The Money Supply, Banking System, and Monetary Policy Chapters 17 & 18 Macroeconomics: Theories and Policies ECON 219 S. Cunningham

What is Money? Money is anything that is generally acceptable to sellers in exchange for goods and services. A liquid asset is an asset that can easily (i.e., quickly, cheaply, conveniently) be exchanged for goods and services. 5

What is Money? Functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value 6

M1 Money Supply Money in the United States Today consists of: Currency is the bills and coins that we use. Deposits are also money because they can be converted into currency and are used to settle debts. 12

What is Money?—M1 M1 is the narrowest and most liquid measure of the money supply. It includes financial assets that are immediately available for spending on goods and services. M1 includes: Currency Travelers’ Checks Demand Deposits (checking accounts) Other Checkable Deposits (interest-bearing checking) Demand Deposits and Checkable Deposits are called transactions accounts—these are checking accounts that can be drawn upon to make payments.

U.S. Money Supply: M1 16

About Currency In 2003, currency was 52% of M1. U.S. currency today is not backed by gold or silver. It is backed only by the confidence and trust of the public. It is a fiduciary monetary system. (“Fiducia” means “trust” in Latin.) Money backed by gold or silver (or something else of value) is called commodity money.

What is Money?—M2 M2 adds to M1 less liquid assets that can be converted to M1 assets quickly and at low cost. Includes everything in M1 Adds: Savings deposits Small denomination time deposits (CDs) Retail money market mutual funds

U.S. Money Supply: M2

U.S. Money Supply: M3

The Federal Reserve System The Federal Reserve System (“the Fed”) serves as the central bank for the United States. A central bank typically has the following functions: It is the bankers’ bank: it accepts deposits from and makes loans to commercial banks. It acts as banker for the federal government. It controls the money supply. Performs certain regulatory functions for the financial industry.

Structure of the Federal Reserve System The primary elements in the Federal Reserve System are: The Board of Governors The Regional Federal Reserve District Banks (FRBs) The Federal Open Market Committee 9

The Federal Reserve Banks 12 District banks Nine directors The directors appoint the district president who is approved by the Board of Governors 12

The Federal Reserve System Instructor Notes: 1) The nation is divided into 12 Federal Reserve districts, each having a Federal Reserve bank. (Some of the larger districts also have branch banks.) 2) The Board of Governors of the Federal Reserve System is located in Washington, D.C. 14

The Board of Governors Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes vacant every two years President appoints a member as Chairman to serve a four-year term 10

Federal Open Market Committee (FOMC) Meets approximately every six weeks to review the economy Made up of the following voting members: 7 members of the Board of Governors 5 of the FRB presidents (they rotate yearly) = 12 FOMC members 15

Functions of the Fed (1) Banking Services and Supervision It supplies currency to banks through its 12 district banks. It holds the reserves of banks in the district bank of each bank. It processes and routes checks to banks through its district banks and processing centers. It makes loans to banks—it is the “lender of last resort”, the “banker’s bank”. It supervises and regulate banks, ensuring that they operate in a sound and prudent manner. It is the banker for the U.S. government. It sells government securities for the U.S. Treasury.

Functions of the Fed (2) Controlling the Money Supply The money supply is varied through the course of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile. Example: 4th quarter holiday season creates an increased demand for money to buy gifts. The Fed also changes the money supply to achieve policy goals set by the FOMC.

Money Supply Growth Rates Source: Monetary Trends Federal Reserve Bank of St. Louis

Policy Goals of the Fed Ultimate Goal: Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation. Intermediate Targets: The Fed does not control output or the prices directly. It does control the money supply. The Fed establishes target growth rates for the money supply, which it believes are consistent with its ultimate goals. The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.

Fed Policy Linkages

The Federal Reserve System The Fed’s Policy Tools The three main policy tools are: 1) Open market operations 2) Discount rate 3) Reserve Requirements 23

Open Market Operations Open Market Operations (OMOs): the buying and selling of government bonds by the Fed to control bank reserves, the fed funds rate, and the money supply. For example, if the FOMC wants to increase the money supply, it gives a directive to the trading desk at the FRB-NY to buy bonds. When the FRB-NY buys bonds, it writes checks on itself, injecting new reserves into the banks of the bond sellers. The increase in reserves result in an increase in the money supply and a reduction in the fed funds rate.

Operating Procedures FOMC Directive: The FOMC issues instructions to the Federal Reserve Bank of NY to implement monetary Policy for a six-week period. The FOMC directs the bond traders at the FRB-NY to buy or sell government bonds to keep the federal funds rate at a specific level. The federal funds rate (“fed funds rate”) is the interest rate that banks charge when they lend excess reserves to each other. The buying and selling of government bonds by the fed to achieve policy objectives are called “open market operations (OMO)”.

Discount Rate The discount rate (sometimes called the “bank rate”) is the rate of interest a Fed District Bank charges a bank in its district when such a bank borrows from the Fed. When the Fed raises the discount rate, it raises the cost of borrowing reserves, reducing the amount of reserves borrowed. Lower levels of reserves result in reduced lending, and reduced money supply.

Reserve Requirement Legal reserves: the cash a bank holds in its vault plus its deposits at the Fed. Reserves held by banks in excess of their reserve requirements are called excess reserves. If the Fed lowers reserve requirements, banks will hold excess reserves which they can then lend. Such lending triggers the expansion multiplier, increasing the money supply. Similarly, the Fed may decrease the money supply by raising reserve requirements.

How Banks Create Money Reserves: Actual and Required The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. The required reserves ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements. Excess reserves are the cash reserves beyond those required, which can be loaned. 48

How Banks Create Money 1 (Simple) Money Multiplier = Reserve Requirement (ratio) 53

The Multiple Creation of Bank Deposits Instructor Notes: 1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. 2) The amount lent becomes a new deposit at another bank. 3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves. 4) The running tally tells us the amounts of deposits and loans created at each stage. 5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits. 59

Money Multiplier: Extended Model Ms = m x MB m = m(rr, C/D, ER/D) where rr = reserves ratio C/D = currency to deposits ratio ER/D = excess reserves to deposits ratio

How Money Supply Changes affect GDP

Policymaking Process Independence from Political Process Congress could change things and weaken this independence Humphrey-Hawkins Reports FOMC Meetings 8 times a year (every 6 weeks) Issue directives

Targeting Monetary Aggregates Ms r2 r1 Md2 Md1 M

Targeting Interest Rates Md2 Md1 r* Ms M1 M2 M

Targeting A Monetary Aggregate Ideal Case LM r2 r1 IS2 IS1 Y* Y

Targeting A Monetary Aggregate Less than Ideal Case (I) LM r IS2 IS1 Y1 Y2 Y

Targeting A Monetary Aggregate Less than Ideal Case (II) LM r IS0 Y1 Y2 Y3 Y

Targeting the Interest Rate LM IS3 IS2 IS1 Y1 Y2 Y3 Y

Evolution of Policy 1970-79: Targeting Fed Funds Rate 1979-82: Targeting Monetary Aggregates 1982-2004: Mixed Approach Inflation Targeting? Time Inconsistency Problem