currently set at 1 percentage point above federal funds rate target Secondary credit discount loan – – – CAMELS rating of 4 or 5 questions asked secondary credit discount rate currently set at ½ percentage point above primary credit discount rate Copyright © Houghton Mifflin Company. All rights reserved. 16 | 26

Discount Lending (cont’d) • Seasonal credit discount loan – program to lend at the

Discount Lending (cont’d) • Seasonal credit discount loan – program to lend at the discount window for small banks – for small banks with seasonal demands for credit (eg. farm banks) – rate equals ½ average fed funds rate + ½ average rate on negotiable CDs over twoweek maintenance period Copyright © Houghton Mifflin Company. All rights reserved. 16 | 27

Discount Lending (cont’d) • How do changes in the discount rate affect the money

Discount Lending (cont’d) • How do changes in the discount rate affect the money supply? • An increase in the amount of discount loans increases the money supply by the amount of the increase in the discount loans times the money multiplier M = mm × (DL + NBR + C) Copyright © Houghton Mifflin Company. All rights reserved. 16 | 28

Reserve Requirements M = mm × (DL + NBR + C) • • Increases

Reserve Requirements M = mm × (DL + NBR + C) • • Increases in the reserve requirements reduce the multiplier because banks hold more reserves and less Not often used to affect the money supply —too blunt a tool Copyright © Houghton Mifflin Company. All rights reserved. 16 | 29

The Tools of Monetary Policy Please insert Table 16. 4 Copyright © Houghton Mifflin

The Tools of Monetary Policy Please insert Table 16. 4 Copyright © Houghton Mifflin Company. All rights reserved. 16 | 30

The Market for Bank Reserves • Fed intervenes daily in market for bank reserves,

The Market for Bank Reserves • Fed intervenes daily in market for bank reserves, so it needs a good model of the reserve market. • Split reserves into parts – Discount loans that depend on the federal funds rate (discount loans for profit DL-Profit) – Non-Borrowed Reserves (NBR) supplied by the Fed – Discount loans that do not depend on the federal funds rate, which include seasonal discount loans + secondary credit discount loans by weak banks with problems + primary credit discount loans by good banks with temporary problems (DL-Business) Copyright © Houghton Mifflin Company. All rights reserved. 16 | 31

The Market for Bank Reserves (cont’d) • Supply curve for reserves – Vertical segment:

The Market for Bank Reserves (cont’d) • Supply curve for reserves – Vertical segment: NBR + DL-Business – Horizontal segment: DL-Profit • Horizontal segment starts at primary credit discount rate (d) • Demand curve for reserves – Downward sloping, as banks desire more reserves, the cheaper they are • Equilibrium point determines equilibrium fed funds rate Copyright © Houghton Mifflin Company. All rights reserved. 16 | 32

The Market for Bank Reserves (cont’d) The demand curve slopes downward because banks want

The Market for Bank Reserves (cont’d) The demand curve slopes downward because banks want to hold more reserves when the federal funds rate is lower Copyright © Houghton Mifflin Company. All rights reserved. 16 | 33

The Market for Bank Reserves (cont’d) The supply of reserves is vertical when ffr

The Market for Bank Reserves (cont’d) The supply of reserves is vertical when ffr is less than the primary discount rate, and horizontal when they are equal Copyright © Houghton Mifflin Company. All rights reserved. 16 | 34

The Market for Bank Reserves (cont’d) Equilibrium in the reserves market occurs at the

The Market for Bank Reserves (cont’d) Equilibrium in the reserves market occurs at the intersection of supply and demand; in this case there are no primary credit discount loans Copyright © Houghton Mifflin Company. All rights reserved. 16 | 35

The Market for Bank Reserves (cont’d) The Open-Market Desk’s Job – Daily analysis of

The Market for Bank Reserves (cont’d) The Open-Market Desk’s Job – Daily analysis of the reserves market – Estimates the amount of reserves available in the market each day – Determine NBR to get ffr* equal to FOMC’s target rate – Engage in open-market operations each day based on the current level of NBR and the desired level Copyright © Houghton Mifflin Company. All rights reserved. 16 | 36

The Market for Bank Reserves (cont’d) When ffr exceeds the Fed’s target, If the

The Market for Bank Reserves (cont’d) When ffr exceeds the Fed’s target, If the Fed engages in purchases in the amount of ∆R, equilibrium ffr will equal the target Copyright © Houghton Mifflin Company. All rights reserved. 16 | 37

The Market for Bank Reserves (cont’d) If demand for reserves is D 2 instead

The Market for Bank Reserves (cont’d) If demand for reserves is D 2 instead of D 1, ffr will rise to equal the discount rate Copyright © Houghton Mifflin Company. All rights reserved. 16 | 38

Should the Fed Pay Interest on Reserves? • Why pay interest on reserves? –

Should the Fed Pay Interest on Reserves? • Why pay interest on reserves? – Required reserves are higher than banks need, so they avoid them by sweep accounts, which are costly – Interest on reserves could increase efficiency; banks would price their services more in line with their economic costs – Because bank reserves are an asset, their return should be determined by the market – The Fed would gain an additional policy tool Copyright © Houghton Mifflin Company. All rights reserved. 16 | 39

Should the Fed Pay Interest on Reserves? (cont’d) • Disadvantages of interest on reserves

Should the Fed Pay Interest on Reserves? (cont’d) • Disadvantages of interest on reserves – Would be costly to the Fed: $700 million to $5 billion per year, depending on the interest rate paid, at current reserve levels – Payment of interest would lead to more reserves being held, so the amount would be even higher – The system of required clearing balances implicitly pays interest Copyright © Houghton Mifflin Company. All rights reserved. 16 | 40