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Money and the Federal Reserve Bank
The objective is to understand the actions of the
Central Bank and its impact on the economy
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Overview
•
•
•
•
What is Money?
The Fed and Monetary Policy
Money and Inflation---Long Run
The Money Multiplier and Bank Runs
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What is Money?
Money’s primary purpose is to serve as a medium of
exchange and thereby to facilitate transactions.
Chapter 7 Table 1
U.S. Monetary Aggregates (January 2002)
Abel/Bernanke, Macroeconomics Update, © 2003 Pearson Education, Inc. All rights reserved
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.
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The Fed and Monetary Policy
in the Short Run
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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
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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.
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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
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Federal Funds Rate Drives all Interest rates
30 yr Mortgage
T-Bill
Fed Funds
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Recent Federal Funds Rate
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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
Central Bank
Fin. Institution delivers T-bills or
Bonds to Central Bank
Supply of
money
Financial Institutions
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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)
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Demand for Money
Why hold money?
–
Liquidity
–
Money is the most liquid asset and is needed
for transactions
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Demand for Money
• The demand for Real Money Balances:
d
M
e
 L( y, r   )
P
• y is real GDP and P is the price level or CPI
• Less money is demanded when the nominal
interest rate is higher.
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Demand and Supply of Money
The demand for money
• Falls as interest rate
increases
The supply of money
• Determined by the Fed
• Falls as expected
inflation rises.
• Falls if the real interest
rate rises.
• Rises as real GDP
increases
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The Money Market
Nominal
interest
rate, R
•Real Money Demand =
Real Money Supply
M
Real Money Supply 
P
• This market clearing
condition determines the
nominal interest rate --the Fed funds rate.
R*
Real Money
e
L
(
y
,
r


)
Demand
(M/P)*
M/P
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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
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Why Is the Fed so Important?
Empirical Evidence: Effects of 60 Basis Points Rise in FF Rate
0.1
0.05
% change
0
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
months
-0.05
-0.1
-0.15
-0.2
Real GDP
Price level (GDP deflator)
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.
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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
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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
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Money and Inflation: Long Run
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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
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Money and Hyperinflation
Austrian Hyperinflation
30,100
9,001,000,000
8,001,000,000
25,100
7,001,000,000
5,001,000,000
15,100
4,001,000,000
10,100
Money supply
6,001,000,000
3,001,000,000
2,001,000,000
5,100
May-24
Mar-24
Jan-24
Nov-23
1,000,000
Sep-23
Jul-23
May-23
Mar-23
Jan-23
Nov-22
Sep-22
Jul-22
May-22
Mar-22
Jan-22
Nov-21
Sep-21
May-21
Mar-21
100
Jul-21
1,001,000,000
Jan-21
Price level
20,100
Time
CPI
Money supply
Money supply is Austrian Crowns in circulation
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Other Hyperinflations
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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
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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
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Money and Banking
Money Multiplier and Bank Runs
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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
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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
$1000
$100
$900
…
Total
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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
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The Money Multiplier
• The Money Multiplier can be expressed as
M
CU / DEP  1
cu  1


1
MB CU / DEP  RES / DEP cu  res
• Money, the Monetary Base, and the Money Multiplier
M
cu  1
M
MB 
MB
MB
cu  res
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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
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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.
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Monetary Variables in the Great Depression
•Consumers Shift to holding Currencycurrency/deposit ratio rises
•Banks become more conservative and hold more reservesreserve/deposits rise
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Great Depression
• Central Bank provides more money (liquidity)  Monetary Base rises
• Money Multiplier falls due to rise in cu and res
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Monetary Variables in the Great Depression
• Due to the fall in the money multiplier, despite the increase in the Monetary Base, the
Money 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.
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CPI in the Great Depression
Goods Prices fall as money supply falls
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The Money Multiplier
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The Monetary Base
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The Money Supply: M1
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