1. Shawn Osell Department of Business and Economics University of Wisconsin – Superior sosell1@uwsuper.edu 1 Interest on Reserves: A Fourth Tool of Monetary Policy

2.  QE1: September, 2008.  IORs: implemented on October, 2008 (Emergency Economic Stabilization Act)  QE2: November 2010 - June, 2011. $60B of T-bills  Operation Twist (decrease long term interest rates)  QE3: Announced Sept, 2012. $40B/month of MBS** 2

3. 3 M2; 1960 – 2012 http://research.stlouisfed.org/

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5. What is the money multiplier? (m)  The maximum change in the money supply due to an initial change in the excess reserves banks hold What is the money multiplier equal to?  m = 1 / required reserve ratio ≡ 1/r i.e. 1/10% = 1/(1/10) = 10   M1 =initial  ER x m i.e. $90 X 10 = $900. 5

6. BankTR (Deposits)RR ER  loans (or bonds) M1Cumulative ΔM1 A$100 from O.M.O. $0$100 $0 B$100$10$90$100$0 C 90 9 8119090 D 81 8.1072.9271171 E 72.9 7.2965.61343.9243.9 F 65.61 Total:$1,000$900 6

7. Can the multiplier be smaller than indicated? The simple money multiplier assumes that: 1.* banks want to lend out all of their ER’s 2. borrowers’ want to borrow all of a bank’s ER’s 3. All loans are deposited back into the banking system. 7

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9. Interest on Required Reserves Interest on Excess Reserves Effective Federal Reserve Rate Target Federal Funds Rate Date Value 2008-10-22 1.40 2008-11-05 1.11 2008-11-19 1.00 2008-12-03 1.00 2008-12-17 0.89 2008-12-31 0.25 2009-01-14 0.25 To present 0.25 Date Value 2008-10-15 0.75 2008-10-22 0.75 2008-10-29 0.65 2008-11-05 0.65 2008-11-12 1.00 2008-11-19 1.00 2008-11-26 1.00 2008-12-03 1.00 2008-12-10 1.00 2008-12-17 0.25 2008-12-24 0.25 0.25 Date Value 2008-10-01 0.97 2008-11-01 0.39 2008-12-01 0.16 2009-01-01 0.15.07 -.20 Date 12/16/2008 0 -.25 9

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13.  Consequences of too much easy credit during the 2000s  Current economy  Europe  Future uncertainty i.e. presidential election.  Low interest rates are not profitable for lenders – no incentive to lend.  How much impact do/can IORs have? *** The opportunity cost of lending or buying liquid assets has decreased. 13

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16. Excess Reserve ratio = e = ER/D; where D = Checkable Deposits. Public can & does hold currency which slows the money creation process. Public preference for currency is measured by Currency ratio = c = C/D Currency has become a larger part of M1 than checkable deposits  C > D. Where is all the currency?: i.e. Overseas, Drug Trade. m = 1 + c r + e + c 16

17. Now, how well can the Fed control the money supply, M1? MB X m = M1 (MBn + DL) X 1 + c = M1 r + e + c The Federal Reserve controls: MBn, r = req. reserve ratio Financial Intermediaries control: e = ER ratio, and DLs = (note: Discount Loans are a right), The public controls: c = Currency Ratio. 17

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19. VariableObs.MeanStd. Dev.MinMax Jan. 1960 – Aug. 2008 ER (Bil.)584.8232414.9451131.1219.015 ER ratio584.0030797.0025858.000558.0511982 Sept. 2008 – May, 2012 ER (Bil.)451,091.961368.021659.4821,618.129 ER ratio452.034559.470678.165090219

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21. Bank Loans and ER ratio after QE1 Regression on loans after QE1 Coef.t Constant7625.366*41.8* ER ratio- 294.78*- 6.66* C ratio- 83.57- 1.09 Adj.-R =.49 21

22.  IORs benefit Financial Intermediaries by lowering the opportunity cost of holding Excess Reserves and the Implicit tax on Required Reserves  Effective/additional Monetary Policy tool  Disincentive for lending  Loss of funds for US Treasury  Can/will be used to moderate future inflation 22