Money Creation and the Money Supply Determinants and Process

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Chapter 9
BuffDaniel Presents Money and Banking

• Money Creation and the Money Supply Determinants
  and Process

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• Multiple Deposit Creation and the Money Supply
  Process
• Four Players
• Central Bank (FED)
• Banks
• Depositors
• Borrowers

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Federal Reserve Balance Sheet

• Assets increase in assets increases the
  Monetary Base
• Securities Treasuries
• Discount loans to banks
• Gold and Special Drawing Rights certificates
• Coins
• Cash items in process (float)
• Physical Plant and others
• Liabilities - increase in liabilities decreases
  the Monetary Base
• Federal Reserve Notes outstanding currency in
  circulation
• Printed by the FED
• Reserves of banks
• Required
• By the reserve requirement (10)
• No interest paid
• Excess
• U.S. Treasury Deposits
• Foreign and other deposits
• Deferred-availability cash items (in process)
  float

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• Monetary Base (bills treasury currency
  coins) Reserves
• MB C R
• Control of the MB
• Open Market Operations
• The most direct method the Fed uses to change the
  monetary base is open market operations, which is
  buying or selling U.S. government securities.
• In an open market purchase the Fed buys
  government securities.
• An open market purchase increases either bank
  reserves or currency in circulation therefore it
  increases the monetary base, which is the sum of
  reserves plus currency (B C R).
• Purchase buy bonds from the banks, gives them
  more money to loan
• Increases the monetary base
• The Fed can reduce the monetary base by an open
  market sale of government securities.
• Sale sells bonds to the banks, takes money away
  from them
• Decreases the monetary base

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• Discount loans at the discount rate trough the
  discount window
• Loan increases the monetary base
• Recalling a loan decreases the monetary base
• When the Fed lends to depository institutions,
  the loans are called discount loans and the
  interest rate on the loans is called the discount
  rate

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Deposit Creation

• Deposit Creation
• Start with 10,000 and a rr 10
• Bank A
• Simple Deposit Multiplier
• Change in Deposits(D) 1/rr x Change in Reserves
  (R)
• rr Reserve Requirements

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• The Money Multiplier
• One way the Fed manages the nations money supply
  is by controlling the monetary base, which is
  comprised of all currency in circulation and
  reserves held by banks.
• Calculation

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• M m x MB
• M Money Supply C D
• m is the money multiplier
• MB Monetary Base R C
• C/D currency-deposit ratio
• C Currency
• D Checkable Deposits
• ER/D is the Excess Reserve Ratio
• ER Excess Reserves
• R RR ER
• R Reserves
• RR Required Reserves
• RR rr x D
• rr reserve requirement (ratio)
• R (rr x D) ER
• MB R C (rr x D) ER C
• Since ER ER/D x D and C C/D x D
• MB (rr x D) (ER/D x D) (C/D x D)
• D (1/(rr ER/D C/D x D) x MB

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• Numbers
• rr .10
• C 400b
• D 800
• ER .8b
• MS 1200b
• m
• MB 480

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• Factors that Determine the Money Supply
• Reserve Requirement (Ratio) rr up, m and MS down
• C/D up, then m and MS down
• ER/D up, then m and MS down
• Changes The money multiplier ____
• What if the FED increases the MB by 20 what will
  the MS be? MS
• What will the change in the MB be if the Fed
  wants the MS to equal 1400? MB

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Tools

• Open Market Operations the purchasing and
  selling of government securities to commercial
  banks and/or the public
• Open market operations, the purchases and sales
  of securities in financial markets by the Fed,
  are the dominant means by which the Fed changes
  the monetary base.
• The Fed began to use open market purchases as a
  policy tool during the 1920s.
• The lack of intervention by the Fed during the
  bank crisis of the early 1930s led Congress to
  establish the Federal Open Market Committee
  (FOMC) to guide open market operations.
• Open market purchases are viewed as expansionary
  and open market sales are viewed as
  contractionary.

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• The FOMC meets eight times a year and issues a
  general directive stating its overall objectives
  for monetary aggregates and interest rates.
• The Federal Reserve Systems account manager is
  responsible for carrying out open market
  operations that fulfill the FOMCs objectives.
• The Open Market Trading Desk, a group of traders
  at the Federal Reserve Bank of New York, trades
  government securities over the counter
  electronically with primary dealers.
• The account manager can conduct open market
  operations through outright purchases and sales
  of Treasury securities or by using Federal
  Reserve repurchase agreements (analogous to
  commercial bank repos).
• For open market sales, the trading desk often
  engages in matched sale-purchase transactions (or
  reverse repos) in which the Fed sells securities
  to dealers who agree to sell them back to the Fed
  in the near future.
• Open market operations intended to change
  monetary policy are known as dynamic
  transactions, while those aimed at offsetting
  fluctuations in the base are called defensive
  transactions.

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• Open market operations have several benefits that
  other policy tools lack control, flexibility,
  and ease of implementation.
• To discern the Feds intentions, Fed watchers
  read carefully the directives issued by the Fed.
• Most used
• To buy bonds the FED offers a higher price which
  lowers interest rates
• To sell bonds the FED offers a lower price which
  raises interest rates
• Types
• Dynamic designed to change the level of MB and
  R
• Defensive designed to offset other things that
  may change the level of MB and R
• A day at the Trading Desk
• Sandy Krieger, Head of Domestic Open Market
  Operations
• New York District Bank
• Traded electronically with primary dealers
  selected by the FED
• Through banks or the nonbank public
• Dealers make offers to the FED
• Advantages
• Complete control not subject to the actions of
  others (banks)
• Flexible and precise
• Easily reversed
• No administrative delays

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• Discount Policy loans to member banks
• Discount policy, which includes setting the
  discount rate and terms of discount lending, is
  the oldest of the Federal Reserves principal
  tools for regulating the money supply.
• The Fed influences the volume of discount loans
  by setting their price (the discount rate) and by
  setting their terms.
• An increase in the discount rate reduces the
  volume of discount loans and exerts upward
  pressure on other interest rates.
• The Fed uses the discount window to make one of
  three types of loans adjustment credit, seasonal
  credit, and extended credit.
• Primary credit is available to health banks and
  may be used to for any purpose.
• Secondary credit is intended for banks not
  eligible for primary credit and may not be used
  to expand a banks assets.
• Temporary, short-term seasonal credit loans
  satisfy seasonal liquidity requirements of
  smaller depository institutions.
• Although the Fed allows banks to borrow from the
  discount window, it discourages banks from heavy
  use of discount loans.
• Discount policy offers the Fed certain advantages
  that the other policy tools do not have.
• The discount window provides the most direct way
  for the Fed to act as a lender of last resort to
  the banking system

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• Discount rate changes mostly ceremonial
• Used in a potential financial crisis (Crisis
  intervention)
• 1970
• 1974
• 1980
• 1984
• Stock market crash of 10/87
• 911 0n 9/11/01
• Quantity of loans
• Types
• Primary Credit loan to most sound banks
• Secondary Credit loans to riskier banks
• Seasonal Credit loans banks in vacation or
  agricultural areas
• Cost of borrowing from the FED
• Interest rate costs
• Concerns raised about the health of the bank
• Refusal to get a loan if you go to many times
• Moral suasion rules for discount window
  operations
• FED is the lender of the last resort

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• Reserve Requirement Percentage of deposits that
  must be held in the FED
• Reserve requirements stem from the Feds mandate
  that banks hold a certain fraction of their
  deposits in cash or deposits with the Fed.
• The Board of Governors sets reserve requirements
  within congressional limits, under authority
  granted by Congress in the Banking Act of 1935.
• In 1980, the Depository Institutions Deregulation
  and Monetary Control Act established uniform
  reserve requirements for all depository
  institutions.
• The Fed changes reserve requirements much more
  rarely than it conducts open market operations.
• Every two weeks, the Fed monitors compliance with
  its reserve requirements by checking a banks
  daily balance.
• Ranges from 8 to 20
• 1937 20
• 1958 13
• 1980 12
• 1992 10
• Now
• 3 on the first 49.3 million
• 10 above 49.3 million
• Advantage
• It effects all banks equally
• Disadvantage
• It is not precise
• Changes would have to be .001 which is not
  practical

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Tool Action MB Money Supply
Open Market Operations Buy Bonds Increases Increases
Sell bonds Decreases Decreases
Discount Window Raise Rates Decreases Decreases
Lower Rates Increases Increases
Reserve Requirement Raise None Lowers
Lower None Raises
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• Goals some conflict
• Major
• High Employment
• Natural Rate of Unemployment 6
• Acceptable
• Frictional between jobs
• Structural mismatch of jobs and skills
• Seasonal
• Unacceptable
• Cyclical due to business cycles
• Economic Growth 2 ½ to 3.5
• Pollution increases
• Price Stability 4.5
• Minor
• Interest Rate Stability
• Financial market stability
• Foreign market stability

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• Problems in Achieving Monetary Policy Goals
• A policy that is intended to achieve one monetary
  policy goal may have an adverse effect on another
  policy goal.
• The Feds tools dont always allow it to achieve
  its monetary policy goals directly.
• The Fed also faces timing difficulties in using
  its monetary policy tools.
• The source of numerical objectives for
  unemployment and inflation
• General guidelines for numerical objectives are
  found in the Employment Act of 1946 and the
  Humphrey-Hawkins Full Employment and Balanced
  Growth Act of 1978. Full employment is believed
  to be about 4.0 to 4.5 percent measured
  unemployment in the mid 2000s.
• The goal for inflation depends upon recent
  experience and the political and historical
  environment. Price stability does not
  necessarily mean zero inflation but rather low
  inflation such as in the 1 to 2 percent range.
• Sustainable growth is thought to be in the 2.5 to
  3.0 percent range.

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• Targets
• Operating
• Reserve aggregates
• Reserves
• Nonborrowed reserves
• Monetary base
• Nonborrowed base
• Federal Funds Rate
• Intermediate
• Monetary aggregates
• M1
• M2
• M3
• Short and long term interest rates
• Criteria for choosing a target
• Measurability
• Controllable
• Have a predictive effect on goals

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• History FED has switched its targets many times
  only recently to the Federal Funds Rate
• Teens Discount rate
• 20s Open market operations
• Prior to the Great depression Raised the
  discount rate to reduce credit
• Late 30s Reserve requirements. Money was no
  longer backed by gold or silver
• 40s Open market operations
• 50s and 60s interest rates and money market
  conditions
• Feds independence established
• 70s M1 and M2 through the Federal Funds Rate
• Early 80s discount rate and Nonborrowed
  reserves
• Late 80s interest rates through discount rates
  and discount loans
• 90s and today Federal Funds rate
• 9/11/01 Fed averted a financial crisis by
  lowering the discount rate so that banks could
  borrow money to meet financial obligations
• Greenspan was out of the country. Vice Chairman
  Roger W. Ferguson was in charge
• 2003 raised the discount rate above the federal
  funds rate to discourage banks from borrowing
  from the FED
• Check Clearing Act will allow paper reproductions
  of checks

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• Taylor Rule
• Federal Funds Rate 2.5 Inflation
  ½(Inflation Gap) ½(GDP Gap)
• Daniel Rule
• FFR 13.98 2.61(Unemployment Rate) .01
  (CPI)
• 93 accuracy