Money in the Economy Mmmmmmm, money!

The Money Supply M1:Currency + travelers checks + checkable deposits M2:M1 + small time deposits + overnight repurchase agreements + overnight Eurodollars + money market mutual fund balances M3:M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money market fund balances

The Creators of Money The three major players whose decisions and actions determine the rate of growth in the money supply are: –The Federal Reserve (Fed) –The Commercial Banking System –The Non-Bank Public

Money Creation Banks create money in their normal, day-to- day profit seeking activities Banks do not try to create money Money creation occurs because we have a fractional reserve commercial banking system. –Banks must hold a fraction of their deposits idle as reserves. They may lend the remainder. As they make loans, new deposits are created, causing the money supply to expand.

Bank Reserves: Definitions Total Reserves = Required reserves plus excess reserves –Required reserves = Deposits X reserve requirement –Excess reserves = Total reserves - required reserves

Money Creation: Assumptions Assumptions: –Banks lend all their excess reserves –The non-bank public does not use cash –Only demand or checkable deposits exist –The required reserve ratio is 10%

Money Creation: Step 1 Assume the Federal Reserve injects $100 into the banking system by granting a loan. –Excess reserves increase by $100 in Bank #1 Banks do not face reserve requirements on injections of reserves by the Fed Bank #1, therefore, has $100 to lend

Money Creation: Step 2 Let Bank #1 make a $100 loan to a member of the non-bank public –It does this by crediting the borrower’s checking account with $100. Let the borrower spend the money. Let the recipient of the money bank at Bank #2 When Bank #1 honors the check, Bank #1’s deposits and reserves fall by $100.

Money Creation: Bank #1 AssetsLiabilities Bank # 1 Reserves100 Discount Loan 100 Loan100 Reserves (100) Demand Deposit 100 Demand Deposit (100) Loan100Discount Loan 100

Money Creation: Step 3 A second bank, Bank #2, has received a new deposit of $100. –Its total reserves increase by ? Its required reserves increase by ? Its excess reserves increase by ? –Bank #2 may now make a loan of ?

Money Creation: Step 4 Bank #2 makes a loan of $90 in the form of a new demand deposit. –When the money is spent and Bank #2 honors the check, deposits and reserves at Bank #2 fall by $90 But Bank #3 now has a new deposit of $90 and may make a loan equal to ?

Money Creation: Summary New Deposit Req Res Ex Res New Loan $100 $100 $10 $ 90 $ 90 $ 90 $ 9.00 $ 81 $ 81 $ 81 $ 8.10 $72.90 $ $ $ 7.29 $65.61 $ $ $ 6.51 $59.05 $ $1,000 $100 $900 $900

Some Simple Formulas Note that in our simple example, demand deposits are a multiple of required reserves –Let R = required reserves –Let r = % reserve requirement –Let D = demand deposits –R = r x D or –D = 1/r x R A change in deposits will be a multiple of the change in reserves –/\D = 1/r x /\R

The Multiplier The simple deposit expansion multiplier is 1/r or 1/reserve requirement –r is a leakage of the lending process If r gets bigger, expansion of deposits gets smaller because banks have fewer excess reserves to lend. If r gets smaller, expansion of deposits gets larger because banks have more excess reserves to lend. The real world multiplier is smaller than our 1/r because –Banks hold idle excess reserves –People hold and use cash

The Fed and the Money Supply Process

Control of the Money Supply The Fed controls the money supply with... –Open Market Operations Purchases and sales of government securities by the Fed on the open market –Discount Window Loans made by the Fed to banks The Fed influences the multiplier with –Changes in the reserve requirement

Open Market Operations Fed Bank Presidents Federal Open Market Comm. Fed Board of Governors Securities Dealers Federal Reserve Bank of New York Commercial Banks Change in Reserves Change in Money Supply

Open Market Operations When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves. –Banks can now make more loans. When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed –Banks can now make fewer loans.

Discount Loans When the Fed makes a discount loan to a bank, the bank is credited with an increase in reserves. –Banks can now make more loans. When a bank repays the Fed, the bank’s reserves are debited. –Banks can now make fewer loans.

Reserve Requirements If the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease. –Banks can made fewer loans. If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase. –Banks can make more loans.

Excess Reserves Banks determine the level of excess reserves –Increases in excess reserves diminish the expansion of deposits. –Decreases in excess reserves increase the expansion of deposits

Currency Changes Members of the non-bank public determine currency in circulation –Increases in currency drains from the banking system, diminish the expansion of deposits –Decreases in currency drains from the banking system, increase the expansion of deposits

Monetary Policy I see rates rising; no, falling; no rising; no --

Monetary Policy A tool of macroeconomic policy under the control of the Federal Reserve that seeks to attain stable prices and economic growth through changes in the rate of growth of the money supply.

Monetary Policy Channels Policy Tools Level & Growth Bank Reserves Size and Growth Rate of Money Supply Volume and Growth of Borrowing and Spending by the Public Full Employment Growth Price Stability

Monetary Transmission Mechanism A monetary transmission mechanism describes the chain of events that occur in an economy as a result of a change in the rate of growth in the money supply. Good monetary policy decisions depend on understanding the way money can cause changes in economic activity.

Monetary Policy Transmission Mechanism: Interest Rates Change in Change in Change in Money Supply Interest Rates GDP Change in Interest Sensitive Spending Change in Exchange Rates Change in Net Exports

Monetary Policy, Interest Rates and GDP Let the Fed raise interest rates – As interest rates increase, the cost of borrowing increases, causing investment (I), consumer durables (C), and GDP to fall. Let the Fed decrease interest rates –As interest rates decrease, the cost of borrowing decreases, causing investment (I), consumer durables (C), and GDP to rise.

Monetary Transmission Mechanism: Exchange Rates Change in Money Supply Change in GDP Change in Interest Rates Change in Exchange Rates

The exchange rate is the price of a currency expressed in terms of another currency. The exchange rate and the interest rate are positively related. –The higher domestic real rates of interest are compared to foreign real interest rates, the higher will be the foreign exchange rate for the domestic economy. Explaining Exchange Rates with Interest Rates

Interest Rate Parity Interest rate parity says that the interest rate differential between any two countries is equal to the expected rate of change in the exchange rate between those two countries.

Interest Rate Parity: Example Assume that U.S. real interest rates are higher than those in other countries. –The high rates of return on U.S. assets will attract foreign buyers, but in order to buy U.S. financial assets, foreigners must first buy dollars. The demand for dollars increases in the global marketplace, causing the dollar to appreciate. The supply of the other currency increases in the global marketplace, causing the other currency to depreciate.

Monetary Policy, Exchange Rates and GDP Let the Fed raise short-term interest rates –As interest rates increase, exchange rates increase, causing net exports (X - M) and GDP to fall. As the value of the dollar increases, we export fewer goods and import more.

Monetary Policy, Exchange Rates and GDP Let the Fed decrease short-term interest rates –As interest rates decrease, exchange rates decrease, causing net exports (X - M) and GDP to rise. As the value of the dollar decreases, we export more goods and import fewer.

Modeling Monetary Policy

Money Market Model Interest rates are determined in the money market through the interaction of money supply and money demand.

Money Supply The real money supply is assumed to be fixed in supply and invariant with respect to the interest rate. –The supply of real money balances is defined as the ratio of nominal money balances and the price level. Real money supply = MS/P

Money Supply Money Interest Rate MS The money supply is shown as a vertical line because we are assuming that it does not change as interest rates increase or decrease. 0

Money Demand and Interest Rates Money demand is assumed to be determined by both interest rates and the level of income. –MD = L(i, Y). The interest rate is the cost of holding money. –As i rises, the opportunity cost of holding money rises so people hold less money and more interest bearing assets. –As i falls, the opportunity cost of holding money falls so people hold more money and fewer interest bearing assets.

Money Demand Money MD i Money demand is drawn as a downward sloping line. Note that at high rates of interest people do not want to hold very much money, but at low rates of interest they are willing to hold higher money balances. i2i2 MD 1 i1i1 MD 2 0

Money Demand and Income Money demand is also assumed to be determined by the level of income. –MD = L(i, Y). People hold money to make transactions. –Higher levels on Y are associated with more transactions. Money demand increases. –Lower levels of Y are associated with fewer transactions. Money demand decreases.

Money Demand i Money MD(Y 2 ) Increases in Y from Y 1 to Y 3 shift money demand to the right. Decreases in Y from Y 3 to Y 2 shift money demand to the left. MD(Y 1 ) MD(Y 3 ) 0

The Money Market i MoneyMS MD The equilibrium rate of interest is determined by the intersection of money demand and money supply. Money supply is vertical because it does not vary with the interest rate by assumption. Money demand slopes down because the opportunity cost of holding money rises and falls with i. ieie 0

The Money Market: Shifts i Money MS 3 MD Increases in the money supply shift the MS line to the right. Decreases in the money supply shift the MS line to the left. Note that increases in the money supply cause the equilibrium rate of interest to decrease while decreases in the money supply cause the equilibrium rate of interest to increase. MS 1 MS 2 i2i2 i1i1 i3i3 0

Money Demand i MoneyMS MD 2 Increases in Y shift money demand to the right. Decreases in Y shift money demand to the left. Note that an increase in money demand causes the equilibrium rate of interest to increase while a decrease in money demand causes the equilibrium rate of interest to decrease. MD 1 MD 3 0

The Money Market: Monetary Policy i MoneyM 1 M 2 M 3 MD Contractionary monetary policy shifts MS to the left, increasing the equilibrium interest rate. Expansionary monetary policy shifts MS to the right, decreasing the equilibrium interest rate. i1i1 i3i3 i2i2 0

i i I 1 I 3 i1i3i1i3 MS 1 MS 2 i1i3i1i3 AE Y AS Y 1 Y 3 AE 1 (i 1 ) AE 3 (i 3 ) Investment MD(Y 1 ) Expansionary Monetary Policy: Step

Expansionary Monetary Policy: Transmission Mechanism: Step 1 An increase in the money supply, other things remaining the same, causes interest rates to fall. –As interest rates fall, interest sensitive spending and net exports increase. –As spending increases, the aggregate expenditure line shifts up to AE 3 Inventories fall, inventories are replaced Y rises, consumption rises, inventories fall, etc. –Y begins to rise towards Y 3, BUT……..

Expansionary Monetary Policy: Transmission Mechanism: Step 2 As Y rises, money demand rises –The increase in money demand puts upward pressure on interest rates causing some investment spending –And net exports to be crowded out As interest sensitive spending and net exports fall we more toward Y 2.

i i I 1 I 2 I 3 i1i2i3i1i2i3 MS 1 MS 2 i1i2i3i1i2i3 AE Y AS Y 1 Y 2 Y 3 AE 1 (i 1 ) AE 4 (i 3 ) Investment MD(Y 1 ) MD(Y 2 ) AE 3 (i 2 ) Expansionary Monetary Policy: Step

Y Y P AE 1 (P 1 ) AE AE 3 (P 1 ) AS Y 1 Y 2 Y 3 AD 1 AD 2 P2P2 P1P We begin at Y 1, where AD< AS*. The economy is in a recessionary gap. To close the gap, the government engages in expansionary monetary policy. The decrease in interest rates causes aggregate expenditures to increase from AE 1 to AE 3. Aggregate demand shifts from AD 1 to AD 2 and Y rises toward Y 3. At point 2, AD > AS*. As the price level rises, AD decreases along the aggregate demand curve. The rising price level causes AE 3 to shift down to AE 2. Equilibrium is established at Y 2 and P 2. AE 2 (P 2 ) 3

Fiscal Policy, One More Time An increase in government spending or a decrease in taxes causes aggregate expenditures to rise. –The shift up in AE sets off the multiplier process, causing Y to rise. –As Y rises, money demand rises, causing interest rates to rise. –As interest rates rise, some investment and net exports are crowded out.

i i I 3 I 1 I i3i1i3i1 MS 1 i3i1i3i1 AE Y AS Y 1 Y 2 Y 3 AE 1 (i 1 ) AE 3 (i 1 ) Investment MD(Y 1 ) MD(Y 2 ) AE 2 (i 3 ) Expansionary fiscal policy with money demand and money supply 0 0 0

Expansionary Fiscal Policy with Rising Interest Rates Transmission mechanism: –G up or T down, AE shifts up to AE 3, inventories fall, production increases, Y rises, consumption rises, inventories fall, etc. Y moves toward Y 3. –As Y rises MD shifts up to MD 2, causing interest rates to rise. –As interest rates rise, investment spending and net exports decrease so AE shifts down to AE 2. –Equilibrium occurs at Y 2.

Combining Expansionary Fiscal and Monetary Policy Transmission mechanism: –But if as interest rates rise, the Fed increases the rate of growth in the MS from MS 1 to MS 2, interest rates do not rise and investment and net exports are not crowded out –If investment and net exports are not crowded out or less investment and net exports are crowded out, the expansion of Y is larger. Y moves toward Y 3.

i i I 3 I 1 I i3i1i3i1 MS 1 MS 2 i3i1i3i1 AE Y AS Y 1 Y 2 Y 3 AE 1 (i 1 ) AE 3 (i 1 ) Investment MD(Y 1 ) MD(Y 2 ) AE 2 (i 2 ) Expansionary Fiscal and Monetary Policy 1 1,

Money and Inflation The Equation of Exchange

Early Monetarist View: MV = PY –A change in the money supply accompanied by no change in the velocity of money leads to an equal change in nominal GDP. –Fact: Velocity is not a constant and, since the deregulation of the banking system in the 1980s, is increasingly unpredictable

The Equation of Exchange MV = PYwhere –M = Money supply –V = Velocity of money The number of times the money supply turns over purchasing a given GDP –P = Price level –Y = Output PY = Nominal GDP

The Equation of Exchange Given a fixed V, –If the Fed increases M, PY must increase –If the Fed decreases M, PY must decrease If V is not fixed, however, changes in the money supply will not have a predictable effect on PY.

The Equation of Exchange Given a fixed Y, –If the Fed increases M, P must increase –If the Fed decreases M, P must decrease In the long-run, Y is fixed. If the Fed increases the money supply when Y cannot respond, the inflation rate rises. This is why economists say that inflation is always a monetary phenomenon.

Monetary Transmission Mechanisms Change in the Change in Change in Change in Money Supply Interest Rates Spending GDP & Exchange Rates Keynesian: The Interest Rate Channel Monetarist: The Asset Price Channel Change in the Change in Change in Money Supply Spending GDP

i i I1I1 i1i1 MS 1 AE Y AS Y 1 Investment MD 1 AE

i i I1I1 i1i1 MS 1 i1i1 AE Y AS Y1Y1 Investment MD 1 AE