TOPIC 5 Fed Policy and Money Markets 1
2 Outline What is Money? What does affect the supply of Money? How the banking system works? What is the Fed and how does it work? What is a monetary policy? What does affect the demand of Money? Asset Portfolio Decision Quantitative Theory of Money Equilibrium in the Money Market The LM curve
3 Money Money is the economic term for assets that are widely used and accepted as payment. The forms of money have be very different: from shells to gold to cigarettes! (Eastern Europe and German Prisoners Of the War camps) Most prices are measured in units of money understanding the role of money is important to understand inflation Many economists believe that money has also impact on real variables (we will talk about that!) Money has 3 functions: 1. Medium of exchange 2. Unit of account 3. Store of Value
4 3 Functions of Money 1. Medium of exchange: Money permits to trade at less cost in time and effort! Barter is inefficient because is difficult and time-consuming to find the trading partner. Other benefit: allows specialization (and rises productivity) 2. Unit of account: Money is the basic unit for measuring economic value Given that goods and services are mostly exchanged for money, it is natural to express economic value in terms of money Caveat: In countries with volatile inflation, money is a poor unit of account because prices must be changed frequently. More stable units of account used (dollars or gold), even if transactions use local currency. 3. Store of Value: money is a way of storing wealth. Other types of assets may pay higher returns, BUT it is a medium of exchange!!
5 Measures of Money The distinction between monetary and non-monetary assets is controversial. Example: MMMFs (money market mutual funds) are organizations that sell shares to the public and invest in short-term gov and corporate debt. Low return and allow for checks (with fee) Are they Money? There are two main official measures of money stock, called monetary aggregates: 1. M1: the most narrow definition, includes mainly currencies and balances held in checking accounts. 2. M2: includes everything in M1 plus less moneylike components: saving deposits, small time deposits, MMMFa, MMDAs (money market deposit accounts).
6 Money Supply Money supply is the amount of money available in an economy In modern economies, money supply is affected by: 1. The Central Bank (the Federal Reserve System in the United States) is the government institution responsible for monetary policies 2. Depositary Institutions (Banks) are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public 3. The public include every person or firm (except banks) that holds money in currency or deposits.
The Banking System: An Introduction Bank Assets and Liabilities: Assets: Liabilities: Loans (TL) + Reserves (TR) Deposits (TD). Reserves = liquid assests held by the bank to meet the demand for withdrawls by depositors or to pay checks How do banks make money? They Lend. How much do they lend? Must keep reserves (minimum required by law). 7
8 The Banking System: An Introduction Fractional reserve banking: banks hold only a fraction of their deposits in reserve. Reserve-depost ratio = required reserves/deposits = m Fractional reserve banking m<1 Assume banks lend all they can: TR = m TD, TD = TL + TR (money held within the banking system) ΔTD = ΔTL + ΔTR
The Banking System: An Example Suppose I put $500 in the bank (remove it from under my mattress). We call the $500 that starts the process the Initial Deposit (ID) *** Suppose that noone else in the economy holds cash. *** Suppose banks lend to their limit. Suppose that m = 0.1. What happens in the banking system (assume nobody wants to hold currency): Step 1: Deposits increase by $500. Step 2: Then, Deposits increase by another $450. Step 3: Then, Deposits increase by another $405. Step 4:.(keep increasing) Step infinity:.(keep increasing) Why do deposits keep increasing? LOANS!!!! 9
10 The Banking System: An Example Step 1: Assets Liabilities TR $ 500 TD $500 TR* =.01*500 = 50 TL = TR TR* = 450 Step 2: Assets Liabilities TR $ 500 TD $950 TL $ 450 TR* =.01*950 = 95 TL = TR TR* = 405 Step 3: Assets Liabilities TR $ 500 TD $ 1355 TL $ 855 TR* =.01* 1355 = 135.5 TL = TR TR* = 364.5 Loans and deposits expand up to a point TR* = TR, that is, TD = TR / m = 5000!
Total Change in Deposits: The Money Multiplier Change in Deposits = ID + ID (1-m) + ID(1-m) 2 +... = ID (1 + (1-m) + (1-m) 2 +.. ) = ID (1/m) Money Multiplier μ m = 1/m Some caveats on the money multipler: The holding of currency out of the banking system Banks hold no excess reserves Day to Day transactions don t cause money supply to change significantly. Bank Runs can be important. 11
Money Supply and Monetary Base MS = Money Supply TC = Total Currency in Circulation (outside banking system) BASE = Monetary base MS = TC + TD ΔMS = ΔTC + ΔTD ΔMS = ΔTC + ΔTR + ΔTL BASE= TC + TR (liabilities of the Central Bank that can be used as money + currency hold by the public) The Central Bank controls directly the monetary base BUT not the money supply! 12
13 Money Supply and Monetary Base Combining the two definitions we get M/BASE = (TC + TD) / (TC + TR) TC/TD = cu = currency/deposit ratio depends on the amount of money the public wants to hold as currency vs deposits. The public can increases or reduces it, by withdrawing or depositing currency Recall TR/TD = m = reserves/deposits ratio determined by the banks + regulation Then Money supply: M = [(cu + 1)/(cu + m) ]* BASE
14 The Money Multiplier (with currency) Money supply is a multiple of the monetary base! General Money multiplier `μ m = (cu + 1)/(cu + m) `μ m is > 1 as long as m < 1! The Money multiplier decreases with cu! Role of the public The Money multiplier decreases with m! Role of the banks
The Fed in the Banking System What is the Fed (central bank)? How Can it Affect Money Supply/Interest Rates? 1. Change the Monetary Base (Reserves). How? Open-market operations (Fed Funds Rate) 2. Change the Money Multiplier. How? a) Reserve Ratio (not used very much) b) Discount Rate (not used very much) 15
16 Notes on Central Banks The Central Bank is The Banks Bank. The Central Bank operates a clearinghouse for bank checks. Each member bank has an account with the Central Bank. In the U.S. the deposits that banks have with the Fed are called federal funds. A closely related term, which is not specific to the U.S., is bank reserves (which consist of deposits with the Central Bank plus vault cash, or currency in the bank s cash machines, teller drawers, and vault). A check written against private bank A and deposited with private bank B reduces bank A s federal funds and increases bank B s federal funds. Thus banks want federal funds so they can honor check withdrawals. They want vault cash to honor cash withdrawals. Upshot: banks need reserves to honor withdrawals. Neither the Fed nor other major Central Banks target growth rates of the money supply (which consists of currency plus various measures of liquid assets like deposits). Fed targets the Federal Funds rate.
17 What is the federal funds rate? Federal funds are the deposits of private banks with the Fed. The federal funds market consists of private banks borrowing and lending their federal funds amongst each other overnight. The federal funds rate is the interest rate on these overnight loans. It is set by supply and demand, not the Fed. The Fed can change the supply of federal funds through open market operations, exerting a powerful indirect effect on the fed funds rate.
18 The federal funds rate vs. the discount rate The discount rate is the interest rate on direct loans from the Fed to private banks. The Fed sets the discount rate. Discount window loans play a minor role in Fed policy. The Fed targets the federal funds rate. This target changes over time. The Fed carries out open market operations to keep the actual rate near the target rate. This is the heart of Fed policy.
19 What are Open Market Operations? Open market operations = Central Bank purchases and sales of government securities on the open market. Open market purchase = A Central Bank purchase of government securities. The seller receives federal funds as payment. federal funds = reserves Central Bank Government Bonds Private Banks
A Fed purchase of government securities drives up the price of those securities, which lowers their yield. A lower yield means a lower interest rate on government securities. raises the supply of federal funds. More federal funds means they are cheaper to borrow, so a lower federal funds rate. (An increase in the supply of federal funds lowers their price ). leaves banks flush with reserves. Banks find it profitable to convert some of their new zero-interest-earning reserves into loans (which in turn creates more deposits, raising the money supply). To get people/firms to borrow more (take the new loans they are offering), banks lower the interest rate on the loans. Bottom Line: A Fed purchase of government securities lowers i. 20
Notes on FOMC directives The Federal Reserve Open Market Committee (FOMC) meets every 6 weeks and issues a directive to the trading desk of the Federal Reserve Bank of New York. Fed Time: the Desk carries out open market operations between 11:30 and 11:45 ET each trading day to keep the actual fed funds rate near the target. The FOMC directive is also asymmetric or symmetric: Symmetric: No bias. Neutral stance. Just as likely to raise as to lower the target next. Asymmetric: A bias toward easing (more likely to lower than raise the target next) or a bias toward tightening (more likely to raise than lower the target next). The symmetry of the directive is not public until over 6 weeks after each meeting. Look at the federal funds rate futures in the WSJ to see what the market thinks. If interested, read the book Maestro by Bob Woodward (book is a biography of Greenspan s Fed - goes into the workings of the Fed in Gory Detail). 21
22 The Fed s Balance Sheet The Fed receives interest on its assets (U.S. government securities). The Fed pays no interest on its liabilities (currency and fed funds). 1997: Fed assets = $522 billion, on which it earned 5%, yielding $26 billion in interest income (called seignorage). Netting off the Fed s $5 billion in expenses, the Fed made $21 billion. The Fed is highly profitable (its profits equal.26% of GDP), which fosters its independence. The Fed returns its profits to the Treasury. In this way, the portion of the public debt held by the Central Bank has been monetized (converted into currency and reserves). The Treasury effectively pays no interest on this portion.
23 The Quantity Equation M*V = P*Y M = a money supply, P = the GDP deflator, Y = real GDP. V = a velocity = PY/M. We define V in this way. If V is constant and Y is beyond the Central Bank s LR control then... When the Central Bank doubles M, the result is a doubling of P. Inflation is always and everywhere a monetary phenomenon. This Friedman quote is not literally correct because of Y and V movements. But a LR correlation of.95 means it s close enough.
The Evolution of Velocity 24
The Evolution of Velocity 25
26 Notes on the Quantity Equation V is defined so that the Quantity Equation holds (so it s really an identity). Therefore one cannot argue with P = MV / Y. Inflation (rising P) is caused by too much money chasing too few goods, i.e. by M rising relative to Y (controlling for how much M we need to transact PY, which is V). Note inflation could rise despite fixed M because of falling Y or rising V (fewer goods relative to the M we need so that P rises). Across countries, however, most differences in inflation (= P growth) are associated with differences in M growth: the correlation between M growth and inflation is above.95 (and the coefficient is about 1) in the LR. V is not fixed in reality. V rises with financial innovation and with i (the nominal interest rate). Recall that i = r + inflation. If, like Y, r is beyond the Central Bank s LR control, then higher inflation translates one-for-one into higher i. Implication: V rises with the rate of inflation. Thus taking into account that V is not fixed only makes the channel from M growth to P growth stronger: when M growth is high it generates inflation, which raises V, which in turn raises inflation further. This is a big deal in hyperinflations.
Money Growth and Inflation 27
Nominal Interest Rates and π 28
Monetizing Government Debt The Central Bank buys public debt with reserves. When public debt is growing faster than GDP, there is political pressure on the Central Bank to monetize some of the government debt b/c fixed nominal debt is easier to pay off the higher is P. public debt pays interest, reserves do not. Large budget deficits are the underlying cause of hyperinflations. The debt and deficit limits in Europe s EMU are meant to prevent member countries from pushing for higher inflation. Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt. 29
CB Independence & Inflation 30
31 Hyperinflations are... sometimes defined as 30% or more inflation in a year. usually characterized by accelerating inflation. (wage indexation) caused by rapid M growth (the Central Bank creating new reserves at a rapid rate). exacerbated by rising velocity (efforts to economize on M). highly disruptive to Y. 1985 Bolivia 10,000%, 1989 Argentina 3100%, 1990 Peru 7500%, 1993 Brazil 2100%, 1993 Ukraine 5000%.
32 Why Do Governments Grow the Money Supply? Short Term Political Gains - reduce unemployment (or raise output). If the economy is capacity constrained - prices must rise (however, this usually occurs with a lag!) Accommodating Supply Shocks - The U.S. in the 70s! (as opposed to breaking the inflation cycle). Financing Government Deficits by Printing Money!!! We will deal with this more next week!
33 Websites with more info The Fed and District Banks (see the Board of Governors website for FOMC minutes and speeches and testimony of FOMC members): http://www.ny.frb.org/links.html Foreign Central Banks: http://www.bog.frb.fed.us/centralbanks.htm Fed Points (each explains something, e.g. how currency gets into circulation): http://www.ny.frb.org/pihome/fedpoint/ Details on how open market operations work: http://www.ny.frb.org/pihome/addpub/omo.html Overview of the Fed: http://www.federalreserve.gov
So far: Money Supply Nominal Money Supply (M s ): Affected By the Fed Fed conducts monetary policy to increase Money Supply - Open Market Purchases - Decrease the reserve ratio - Decrease the Discount Rate 34
35 Money Demand Agents decide how much wealth to keep as money: Portfolio allocation decision 3 main characteristics of assets matter: 1. Expected Return: the higher the expected return the higher consumption the agent can enjoy! 2. Risk: agents are risk-averse, hence to hold a risky asset, it must have a higher expected return 3. Liquidity: the easier is to exchange the asset for goods, services or other assets, the more attractive is the asset. Money is highly liquid! Money is the most liquid BUT has a low return!
36 Money Demand (continued) Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions. As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions. This is the liquidity demand for money. As the nominal interest rate on non-money assets (bonds), i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases. Since i = r + π e, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).
37 Money Demand (continued) Other factors affecting Money Demand: Wealth Risk Liquidity of Alternative Assets Payment Technologies
38 Money Demand Function Our model for the demand for nominal money balances takes the following form M d = P L d (Y, i) where M d = demand for nominal money balances (demand for M1) L d = demand for liquidity function P = aggregate price level (CPI or GDP deflator) Y = real income (real GDP) i = nominal interest rate on non-money assets
39 Real Money Balances The demand for real balances Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances function: M d /P = L d (Y, r + π e ) The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money). The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio demand for money (captured by r and π e ).
Money Demand 40
Money Demand/Money Supply Interactions The Money Market is in Equilibrium when Real Money Demand = Real Money Supply where Real Money Supply = M s /P Real Money Demand = M d /P = L d (Y, r + π e ) Note: The money supply curve does not change with interest rates (it is verticle) What shifts real money supply: M, P What shifts real money demand: Y, π e 41
42 Money Market Equilibrium Money Market M s r e M d = L d (Y,π e ) M/P
43 Money Market Equilibrium Increasing Y Money Market r 1 M s r 0 Y increases M d = L d (Y 1, ) M d = L d (Y 0,..) M/P Suppose Y increases from Y 0 to Y 1 (Holding Money Supply fixed!)
44 Positive Relationship Between Y and r (in Money Market) Soon to be LM curve r 1 r 0 Y Y 1 Y
45 Shifts in LM curve - An increase in M (Step 1) Money Market M s M s 1 r e 0 r e 1 1 M d = L d (Y,π e ) M/P M 1 /P
An increase in M - Step 2 A fall in r, will increase I, causing Y to increase - which causes M d (and r) to increase. Y increases Money Market M s M s 1 r e r e 2 0 2 r e 1 1 M increases M d1 = L d (Y 1,π e ) M d = L d (Y,π e ) M/P M 1 /P This process is known as monetary feedback - increasing M will cause r to fall, I to increases, Y to increase, money demand to increase and r to increase. The net effect on r will be to fall. Can we represent this process in a more concise form? 46
47 Interest Rates and Output There are two effects between interest rates and output. 1) The IS curve. As interest rates fall, Investment increases and Y increases. r falling causes Y to increase (negative relationship - the IS curve) 2) The LM curve. The transaction motive for holding money (the monetary feedback mechanism). As Y increases, demand for money increases and r increases. Y increasing causes r to increase (positive relationship - the LM curve) What is the LM curve? Next slide...
48 The LM (Liquidity-Money) Curve LM Curve: (drawn in (Y-r) space) - represents the relationship of Y and r through the money market (specifically - Y s affect on money demand). The LM Curve relates real interest rates to real changes in output in the money market. As Y increases - M d shifts upwards - causing real interest rates to rise (increase in transactions demand increases the demand for money). What shifts the LM curve? Money: Increasing Money Supply increases M/P causing the LM curve to the right. Prices: Increasing Prices causes real Money Balances to fall shifting LM curve to the left. π e : Increasing expected inflation causes returns on bonds (assets other than money) to increase making it less attractive to hold cash. Causes LM curve to shift right!
49 Shifting the LM curve Thought experiment: Suppose M increases. What level of Y is needed to hold r constant. Or, put another way, what would happen to r if Y was held constant? M s M s 1 r 0 x r 0 x LM(M 0 ) LM(M 1 ) z r 1 r 1 z M d (Y 0 ) Money Market LM curve Y 0 An increase in the nominal money supply will cause the LM curve to shift to the right.