1. Chapter Sixteen Monetary Control

2. Copyright © Houghton Mifflin Company. All rights reserved.16 | 2 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 M1 or M2 Monetary Control

3. Copyright © Houghton Mifflin Company. All rights reserved.16 | 3 The Money Supply Money supply = Money multiplier × Monetary base Money supply: M1 or M2 or M3 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

4. Copyright © Houghton Mifflin Company. All rights reserved.16 | 4 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 Money Creation and Destruction

5. Copyright © Houghton Mifflin Company. All rights reserved.16 | 5 Federal Reserve Balance Sheet, 12/31/2004 ($ billions) AssetsLiabilities + Capital Securities750.86Monetary Base 781.55 Discount Loans 0.04Other Liabilities 9.86 Other64.05Capital23.54 Total814.95Total814.95

6. Copyright © Houghton Mifflin Company. All rights reserved.16 | 6 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 Open-Market Operations

7. Copyright © Houghton Mifflin Company. All rights reserved.16 | 7 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... How Banks Create Money

8. Copyright © Houghton Mifflin Company. All rights reserved.16 | 8 Effect of $4 Million Open-Market Purchase BankNew Deposits Additional Reserves Loans Made First4.000.4003.60 Second3.600.3603.24 Third3.240.3242.92 Fourth2.920.2922.63... Total40.004.00036.00

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

10. Copyright © Houghton Mifflin Company. All rights reserved.16 | 10 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 Money Multiplier (cont’d)

11. Copyright © Houghton Mifflin Company. All rights reserved.16 | 11 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 Realistic Money Multipliers

12. Copyright © Houghton Mifflin Company. All rights reserved.16 | 12 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. M1 = D + C Realistic Money Multipliers (cont’d)

13. Copyright © Houghton Mifflin Company. All rights reserved.16 | 13 Different measures of the money supply will have different multipliers M2 = D + C + N + MMF (MMF signifies money market mutual funds.) The M2 multiplier is the ratio of M2 to the monetary base: Mm2 = M2 / MB Realistic Money Multipliers (cont’d)

14. Copyright © Houghton Mifflin Company. All rights reserved.16 | 14 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 Bank Reserves

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

16. Copyright © Houghton Mifflin Company. All rights reserved.16 | 16 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) How People & Banks Affect the Money Supply

17. Copyright © Houghton Mifflin Company. All rights reserved.16 | 17 Please insert Table 16.3 How People & Banks Affect the Money Supply (cont’d)

18. Copyright © Houghton Mifflin Company. All rights reserved.16 | 18 The rate of decline in the M1 multiplier increased in the 1990s with the advent of sweep accounts How People & Banks Affect the Money Supply (cont’d) Figure 16.1 Money Multipliers

19. Copyright © Houghton Mifflin Company. All rights reserved.16 | 19 Both components of the M1 multiplier rose rapidly beginning in 1995 How People & Banks Affect the Money Supply (cont’d) Figure 16.2a Components of the Numerator of the M1 Money Multiplier

20. Copyright © Houghton Mifflin Company. All rights reserved.16 | 20 The components of the M2 numerator also rose sharply after 1995 How People & Banks Affect the Money Supply (cont’d) Figure 16.2b Components of the Numerator of the M2 Money Multiplier

21. Copyright © Houghton Mifflin Company. All rights reserved.16 | 21 The components of the denominator of the multipliers Figure 16.3a Components of the Denominator of the Money Multipliers (Other Than C/D) How People & Banks Affect the Money Supply (cont’d)

22. Copyright © Houghton Mifflin Company. All rights reserved.16 | 22 Movements in the denominator are dominated by movements in the ratio of currency to transactions deposits over time Figure 16.3b Components of the Denominator of the Money Multipliers How People & Banks Affect the Money Supply (cont’d)

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

24. Copyright © Houghton Mifflin Company. All rights reserved.16 | 24 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 M1 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

25. Copyright © Houghton Mifflin Company. All rights reserved.16 | 25 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) Discount Lending

26. Copyright © Houghton Mifflin Company. All rights reserved.16 | 26 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 Discount Lending (cont’d)

27. Copyright © Houghton Mifflin Company. All rights reserved.16 | 27 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 two- week maintenance period Discount Lending (cont’d)

28. Copyright © Houghton Mifflin Company. All rights reserved.16 | 28 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) Discount Lending (cont’d)

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

30. Copyright © Houghton Mifflin Company. All rights reserved.16 | 30 Please insert Table 16.4 The Tools of Monetary Policy

31. Copyright © Houghton Mifflin Company. All rights reserved.16 | 31 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) The Market for Bank Reserves

32. Copyright © Houghton Mifflin Company. All rights reserved.16 | 32 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 The Market for Bank Reserves (cont’d)

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

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

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

36. Copyright © Houghton Mifflin Company. All rights reserved.16 | 36 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 The Market for Bank Reserves (cont’d)

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

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

39. Copyright © Houghton Mifflin Company. All rights reserved.16 | 39 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 Should the Fed Pay Interest on Reserves?

40. Copyright © Houghton Mifflin Company. All rights reserved.16 | 40 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 Should the Fed Pay Interest on Reserves? (cont’d)