Unit 3 Lecture 2 EC 311 Susanto THE

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Unit 3 Lecture 2 – EC 311 Susanto THE DEPOSIT CREATION PROCESS, THE MONEY

Unit 3 Lecture 2 – EC 311 Susanto THE DEPOSIT CREATION PROCESS, THE MONEY MULTIPLIER, AND TOOLS OF MONETARY POLICY

The Price Stability Goal • Low and stable inflation • Inflation: – – Increase

The Price Stability Goal • Low and stable inflation • Inflation: – – Increase in overall price levels Creates uncertainty and difficulty in planning for the future Lowers economic growth Strains social fabric • Nominal anchor to contain inflation expectations – Ties down price levels within a narrow range to promote price stability • Time-inconsistency problem – Tendency towards pursuing expansionary economic policy to boost the economy This raise inflation expectations Drives wages and prices up [No real output growth]

Fed’s Balance Sheet Federal Reserve System Assets Liabilities Government securities Currency in circulation Discount

Fed’s Balance Sheet Federal Reserve System Assets Liabilities Government securities Currency in circulation Discount loans Reserves Monetary Base, MB = C + R • Monetary Liabilities – Currency in circulation: in the hands of the public – Reserves: bank deposits at the Fed and vault cash • Assets – Government securities: holdings by the Fed that affect money supply and earn interest – Discount loans: provide reserves to banks and earn the discount rate

Fed Balance Sheet

Fed Balance Sheet

Control of the Monetary Base: Fed Open Market Operations Open Market Purchase from Bank

Control of the Monetary Base: Fed Open Market Operations Open Market Purchase from Bank The Banking System Assets Liabilities Assets Securities – $100 Reserves + $100 The Fed Securities + $100 Liabilities Reserves + $100 Result: R $100, MB $100 – No change in currency • The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits • It always increases the monetary base by the amount of the purchase • The effect of open market operations (OMO) on the monetary base is more certain than the effect on reserves • The Fed can more effectively control the monetary base using OMO 15 -5

Shifts From Deposits into Currency Public Assets Liabilities Assets Deposits – $100 Currency +

Shifts From Deposits into Currency Public Assets Liabilities Assets Deposits – $100 Currency + $100 The Fed Liabilities Currency + $100 Reserves – $100 Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R $100, C $100 MB unchanged A shift from deposits and currency decreases reserves by the same amount This has no effect on the monetary base (R up by same amount as C down) © 2004 Pearson Addison. Wesley. All rights reserved 15 -6

Discount Loans Banking System Assets Liabilities The Fed Assets Liabilities Reserves + $100 Discount

Discount Loans Banking System Assets Liabilities The Fed Assets Liabilities Reserves + $100 Discount loan + $100 Result: R $100, MB $100 Conclusion: Fed has better ability to control MB than R 15 -7

Fed’s Ability to Control the Monetary Base • Two primary features to determine monetary

Fed’s Ability to Control the Monetary Base • Two primary features to determine monetary base: – Open market operations (OMO) – Discount lending • Open market operations are controlled by the Fed • The Fed cannot determine the amount of borrowing by banks • Split the monetary base into two components MBn = MB - BR – MBn : non-borrowed monetary base (primarily from OMO) – MB: monetary reserves – BR: borrowed reserves by the banks from the Fed

Deposit Creation: Single Bank First National Bank Liabilities Assets Securities Reserves – $100 +

Deposit Creation: Single Bank First National Bank Liabilities Assets Securities Reserves – $100 + $100 First National Bank Liabilities Assets Securities Reserves Loans – $100 + $100 First National Bank Liabilities Assets Securities Reserves Loans Deposits – $100 $0 + $100 Deposits 15 -9 $0

Deposit Creation: Banking System Assets Reserves Loans + $100 + $10 + $90 +$9

Deposit Creation: Banking System Assets Reserves Loans + $100 + $10 + $90 +$9 + $81 Bank A Liabilities Deposits + $100 Bank B Liabilities Deposits + $90 15 -10

Deposit Creation 15 -11

Deposit Creation 15 -11

Deposit Creation If Bank A buys securities with $90 check Bank A Assets Liabilities

Deposit Creation If Bank A buys securities with $90 check Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same Whether bank makes loans or buys securities, get same deposit expansion 15 -12

Deposit Multiplier Simple Deposit Multiplier 1 D = R r Deriving the formula R

Deposit Multiplier Simple Deposit Multiplier 1 D = R r Deriving the formula R = RR = r D D= 1 r R D = 1 r R D: change in total deposits R: change in reserves r: required reserve ratio R: total reserves RR: required reserves r: required reserve ratio D: total deposits 15 -13

Deposit Creation: Banking System as a Whole Assets Securities Reserves Loans – $100 +

Deposit Creation: Banking System as a Whole Assets Securities Reserves Loans – $100 + $1000 Banking System Liabilities Deposits + $1000 Critique of Simple Model • Deposit creation stops if: 1. Proceeds from loan kept in cash 2. Bank holds excess reserves, i. e. , not use all excess reserves to buy securities or make loans • Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change. 15 -14

Factors that Determine the Money Supply • Changes in the nonborrowed monetary base MBn

Factors that Determine the Money Supply • Changes in the nonborrowed monetary base MBn – The money supply is positively related to the non-borrowed monetary base MBn • Changes in borrowed reserves from the Fed – The money supply is positively related to the level of borrowed reserves, BR, from the Fed • Changes in the required reserves ratio – The money supply is negatively related to the required reserve ratio. • Changes in currency holdings – The money supply is negatively related to currency holdings. • Changes in excess reserves – The money supply is negatively related to the amount of excess reserves.

Money Supply Response

Money Supply Response

The Money Multiplier • Define money as currency plus checkable deposits: M 1 •

The Money Multiplier • Define money as currency plus checkable deposits: M 1 • Link the money supply (M) to the monetary base (MB) and let m be the money multiplier Full Model M = m (MBn + DL), where MBn is non-borrowed MB and DL are discount loans

Application: The Great Depression Bank Panics, 1930 - 1933. • Bank failures (and no

Application: The Great Depression Bank Panics, 1930 - 1933. • Bank failures (and no deposit insurance) determined: – Increase in deposit outflows and holding of currency (depositors) – An increase in the amount of excess reserves (banks) • For a relatively constant MB, the money supply decreased due to the fall of the money multiplier.

Deposits at Failed Banks: 1929– 33 16 -19

Deposits at Failed Banks: 1929– 33 16 -19

Money Supply and Monetary Base: 1929– 33 16 -20

Money Supply and Monetary Base: 1929– 33 16 -20

Tools of Monetary Policy • Open market operations • Reserve requirements • The Discount

Tools of Monetary Policy • Open market operations • Reserve requirements • The Discount window (the Fed as “lender of last resort”)

Open Market Operations Conducted by the New York Fed using mostly T bills Two

Open Market Operations Conducted by the New York Fed using mostly T bills Two Types 1. Dynamic: Meant to change MB e. g. changes in Treasury deposits with the Fed 2. Defensive: Meant to offset other factors affecting MB, typically uses repos (agreement to purchase now and sell 1 -15 days from now) or reverse repos (agreement to sell now and purchase 1 -15 days from now) e. g. float is predicted to decrease

OMOs Advantages of Open Market Operations 1. Fed has complete control – the Fed

OMOs Advantages of Open Market Operations 1. Fed has complete control – the Fed decides the amount and the type of OMOs With discount loans this is left up to the banks 2. Flexible and precise – they can be used up to any amount and for either temporary or permanent changes in MB 3. Easily reversed – if a mistake or another event occurs 4. Implemented quickly – matter of minutes

Discount Loans Three Types 1. Primary Credit (Lombard facility)– most important type of loan

Discount Loans Three Types 1. Primary Credit (Lombard facility)– most important type of loan (for short term liquidity problems). 2. Secondary Credit – for problems that banks have that are in vacation or agricultural areas. Higher rate than for 1. 3. Extended Credit – banks that require loans for a prolonged period of time – e. g. Continental Illinois in 1984. Rate is 0. 5% higher than on 2, and proposal has to be submitted.

Discount loans Lender of Last Resort Function – easiest way to provide reserves during

Discount loans Lender of Last Resort Function – easiest way to provide reserves during a crisis 1. To prevent banking panics - if banks were allowed to fail, FDIC fund not big enough as it only contains equivalent of 1% of deposits Examples: Continental Illinois and Franklin National 2. Also many accounts have >$100 K so they would not be covered by FDIC 3. To prevent nonbank financial panics Examples: 1987 stock market crash Announcement Effect - Problem: False signals

Discount Policy Advantages 1. Lender of Last Resort role Disadvantages 1. Confusion interpreting discount

Discount Policy Advantages 1. Lender of Last Resort role Disadvantages 1. Confusion interpreting discount rate changes – announcement effect 2. Fluctuations in discount loans cause unintended fluctuations in money supply – makes it harder to control the Money supply 3. Not fully controlled by Fed – OMOs can be easily reversed…discount loans cannot

Extreme proposals for ending discount loans 1. Abolish discounting (Milton Friedman) A. Eliminates fluctuations

Extreme proposals for ending discount loans 1. Abolish discounting (Milton Friedman) A. Eliminates fluctuations in money supply B. However, lose lender of last resort role 2. Tie discount rate to market rate (e. g. Fed funds rate) A. Less fluctuations of discount loans and money supply B. Easier administration C. No false announcement signals D. But loss of ability to clearly signal intentions

Reserve Requirements • Depository Institutions Deregulation and Monetary Control Act of 1980 sets the

Reserve Requirements • Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions • 3% of the first $48. 3 million of checkable deposits; 10% of checkable deposits over $48. 3 million • The Fed can vary the 10% requirement between 8% to 14%

Reserve Requirements Advantages 1. Powerful effect Disadvantages 1. Small changes have very large effect

Reserve Requirements Advantages 1. Powerful effect Disadvantages 1. Small changes have very large effect on money supply 2. Raising causes liquidity problems for banks 3. Frequent changes cause uncertainty for banks 4. Effectively a tax on banks

Reforms of reserve requirements 1. Abolish reserve requirements – or have zero reserve requirements

Reforms of reserve requirements 1. Abolish reserve requirements – or have zero reserve requirements (as in Canada and the UK) 2. 100% reserve requirements (Milton Friedman) A. Advantage: complete control of money supply B. Disadvantage: Fed controls official money supply but not economically relevant money supply (deposits made by the general public) 3. Corridor system Sets up a standing lending facility (lombard facility) and stands ready to loan overnight any amount banks ask for at a fixed interest rate (lombard rate) Supply of reserves is infinitely elastic at this interest rate