1. Maclachlan, Money & Banking Fall 2006 1 The Money Supply Process and Monetary Policy Tools Week 9

2. Maclachlan, Money & Banking Fall 2006 2 Consider the narrowest definition of money: M1. Consists of … currency checkable deposits travelers checks

3. Maclachlan, Money & Banking Fall 2006 3 How do banks create new deposits? They must have excess reserves. When they make a loan with the excess reserves, a new deposit is created.

4. Maclachlan, Money & Banking Fall 2006 4 Bank reserves consist of …. Vault cash (includes cash in ATM’s). Deposits at the Fed.

5. Maclachlan, Money & Banking Fall 2006 5 Government securities Discount loans Fed notes in circulation Deposits of member banks Fed AssetsFed Liabilities

6. Maclachlan, Money & Banking Fall 2006 6 Monetary Base (aka High Powered Money) Currency in circulation + Bank Reserves = Fed notes and coins in circulation + vault cash + bank deposits at Fed

7. Maclachlan, Money & Banking Fall 2006 7 Money Supply Process: Simple Model Assumptions: 10% required reserve ratio. Banks hold no excess reserves. No currency. What happens to the money supply when the Fed purchases $100 of Treasury securities?

8. Maclachlan, Money & Banking Fall 2006 8 Deposit Creation

9. Maclachlan, Money & Banking Fall 2006 9 Deposits at Failed Banks: 1929–33

10. Maclachlan, Money & Banking Fall 2006 10 e, c: 1929–33

11. Maclachlan, Money & Banking Fall 2006 11 Money Supply and Monetary Base: 1929–33

12. Maclachlan, Money & Banking Fall 2006 12 Monetary Policy

13. Maclachlan, Money & Banking Fall 2006 13 Three Tools of Monetary Policy Open market operations Discount rate Reserve requirements

14. Maclachlan, Money & Banking Fall 2006 14 Open Market Operations 2 Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly

15. Maclachlan, Money & Banking Fall 2006 15 Discount Loans 3 Types 1.Primary Credit 2.Secondary Credit 3.Seasonal Credit Lender of Last Resort Function 1.To prevent banking panics FDIC fund not big enough Example: Continental Illinois 2.To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident

16. Maclachlan, Money & Banking Fall 2006 16 How Primary Credit Facility Puts Ceiling on i ff Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2

17. Maclachlan, Money & Banking Fall 2006 17 Discount Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting discount rate changes 2.Fluctuations in discount loans cause unintended fluctuations in money supply 3.Not fully controlled by Fed

18. Maclachlan, Money & Banking Fall 2006 18 Reserve Requirements Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks

19. Maclachlan, Money & Banking Fall 2006 19 Goals of Monetary Policy Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict

20. Maclachlan, Money & Banking Fall 2006 20 Money Supply Target 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i''

21. Maclachlan, Money & Banking Fall 2006 21 Interest Rate Target 1.M d fluctuates between M d' and M d'' 2.To set i-target at i* M s fluctuates between M' and M''

22. Maclachlan, Money & Banking Fall 2006 22 Criteria for Choosing Targets 1.Measurability 2.Controllability 3.Ability to predictably affect goals Interest rates aren’t clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates