Presentation on theme: "TOPIC 5 Fed Policy and Money Markets 1. 2 Outline What is Money? What affects the supply of money? –How does the banking system work? –What is the Fed?"— Presentation transcript:
TOPIC 5 Fed Policy and Money Markets 1
2 Outline What is Money? What affects the supply of money? –How does the banking system work? –What is the Fed? How does it work? –What is monetary policy? What affects the demand for money? –Asset Portfolio Decision –Quantitative Theory of Money Equilibrium in the Money Market The LM curve
Overview of Money and The Banking System 3
4 Money “Money” is the economic term for assets that are widely used and accepted as payment. Historically, the forms of money have been very different: from shells to gold to cigarettes (Eastern Europe and German Prisoners Of War camps) Most prices are measured in units of money → understanding the role of money is important to understanding inflation. Many economists believe that money also has an impact on real variables (mostly in the short run) Reading list: #61, 62, 78,
5 Three Functions of Money 1.Medium of exchange: Money permits trade of goods and services at lower cost (in terms of time and effort) Barter is inefficient because it is difficult and time-consuming to find a trading partner. Other benefit: allows specialization (and increases productivity) 1.Unit of account: Money is the basic unit for measuring economic value Given that goods and services are mostly exchanged for money, it is natural to express economic value in terms of money Caveat: In countries with volatile inflation, money is a poor unit of account because prices must be changed frequently. More stable units of account like dollars or gold are used even if transactions use local currency. 2.Store of Value: money is a way of storing wealth. Other types of assets may pay higher returns, BUT money is also a medium of exchange. Reading: #58
6 Measures of Money The distinction between monetary and non-monetary assets is controversial. Example: MMMFs (money market mutual funds) are organizations that sell shares to the public and invest in short-term government and corporate debt. MMMFs pay low returns and allow for checking (with fees)…Are they Money? There are two main official measures of money stock, called monetary aggregates: 1.M1: the most narrow definition, includes mainly currencies and balances held in checking accounts. 2.M2: includes everything in M1 plus other “money like” components: saving deposits, small time deposits, MMMFs, MMDAs (money market deposit accounts), etc..
7 Money Supply Money supply is the amount of money available in an economy In modern economies, money supply is affected by: 1.Central Banks (the Federal Reserve System in the United States). The central bank is a government institution responsible for monetary policies within an economy. 2.Depositary Institutions. Deposit Institutions are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public. 3.The public. The public includes every person or firm (except banks) that hold money in currency or deposits (think of money in your pocket or money in your firm’s “petty cash” drawer)
8 The Banking System: An Introduction Bank Assets and Liabilities: Assets:Loans (TL) + Reserves (TR) Liabilities:Deposits (TD) (and potentially other stuff). Reserves = liquid assets held by the bank to meet the demand for withdrawals by depositors or to pay checks How do banks make money? They Lend. How much do they lend? Must keep a minimum amount of reserves (required by law). Definition:m = required reserve ratio
9 The Banking System: An Introduction Fractional reserve banking: Banks hold only a fraction of their deposits in reserve. Reserve-deposit ratio:= required reserves/deposits = m Fractional reserve banking: → m < 1 (100% reserve banking → m = 1) Assume banks lend all they can: -TR = m*TD -Implies banks only hold required reserves Implications: - TD = TL + TR (money held within the banking system) -ΔTD = ΔTL + ΔTR (equation holds in changes) Must Read: Supplemental Notes 8
10 The Banking System: An Example Suppose I put $500 in the bank (remove it from under my mattress). We call the $500 that starts the process the ‘Initial Deposit’ (ID) Two Strong Assumptions: 1) Suppose that no one else in the economy holds cash. 2) Suppose banks only hold required reserves. Minor Assumption:Suppose that m = 0.1. What happens in the banking system: Step 1: Deposits increase by $500 (initial deposit). Step 2: Then, Deposits increase by another $450. Step 3: Then, Deposits increase by another $405. Step 4: ………….(keep increasing) Step infinity: ………….(keep increasing) Why do deposits keep increasing? LOANS!!!!
11 The Banking System: An Example Step 1:AssetsLiabilities TR $ 500TD $500 TR r =.1*500 = 50→ΔTL = TR – TR r = 450 Step 2:AssetsLiabilities TR $ 500TD $950 TL $ 450 TR r =.1*950 = 95→ ΔTL = TR – TR r = 405 Step 3:AssetsLiabilities TR $ 500TD $ 1355 TL $ 855 TR r =.1* 1355 = 135.5→ ΔTL = TR – TR r = The process continues ….. Loans and deposits expand up to a point TR r (required reserves) = TR (actual reserves). That is, TD = TR / m = 5000 !
12 The Money Multiplier: Formula Intuition Total Change in Deposits:= ID + ID (1-m) + ID(1-m) 2 + … = ID (1 + (1-m) + (1-m) 2 + … ) = ID (1/m) Simple Money Multiplier μ m = 1/m TD = (1/m) ID I want to stress that above equation only holds if: –There are no holding of currency out of the banking system –Banks may only hold required reserves
13 A More Realistic Model: Money Supply and Monetary Base More Definitions: MS = Money Supply TC = Total Currency in Circulation (held outside banking system) BASE = Monetary base Some Formulas: MS = TC + TD(Money = money held in banks + money held outside banks) ΔMS = ΔTC + ΔTD(Equation holds in changes) ΔMS = ΔTC + ΔTR + ΔTL(Substitute in change ΔTD = ΔTR + ΔTL) BASE = TC + TR (All the physical currency in the economy) Base = actual currency in the economy (held in the banks as reserves or held by the public outside the banking system)
14 Money Supply and Monetary Base Combining the two definitions (for MS and Base) we get: MS/BASE = (TC + TD) / (TC + TR) Define:TC/TD = cu = currency/deposit ratio. Depends on the amount of money the public wants to hold as currency vs deposits. The public can increases or reduces cu, by withdrawing or depositing currency Recall TR/TD = reserves/deposits ratio determined by the banks + regulation (Define m* = actual reserve ratio held by banks such that: m* ≥ m ) With some algebra, we can re-write the Money supply as: MS = [(cu + 1)/(cu + m*) ]* BASE
15 More Generally…. Remember: MS = [(cu + 1)/(cu + m*) ]* BASE If cu > 0 and m* > m, the money multiplier can be expressed as: μ* m = (cu + 1)/(cu + m*) - μ* m > 1 as long as m < 1! - The Money multiplier decreases with cu! Role of the public - The Money multiplier decreases with m*! Role of the banks Holding the base constant, the money supply (MS) will fall if people prefer holding cash outside of banking system (cu increases) or if banks start holding excess reserves (m* increases above m).
Overview of The Federal Reserve 16
17 What is the Fed? Overview Quasi-public agency that oversees the U.S. banking system. For the most part, independent of Executive and Legislative branches. 7 of the governing members (Governors) at the Fed are Presidential Appointments with Senate Confirmation (like Supreme Court Justices). Has its own budget 12 member governing board – the 7 above members plus 5 rotating members from the Federal reserve branch banks (privately owned). Additional resource: “Federal Reserve System Purposes and Functions”:
18 What Part of the Money Supply Is Controlled by Fed? Remember (from previous slide): MS = [(cu + 1)/(cu + m*) ]* BASE Fed controls: Base m (by law - the required reserve ratio) m* (by influencing the discount rate and other policies) Fed does not perfectly control the money supply any time: cu > 0 (some people hold currency outside of banking system) m* > m (banks hold excess reserves) If cu = 0 and m = m*, MS = Base/m = Base μ m = TR μ m
19 How Does the Fed Control Money Supply? How can the Fed affect money supply (and thereby interest rates)? By creating reserves. a) Open Market Operations (change the monetary base directly) b) Reserve Ratio (not used very much – change the money multiplier) c) Discount Window (discount rate – change the money multiplier) d) Paying Interest on Excess Reserves (change the money multiplier!) e) New Instruments (TARP, etc. – increase the money multiplier/base) Note:The discount rate/new instruments could increase the money supply by inducing banks to hold fewer “excess reserves” (by bringing m* close to m).
20 Notes on Central Banks The Central Bank is The Banks’ Bank. The Central Bank operates as a clearinghouse for bank checks. Each member bank has an account with the Central Bank. In the U.S. the deposits that banks have with the Fed are called federal funds. A closely related term, which is not specific to the U.S., is banks’ reserves (which consist of federal funds plus “vault cash”, or currency in the bank’ s cash machines, teller drawers, and vault). A check written against private bank A and deposited with private bank B reduces bank A’s federal funds and increases bank B’s federal funds. Thus banks want federal funds so they can honor check withdrawals. They want vault cash to honor cash withdrawals. Upshot: banks need reserves to honor withdrawals. Neither the Fed nor other major Central Banks target growth rates of the money supply (which consists of currency plus various measures of liquid assets like deposits). Fed targets the Federal Funds rate.
21 What is the federal funds rate? Federal funds are the deposits of private banks with the Fed. The federal funds market consists of private banks borrowing and lending their federal funds amongst each other overnight. The federal funds rate is the interest rate on these overnight loans. It is set by supply and demand, not by the Fed. The Fed can change the supply of federal funds through open market operations, exerting a powerful indirect effect on the fed funds rate. The Fed targets the federal funds rate and carries out open market operations to keep the actual rate near the target rate.
22 What are Open Market Operations? Open market operations = Central Bank purchases and sale of government securities on the open market. Open market purchase (sale) = Central Bank purchases (sells) government securities. The seller (buyer) receives (uses) federal funds as payment. federal funds Government Bonds Central Bank Private Banks = reserves
23 A Fed purchase of government securities … Raises the supply of federal funds. More federal funds means they are cheaper to borrow, so a lower federal funds rate. (An increase in the supply of federal funds lowers their “price”); Drives up the price of those securities, which lowers their yield. A lower yield means a lower interest rate on government securities; Leaves banks flush with reserves. Banks find it profitable to convert some of their new zero-interest-earning reserves into loans (which in turn creates more deposits, raising the money supply). To get people/firms to borrow more (take the new loans they are offering), banks lower the interest rate on the loans. Bottom Line: A Fed purchase of government securities lowers i.
24 Notes on FOMC directives The Federal Reserve Open Market Committee (FOMC) meets every 6 weeks (or so) and issues a directive to the trading desk of the Federal Reserve Bank of New York. Fed Time: the Desk carries out open market operations between 11:30 and 11:45 ET each trading day to keep the actual fed funds rate near the target. The FOMC directive is also asymmetric or symmetric: Symmetric: No bias. Neutral stance. Just as likely to raise as to lower the target next. Asymmetric: A bias toward easing (more likely to lower than raise the target next) or a bias toward tightening (more likely to raise than lower the target next). The minutes of the regularly scheduled Fed open market meetings are not public until 3 weeks after each meeting. Look at the federal funds rate futures in the WSJ to see what the market thinks.
25 Federal Reserve’s Lending The discount rate is the interest rate on direct loans from the Fed to private banks. The Fed sets the discount rate. Discount window loans used to play a minor role in Fed policy (primary and secondary credit discount loan since 2003) With the recent crisis, more banks have used discount windows loans together with new borrowing channels. New Monetary Policy instruments: Term Auction Facility (TAF), Term Asset- Backed Securities Loan Facility (TALF), Commercial Paper Funding Facilities (CPFF), …
26 Dramatic Increase in Monetary Base Post Lehman
27 More Muted Response in Money Supply (M1)
28 Why Did Dramatic Increase in Base Not Have Big Effect on Money Supply? Excess Reserves in Banking System
29 Why Did Dramatic Increase in Base Not Have Big Effect on Money Supply? Falling Money Multiplier (M1)
30 Why Are Banks Holding Excess Reserves? Higher interest paid on excess reserves
31 Improving Health in Banking System: Bank Borrowing From Federal Reserve
32 The Fed’s Balance Sheet The Fed receives interest on its assets (U.S. government securities + loans to banks). The Fed pays interest on fed funds. The Fed is highly profitable, which fosters its independence. The Fed returns its profits to the Treasury. Hence the interest that the Treasury pays on securities held by the Fed is not a cost for the Government: that portion of public debt is effectively monetized (pays 0 interest)
The Quantity Theory: Money and Inflation 33
34 The Quantity Theory of Money: Quantity Equation M*V = P*Y M = money supply, P = the GDP deflator, Y = real GDP V = velocity = PY/M. We define V in this way. If V is constant and Y is beyond the Central Bank’s LR control then... When the Central Bank doubles M, the result is a doubling of P “Inflation is always and everywhere a monetary phenomenon” This Friedman quote is not literally correct because of Y and V movements. But a LR correlation of.95 means it’s close enough. Additional Reference: Memorializing Milton Friedman: A Review of his Major Works, (Ramrattan and Szenberg, American Economist, Spring 2008, Vol. 52 Issue 1, p )
35 The Evolution of Velocity (M1)
36 The Evolution of Velocity (M2)
37 Notes on the Quantity Equation V is defined so that the Quantity Equation holds. Identity: P = MV / Y. Inflation (rising P) is caused by too much money chasing too few goods, i.e. by M rising relative to Y (controlling for how much M we need to transact PY, which is V). Note inflation could rise despite fixed M because of falling Y or rising V. Across countries, however, most differences in inflation (P growth) are associated with differences in M growth: correlation between M growth and inflation is above.95. V is not fixed in reality. V rises with financial innovation and with i (the nominal interest rate). Recall that i = r +π. If, like Y, r is beyond the Central Bank’s LR control, then higher inflation translates one-for-one into higher i. Implication: V rises with the rate of inflation. Thus taking into account that V is not fixed only makes the channel from M growth to P growth stronger: when M growth is high it generates inflation, which raises V, which in turn raises inflation further. This is a big deal in hyperinflations.
38 Money Growth and Inflation: 1990
Money Growth and Inflation: Singapore U.S. Switzerland Argentina Indonesia Turkey Belarus Ecuador Correlation between inflation and money growth ~ 0.90 over long periods of time. Data from Greg Mankiw’s Text Book
U.S. inflation and money growth, slide 40 0% 3% 6% 9% 12% 15% M2 growth rate inflation rate
41 Nominal Interest Rates and π (Fisher Equation: i = r + π)
42 Monetizing Government Debt When public debt is growing faster than GDP, there is political pressure on the Central Bank to monetize some of the government debt because: –public debt pays interest, reserves do not; –fixed nominal debt is easier to pay off the higher is P. Large budget deficits are the underlying cause of hyperinflations. The debt and deficit limits in Europe’s EMU are meant to prevent member countries from pushing for higher inflation. Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt. The Central Bank buys public debt with reserves (increases monetary base!).
43 CB Independence & Inflation
44 CB Independence & Inflation (Same Picture–Different Authors) Data: Alesina and Summers 1993 (Data from )
45 Hyperinflations are... sometimes defined as 30% or more inflation in a year usually characterized by accelerating inflation (wage indexation) caused by rapid M growth (the Central Bank creating new reserves at a rapid rate) exacerbated by rising velocity (efforts to economize on M) highly disruptive to Y 1985 Bolivia 10,000%, 1989 Argentina 3100%, 1990 Peru 7500%, 1993 Brazil 2100%, 1993 Ukraine 5000%.
46 Why Do Governments Grow the Money Supply? Short Term Political Gains - reduce unemployment (or raise output). If the economy is capacity constrained - prices must rise (however, this usually occurs with a lag!) Accommodating Supply Shocks - The U.S. in the 70s! (as opposed to breaking the inflation cycle). Financing Government Deficits by Printing Money!!! We will deal with these reasons more as the course progresses.
47 Resources The Fed and District Banks (see the Board of Governors website for FOMC minutes and speeches and testimony of FOMC members): Foreign Central Banks: Fed Points (each explains something, e.g. how currency gets into circulation): Details on open market operations: Overview of the Fed:
The Money Market: Money Demand, Money Supply, and the LM Curve 48
49 Money Supply (Summary) Remember:MS = [(cu + 1)/(cu + m*) ]* BASE Define Nominal Money Supply (M s ): Fed conducts monetary policy to increase Money Supply: - Open Market Purchases (increase Base) - Decrease the reserve ratio (decrease m) - Decrease the Discount Rate (decrease m*) Also influenced by the public: - Bank runs (increase in cu) - Bank precautionary motives (increase in m* above m)
50 Money Demand Agents decide how much wealth to keep as money: Portfolio allocation decision 3 main characteristics of assets matter: 1.Expected Return: The higher the expected return the higher consumption the agent can enjoy! 2.Risk:Agents are risk-averse, hence to hold a risky asset, it must have a higher expected return 3.Liquidity: The easier is to exchange the asset for goods, services or other assets, the more attractive is the asset. Money is highly liquid! Money is the most liquid BUT has a low return!
51 Money Demand (continued) Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions. As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions. This is the liquidity demand for money. As the nominal interest rate on non-money assets (bonds), i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases. Since i = r + π e, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).
52 Money Demand (continued) Other factors affecting Money Demand: –Wealth –Risk –Liquidity of Alternative Assets –Payment Technologies
53 Money Demand Function Our model for the demand for nominal money balances takes the following form M d = P·L d (Y, i) where M d = demand for nominal money balances (demand for M1) L d = demand for liquidity function P = aggregate price level (CPI or GDP deflator) Y = real income (real GDP) i = nominal interest rate on non-money assets
54 Real Money Balances The demand for real balances Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances function: M d /P = L d (Y, r + π e ) The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money). The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio demand for money (captured by r and π e ).
55 Money Demand
56 Money Market The Money Market is in Equilibrium when: Real Money Demand = Real Money Supply where Real Money Supply = M s /P Real Money Demand = M d /P = L d (Y, r + π e ) Note: The money supply curve does not change with interest rates (it is vertical) What shifts real money supply: M, P What shifts real money demand: Y, π e
57 Money Market Equilibrium M d = L d (Y,π e ) MsMs M/P Money Market rere
58 Money Market Equilibrium – Increasing Y M d = L d (Y 0,..) MsMs M/P Suppose Y increases from Y 0 to Y 1 (Holding Money Supply fixed!) Money Market r0r0
59 Money Market Equilibrium – Increasing Y M d = L d (Y 0,..) MsMs M/P Suppose Y increases from Y 0 to Y 1 (Holding Money Supply fixed!) Money Market r0r0 Y increases r1r1 M d = L d (Y 1,…)
60 Positive Relationship Between Y and r (in Money Market) Y Y 1 Y r0r0 r1r1
61 Positive Relationship Between Y and r (in Money Market) Y Y 1 Y We will refer to this as the LM curve r0r0 r1r1
62 The LM (Liquidity-Money) Curve LM Curve: (drawn in (Y-r) space) - represents the relationship of Y and r through the money market (specifically - Y’s affect on money demand). See: Supplemental Notes 9; to add some mathematical structure, see: Supplemental Notes 10 The LM Curve relates real interest rates to real changes in output in the money market. As Y increases - M d shifts upwards - causing real interest rates to rise (increase in transactions demand increases the demand for money). What shifts the LM curve? Money:Increasing Money Supply increases M/P causing the LM curve to the right. Prices:Increasing Prices causes real Money Balances to fall shifting LM curve to the left. π e : Increasing expected inflation causes returns on bonds (assets other than money) to increase making it less attractive to hold cash. Causes LM curve to shift right!
63 Shifting the LM curve: An Increase in M Thought experiment: Suppose M increases. What level of Y is needed to hold r constant? Or, put another way, what would happen to r if Y was held constant? Money Market LM curve r0r0 r0r0 x x M d (Y 0 ) Y0Y0 M s M s 1 z r1r1 r1r1 z LM(M 0 ) LM(M 1 ) An increase in the nominal money supply will cause the LM curve to shift to the right (or shift down, if you prefer that metric).
64 Interest Rates and Output There are two effects driving the relationship between interest rates and output: 1)The IS curve. As interest rates fall, Investment increases and Y increases. r falling causes Y to increase (negative relationship - the IS curve) 2)The transaction motive for holding money. As Y increases, demand for money increases and r increases. Y increasing causes r to increase (positive relationship - the LM curve) In equilibrium, both relationships need to be satisfied. We will work through this intuition in the next topic. However, before we do, we will see why we need to summarize the money market as the LM curve (as opposed to just Money Supply and Money Demand). Remember: Everywhere along the LM curve represents equilibrium in the money market.
65 An Illustration of “Monetary Feedback” in Money Market Suppose M increases M d = L d (Y,π e ) M s M s 1 M/P M 1 /P Money Market rere re1re1 0 1
66 An Illustration of “Monetary Feedback” in Money Market A fall in r, will increase I, causing Y to increase - which causes M d (and r) to increase…. M d = L d (Y,π e ) M s M s 1 M/P M 1 /P Money Market rere re1re re2re2 M increases Y increases M d 1 = L d (Y 1,π e ) This process is known as monetary feedback - increasing M will cause r to fall, I to increases, Y to increase, money demand to increase and r to increase. The net effect on r will be to fall. The IS-LM representation will express this process in a more concise form?