1. Monetary Policy and The Money Supply

2. THE FED and MONETARY POLICY
THE FEDERAL RESERVE (“the Fed”) is a semi-governmental agency whose job is to control the supply of money and credit and interest rates.
The Fed is the “Central Bank” for the United States. Virtually every country in the world has a central bank. The actions of a central bank are called “monetary policy.” For short-hand, we can describe what the Fed does as “printing money.”
The US Federal Reserve System was created in 1913, It’s legal mandate was: "to furnish an elastic currency, …, to establish a more effective supervision of banking in the United States, and for other purposes"

3. The Fed can be imagined as having the ability to create money and credit in the Credit Market. (The Fed can also take money and credit out of the Credit Market.)
Before the creation of the Fed, the banking system had ways of creating money and credit, in a less controlled, but similar fashion, to what central banks are able to do.

4. FED POLICY -- OPEN MARKET OPERATIONS (OMOs)
Open Market Operations are the most important part of monetary policy. OMOs are the act of the Fed buying and selling Treasury bonds so as to change the money supply.
(In fact, the Fed could buy or sell anything and the results would be the same. Treasury bonds are just “how it’s done.”)

5. OPEN MARKET OPERATIONS (OMOs)
Imagine that the Fed wants to increase the money supply. To do so they “print” $1 billion. This money must somehow get into the economy.
To accomplish this, the FED will buy $1 billion dollars worth of Treasury bonds (mainly) from banks.
Banks now have an extra $1 billion to lend. This will typically lead to a decrease of interest rates as banks try to find additional customers for the new $1 billion.

6. OPEN MARKET OPERATIONS
Fed increases the money supply:
-- Fed buys Treasury bonds
-- Interest rates fall
-- More people borrow; Spending rises
-- More money is now circulating
Fed decreases the money supply:
-- Fed sells Treasury bonds
-- Interest rates rise
-- Fewer people borrow; Spending falls
-- Less money is now circulating

7. Fed increases the money supply (“prints money”)
Fed buys Treasury bonds
Interest rates fall
More people borrow
More spending
Banks
(the Credit Market)
The FED
money
T-bonds
More loans
Lower interest rates

8. Fed decreases the money supply (“takes money out of circulation”)
Fed sells Treasury bonds
Interest rates rise
Fewer people borrow
Less spending
Banks
(the Credit Market)
The FED
T-bonds
money
Fewer loans
Higher interest rates

9. In this version of monetary policy:
MS increase => Fed buys T-bonds =>
bank Reserves rise => interest rates fall => banks make more loans => spending rises
MS decrease => Fed sells T-bonds =>
bank Reserves fall => interest rates rise => banks make fewer loans => spending falls

10. SUMMARY
Increase MS
Decrease MS
the Fed …
buys T-bonds from banks
sells T-bonds to banks
bank reserves …
rise
fall
interest rates …
banks …
lend more
lend less
spending …
rises
falls

11. Bank Reserves are money held by banks as:
1. vault cash
2. deposits at a Fed bank
Bank Reserves are:
1. Required Reserves. The Fed requires banks to hold a certain level of reserves
2. Excess Reserves. A bank may choose to hold more than is required
Since 2008 bank excess reserves have been very, very large by any historical comparison.

12. How would the Fed know how much money to print?
Printing more money was presumed to lead to increased spending.
According to x = p + q, we expect a combination of effects:
1. more spending raises real GDP (q) and employment.
This is good
2. more spending raises inflation. This is bad

13. The Fed’s problem is therefore, “How do we get the amount of spending (x) that produces the ‘right’ combination of q and p?”
If the Fed judges that spending is too low – and inflation is not too high -- they print more.
If the Fed judges that spending is too high they print less.
The Fed is often described as having a “dual mandate” –
keeping inflation low and growth high.
It has generally seen these as opposing objectives

14. The Fed actually chose an “intermediate target” as a guide since the link between printing and spending is not precise.
That target was an interest rate – specifically the Federal Funds Rate (FFR). This is the rate at which banks lend to each other for very short periods (e.g. overnight). The Fed publically announces its targets.
Rather than directly asking, “What is the right amount of spending for this economy right now?” the Fed asked itself, “What is the right level of interest rates for this economy right now?”
The next problem for the Fed is therefore, “How much do we have to print (how many T-bonds must we buy or sell) in order to get the interest rate where we think it ought to be.

15. Controlling interest rates
If the interest rate starts to rise above the target, this is interpreted as “there’s not enough money.” The Fed must increase the money supply (i.e. buy T-bonds) so as to push the interest rate back down to its target.
If the interest rate starts to fall below the target, this is interpreted as “there’s too much money.” The Fed must decrease the money supply (i.e. sell T-bonds) so as to push the interest rate back up to its target.
Note that the Fed has, in the short run, lost control of the money supply: It must print as much or as little as is needed to keep the interest rate on target.
The Fed actually kept more control by the ability to change the target when it thought it necessary.

16. SUMMARY. IF …
Interest rates rise above target
Interest rates fall below target
The Fed assumes …
there is not enough money (the shortage of money is raising its price)
there is too much money (the surplus of money is lowering its price)
The Fed …
prints more money (buys T-bonds)
removes money (sells T-bonds)
Interest rates …
fall back to the target
rise back to the target.

17. SOME RECENT CHANGES BROUGHT ON BY THE FINANCIAL CRISIS OF 2008

18. Starting in 2008 …
Banks found themselves holding Mortgage Backed Securities (MBSs) whose value fell dramatically as housing prices declined. The banking sector looked weak and dangerous. As a result …
1. The fed bought huge quantities of MBSs from banks with ‘newly printed money.’
2. The Fed began to pay interest on excess reserves (IOER). That is, a bank could make a small return just by holding – not lending – money.
3. Banks massively increased their holding of excess reserves (i.e. reserves beyond the legal requirement).
In short, the Fed greatly increased the money supply but much of that increase was held by banks rather than being loaned and spent.

19. Roughly speaking, no bank will lend money if they can make more by holding it (after accounting for the risk of loss) .
It appears that banks are being paid NOT to make loans. Why?
SPECULATION FOLLOWS

20. SPECULATIONS
The money held by banks puts the banking sector in good financial shape after the disaster than began in 2008
Money held by banks does not cause inflation, since it is not spent.
By changing IOER (presumably raising IOER) the Fed can change interest rates while banks still hold a lot of reserves. Previously, raising interest rates was done by reducing bank reserves. This need no longer be the case.

21. By law, the Fed has two jobs:
1. regulate spending
2. regulate the health of the banking system
SPECULATION
The severity of the crisis in 2008 meant that the Fed’s priority switched from 1 to 2.