TOPIC 5

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 firm’s “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 < 1 (100% reserve banking → m = 1) • Assume banks lend all they can: • - TR = m*TD • - Implies banks only hold required reserves • Implications: • - TD = TL + TR (money held within the banking system) • - ΔTD = ΔTL + ΔTR (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 = .1*500 = 50 → ΔTL = TR – TRr = 450 • Step 2: Assets Liabilities • TR $ 500 TD $950 • TL $ 450 • TRr = .1*950 = 95 → ΔTL = TR – TRr = 405 • Step 3: Assets Liabilities • TR $ 500 TD $ 1355 • TL $ 855 • TRr = .1* 1355 = 135.5 → ΔTL = TR – TRr = 364.5 • The process continues ….. Loans and deposits expand up to a point TRr (required reserves) = TR (actual reserves). • That is, TD = TR / m = 5000 !

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) • ΔMS = ΔTC + ΔTD (Equation holds in changes) • ΔMS = ΔTC + ΔTR + ΔTL (Substitute in change ΔTD = ΔTR + ΔTL) • 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 > 0 and m* > m, the money multiplier can be expressed as: • μ*m= (cu + 1)/(cu + m*) • - μ*m > 1 as long as m < 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”: • <http://www.federalreserve.gov/pf/pf.htm>

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 > 0 (some people hold currency outside of banking system) • m* > 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 A’s federal funds and increases bank B’s 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 fundsmeans 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 11:30 and 11:45 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 weeksafter each meeting. • Look at the federal funds rate futuresin the WSJ to see what the market thinks.

25. Federal Reserve’s Lending • The discount rateis 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? Falling Money Multiplier (M1)

29. Why Did Dramatic Increase in Base Not Have Big Effect on Money Supply? Excess Reserves in Banking System

30. Federal Funds Rate Over Time

31. Why Are Banks Holding Excess Reserves?Higher interest paid on excess reserves

32. Why Are Banks Holding Excess Reserves?Higher interest paid on excess reserves

33. Measure of Health of Banking System:Bank Borrowing From Federal Reserve

34. The Fed’s 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)

35. The Quantity Theory: Money and Inflation

36. The Quantity Theory of Money: Quantity Equation • M*V = P*YM = 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 Bank’s 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 it’s 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)

37. The Evolution of Velocity (M1)

38. The Evolution of Velocity (M2)

39. The Evolution of PY/Base

40. 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). • Noteinflation 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 +π. If, like Y, r is beyond the Central Bank’s 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.

41. 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 Mankiw’s Text Book

42. Money Growth and Inflation: 2014

43. 15% M2 growth rate 12% 9% 6% 3% inflation rate 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 U.S. inflation and money growth, 1960-2006 slide 43

44. Nominal Interest Rates and π (Fisher Equation: i = r + π)

45. Monetizing Government Debt • 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 Europe’s 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. The Central Bank buys public debt with reserves (increases monetary base!).

46. CB Independence & Inflation

47. CB Independence & Inflation (Same Picture–Different Authors) Data: Alesina and Summers 1993 (Data from 1955-1988)

48. 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%.

49. 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 Deficitsby Printing Money!!! • We will deal with these reasons more as the course progresses.

50. 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