Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 13 Money, Banks, and the Federal Reserve

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Money as a Tool of Stabilization Policy Recall: Monetary and fiscal policy are stabilization tools –Purpose is to stabilize the economy’s business cycles and reduce volatility of swings of actual GDP away from natural real GDP For three decades prior to 2007, monetary policy has been the major stabilization tool –Conquered double-digit inflation in the late 1970s Cost: Negative output gap from –Potentially responsible for “The Great Moderation” (mid-1980s – 2007) –Fiscal policy rarely used for stabilization purposes In the Global Economic Crisis (early 2009), monetary policy ran out of ammunition after the federal funds rate was pushed to zero –Traditional fiscal policy stimulus used instead

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Definitions of Money M1 is the U.S. definition of the money supply that includes only currency (CU), transactions accounts or deposits (D), and traveler’s checks –Algebraically: M1 = CU + D M2 is the U.S. definition of the money supply that includes M1; savings deposits, including money market deposit accounts; small time deposits; and money market mutual funds –Does not include financial assets like stock and bond mutual funds High-powered Money (H) is the sum of currency hold outside depository institutions and the reserves (RES) held inside them –Algebraically: H = CU + RES –H is also sometimes referred to as the Monetary Base.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Table 13-1 Components of the M1 and M2 Measures of the Money Supply, October 2010 ($ billions)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved M S Definitions and the Instability of M D Demand for M1 and M2 likely to be unstable –Shifts may occur when omitted assets or assets in the other type of money become relatively more attractive Monetarists endorse a constant growth rate rule (CGRR) for “the money supply” –Because of the instability of M S, it is very difficult for monetarists to choose which type of money’s growth to target –This school of thought called monetarism is now largely obsolete for this reason

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Process of Money Creation Suppose there is a $100 deposit of gold coins. –Assume the reserve ratio (e) is 10%, so the bank keeps 10% of all deposits as reserves. Therefore the bank can loan out the remaining $90 of gold coins. –Assuming the public holds no currency, the new $90 loan will be spent and then redeposited by the new holder of the $90 –The bank keeps $9 to meet the 10% reserve requirement, and then can make another loan of $81. –This process repeats and repeats… and ultimately the original deposit of $100 leads to the creation of $1000 units of money, all in the form of bank deposits!

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Money Multiplier Equations The money creation process can be represented algebraically to show how the amount of high-powered money (H) affects the total value of deposits (D) when there are no currency holdings (and e = reserve ratio): When the public holds a fraction of its deposits as currency (where c = CU/D), the money multiplier equation becomes: –Note: The coefficient of H is called the Money Multiplier

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Gold Discoveries and Bank Panics Recall the money supply equation: –M S only depends on c, e and H Before the Fed was established in 1913 and the creation of deposit insurance in 1934, the U.S. was subject to shocks to M S –Gold discoveries affected H  higher inflation Examples: California in 1848 and Alaska in 1898 –Banking panics occurred roughly one per decade  fear for safety of deposits  cash withdrawals  c ↑  M S ↓ –In preparation for possible withdrawals, banks would increase reserves  ↑  M S ↓ –Now, the Fed can increase H in response to c ↑ or e ↑ –Deposit insurance  no more bank panices

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Table 13-2 A Simplified Version of the Fed’s Balance Sheet (all values in $ billions)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Fed Tools for Changing M S Open Market Operations are purchases and sales of government securities made by the Federal Reserve in order to change H –An open market purchase (sale) of bonds would increase (decrease) the money supply –An open market purchase (sale) of bonds would increase (decrease) the price of Treasuries, which would decrease (increase) the interest rate The Discount Rate is the interest rate the Federal Reserve charges depository institutions when they borrow reserves. –An increase (decrease) in the discount rate would tend to decrease (increase) the money supply –The Fed reduced the discount rate from 5.25% to less than 0.25% between the summer of 2007 and January, 2009 Required Reserves are the reserves that Federal Reserve regulations require depository institutions to hold. –An increase (decrease) in the required reserve ratio would tend to decrease (increase) the money supply

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Difficulties in Controlling M S The Federal Reserve cannot control the money supply precisely for several reasons: –Multiple definitions of money. –The public chooses the amount of currency it holds. –Funds shifting between accounts subject to reserve requirements (like deposits) and those that are not (like money market mutual funds) will change the average reserve ratio. A Money-Multiplier Shock is any event that causes the money multiplier to change.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Theories on the Demand for Money In the early 1950’s, William J. Baumol and James Tobin demonstrated that the transactions demand for money depends on the interest rate James Tobin also showed that people demand money as a store of value as part of an effort to diversify their portfolios of financial assets Milton Friedman had a similar approach to Tobin’s portfolio theory suggesting that money demand depends on both income and wealth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 13-1 Alternative Allocations of an Individual’s Monthly Paycheck Between Cash and Savings Deposits

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Perspective Plastic Replaces Cash, and the Cell Phone Replaces Plastic

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 13-2 Effects on Real Output of Policies that Either Stabilize the Interest Rate or Stabilize the Real Money Supply When Either Commodity Demand or Money Demand Is Unstable

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Fed Target Policies The Federal Reserve has a choice of policy targets in its conduct of monetary policy: –Target the money supply –Target the interest rate –Target inflation The unpredictability of M D and the resulting volatility of interest rates has caused the Fed to target interest rates since the early 1980s.