Download Monetary policy and the Federal Reserve

Money and the Central Bank
The objective is to understand inflation and interest rates and
their relation to real GDP and the supply of money.
1
Overview
•
•
•
•
What is Money?
The Fed and Monetary Policy--Short Run
Money and Inflation--Long Run
The Money Multiplier, Bank Runs, and
Financial Crisis
2
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.
3
What does the Fed Do?
Fed controls monetary aggregates and the Federal Funds rate
Fed regulates banks and the SEC regulates Investment Banks
Bernanke sits here
Board Room at the Federal Reserve Board
Federal Reserve Board, Washington, DC
4
Federal Funds Rate
Federal Reserve sets the Federal Funds rate
The Federal Funds Rate (FF) is the rate banks charge each other for borrowing reserves overnight
5
Federal Funds Rate Drives all Interest Rates
30 yr Mortgage
Fed Funds
T-Bill
6
How Does the Fed Manage the Fed Funds Rate?
Supply of Money and Open Market Operations
Open Market Purchase of Securities: Fed buys T-bills from a
bank, thereby increasing the amount of money in circulation
Central Bank pays cash for the T-bill
Supply of
money
Central Bank Bank delivers T-bills to Central Bank
Commercial Bank
Open Market Sale of Securities: Fed sells T-bills to a bank,
thereby decreasing the amount of money in circulation
7
Supply of Money
• Ms is the nominal supply of money
• Then Ms /P is the real supply of money
where P is the aggregate nominal price level
(CPI)
8
Demand for Money
• The (transactions) demand for Real Money Balances
d
M
 L( y, R )
P
y is real GDP and R is the nominal interest rate
• More money is demanded when real GDP is higher
(captures the volume of transactions)
• Less money is demanded when the nominal interest rate
is higher (captures the cost of holding money)
9
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
10
The Money Market
Nominal
interest
rate, R
s
M
Real Money Supply 
P
R*
• Real Money Demand =
Real Money Supply
• In the short run, this
market clearing condition
determines the nominal
interest rate --- the Fed
funds rate.
Real Money Demand = L ( y , R )
(M/P)*
Real Money Balances, M/P
11
Effect of Open Market Purchase
(short-run, before goods prices adjust)
Fed
funds
rate
Real Money Supply
R
R’
Real Money Demand
M/P
(M/P)’
M/P
Liquidity effect of open-market operations:
• Open-market purchase increases money held by banks as reserves
• Banks lower interest rate to encourage money to be loaned out
12
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 or more.
13
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
14
Long Run Effect of
Increasing Money Supply
Fed funds
rate
Only long-run 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 initially lowers the Fed funds rate, but this
effect is temporary
15
Long Run Effects on the Economy
A policy of attempting to keep 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
16
Money and Inflation: Long Run
17
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
18
Fed’s Reaction Function
• In the US, the Fed seems to set the Fed funds rate using the following
rule (Taylor rule)
R = 1.5*π + 0.5*ydev + 1.0
– R is the Fed funds rate
– π is the rate of inflation over the preceding four quarters
– ydev is the percentage deviation of output from the trend real GDP
• If the real GDP is below the trend line (ydev less than zero) then the
Fed will lower the Fed funds rate
• If π continues to rise, then the Fed will increase the Fed funds rate
19
20
The Money Multiplier and the
Endogenous Creation of Money by the
Private Sector
21
Money with Commercial Banks
• 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 currency held by banks, RES (i.e.,
bank reserves)
MB= CU +RES
22
Bank Reserves
• Required Reserves
– a 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
23
Money Creation in a Fractional Reserve Banking System
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
24
The Money Multiplier
• The Money Multiplier, m, is the relation between
M and MB
M = m*MB
• The Money Multiplier can be expressed as
m
M
CU / DEP  1
cu  1


1
MB CU / DEP  RES / DEP cu  res
• A rise in cu or a rise in res lowers the multiplier m
25
The Money Multiplier, Currency, and Reserves
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
26
The Money Multiplier and Bank Runs
• Sometimes households 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
– Note that the first to withdraw receive the full value of their
deposits, which causes a bank run
•
Implication-----cu rises, money supply falls, and banks fail.
27
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
28
Great Depression
• Central Bank provides more money (liquidity)  Monetary Base rises
• Money Multiplier falls due to rise in cu and res
29
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 recent financial crises in the US, in which households and banks
become more conservative (banks freeze their lending), so the money multiplier falls.
30
CPI in the Great Depression
Goods Prices fall as money supply falls
31
The Money Multiplier
32
The Monetary Base
33
The Money Supply: M1
34
Recent U.S. Financial Crisis
GSE = government sponsored enterprise
ABS = asset back security
Source: Adrian and Shin, “Money, Liquidity
and Monetary Policy,” NY Fed Staff
Report, January 2009.
Mortgages are now mostly market-based and not bank-based.
35
Recent U.S. Financial Crisis
Credit Crunch
36
Recent U.S. Financial Crisis
Non-bank lenders contracted during the recent financial crisis
37
Recent U.S. Financial Crisis
When your home value rises, your leverage ratio falls. The
opposite is true for Investment Banks. Why?
38
7
Recent U.S. Financial Crisis
Security
Apr-2007
8
Aug-2008
Haircut is the difference between the market value of a security and
the price at which it is sold in the repo market (for later
repurchase). A rise in the haircut leads to a fall in leverage.
39
Recent U.S. Financial Crisis
Leverage peaks on the onset of a crisis.
40