Download Fractional Reserve Banking

Money and Interest Rates
MBA 774
Macroeconomics
Class Notes – Part 2
1
What is Money?
• Medium of exchange
– Allows transactions not based on barter
– Avoids the need for a “double coincidence of wants”
• Unit of account
– Common measure of value for goods, services, and
contracts
• Store of value
– Allows for transfer of wealth through time
– Most liquid of all assets
2
Types of Money
• Pure Commodity
– Scarce commodity is agreed on as “money”
– For example: gold, silver, cattle, cigarettes
• Commodity Standard
– Certificates representing claims on a commodity are
issued and used instead of the commodity itself
– For example: the US was once on a “gold standard”
• Fiat Money
– Money established by government decree
– Fiat money has no intrinsic value
3
US Measures of Money
• Currency = Bills and coins outside U.S. Treasury, Federal
Reserve Banks and the vaults of depository institutions
• M1 = Currency plus travelers’ checks, demand deposits, other
checkable deposits
• M2 = M1 plus savings deposits, small-denomination time
deposits, retail money market mutual funds, and overnight
repurchase agreements
• M3 = M2 plus large-denomination time deposits, institutional
money funds, and Eurodollars (discontinued in 2005)
• L = M3 plus other liquid securities such as savings bonds and
short-term Treasury securities
4
US Money Supply Statistics
Measure
USD Billions
% of M3
1-yr %Chg
Currency
741
10.8%
3.5%
M1
1,358
19.7%
-1.0%
M2
6,879
100.0%
4.4%
Source: Federal Reserve Statistical Release H.6
5
The US Federal Reserve
• Federal Reserve System is the US “central bank”
– Foreign counterparts include the European Central Bank
(ECB), The Bank of England, and the Bank of Japan
• Founded in 1913 by congress, “to provide the nation
with a safer, more flexible, and more stable
monetary and financial system.”
• Primary functions are
– Monetary policy
– Banking supervision and regulation
– Providing certain services (e.g., check clearing)
6
The US Federal Reserve (2)
• The “System” is composed of 12 regional banks and
a Board of Governors in Washington, DC
– Governors, the Chairman and Vice-Chairman are
appointed by the President and confirmed by the Senate
• Monetary policy is overseen by the “Federal Open
Market Committee” or FOMC which includes
– Board of Governors
– Fed Bank of NY President
– 4 other regional bank presidents on a rotating basis
7
Monetary Policy (1)
• About every six weeks the FOMC meets to determine
monetary policy for the US
• In practice, this means determining the target for
the “Federal Funds Rate”
– an inter-bank overnight interest rate
• Fed decreases (increases) the Fed Funds rate by
buying (selling) government securities which
increases (decreases) the available money supply
– The Federal Reserve Bank of NY makes these purchases or
sales on the open market--hence the name Federal Open
Market Committee.
8
Monetary Policy (2)
8.00%
Fed Funds Target
Fed Funds Actual
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
0.00%
9
The Fed’s Actions around 9/11
4.00%
3.50%
3.00%
2.50%
Fed Funds Actual
Fed Funds Target
2.00%
1.50%
1.00%
0.50%
Stock Markets Re-open
9/
9/
01
9/
11
/0
1
9/
13
/0
1
9/
15
/0
1
9/
17
/0
1
9/
19
/0
1
9/
21
/0
1
9/
23
/0
1
9/
25
/0
1
9/
27
/0
1
9/
5/
01
9/
7/
01
0.00%
10
Monetary Policy (3)
• The official objectives of US monetary policy are,
“economic growth in line with the economy's
potential to expand, a high level of employment,
stable prices (that is, stability in the purchasing
power of the dollar), and moderate long-term
interest rates.”
• Conceptually, the Fed will raise (the real) interest
rate if GDP is greater than “Potential GDP” and viceversa
11
Aside: Real vs. Nominal Rates
• It is often said that the interest rate is the “cost of
money.” Is this true?
• Ultimately, we use money to obtain consumption
goods
• Think of the interest rate in terms of trading some
real amount of consumption in one time period for
some real amount of consumption in another time
period
– Note however, borrowing and lending contracts are stated
in nominal terms.
12
Aside: Real vs. Nominal Rates
• The real rate of interest (R*) can be defined as
approximately,
Real Interest Rate =
Nominal Interest Rate - Anticipated Inflation
• In 2004, what was R* in the
– the US?
– Japan?
13
Monetary Policy (4)
• Potential GDP is the rate of economic activity that
leads to stable prices and employment
• Intuitively it is the amount of output that is
generated by utilizing all available resources at
there highest sustainable level.
• Algebraically, we can think of it as
PotGDP = (aggregate hours available for work) x
(average output per hour)
14
Monetary Policy (5)
• Economists often discuss the Potential GDP Growth
Rate which is approximately
PotGDP Growth = Labor Force Growth Rate
+ Productivity Growth Rate
• We can calculate PotGDP Growth with this formula
for the last 50 years
15
Historical Potential GDP
10.0%
Productivity Growth
Labor Force Growth
8.0%
6.0%
4.0%
2.0%
0.0%
20
00
19
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
19
50
-2.0%
16
Better Estimates of PotGDP
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
PotGDP-Congressional Budget Office Estimates
PotGDP-( 5yr- Moving Average from Previous Graph)
00
20
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
19
19
50
0.0%
17
Monetary Policy and the GDP Gap
Note: GDP Gap = (Actual GDP - PotGDP) / PotGDP
10.0%
Real Fed Funds
GDP-Gap
5.0%
0.0%
-5.0%
Monetary Policy
Regime Change
20
05
20
00
19
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
-10.0%
18
NAIRU
• Another way of thinking about potential output is
the equilibrium rate of unemployment or NAIRU
(Non-accelerating Inflation Rate of Unemployment)
• NAIRU is the rate of unemployment below which
there will be inflationary pressures
• The exact level of NAIRU is an issue of debate.
– Most economists believe it is somewhere between 4% and
6% in the US and Japan. Probably higher in Europe (7-8%).
19
Monetary Policy and NAIRU
Note: U-NAIRU is actual unemployment minus NAIRU and is sometimes called the employment gap.
10.0%
Real Fed Funds
U-NAIRU
5.0%
0.0%
Monetary Policy
Regime Change
20
05
20
00
19
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
-5.0%
20
Other Mechanisms
for Monetary Policy
• The Fed also has two other ways of controlling
monetary policy
– The discount rate
– Reserve requirements
• Reserve requirements (rr) directly affect the level of
money via the “money multiplier” (1/rr)
– Example, if the reserve requirement is 20% of deposits
then the money multiplier is 1/0.2 = 5
21
Fractional Reserve Banking
• The Fed buys a $1,000 (market value) treasury bond
from a bond dealer
• The dealer deposits the $1,000 proceeds into its
bank, FirstBank
– Money supply increases by $1,000
• FirstBank only has to keep $200 as reserves and
loans the $800 balance:
FirstBanks Balance Sheet
Assets
Liabilities
Reserves
$200
Deposits
Loans
$800
$1,000
22
Fractional Reserve Banking (2)
• Assume FirstBank made an $800 computer loan to
a student. Money supply increases to $1,800
• The student buys a computer at BestBuy which
deposits the $800 at its bank, SecondBank
• SecondBank also loans out all but 20%
SecondBank Balance Sheet
Assets
Liabilities
Reserves
$160
Deposits
Loans
$640
$800
• Now money supply = 1,000 + 800 + 640 = 2,440
23
Fractional Reserve Banking (3)
• This practice of keeping 20% reserves and loaning
out the rest continues indefinitely
• However, the ultimate increase in the money supply
(DMS) is finite and equal to
DMS = DD / rr
DMS = $1,000 / 0.2
DMS = $5,000
where DD is the original increase in money by the Fed
[ Mathgeeks note, its a converging geometric sequence:
1+x+x2+x3+... = 1/(1-x) where x = (1-rr) ]
24
Fed Reserve Requirements
Type of Deposit
Net transaction accounts
$0 million-$8.5 million
$8.5 million-$45.8 million
More than $45.8 million
Nonpersonal time deposits
Eurocurrency liabilities
Requirement
% of Deposits
Effective Date
0
3
10
0
0
12/21/06
12/21/06
12/21/06
12/27/90
12/27/90
Required reserves must be held in the form of deposits with Federal Reserve Banks or vault
cash. Nonmember institutions may maintain reserve balances with a Federal Reserve Bank
indirectly, on a pass-through basis, with certain approved institutions. Under the Monetary
Control Act of 1980, depository institutions include commercial banks, savings banks,
savings and loan associations, credit unions, agencies and branches of foreign banks, and
Edge Act corporations.
See also: http://www.federalreserve.gov/monetarypolicy/0693lead.pdf
25
Interest Rates
• There are lots of important USD interest rates
–
–
–
–
–
–
–
–
–
Federal funds rate
Discount rate
Prime rate
Commercial paper rate
LIBOR and Eurodollar (similar for other currencies)
T-bill, T-note, T-bond rate
Swap rates
Corporate bond rates
Overnight repurchase rate or “Repo” rate
• Rates depend on credit risk, liquidity, and maturity
26
Government Issues
20
3-month T-Bill
20-year T-Bond
Term Spread
15
10
Thru
6/07
5
0
20
04
19
99
19
94
19
89
19
84
19
79
19
74
19
69
19
64
19
59
19
54
19
49
19
44
19
39
19
34
-5
27
Corporate Bonds
20
Moody's AAA Corp
Moody's Baa Corp
Baa Credit Spread (over Treasuries)
15
10
Thru
6/07
5
20
04
19
99
19
94
19
89
19
84
19
79
19
74
19
69
19
64
19
59
19
54
19
49
19
44
19
39
19
34
0
28
A Model of the Money Market
• More detail about what affects interest rates
• For now consider “money” to be M1
• Also we assume that the money supply is controlled
by the central bank (e.g., the US Federal Reserve)
• Specifically, the central bank fixes the amount of
money in the aggregate economy (MS) at a level it
desires regardless of other factors
29
Individual Money Demand
• Individuals’ demand for money is based on
– The expected (real) return on money:
• Money (M1) pays little or no interest
• => higher interest rates will lead to less demand for money
– The riskiness of the return
• The risk of holding money comes from variation in the
price level. Why?
– Liquidity
• The primary value associated with money is derived from
liquidity
• Since a primary use of money is as a medium of exchange,
this implies an increase in the value of individual
transactions increases the demand for money
30
Aggregate Money Demand
• Aggregate money demand is the sum of demand
for money by all households and firms in the
economy
• In aggregate we can say the determinants of the
aggregate demand for money are
– The interest rate
– The price level (think CPI)
– Real national income (or GNP or GDP)
• Because this determines the need for liquidity
31
Aggregate Money Demand
• Define aggregate money demand as
MD
= P * L(R,Y)
or
MD / P = L(R,Y)
where,
MD = Aggregate money demand
P = Price level
R = Interest rate
Y = Real national income (or GNP or GDP)
and,
L decreases as R increases
L increases as Y increases
32
Aggregate Money Demand
Interest Rate (R)
Interest Rate (R)
Increase in Y
L(R,Y2)
L(R,Y)
Aggregate
Real Money
(M/P)
L(R,Y1)
Aggregate
Real Money
(M/P)
33
Equilibrium in the Money
Market
In equilibrium, MS = MD = P*L(R,Y)
Interest Rate (R)
Real Money
Supply
R2
2
1
R1
3
R3
Q2
MS/P
Q3
Aggregate Real
Money Demand
L(R,Y)
Aggregate
Real Money
(M/P)
34
Increase in Money Supply
Suppose the money supply increases from M1/P to M2/P
Interest Rate (R)
Real Money
Supply Increases
R1
1
2
R2
M1/P
M2/P
Aggregate Real
Money Demand
L(R,Y)
Aggregate
Real Money
(M/P)
35
Increase in GDP
Suppose real income (GDP) increases from Y1 to Y2
Interest Rate (R)
Real Money
Supply
R2
2
R1
1
1’
L(R,Y2)
L(R,Y1)
MS/P
Q1’
Aggregate
Real Money
(M/P)
36