Lecture Outlines - Week 9
Monetary Policy (Ch. 14 of Schiller)
Note to students: You should also read Chapter 13 of Schiller to understand basic money and banking
Monetary policy is the dominant method of modifying the business cycle -- it is our key macroeconomic policy tool. It is conducted by the Federal Reserve Bank (called "The Fed"), which is the nation's central bank authority. The Fed Chairman, Alan Greenspan, is considered to be the most powerful person in the world, and a single word uttered by him can change the stock market and redirect our economy.
Monetary policy occurs by changing interest rates and the money supply.
Thus to understand how monetary policy works, we first have to understand how the Fed operates.
The Fed was created by an Act of Congress early in the 20th century in response to a number of financial panics caused by poor banking practices.
Each of the 12 regional Federal Reserve Banks acts as a central bank for the region's private banks. Here are some central bank services provided to private banks:
- Clearing checks between private banks.
- Holding cash reserves of private banks.
- Providing currency to private banks.
- Providing loans to private banks, called "discounting."
From a macroeconomic perspective, however, the most important function of the Fed is in controlling the nation's money supply.
What is money?
- Medium of Exchange: Widely recognized in a community, or a country, or globally, as having an exchange value for goods and services.
- Store of Value: The money retains value over time.
- Unit of Account: We can record debts or savings in money units.
What is money?
The most restrictive measure of money is called "M1" and it has the following elements:
- Currency, both paper money and coin. Most currency is "fiat money", meaning that it lacks intrinsic commodity value, unlike gold coins. It is a store of value to the extent that we trust the government to control the supply of money and prevent inflation. Fiat money fails when people lose confidence in it (ex: Russia).
- Traveler's checks.
- Checking accounts.
Other, broader measures of money are called "M2" and "M3." Note that M2 contains M1 plus "near money" in savings accounts. M3 is even more general than M2.
The Fed can control M1 and M2 through the following levers:
- Reserve requirements: The percentage of deposits that private banks must hold on reserve either as vault cash or on deposit at the Fed.
- Discount rates: The interest rate the Fed charges when it loans out money.
- Open market operations: The Fed can directly increase or decrease the money supply by buying and selling government securities.
- Reserve requirements and the money supply:
We will learn about the relationships between reserve requirements and the money supply below. Chapter 13 provides background reading.
Note: Banks make money by lending out money at an interest rate above what they pay on deposits. Suppose that all banks are required to hold 10 percent of deposits as either vault cash or on deposit at the Fed. When a deposit is made at a bank, they are thus required to hold 10 percent of the deposit on reserve, but the remaining 90 percent of the new deposit is called excess reserves, which banks loan out to make money.
Round 1:
Suppose that Bank A holds excess reserves of $10,000, and loans it out to Jimbo as a student loan. Jimbo deposits that money in his checking account at Bank B.
Note that the money supply M1 has now increased by $10,000.
Round 2:
Then Bank B holds $1,000 of Jimbo's deposits on reserve, and loans out the remaining $9,000 to Jasper, who deposits it in his checking account at Bank C.
Note that the money supply has now increased again by $9,000.
Round 3:
Then Bank C holds $900 of Jasper's deposit on reserve, and loans out the remaining $8,100 to Harriet, who deposits it in her checking account at Bank D.
Note that the money supply has now increased again by $8,100.
...
This example demonstrates how money is created in a fractional-reserve banking system.
The Money Multiplier tells us the ultimate amount of new money created by an initial injection of new money into the system.
Money Multiplier = 1/(required reserve ratio).
Note: Required reserve ratio is the percentage of deposits that must be held by a bank in required reserves. Thus if required reserves are 10 percent of all deposits, then the money multiplier is 1/0.1 = 10. If required reserves are 20 percent of all deposits, then the money multiplier is 1/0.2 = 5.
Thus if there is an initial $10,000 in excess reserves, and the money multiplier is 10, then the total increase in new money is:
Excess Reserves X money multiplier = $10,000 X 10 = $100,000.
- This is also known as an increase in lending capacity.
How Does the Fed Control the Money Supply With the Required Reserve Ratio?
EX: What happens if the Fed raises the required reserve ratio?
- The money multiplier becomes smaller, and thus new deposits generate a smaller increase in the money supply.
- Thus raising the required reserve ratio is a way to slow growth in the money supply.
EX: What happens if the Fed lowers the required reserve ratio?
- The money multiplier becomes larger, and thus new deposits generate a larger increase in the money supply.
- Thus lowering the required reserve ratio is a way to speed the growth in the money supply.
REFERENT: See Table 14.1 on page 303 of Schiller.
2. The Discount Rate
The discount rate is the rate charged by the Fed on loans it makes to private banks. This is called "discounting." The main reason why private banks borrow from the Fed is because they obviously want to keep excess reserves close to zero, and sometimes they find themselves holding inadequate reserves, at which point they may borrow reserves from the Fed.
If the Fed raises the discount rate, they raise the cost of borrowing, and thus reduce the quantity of money demanded by banks. Since this may force banks to either sell government securities or borrow excess reserves from other banks (at the "Feds Fund" rate of interest), you can see that it would have the net effect of reducing the money supply.
3. Open-Market Operations
The third and most common method the Fed uses to affect the money supply are open-market operations.
A. Open-Market Purchases: Suppose that the Fed goes out and buys $100 million in US Treasury bonds in the bond market. In this transaction people who sold bonds now have money, at least part of which is deposited in checking accounts.
Thus an open-market purchase injects new excess reserves into the banking system, and through fractional-reserve lending the banking system then increases the money supply.
B. Open-Market Sales: Suppose that the Fed goes out and sells $100 million in US Treasury bonds in the bond market. In this transaction people who bought bonds now have bonds instead of money, at least part of which was drawn from checking accounts.
Thus an open-market sale reduces balances in checking accounts, and thus reduces excess reserves in the banking system. Thus those excess reserves are never loaned out, and so the money supply is smaller than it would have been without the open-market sale.
We now understand the three key tools by which the Fed controls the money supply in the US.
If the Fed reduces the required reserve ratio, reduces the discount rate, or performs an open-market purchase of bonds, the money supply is increased. This is called expansionary monetary policy.
If the Fed increases the required reserve ratio, increases the discount rate, or performs an open-market sale of bonds, the money supply is decreased. This is called contractionary monetary policy.
How does monetary policy affect the macroeconomy? Here's an illustration based on expansionary monetary policy:
- The Money Market:
In addition to the money supply, there is also money demand, essentially the demand for borrowing money. The interest rate is the "price" of money, and as you would expect, the money demand curve is inversely related to the interest rate.
DRAW MONEY SUPPLY AND DEMAND
When the Fed increase the money supply, equilibrium interest rates fall in the money market, and the quantity of money borrowed rises.
2. Aggregate Demand:
More money borrowed means more spending on things like home improvement, living expenses, business expansion, etc. All this extra demand for goods and services affects aggregate demand. Thus when the money supply is expanded, aggregate demand increases for goods and services in the economy.
Decreased interest rates lead to increased investment and consumption which lead to increased aggregate demand.
The ultimate purpose of macro policy is to stabilize the economy at or near its full-employment level, with low inflation. Thus if we are in a recession, the Fed will likely engage in expansionary monetary policy, while if the economy is operating at full employment with high levels of inflation, then the Fed will likely engage in contractionary monetary policy.
SEE FIGURE 14.6 FROM TEXT