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Introduction to Money Supply The Money Supply The relationship between the quantity of money supplied and nominal interest rate i. On any given day, the.

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Presentation on theme: "Introduction to Money Supply The Money Supply The relationship between the quantity of money supplied and nominal interest rate i. On any given day, the."— Presentation transcript:

1 Introduction to Money Supply The Money Supply The relationship between the quantity of money supplied and nominal interest rate i. On any given day, the quantity of money is fixed independent of interest rate i. The quantity of money supplied is determined by bank lending and the Fed. The market for money Money M0M0 MS i0i0

2 The market for money Equilibrium Money supplied is fixed in the short-run. i is determined by the intersection of MS and MD Interest Rate Adjustment When the interest rate is above its equilibrium level, the quantity of money supplied exceeds the quantity of money demanded (or needed). People hold too much money, so they try to get rid of it by buying other financial assets. The demand for financial assets increases, the prices of these assets rise, and the interest rate falls. Money M0M0 i0i0 MD i1i1 M1M1 MS Introduction to Money Supply

3 The market for money Equilibrium Money supplied is fixed in the short-run. i is determined by the intersection of MS and MD Interest Rate Adjustment When the interest rate is below its equilibrium level, the quantity of money demanded (or needed) exceeds the quantity of money supplied. People are holding too little money, so they try to get more money by selling other financial assets. The demand for financial assets decreases, the prices of these assets fall, and the interest rate rises. Money M0M0 i0i0 MD i1i1 M1M1 MS Introduction to Money Supply

4 Banks as financial intermediaries What role do banks play in the creation of the supply of money? Commercial banks bring savers and investors together Banks use checking and savings deposits to make loans balance sheet for a bank balance sheet has two sides: ­Liabilities – the source of the funds for the bank checking accounts savings accounts ­Assets (generate income for banks via interest payments) Mortgages car loans US Treasury Bonds required reserves excess reserves (big withdrawal insurance) ­Net worth = assets – liabilities Money Supply and Banks

5 Banks as financial intermediaries Example: Balance for a bank Assets Liabilities 300 reqd reserves3000 deposits 50 excess reserves 900 US T-bonds 2000 car loans250 net worth3250 Reserves: assets not lent out by banks Banks are Required to hold a fraction of Reserves (R R ) Reserves in Excess of R R are called excess reserves (R E ) If = 10%, the bank holds R R = 3000 X 0.1 = 300, R = R R + R E = $350 Money Supply and Banks

6 The process of money creation Example: banks role in determining the supple of money You walk into Bank 1 and deposit $1000 into your checking account ­MS does not change because currency held by the public and in checking accounts are both part of the MS ­If the = 10%, Bank 1 holds $100 of the $1000 deposit as R R & lends $900 to George. George uses the $900 to buy a TV from BuyMart ­BuyMart deposits the $900 into its account at Bank 2 ­MS does not change because currency held by the public and in checking accounts are both part of the MS ­Since the = 10%, Bank 2 holds $90 of the $900 deposit as R R & lends $810 to Jill Yada yada yada… The original deposit of $1000 is used to create money via lending: = 10,000 Increases in bank deposits creates money in the economy via increased bank lending even though the actual number of bills in the economy has not changed! Money Supply and Banks

7 The process of money destruction Example: banks role in determining the supple of money You withdrawal $1000 from your checking account at Bank 1 ­MS does not change because currency held by the public and in checking accounts are both part of the MS ­If the = 10%, Bank 1 holds $100 less in R R and lends out $900 less. Bank 1 cannot lend George the $900 he needs to buy a TV. ­George does not spend the $900 at BuyMart ­BuyMart deposits $900 less in its account at Bank 2. ­Since the = 10%, Bank 2 holds $90 less in R R and does lends out $810 less. Yada yada yada.. Hence, the original withdrawal $1,000 destroys money via less lending: Withdrawals collapse the money in an economy via less bank lending even though the actual number of bills in the economy has not changed! Money Supply and Banks

8 Demand for reserves Example: Suppose = 0.1, D = 50 (billion $), and demand for excess reserves is given by Derive reserves demand. 20 Federal Funds Market 28 Q DRDR i ff 5 Money Supply and the Fed D ER

9 Supply of reserves A bank that cant meet its reserve requirement (R R ) borrows from a bank that has excess reserves in the federal funds market and Q S remains unchanged. The vertical part of reserves supply curve is the amount of reserves the Fed supplies to the federal funds market. When banks borrow from the Fed, discount loans rise, borrowed reserves (R B ) increase, the quantity of reserves supplied increases. When banks sell US Treasury securities to the Fed, non-borrowed reserves (R N ) increase, which increases the quantity of reserves. Hence, the supply of reserves is the sum The horizontal part of the reserves supply curve is the discount rate (i d ) If the federal funds rate is less than the discount rate (i ff < i d ), banks will not borrow from the Fed because ­Insurance purchased from the Fed is more expensive than from other banks If the federal funds rate is more than the discount rate (i ff > i d ), banks will want to borrow from the Fed instead of other banks ­Insurance purchased from other banks is more expensive than from the Fed. Money Supply and the Fed

10 Supply of reserves Example: Suppose R B = 0 (billion $), R N = 28 (billion $) and i d = 3 (percent). Graph the supply of reserves in the figure below. Vertical part: R B + R N = = 28 Horizontal part: i d = 3 Federal Funds Market 28Q SRSR i ff 3 Money Supply and the Fed

11 Federal funds market equilibrium If demand for reserves intersects the vertical section of the supply of reserves, then The federal funds interest rate is less than the discount interest rate (i ff < i d ) A bank would rather borrow from other banks The quantity of reserves equals R N + R B If demand for reserves intersects the horizontal section of the supply of reserves, the federal funds interest rate equals the discount interest rate (i ff = i d ) A bank is indifferent between borrowing from other banks or the Fed However, the bank borrows from the Fed because something (a crisis) has dried up all of the excess reserves held by banks. The equilibrium quantity of reserves exceeds R N + R B The difference between equilibrium quantity of reserves and R N + R B is the quantity of discount loans made by the Fed Money Supply and the Fed

12 Federal funds market equilibrium Example: Suppose = 0.1, D = 50, R B = 0, R N = 28, i d = 3, and excess reserves demand is Graph the reserves supply and demand. Vertical part: R N + R B = 28 Horizontal part: i d = 3 i ff (percent)(Billions $) Federal Funds Market 28Q DRDR i ff 5 2 SRSR 3 Equilibrium Money Supply and the Fed

13 Federal funds market equilibrium Example (continued ): Suppose the Fed increases the discount rate to 4 (percent). Show the effect of this policy change in the figure below. Federal Funds Market 28Q i ff 2 SRSR 3 DRDR SRSR 4 The horizontal section i d = 4 The vertical section no change Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target Money Supply and the Fed

14 Federal funds market equilibrium Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. Federal Funds Market 28Q i ff 2 SRSR 3 DRDR DRDR 4 29 The new equilibrium: i ff = 3 Money Supply and the Fed

15 Federal funds market equilibrium Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. Federal Funds Market 28Q i ff SRSR 3 DRDR 29 In the past, the Fed has tried slowing the economy by increasing. Doing this creates a big collapse in bank lending to businesses and consumers. In addition, the Fed has to make $1 billion in discount loans to banks because R E dried up. So even though total reserves have increased via discount lending ($1 billion in the diagram above), this cash is sitting idle. The effect is a reduction in money supply. Money Supply and the Fed

16 Federal funds market equilibrium Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. Money M0M0 i0i0 MS MD This increases r provided inflation remains unchanged. MS M1M1 i1i1 Money Supply and the Fed

17 Federal funds market equilibrium Example (continued ): Suppose instead the Fed increases the required reserve ratio to 14 (percent). Show the effect of this policy change in the figure below. Y0Y0 PL 1 YFYF AD Higher r decreases I, but also reduces net exports. These collapse AD. This results in lower prices and real GDP. In the past, small increases in have put a hot economy (one that is growing too fast) into a recessionary gap. The Fed has not changed the since 1992 AD Y1Y1 PL 0 AS AD-AS-Y FE Money Supply and the Fed

18 Open Market Operations The Fed conducts an Open Market Purchase (OMP) by buying Treasury bonds from banks Cash flows from the Fed to Banks The quantity of reserves in the federal funds market rises The federal funds interest rate declines This is an exPansionary monetary policy The Fed conducts an Open Market Sale (OMS) by selling Treasury bonds to banks The Fed has bonds to sell because it purchased them directly from ­Treasury in the primary market (this is called monetizing the debt) ­Banks in the secondary market in a previous OMP Banks give cash (reserves) to the Fed in exchange for Treasury bonds The quantity of reserves in the federal funds market declines The federal funds interest rate increases This is a reStrictive monetary policy Money Supply and the Fed

19 Federal funds market equilibrium Example (continued ): Suppose instead of changing i d or the Fed performs an OMP by buying a half of a billion dollars worth of bonds from banks (R N = = 28.5). Show the effect of this policy change in the figure below. Federal Funds Market 28Q i ff SRSR 2 DRDR SRSR The horizontal section no change The vertical section R N + R B = (28 +.5) + 0 = 28.5 New equilibrium Money Supply and the Fed

20 SRSR Federal funds market equilibrium Example (continued ): Suppose instead of changing i d or the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Federal Funds Market 28Q i ff SRSR 2 DRDR Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target. Money Supply and the Fed

21 SRSR SRSR 28 3 Federal funds market equilibrium Example (continued ): Suppose instead of changing i d or the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Federal Funds Market Q i ff 2.5 DRDR Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target. So the Fed lowers the discount rate to 2.5 SRSR Money Supply and the Fed

22 Federal funds market equilibrium Example (continued ): Suppose instead of changing i d or the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Increased R N means banks have more cash to lend to consumers and business. The money supply increases via increased lending If inflation remains unchanged, r will fall too, increasing I (and X). Money M0M0 i0i0 MS MD MS M1M1 i1i1 Money Supply and the Fed

23 Federal funds market equilibrium Example (continued ): Suppose instead of changing i d or the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Lower r increases I, but also increases net exports. These increase AD. This results in higher GDP, lower unemployment, and higher prices Y0Y0 PL 1 YFYF AD PL 0 AS AD-AS-Y FE Money Supply and the Fed

24 An OMS is the opposite of an OMP. If the Fed sells 0.5 (billion $) in US Treasury securities to banks, then 0.5 (billion $) in US Treasury securities leaves the Feds vault while 0.5 (billion $) in cash from member banks enters the Feds vault. This decreases R N by 0.5 (billion $) and total reserves from 28 to 27.5 (billion $), decreasing reserves supply. The equilibrium federal funds interest rises while MS falls. i rises, which raises r if inflation does not change. Hence, I and X decline, decreasing AD Lower AD results in less output and lower prices. Federal funds market equilibrium Example (continued ): Suppose instead the Fed performs an OMS by selling a half of a billion dollars worth of bonds to banks (R N = = 27.5). Explain how this policy change affects the economy. Money Supply and the Fed

25 To prevent this in October of 2008, the Fed began paying Interest on Reserves (IOR), which is currently about 0.25% idid Money Supply and the Financial Crisis Interest on Reservesthe new tool The Feds rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market Q i ff DRDR -i ff 0 SRSR IOR i ff Crisis mode

26 idid Interest on Reservesthe new tool The Feds rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market Q 0 DRDR This allows the Fed to buy SRSR IOR i ff Money Supply and the Financial Crisis

27 IOR idid Interest on Reservesthe new tool The Feds rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market Q 0 DRDR This allows the Fed to buy or sell as many securities as it wants without changing the federal funds rate. SRSR i ff Money Supply and the Financial Crisis

28 Interest on Reservesthe new tool The Feds rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market Q i ff 0 DRDR The federal reserve can also raise and lower the federal funds rate by simply raising IOR and i d simultaneously. idid SRSR IOR Money Supply and the Financial Crisis

29 Interest on Reservesthe new tool The Feds rescue of the financial system in included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market i ff 0 DRDR The Fed will need to conduct several controlled OMS while carefully raising IOR to reduce its $2-3 trillion balance while keeping a eye on inflation. Q i ff idid SRSR This should hopefully return the federal funds market to its pre- crisis state. Money Supply and the Financial Crisis

30 Money Supply growth is the percent change in the stock of money Inflation is the percent change in the Price Level (PL) from one year to the next. Hyperinflation is really high inflation How high is really high? Its a judgment call Usually we talk about ridiculously high examples. Compounding is important to remember. Examples of Hyperinflation YouTube inflation video 1 YouTube inflation video 2 Money Supply Growth and Inflation

31 March,1922 Feb., 1920 Nov.,1922 Feb., 1923 Hyperinflation in the Weimar Republic (Germany, post WWI) Money Supply Growth and Inflation

32 July, 1923 Sept., 1923 Oct., 1923 Hyperinflation in the Weimar Republic (Germany, post WWI) Why did this happen? In Nov. of 1918, there were 29,200,000,000 paper marks in circulation A year later, 497,000,000,000,000,000,000 paper marks in circulation That was a massive increase in the money supply, an increase of 1,702,054,794,421% Money Supply Growth and Inflation

33 Yugoslavia had inflation problems in the 1980s, but in 1993 things really got bad. $1 = 900 Dinar (1/1/93) $1 = 2,000,000 Dinar (11/12/93) $1 = 13,000,000 Dinar (11/23/93) $1 = 64,000,000 Dinar (11/31/93 ) $1 = 6,400,000,000 Dinar (12/15/93) PRICES WERE DOUBLING EVERY DAY $1 = 12,000,000,000,000,000,000,000 Dinar (1/24/94) Money Supply Growth and Inflation

34 Keynes vs. Hayek Keynes: advocate of proactive government intervention Budget deficits in recessions Surpluses in economic expansions Both can be used to manage AD, ensuring full employment Hayek: advocate of economic freedom Government intervention results in less economic freedom Economic efficiency "The problem was that under central planning, there was no economic calculation--no way to make a rational decision to put this resource here or buy that good there, because there was no price system to weigh the alternatives." Socialism told us that we had been looking for improvement in the wrong direction. The thesis in The Road to Serfdom is Government intervention leads to more intervention Each intervention has unintended consequences, which distort markets Unintended consequences of well-intentioned policy generates the need for more interventions because consequences need to be corrected. It is this dynamic that leads society down the road to serfdom. The tree and western wild fire analogies

35 Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps. Hayekians are not concerned with short-run fluctuations, advocating instead for pro- growth, free-market (not pro-business) polices. Keynes vs. Hayek

36 AD-AS-Y FE AD AS Y PL Hayek Keynes Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps. Hayekians are not concerned with short-run fluctuations, advocating instead for pro- growth, free-market (not pro-business) polices. Watch the Fear the boom and bust video on YouTubeFear the boom and bust Keynes vs. Hayek


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