Money and the Federal Reserve Bank The objective is to understand the actions of the Central Bank and its impact on the economy
Overview • What is Money? • The Fed and Monetary Policy • Money and Inflation---Long Run • The Money Multiplier and Bank Runs
What is Money? Money’s primary purpose is to serve as a medium of exchange and thereby to facilitate transactions. Note that the use of credit cards does not eliminate the use of money, as money is often used to pay off a credit card balance. Credit cards simply delay the payment of a good.
What does the Fed Do? It controls monetary aggregates to affect the economy and financial markets Board Room at the Federal Reserve Board Federal Reserve Board, Washington, DC
Fed Actions The Fed manages the economy by managing • The interest rate---the Federal Funds (FF) Rate • Regulate the banking system NB: The SEC is supposed to regulate Investment Banks.
Federal Funds Rate Federal Reserve Sets the Target Federal Funds Rate The Federal Funds Rate (FF) is the rate banks charge each other for borrowing reserves overnight
Federal Funds Rate Drives all Interest rates 30 yr Mortgage T-Bill Fed Funds
How Does the Fed Manage the Fed Funds Rate? Supply of Money and Open Market Operations Open Market Purchase: When the Fed buys T-bills, it credits the reserve account of the selling Financial Institution (Bank) by the amount of the purchase, thereby increasing the amount of money in circulation C.B. pays Cash or makes Deposits in the account of the financial institution at the Fed Supply of money Fin. Institution delivers T-bills or Bonds to Central Bank Central Bank Financial Institutions
Supply of Money • M is the nominal supply of money • Then M/P is the real supply of money where P is the aggregate nominal price level (CPI)
Demand for Money Why hold money? • Liquidity • Money is the most liquid asset and is needed for transactions
Demand for Money • The demand for Real Money Balances: • y is real GDP and P is the price level or CPI • Less money is demanded when the nominal interest rate is higher.
The demand for money Falls as interest rate increases Falls as expected inflation rises. Falls if the real interest rate rises. Rises as real GDP increases The supply of money Determined by the Fed Demand and Supply of Money
The Money Market Real Money Demand = Real Money Supply This market clearing condition determines the nominal interest rate --- the Fed funds rate. Real Money Supply Nominal interest rate, R R* Real Money Demand (M/P)* M/P
Effect of Open Market Purchase Fed funds rate R R’ Money Demand M/P (M/P)’ M/P Increase of currency in circulation via an open market purchase lowers the Fed funds rate
Why Is the Fed so Important? Empirical Evidence: Effects of 60 Basis Points Rise in FF Rate % change months Empirical evidence shows that a rise in the Fed Funds Rate brings down Prices and Real GDP in subsequent periods at horizons of 18 months.
Short Run Effects on the Economy The Short Run Impact of a Federal Funds-rate cut Real GDP Growth Employment Investment Real Wages Stock Prices Bond Prices FF Rate Cut is designed to cut real interest rates and stimulate investment demand
Long Run Effects on the Economy • A policy of keeping the Fed Funds Rates low may require the central bank to continuously increase the supply of money In the long run this leads to inflation
Long Run Effect of Increasing Money Supply Fed funds rate Only effect is to increase the price level R R’ Money Demand M/P (M/P)’ M/P Increase of currency in circulation via an open market purchase lowers the Fed funds rate
Money and Hyperinflation Money supply is Austrian Crowns in circulation
Why is high inflation bad? • With high inflation people want to economize on holding money • High inflation and price uncertainty makes it difficult to evaluate the profitability of projects
Policy Trade-off • In Recession: Fear of rising unemployment and falling income leads the Fed to lower the Fed Funds rate • Cost of this Policy : Greater inflation in the long run • In Economic Booms: Fear of Inflation, so raise interest rates • Cost of this policy: Lower Economic Growth
Money Multiplier and Bank Runs Money and Banking
Reserve Requirements • Required Reserves • Specified percentage of commercial bank deposits (checking deposits) must be held as reserves (vault cash or deposit at the Central Bank) • Excess Reserves • Typically, to meet withdrawals of cash, banks hold more reserves than what’s required
Invisible Money Creation: Money Multiplier 10 percent reserve requirement Deposit Reserves Loans 1st Round $100 $10 $90 2nd Round $90 $9 $81 3rd Round $81 $8.10 $72.90 4th Round $72.90 $7.29 $65.61 … Total $1000 $100 $900
The Money Multiplier • Money available in the economy is currency held by the public, CU plus bank deposits DEP M = CU+DEP • The Monetary Base is currency held by the public, CU plus reserves, RES held by banks MB= CU +RES
The Money Multiplier • The Money Multiplier can be expressed as • Money, the Monetary Base, and the Money Multiplier
The Money Multiplier and Bank Runs What if households decide to withdraw their deposits and hold more currency per dollar of bank deposit?---cu rises • The bank would use the reserves to return the Deposits • Less money would be loaned out • Money Supply will fall What if banks become conservative and hold more reserves per dollar of deposit?----res rises • Less money would be loaned out • Money Supply will fall
The Money Multiplier and Bank Runs • In may cases, households may fear that banks don’t have adequate assets to cover their liabilities (demand deposits) • They may want to withdraw their deposits and hold cash • What if banks start running out of reserves • Loans have to be liquidated at significant losses • Sudden loan liquidation may not be enough to cover all the deposit withdrawals • The fear of depositors that they may loose their bank deposits causes a run on the bank • Implication-----cu rises, money supply falls, and banks fail.
Monetary Variables in the Great Depression Consumers Shift to holding Currencycurrency/deposit ratio rises Banks become more conservative and hold more reservesreserve/deposits rise
Great Depression Central Bank provides more money (liquidity) Monetary Base rises Money Multiplier falls due to rise in cu and res
Monetary Variables in the Great Depression Due to the fall in the money multiplier, despite the increase in the Monetary Base, theMoney Supply falls This is similar to the current financial crises in the US, in which households and banks become more conservative (banks freeze their lending), so the money multiplier falls.
CPI in the Great Depression Goods Prices fall as money supply falls