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Fed Policy and Money Markets

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Title: Fed Policy and Money Markets


1
TOPIC 5
  • Fed Policy and Money Markets

2
Outline
  • What is Money?
  • What affects the supply of money?
  • How does the banking system work?
  • What is the Fed? How does it work?
  • What is monetary policy?
  • What affects the demand for money?
  • Asset Portfolio Decision
  • Quantitative Theory of Money
  • Equilibrium in the Money Market
  • The LM curve

3
  • Overview of Money and The Banking System

4
Money
  • Money is the economic term for assets that are
    widely used and accepted as payment.
  • Historically, the forms of money have been very
    different from shells to gold to cigarettes
    (Eastern Europe and German Prisoners Of War
    camps)
  • Most prices are measured in units of money ?
    understanding the role of money is important to
    understanding inflation.
  • Many economists believe that money also has an
    impact on real variables (mostly in the short
    run)

5
Three Functions of Money
  • Medium of exchange Money permits trade of goods
    and services at lower cost (in terms of time and
    effort)
  • Barter is inefficient because it is difficult and
    time-consuming to find a trading partner.
  • Other benefit allows specialization (and
    increases productivity)
  • Unit of account Money is the basic unit for
    measuring economic value
  • Given that goods and services are mostly
    exchanged for money, it is natural to express
    economic value in terms of money
  • Caveat In countries with volatile inflation,
    money is a poor unit of account because prices
    must be changed frequently. More stable units of
    account like dollars or gold are used even if
    transactions use local currency.
  • Store of Value money is a way of storing wealth.
  • Other types of assets may pay higher returns, BUT
    money is also a medium of exchange.

6
Measures of Money
  • The distinction between monetary and non-monetary
    assets is controversial.
  • Example MMMFs (money market mutual funds) are
    organizations that sell shares to the public and
    invest in short-term government and corporate
    debt. MMMFs pay low returns and allow for
    checking (with fees)Are they Money?
  • There are two main official measures of money
    stock, called monetary aggregates
  • M1 the most narrow definition, includes mainly
    currencies and balances held in checking
    accounts.
  • M2 includes everything in M1 plus other money
    like components saving deposits, small time
    deposits, MMMFs, MMDAs (money market deposit
    accounts), etc..

7
Money Supply
  • Money supply is the amount of money available in
    an economy
  • In modern economies, money supply is affected by
  • Central Banks (the Federal Reserve System in the
    United States). The central bank is a government
    institution responsible for monetary policies
    within an economy.
  • Depositary Institutions. Deposit Institutions
    are privately owned banks and thrift institutions
    that accept deposits from and make loans directly
    to the public.
  • The public. The public includes every person or
    firm (except banks) that holds money in currency
    or deposits (think of money in your pocket or
    money in your firms petty cash drawer)

8
The Banking System An Introduction
  • Bank Assets and Liabilities
  • Assets Loans (TL) Reserves (TR)
  • Liabilities Deposits (TD) (and potentially
    other stuff).
  • Reserves liquid assets held by the bank to
    meet the demand for
  • withdrawals by depositors or to pay
    checks
  • How do banks make money? They Lend.
  • How much do they lend? Must keep a minimum
    amount of reserves (required by law).
  • Definition m required reserve ratio

9
The Banking System An Introduction
  • Fractional reserve banking Banks hold only a
    fraction of their deposits in reserve.
  • Reserve-deposit ratio required
    reserves/deposits m
  • Fractional reserve banking ? m lt 1 (100
    reserve banking ? m 1)
  • Assume banks lend all they can
  • - TR mTD
  • - Implies banks only hold required reserves
  • Implications
  • - TD TL TR (money held within the
    banking system)
  • - ?TD ?TL ?TR (equation holds in changes)
  • Must Read Supplemental Notes 8

10
The Banking System An Example
  • Suppose I put 500 in the bank (remove it from
    under my mattress).
  • We call the 500 that starts the process the
    Initial Deposit (ID)
  • Two Strong Assumptions 1) Suppose that no one
    else in the economy holds cash.
  • 2) Suppose banks only hold required
    reserves.
  • Minor Assumption Suppose that m 0.1.
  • What happens in the banking system
  • Step 1 Deposits increase by 500 (initial
    deposit).
  • Step 2 Then, Deposits increase by another
    450.
  • Step 3 Then, Deposits increase by another
    405.
  • Step 4 .(keep increasing)
  • Step infinity .(keep increasing)
  • Why do deposits keep increasing? LOANS!!!!

11
The Banking System An Example
  • Step 1 Assets Liabilities
  • TR 500 TD 500
  • TRr .1500 50 ? ?TL TR TRr 450
  • Step 2 Assets Liabilities
  • TR 500 TD 950
  • TL 450
  • TRr .1950 95 ? ?TL TR TRr 405
  • Step 3 Assets Liabilities
  • TR 500 TD 1355
  • TL 855
  • TRr .1 1355 135.5 ? ?TL TR TRr 364.5
  • The process continues .. Loans and deposits
    expand up to a point TRr (required reserves) TR
    (actual reserves).

12
The Money Multiplier Formula Intuition
  • Total Change in Deposits ID ID (1-m)
    ID(1-m)2
  • ID (1 (1-m) (1-m)2 )
  • ID (1/m)
  • Simple Money Multiplier µm 1/m
  • TD (1/m) ID
  • I want to stress that above equation only holds
    if
  • There are no holding of currency out of the
    banking system
  • Banks may only hold required reserves

13
A More Realistic Model Money Supply and
Monetary Base
  • More Definitions
  • MS Money Supply
  • TC Total Currency in Circulation (held
    outside banking system)
  • BASE Monetary base
  • Some Formulas
  • MS TC TD (Money money held in banks
    money held outside banks)
  • ?MS ?TC ?TD (Equation holds in changes)
  • ?MS ?TC ?TR ?TL (Substitute in change ?TD
    ?TR ?TL)
  • BASE TC TR (All the physical currency in
    the economy)
  • Base actual currency in the economy (held in
    the banks as reserves or held by the public
    outside the banking system)

14
Money Supply and Monetary Base
  • Combining the two definitions (for MS and Base)
    we get
  • MS/BASE (TC TD) / (TC TR)
  • Define TC/TD cu currency/deposit ratio.
  • Depends on the amount of money the public
    wants to hold as currency vs deposits.
  • The public can increase or reduce cu by
    withdrawing or depositing currency
  • Recall TR/TD reserves/deposits ratio determined
    by the banks regulation
  • (Define m actual reserve ratio held by banks
    such that m m )
  • With some algebra, we can re-write the Money
    supply as
  • MS (cu 1)/(cu m) BASE

15
More Generally.
  • Remember MS (cu 1)/(cu m) BASE
  • If cu gt 0 and m gt m, the money multiplier can be
    expressed as
  • µm (cu 1)/(cu m)
  • - µm gt 1 as long as m lt 1!
  • - The Money multiplier decreases with cu!
    Role of the public
  • - The Money multiplier decreases with m!
    Role of the banks
  • Holding the base constant, the money supply (MS)
    will fall if people prefer holding cash outside
    of banking system (cu increases) or if banks
    start holding excess reserves (m increases above
    m).

16
  • Overview of The Federal Reserve

17
What is the Fed?
  • Overview
  • Quasi-public agency that oversees the U.S.
    banking system.
  • For the most part, independent of Executive and
    Legislative branches.
  • 7 of the governing members (Governors) at the Fed
    are Presidential Appointments with Senate
    Confirmation (like Supreme Court Justices).
  • Has its own budget
  • 12 member governing board the 7 above members
    plus 5 rotating members from the Federal reserve
    branch banks (privately owned).
  • Additional resource Federal Reserve System
    Purposes and Functions
  • lthttp//www.federalreserve.gov/pf/pf.htmgt

18
What Part of the Money Supply Is Controlled by
Fed?
  • Remember (from previous slide)
  • MS (cu 1)/(cu m) BASE
  • Fed controls
  • Base
  • m (by law - the required reserve ratio)
  • m (by influencing the discount rate and other
    policies)
  • Fed does not perfectly control the money supply
    any time
  • cu gt 0 (some people hold currency outside of
    banking system)
  • m gt m (banks hold excess reserves)
  • If cu 0 and m m, MS Base/m
    Base µm TR µm

19
How Does the Fed Control Money Supply?
  • How can the Fed affect money supply (and thereby
    interest rates)?
  • By creating reserves.
  • a) Open Market Operations (change the
    monetary base directly)
  • b) Reserve Ratio (not used very much
    change the money multiplier)
  • c) Discount Window (discount rate change
    the money multiplier)
  • d) Paying Interest on Excess Reserves
    (change the money multiplier!)
  • e) New Instruments (TARP, etc. increase
    the money multiplier/base)
  • Note The discount rate/new instruments could
    increase the money supply by inducing banks to
    hold fewer excess reserves (by bringing m
    close to m).

20
Notes on Central Banks
  • The Central Bank is The Banks Bank. The
    Central Bank operates as a clearinghouse for bank
    checks. Each member bank has an account with the
    Central Bank. In the U.S. the deposits that
    banks have with the Fed are called federal funds.
  • A closely related term, which is not specific to
    the U.S., is banks reserves (which consist of
    federal funds plus vault cash, or currency in
    the banks cash machines, teller drawers, and
    vault).
  • A check written against private bank A and
    deposited with private bank B reduces bank As
    federal funds and increases bank Bs federal
    funds. Thus banks want federal funds so they can
    honor check withdrawals. They want vault cash to
    honor cash withdrawals. Upshot banks need
    reserves to honor withdrawals.
  • Neither the Fed nor other major Central Banks
    target growth rates of the money supply (which
    consists of currency plus various measures of
    liquid assets like deposits).
  • Fed targets the Federal Funds rate.

21
What is the federal funds rate?
  • Federal funds are the deposits of private banks
    with the Fed.
  • The federal funds market consists of private
    banks borrowing and lending their federal funds
    amongst each other overnight.
  • The federal funds rate is the interest rate on
    these overnight loans. It is set by supply and
    demand, not by the Fed.
  • The Fed can change the supply of federal funds
    through open market operations, exerting a
    powerful indirect effect on the fed funds rate.
  • The Fed targets the federal funds rate and
    carries out open market operations to keep the
    actual rate near the target rate.

22
What are Open Market Operations?
Open market operations Central Bank purchases
and sale of government securities on the open
market.
Open market purchase (sale) Central Bank
purchases (sells) government securities. The
seller (buyer) receives (uses) federal funds as
payment.
federal funds

reserves
Private Banks
Central Bank
Government Bonds
23
A Fed purchase of government securities
  • Raises the supply of federal funds. More federal
    funds means they are cheaper to borrow, so a
    lower federal funds rate. (An increase in the
    supply of federal funds lowers their price)
  • Drives up the price of those securities, which
    lowers their yield. A lower yield means a lower
    interest rate on government securities
  • Leaves banks flush with reserves. Banks find it
    profitable to convert some of their new
    zero-interest-earning reserves into loans (which
    in turn creates more deposits, raising the money
    supply). To get people/firms to borrow more
    (take the new loans they are offering), banks
    lower the interest rate on the loans.
  • Bottom Line A Fed purchase of government
    securities lowers i.

24
Notes on FOMC directives
  • The Federal Reserve Open Market Committee (FOMC)
    meets every 6 weeks (or so) and issues a
    directive to the trading desk of the Federal
    Reserve Bank of New York.
  • Fed Time the Desk carries out open market
    operations between 1130 and 1145 ET each
    trading day to keep the actual fed funds rate
    near the target.
  • The FOMC directive is also asymmetric or
    symmetric
  • Symmetric
  • No bias. Neutral stance. Just as likely to
    raise as to lower the target next.
  • Asymmetric
  • A bias toward easing (more likely to lower than
    raise the target next) or a bias toward
    tightening (more likely to raise than lower the
    target next).
  • The minutes of the regularly scheduled Fed open
    market meetings are not public until 3 weeks
    after each meeting.
  • Look at the federal funds rate futures in the WSJ
    to see what the market thinks.

25
Federal Reserves Lending
  • The discount rate is the interest rate on
    direct loans from the Fed to private banks. The
    Fed sets the discount rate.
  • Discount window loans used to play a minor role
    in Fed policy (primary and secondary credit
    discount loan since 2003)
  • With the recent crisis, more banks have used
    discount windows loans together with new
    borrowing channels.
  • New Monetary Policy instruments Term Auction
    Facility (TAF), Term Asset-Backed Securities Loan
    Facility (TALF), Commercial Paper Funding
    Facilities (CPFF),

26
Dramatic Increase in Monetary Base Post Lehman
27
More Muted Response in Growth of Money Supply (M1)
28
Why Did Dramatic Increase in Base Not Have Big
Effect on Money Supply? Excess Reserves in
Banking System
29
Why Did Dramatic Increase in Base Not Have Big
Effect on Money Supply? Falling Money
Multiplier (M1)
30
Federal Funds Rate Over Time
31
Why Are Banks Holding Excess Reserves? Higher
interest paid on excess reserves
32
Improving Health in Banking System Bank
Borrowing From Federal Reserve
33
The Feds Balance Sheet
  • The Fed receives interest on its assets (U.S.
    government securities loans to banks).
  • The Fed pays interest on fed funds.
  • The Fed is highly profitable, which fosters its
    independence. The Fed returns its profits to the
    Treasury.
  • Hence the interest that the Treasury pays on
    securities held by the Fed is not a cost for the
    Government that portion of public debt is
    effectively monetized (pays 0 interest)

34
  • The Quantity Theory Money and Inflation

35
The Quantity Theory of Money Quantity Equation
  • MV PY M money supply, P the GDP
    deflator, Y real GDP
  • V velocity PY/M. We define V in this way.
  • If V is constant and Y is beyond the Central
    Banks LR control then ...
  • When the Central Bank doubles M, the result is a
    doubling of P
  • Inflation is always and everywhere a monetary
    phenomenon
  • This Friedman quote is not literally correct
    because of Y and V movements. But a LR
    correlation of .95 means its close enough.
  • Additional Reference Memorializing Milton
    Friedman A Review of his Major Works, 1912-2006
    (Ramrattan and Szenberg, American Economist,
    Spring 2008, Vol. 52 Issue 1, p. 23-38)

36
The Evolution of Velocity (M1)

37
The Evolution of Velocity (M2)

38
Notes on the Quantity Equation
  • V is defined so that the Quantity Equation holds.
    Identity P MV / Y .
  • Inflation (rising P) is caused by too much money
    chasing too few goods, i.e. by M rising relative
    to Y (controlling for how much M we need to
    transact PY, which is V).
  • Note inflation could rise despite fixed M because
    of falling Y or rising V. Across countries,
    however, most differences in inflation (P growth)
    are associated with differences in M growth
    correlation between M growth and inflation is
    above .95.
  • V is not fixed in reality. V rises with
    financial innovation and with i (the nominal
    interest rate). Recall that i r p. If, like
    Y, r is beyond the Central Banks LR control,
    then higher inflation translates one-for-one into
    higher i. Implication V rises with the rate of
    inflation.
  • Thus taking into account that V is not fixed only
    makes the channel from M growth to P growth
    stronger when M growth is high it generates
    inflation , which raises V, which in turn raises
    inflation further. This is a big deal in
    hyperinflations.

39
Money Growth and Inflation 1990
40
Money Growth and Inflation 1996-2004
Turkey
Ecuador
Indonesia
Belarus
Argentina
U.S.
Switzerland
Singapore
Correlation between inflation and money growth
0.90 over long periods of time. Data from Greg
Mankiws Text Book
41
U.S. inflation and money growth, 1960-2006
slide 41
42
Nominal Interest Rates and p (Fisher Equation
i r p)
43
Monetizing Government Debt
The Central Bank buys public debt with reserves
(increases monetary base!).
  • When public debt is growing faster than GDP,
    there is political pressure on the Central Bank
    to monetize some of the government debt because
  • public debt pays interest, reserves do not
  • fixed nominal debt is easier to pay off the
    higher is P.
  • Large budget deficits are the underlying cause of
    hyperinflations. The debt and deficit limits in
    Europes EMU are meant to prevent member
    countries from pushing for higher inflation.
  • Central Bank independence from fiscal authorities
    can insulate it from pressure to monetize the
    public debt.

44
CB Independence Inflation
45
CB Independence Inflation (Same
PictureDifferent Authors)
Data Alesina and Summers 1993 (Data from
1955-1988)
46
Hyperinflations are ...
  • sometimes defined as 30 or more inflation in a
    year
  • usually characterized by accelerating inflation
    (wage indexation)
  • caused by rapid M growth (the Central Bank
    creating new reserves at a rapid rate)
  • exacerbated by rising velocity (efforts to
    economize on M)
  • highly disruptive to Y
  • 1985 Bolivia 10,000, 1989 Argentina 3100, 1990
    Peru 7500, 1993 Brazil 2100, 1993 Ukraine
    5000.

47
Why Do Governments Grow the Money Supply?
  • Short Term Political Gains - reduce unemployment
    (or raise output). If the economy is capacity
    constrained - prices must rise (however, this
    usually occurs with a lag!)
  • Accommodating Supply Shocks - The U.S. in the
    70s! (as opposed to breaking the inflation
    cycle).
  • Financing Government Deficits by Printing
    Money!!!
  • We will deal with these reasons more as the
    course progresses.

48
Resources
  • The Fed and District Banks (see the Board of
    Governors website for FOMC minutes and speeches
    and testimony of FOMC members)
    http//www.ny.frb.org/links.html
  • Foreign Central Banks http//www.bog.frb.fed.us/
    centralbanks.htm
  • Fed Points (each explains something, e.g. how
    currency gets into circulation)
    http//www.ny.frb.org/pihome/fedpoint/
  • Details on open market operations
    http//www.ny.frb.org/pihome/addpub/omo.html
  • Overview of the Fed http//www.federalreserve.gov

49
  • The Money Market
  • Money Demand, Money Supply, and the LM Curve

50
Money Supply (Summary)
  • Remember MS (cu 1)/(cu m) BASE
  • Define Nominal Money Supply (Ms)
  • Fed conducts monetary policy to increase Money
    Supply
  • - Open Market Purchases (increase Base)
  • - Decrease the reserve ratio (decrease m)
  • - Decrease the Discount Rate (decrease m)
  • Also influenced by the public
  • - Bank runs (increase in cu)
  • - Bank precautionary motives (increase in m
    above m)


51
Money Demand
  • Agents decide how much wealth to keep as money
    Portfolio allocation decision
  • 3 main characteristics of assets matter
  • Expected Return The higher the expected return
    the higher consumption the
    agent can enjoy!
  • Risk Agents are risk-averse, hence to hold a
    risky asset, it must have a higher expected
    return
  • Liquidity The easier it is to exchange the
    asset for goods, services or other assets,
    the more attractive is the asset.
  • Money is highly liquid!
  • Money is the most liquid BUT has a low return!


52
Money Demand (continued)
  • Nominal money demand is proportional to the
    price level. For example, if prices go up by 10
    then individuals need 10 more money for
    transactions.
  • As Y increases, desired consumption increases
    and so individuals need more money for the
    increased number of desired transactions. This is
    the liquidity demand for money.
  • As the nominal interest rate on non-money
    assets (bonds), i, increases the opportunity cost
    of holding money increases and so the demand for
    nominal money balances decreases.
  • Since i r pe, we can decompose the effects
    on an increase in i into real interest rate
    increases (holding expected inflation fixed) and
    expected inflation increases (holding the real
    interest rate fixed).


53
Money Demand (continued)
  • Other factors affecting Money Demand
  • Wealth
  • Risk
  • Liquidity of Alternative Assets
  • Payment Technologies


54
Money Demand Function
  • Our model for the demand for nominal money
    balances takes the following form
  • Md
    PLd(Y, i)
  • where
  • Md demand for nominal money balances
    (demand for M1)
  • Ld demand for liquidity function
  • P aggregate price level (CPI or GDP
    deflator)
  • Y real income (real GDP)
  • i nominal interest rate on non-money
    assets


55
Real Money Balances
  • The demand for real balances
  • Since the demand for nominal balances is
    proportional to the aggregate price level, we can
    divide both sides of the nominal money demand
    equation by P.
  • This gives the liquidity demand function or the
    demand for real balances function
  • Md/P
    Ld(Y, r pe)
  • The left-hand-side of the above equation is the
    demand for nominal balances divided by the
    aggregate price level or the demand for real
    balances (the real purchasing power of money).
  • The right-hand side is the liquidity demand
    function. The demand for real balances is
    decomposed into a transactions demand for money
    (captured by Y) and a portfolio demand for money
    (captured by r and pe).


56
Money Demand


57
Money Market
  • The Money Market is in Equilibrium when
  • Real Money Demand Real Money Supply
  • where Real Money Supply Ms/P
  • Real Money Demand Md/P Ld(Y, r pe)
  • Note The money supply curve does not change
    with interest rates (it is vertical)
  • What shifts real money supply M, P
  • What shifts real money demand Y, pe


58
Money Market Equilibrium
Money Market
Ms

re
Md Ld(Y,pe)
M/P
59
Money Market Equilibrium Increasing Y

Money Market
Ms
r0
Md Ld(Y0,..)
M/P Suppose Y increases from Y0
to Y1 (Holding Money Supply fixed!)
60
Money Market Equilibrium Increasing Y

Money Market
Ms

r1
r0
Y increases
Md Ld(Y1,)
Md Ld(Y0,..)
M/P Suppose Y increases from Y0
to Y1 (Holding Money Supply fixed!)
61
Positive Relationship Between Y and r (in Money
Market)

r1
r0
Y Y1 Y
62
Positive Relationship Between Y and r (in Money
Market)

We will refer to this as the LM curve

r1
r0
Y Y1 Y
63
The LM (Liquidity-Money) Curve
  • LM Curve (drawn in (Y-r) space) - represents
    the relationship of Y and r through the money
    market (specifically - Ys effect on money
    demand). See Supplemental Notes 9 to add some
    mathematical structure , see Supplemental Notes
    10
  • The LM Curve relates real interest rates to real
    changes in output in the money market.
  • As Y increases - Md shifts upwards - causing real
    interest rates to rise (increase in transactions
    demand increases the demand for money).
  • What shifts the LM curve?
  • Money Increasing Money Supply increases M/P
    causing the LM curve to shift right.
  • Prices Increasing Prices causes real Money
    Balances to fall shifting the LM curve to the
    left.
  • p e Increasing expected inflation causes
    returns on bonds (assets other than money) to
    increase making it less attractive to hold cash.
    Causes LM curve to shift right!


64
Shifting the LM curve An Increase in M
  • Thought experiment Suppose M increases. What
    level of Y is needed to hold r constant?
  • Or, put another way, what would happen to r if Y
    was held constant?

Ms Ms1
LM(M0)

LM(M1)
r0
x
r0
x
z
r1
r1
z
Md(Y0)
Y0
Money Market
LM curve
An increase in the nominal money supply will
cause the LM curve to shift to the right (or
shift down, if you prefer that metric).
65
Interest Rates and Output
  • There are two effects driving the relationship
    between interest rates and output
  • 1) The IS curve. As interest rates fall,
    Investment increases and Y increases.
  • r falling causes Y to increase (negative
    relationship - the IS curve)
  • 2) The transaction motive for holding money. As
    Y increases, demand for money increases and r
    increases.
  • Y increasing causes r to increase (positive
    relationship - the LM curve)
  • In equilibrium, both relationships need to be
    satisfied. We will work through this intuition
    in the next topic.
  • However, before we do, we will see why we need to
    summarize the money market as the LM curve (as
    opposed to just Money Supply and Money Demand).
  • Remember Everywhere along the LM curve
    represents equilibrium in the money market.


66
An Illustration of Monetary Feedback in Money
Market
Suppose M increases
Money Market
Ms Ms1

0
re
1
re1
Md Ld(Y,pe)
M/P M1/P
67
An Illustration of Monetary Feedback in Money
Market
  • A fall in r, will increase I, causing Y to
    increase - which causes Md (and r) to increase.

Money Market
Ms Ms1

Y increases
0
re
2
re2
1
re1
Md1 Ld(Y1,pe)
Md Ld(Y,pe)
M increases
M/P M1/P
  • This process is known as monetary feedback -
    increasing M will cause r to fall, I to
    increases, Y to increase, money demand to
    increase and r to increase. The net effect on r
    will be to fall.
  • The IS-LM representation will express this
    process in a more concise form.
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