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Transcript
Monetary Policy Money, Interest & Money Supply History of The Federal Bank • First Bank of the United States (1BUS) – Alexander Hamilton – Objective was to create stability & provide young nation with ability to deal with foreign entities. – Charter was for 20 years (1791 - 1811) • Second Bank of the United States (2BUS) – Result on inflation during War of 1812 – Privately owned with public obligations. – 20 year charter (1816 - 1836) – President Jackson ended bank in 1833. History of Federal Banks • No National bank until 20th Century • Panic of 1907 – Money supply got tight – Pressure on banks – Pyramid reserves • Small banks reserves at larger banks • Federal Reserve Act of 1913 • Created the “Fed” The Federal Reserve • Responsibilities include – Supervising member banks • Interesting point that member banks technically own & control Federal Reserve. • Creates a political buffer. • Reports to Congress – Cash Reserves – Money Supply • Moves money in & out of circulation. The Federal Reserve • What does the Fed do? – Check Clearing – Loans for banks • Maintains reserves through S-T loans & loans to banks in trouble. – Federal Government’s Bank (The Treasury) – Supervises Member Banks • Reserves, Charters & Mergers. – Regulates the Money Supply • Replaces old money & monitors supply What is Money? • 3 Components – Medium of exchange • Usable for buying and selling of goods & services – Unit of account • Allows for easy accounting of value & comparisons – Store of Value • Retains value over time What is the Money Supply? • Money supply (MS) – Measures amount of money in circulation – 4 different Kinds • • • • M1 – Most liquid M2 M3 L – Least liquid Federal Reserve • Types of Monetary Measures • M1 – Currency in circulation + Checking accounts + travellers checks • M2 – M1 + Money Market accounts & mutual funds + other S-T saving deposits • M3 – M2 + L-T savings deposits • L – M3 + Savings bonds + S-T treasuries Money Supply & Interest Rates Interest rate Money supply Quantity (supply) set by the Fed r1 re r2 Money demand Md 1 Md e M d2 Quantity of money Money Supply & Interest Rates Interest rate Money supply Increases in demand: MD shifts, MS constant so results in r increases r2 r1 MD2 MD1 M de Quantity of money Money Supply & Interest Rates Interest rate Money supply Higher r leads to Higher price levels & lower outputs P2 r2 MD2 r1 P1 AD MD1 M de Quantity of money Y2 Y1 Quantity of output Money Supply & Interest Rates Interest rate Money supply Increased MS leads to increase AD & higher output MS2 P1 r1 AD2 r2 MD1 Mde1 Mde2 Quantity of money AD1 Y1 Y2 Quantity of output How the Fed Can Change MS • Fed Tools 1. 2. 3. 4. 5. Open Market Operations Fed Funds Rate & Discount Rate Reserve Requirements for investors Regulation of consumer credit Moral suasion 1. Open Market Transactions • To Increase the money supply – Fed buys US securities on the market • Money exchanged for bonds which increases the Money Supply. Money used by Fed to buy bonds was not in circulation but now it is. • Increasing supply known as Easy-money policy • Consequences include – – – – – Easier credit Lower interest rates initially Higher aggregate demand Leads to inflation Tool for fighting recessionary times 1. Open Market Transactions • To Decrease the money supply – Fed sells US securities on the market • Bonds exchanged for money which decreases the Money Supply. Money used to purchase bonds in the hands of Government so out of circulation. • Decreasing supply known as Tight-money policy • Consequences include – – – – – Tighter credit Higher interest rates initially Lower aggregate demand Fights inflation Greenspan used policy to manage growth 1. Open Market Transactions • Effects of decreasing the money supply – – – – – – Fed sells bonds for dollars More bonds in market, fewer dollars Fewer dollars = less loanable funds Less $ available for loans = higher interest rates Higher r = Lower C & I in GDP Result is a shift in GDP results • Khan video on increasing MS through open market – http://www.khanacademy.org/humanities--other/finance/core-finance/v/fed-open-market-operations 2. Fed Funds Rate & Discount Rate • Fed Funds Rate – Rate member banks charge each other – Lower than Discount rate • Discount rate – Rate Fed Charges member banks • Prime rate – Rate commercial banks charge their best customers. • Effects – Lowering discount rate • Encourages borrowing because the price of money or cost of borrowing decreases • Increases loans, investments & money supply. – Raising discount rate • Decreases amount of loans, investments & MS. 2. Effects of Rate Changes • Effects – Lowering Fed Funds Rate & Discount Rate • Encourages borrowing because the price of money or cost of borrowing decreases • Increases loans, investments & money supply. – Raising Fed Funds Rate & Discount Rate • Decreases amount of loans, investments & MS. • Khan Academy – Discount Rate – http://www.khanacademy.org/humanities--other/finance/banking-and-money/v/the-discount-rate 2. Taylor Rule • Economist John Taylor rules for the Fed’s target Fed Funds Rate • (assumes target of 2% inflation • GDPreal = GDPpot + Inflation • If GDPreal up 1%, then Fed Funds up ½ %. • If Inflation 1% > target, then Fed Funds up ½ %. 3. Reserve Requirements • Amount of money banks must keep on hand. • If reserve requirement changes, amount available for loans change with it. • Example – if a bank has 10,000,000 in deposits & reserve ratio is 10%, then bank must have $1,000,000 in the bank. – Rest can be used for loans. In this case $9,000,000. 3. Reserve Requirements • Lowering reserve requirement – Increases amount available for loans – Increases MS – Reduces rates because of greater supply – Increases investments • Raising reserve requirement – Decreases amount available for loans – Decreases MS 3. Reserve Requirements • Reserve ratio = (Bank’s Required Reserves) (Bank’s Liabilities {deposits}) • Monetary Multiplier = 1 / (required reserve ratio) . Effects of multipier • Beleagured State Bank (BSB) – – – – . Deposits RR Reserves – Funds – Loans 10% RR $100M 10% $10M 25% RR $100M 25% $25M $90M $75M – Effects of raising RR in this case is reduction in funds available for loans of $15M for BSB alone. • Multipler 1/.1 = 10X 1/.25 = 4X Other Controls • 4. Credit Card rates – Revoked in 1952 – Set rates on consumer credit cards • 5. Moral Suasion – Unofficial pressures placed on banks – “you don’t have to do this but …” Limitations • Forecasts • If forecast is wrong, then so is the policy • Timing • Time lags with implementing changes in policy • Trade-offs • Monetary policy a tool to fight inflation or recession Trade-Offs • Growth – Good. • Inflation – Bad. Tight Money • Easy Money – Increases growth (good) – Increases inflation (bad) • Tight Money – Decreases growth (bad) – Decreases inflation (good) Easy Money Summary – Expansionary MP • Problem: unemployment & recession – Fed buys bonds, lowers RR, lowers DR – Money supply – Excess reserves up – Fed Funds rate falls – Interest rates falls – Investment spending up – Aggregate Demand up – Real GDP up • Opposite is true for restrictive MP Expansionary Policy Money Supply up Interest Rates down Exchange rates down Investments up AD up GDPR up GDPN up Exports up Imports down Price Level up Inflation up Unemploy -ment down Determining Nominal Interest Rates Rate of interest, i MS ie MD Me Quantity Money Determining Real Interest Rates Rate of interest, r S If Quantity of funds represents all funds, Govt. debt affects demand. If only private funds, Govt. debt affects supply re D Qe Quantity of funds Annual rate of inflation, % Phillip’s Curve Trade-off between inflation & unemployment. As economy heats up, unemployment drops & inflation goes up PClr PCsr Unemployment rate, % Long-run unemployment Set by LRAS & potential GDP, therefore long-run Phillip’s curve is vertical Investment Demand Rate of interest, r Relationship between Nominal interest rates & Investment (GDP) i ID I Investment Graph Relationships i Money Market MS i Investment Demand MS i i i i MD M M Contraction of MS leads to higher i, which reduces I, causing GDP to fall Graph reversed so GDP is falling M Y Y GDPR I I I I I I Laffer Curve 100 Tax rate, % Shape of curve subject of debate Maximum Tax Revenue 0 Tax revenue, $ Inflation & the Economy • Khan Videos on Inflation & Economy • Moderate inflation in a good economy – Good visual presentation of relationships (3 minutes) – http://www.khanacademy.org/humanities--other/finance/microeconomicsmacroeconomics/v/moderate-inflation-in-a-goodeconomy • Stagflation – Low growth with high inflation – Short video (3 minutes) built on prior video – http://www.khanacademy.org/humanities--other/finance/microeconomicsmacroeconomics/v/stagflation Inflation & Deflation Tutorials • Khan Academy – Inflation, Deflation & Capacity Utilization, part 1 (12:32) • http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation--deflation---capacity-utilization – Inflation, Deflation & Capacity, part 2 (11:49) • http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation--deflation---capacity-utilization-2 – Effects of Obama’s stimulus bill (13:20) • http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation---deflation-3--obama-stimulus-plan