How does the government stabilize the economy? The government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress and the president to adjust to the G in aggregate demand. 2. Monetary Policy- Actions by the Federal Reserve Bank (our central bank) to adjust the money supply (M1).
The monetary base is the sum of currency in circulation and the reserves held by banks.
Monetary policy is the Fed adjusting the components of the monetary base to expand/contract the money supply.
Effects of Low Interest Rates Generally, low interest rates stimulate the economy because there is more money available to lend. Consumers buy cars and houses. Businesses expand, buy equipment, etc. Effects of High Interest Rates The Fed raises interest rates as an effective way to fight inflation. Since the cost of borrowing has increased, consumers and business will cut back on their spending.
How the FED Stabilizes the Economy 58
Fractional Reserve Banking instead of letting demand deposits sit in the vaults, banks lend out that money to earn interest. It is unlikely that on any given day, all depositors will come withdraw their money so banks only need to hold on to a small reserve. #1. The Required Reserve Ratio The required reserve ratio (RRR) is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out). The RRR is set by the Federal Reserve. The excess reserves are reserves over and above the amount needed to satisfy the minimum reserve ratio; this is what banks can lend out. [Total] Reserves = required + excess reserves Ex. If the RR is 10% and a bank has $1,000, it has to keep a reserve of $100 and can lend out its excess reserve of $900
MONEY CREATION HOW BANKS CREATE MONEY Required Reserve = 10%
The Money Multiplier/Simple Deposit Multiplier Simple Deposit Multiplier Change in MS over time = Required Reserve Ratio (.rrr) Money Creation = excess reserve x money multiplier 1 OR excess reserve/.rrr Loan money banks can lend. Demand Deposit = amount of money deposited into banks. 1. Billy Bob deposits $1000 and the required reserve is.05 a. What is the immediate effect on the money supply (M1)? b. How will the bank respond to Billy Bob s deposit (RR and ER)? Still M1, cash demand deposit $50, $950 c. Calculate the maximum change over time in the amount of loans the banking system can make. $950/.05 = $19,000 d. Calculate the maximum change in the amount of demand deposits in the banking system. $1000/.05 = $20,000 e. Calculate the maximum change over time in the money supply the banking system can make. $950/.05 = $19,000 61
Question: Assume that the reserve requirement is 20 percent and banks hold no excess reserves. Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate the maximum change in demand deposits in the banking system. Answer: (The money multiplier of) 5 x $100 = $500. (2009 EXAM - 14% answered correctly.)
The Money Multiplier/Simple Deposit Multiplier Simple Deposit Multiplier = 1 Required Reserve (.rrr) Change in MS over time Money Creation = excess reserve x money multiplier MORE PRACTICE OR excess reserve/.rrr 1. If the reserve requirement is.1, what will happen to the money supply if a bank has excess reserves of $1000? 2. If the FED decreases the reserve requirement from.50 to.20 what will happen to the money multiplier? In reality, not all money is redeposited into banks and banks don t always lend out their entire excess reserves; these leaks reduce the size of the money multiplier. During normal times, the M1 money multiplier in the United States is about 1.9. 63
Using Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? Decrease the Reserve Ratio Expansionary MP 1. Banks hold less money and have more excess reserves 2. Banks create more money by loaning out excess 3. Money supply increases, interest rates fall, AD goes up 2. If there is inflation, what should the FED do to the reserve requirement? Increase the Reserve Ratio Contractionary MP 1. Banks hold more money and have less excess reserves 2. Banks create less money 3. Money supply decreases, interest rates up, AD down 64
When the Fed makes adjustments to the required reserve, it is moving money in and out of circulation. If the Fed decreases the RR, banks can lend out more money and thus increase the money supply.
A T-account summarizes a bank s assets (left) and liabilities (right) Assets Liabilities Required Reserve = 10% Required Reserve: $100 Demand Deposit: $1000 Excess Reserve: $900 Owner s Equity: $0 $1000 = $1000 Assets money it loans out and its reserves Liabilities - money it owes to depositors (savers) ASSETS = LIABILITIES Term to know: Owner s Equity owner s investment; assets minus liabilities Net worth = assets minus liabilities
Assets Liabilities Required Reserve = 10% Required Reserve: $100 Loans: $600 Excess Reserve: $300 Demand Deposit: $1000 A. Calculate the maximum amount of new loans this bank can make. B. Calculate the maximum change over time in loans. C. Calculate the maximum change over time in the money supply. $300 $300/.10 = $3000 $3000
A commercial bank holds $500,000 in demand deposit liabilities and $120,000 in reserves. If the required reserve ratio is 20 percent, what is the maximum amount this bank can loan out? How much money can the entire banking system create? Assets Liabilities Reserves: $120,000 Loans: $380,000 Demand Deposit: $500,000 Require Reserves = $100,0000 The bank can still loan out $20,000. That $20,000 will lead to an increase of $100,000 in the money supply.
Assets Liabilities Required Reserves: $400 - $400 Loans: $3,600 Demand Deposit: $4,000 - $400 Elliott withdraws $400 from his checking account at the local bank and keeps the money in his wallet. How will the withdrawal change the t-account of the local bank? Assets Liabilities Required Reserves: $0 The bank needs a RR of $360 Loans: $3,600 Loans: $3,240 Demand Deposit: $3,600 Required Reserve = 10% Assume the bank responds by calling in some of its loans to meet its RR requirement. How will this effect the money supply? -360/.10 = -3,600
The Fed rarely makes changes to the required reserve as it can be extremely disruptive to the banking system. But in the event that a bank falls below it required reserve, it can borrow from other banks or as a last resort, it can borrow from the Fed.
Federal Funds Rate The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves. The FED can t simply tell banks what interest rate to use. Banks decide on their own. The FED influences them by setting a target rate and using open market operations to hit the target. 71
OPEN MARKET OPERATIONS when the FED buys or sells government bonds (securities). most important and widely used monetary policy tool The Fed buy securities from banks (buys up low liquidity money)
Banks now have high liquidity money that can be lent out.
Since banks now have more money to loan out, the federal fund rate and interest rates fall.
To increase the money supply, the FED should BUY government securities. To decrease the money supply, the FED should SELL government securities.
If a bank owns a $1000 treasury bond, is that bond be counted as an asset or liability? Assets Liabilities Required Reserves: $400 Loans: $3,600 T- Bonds: $1,000 Demand Deposit: $4,000 Net Worth: $1,000 If the Fed purchases that $1000 treasury bond from the bank and the RR is 10%, how much money will be created over time by the banking system? 1,000/.10 = $10,000 change in the money supply What happens to the federal funds rate?
The Fed now owns the T-Bill and commercial banks have cash to lend out. The Fed used money from its vaults (monetary base) to purchase T-bill from commercial banks so it owes the MB $100m. Commercial banks now own T-Bills (and have less $) and the Fed now has more cash in its vaults (excess reserve). The Fed now has $100m to add to the MB
Federal Funds Rate 78
#3. The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. The Fed is the lender of the last resort. To increase the money supply, the FED should DECREASE the Discount Rate. To decrease the money supply, the FED should INCREASE the Discount Rate. 79
The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED Federal Reserve Commercial Bank s Assets Liabilities Assets Liabilities Securities $160 $80 Reserves Reserves $80 $400 Deposits $80 Currency Loans $320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED Federal Reserve Commercial Bank s Assets Liabilities Assets Liabilities Securities $160 $100 Reserves (+ $20) Reserves (+ $20) $100 $500 Deposits (+ $300) Loans $20 $80 Currency Loans (+ $100) Note: Money supply (M1) = Currency + Deposits = $580. $420 $20 Amount owed to Fed (+ $20)
Which of the following policy actions is consistent with expansionary monetary policy? (1) The Trading Desk at the Federal Reserve Bank of New York carries out a $5 billion open market purchase. (2) The Federal Reserve lowers reserve requirements. (3) The Board of Governors accepts a request from the Boards of Directors of the Reserve Banks to increase the discount rate. a. (1) + (3) b. (1) + (2) c. (1) + (2) + (3) d. (2) + (3)
If real GDP is growing at 6 percent and the inflation rate is at 10 percent, which of the following policies might be appropriate? (1) The Federal Open Market Committee decides to lower the federal funds rate target. (2) The Federal Open Market Committee decides to make no change in the federal funds rate target. (3) The Federal Open Market Committee decides to increase the federal funds rate target. a. (1) b. (1) + (2) c. (2) + (3) d. (3)
Economic growth over the past year, measured by real gross domestic product (GDP) for the United States, has been negative. The number of jobs has declined, and the already high unemployment rate has been rising. Inflation pressures remain persistent. Most inflation, wage, and salary indicators suggest that inflation has not subsided over the past year despite the decline in economic growth. Nominal interest rates are very high, reflecting high inflationary expectations. Your group is concerned that continued inflationary pressures are undermining the economy s already weak performance. Raise/decrease/maintain the federal funds rate target? How will your policy likely affect both the economy and the inflation rate? What effect is your policy likely to have on the level of employment over the next six months to a year?