Principles of Macroeconomics
Principles of Macroeconomics ECO 230
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CHAPTER 15 MONETARY POLICY Chapter Outline History amp Structure of the Federal Reserve System Functions of the Federal Reserve Tools of Monetary Policy Open Market Operations Change in the Discount Rate Change in the Required Reserve Ratio Summary of Monetary Policy Tools Impacts of Monetary Policy on the Economy The Loanable Funds Market Monetary Policy and Interest Rates The Impact of Monetary Policy on the Economy The Federal Reserve is the United States Central Bank It is probably the most powerful yet least understood organization in our economy Its actions may affect everyday consumers whenever we purchase things on credit take out a loan or feel the effects of in ation or unemployment We will examine the history structure and operations of the Federal Reserve Functions of the Federal Reserve include 1 check collection and clearing 2 holding bank reserves 3 acting as a scal agent of the federal government 4 supervising financial intermediaries 5 providing and controlling the money supply 6 being the lender of last resort The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the banking system History amp Structure of the Federal Reserve The Federal Reserve quotthe Fedquot was founded in 19131914 after four severe banking panics Two other central banks were set up in the 1800s but each lasted only a short time The Federal Reserve is chartered by the federal government but is largely independent of the authority of the Congress and President The Fed must only report to the Congress periodically and operate within broad mandates The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the banking system The lender of last resort is probably the Fed39s biggest responsibility Many economists believe that the Great Depression was due mainly to the collapse of our banking system The Fed did not do enough to prevent its collapse When a business needs money it can often go to the bank for help Before the Federal Reserve was created banks had nowhere to turn to when they were in trouble The Fed is now there to back them up The unique structure of the Federal Reserve is a consequence of history and politics Figure 1 gives a breakdown of the main divisions within the Fed Boar of Federal Open Monetary Governors ymarket Committee Policy 12 District Banks Figure 1 The Board of Governors consists of 7 members and is the highest governing body of the Federal Reserve The Board of Governors is the highest governing body of the Federal Reserve It consists of 7 members including the chairperson currently Alan Greenspan The chair is appointed to a 4year term by the President of the US The appointment is usually staggered with the election of President of US ie every two years either the President or chair comes up for electionappointment However this staggered cycle was disrupted when Paul Volcker resigned early from the Federal Reserve in 1987 The other siX members of the Board of Governors are appointed to 14year terms by the President of the United States and they must be con rmed by the Senate The long terms try to assure stability and continuity in the Fed39s policy decisions However many of the board members do not serve their full terms and leave early to work in the private sector The Twelve District Banks were initially designed to decentralize the Federal Reserve The United States has a long history of being fearful of centralization and this was a way to diffuse the power However although the District Banks have some autonomy they ultimately fall under the leadership of the Board of Governors when it comes to monetary policy The District Banks perform numerous functions in their respective areas They regulate and supervise banks and bank holding companies run a checkclearing service do research and monitor economic activity circulate the currency sell savings bonds and so on Moreover the New York Federal Reserve Bank conducts open market operations and foreign exchange stabilization which will be explained below The FOMC Federal Open Market Committee is responsible for directing monetary policy The committee is made up of 12 members 7 from Board of Governors plus 5 Presidents of the District Banks on a rotating basis one of which is always from the New York Fed This committee meets about every 6 weeks to discuss monetary policy and decide what course of action to take The committee meets more often if there is something pressing to deal with An Open Market Operation is the purchase or sale of government securities via transactions in the open market The Discount Rate is the interest rate at which the Federal Reserve lends funds to banks The Required Reserve Ratio is the percentage of deposits banks must keep on hand Tools of Monetary Policy The Federal Reserve like the government conducts stabilization policy In other words it helps the economy achieve stable prices low unemployment and high rates of economic growth Fiscal policy is the term used when the government attempts to stabilize the economy The Federal Reserve s attempt at stabilization policy is referred to as Monetary Policy There are three quottoolsquot that the Fed can use to conduct monetary policy They are 1 Open Market Operations OMO 2 Change in the discount rate and 3 Change in the reserve requirement ratio T001 1 Open Market Operations An Open Market Operation is by far the most important tool of the Fed and it is used daily An Open Market Operation is the purchase or sale of government securities via transactions in the open market Government securities are government debt ie TBills TNotes or TBonds In other words an open market operation is simply the purchase or sale of secondary government debt by the Federal Reserve An Open Market Purchase is the Fed s purchase of government securities An Open Market Sale is the Fed39s sale of government securities The Open Market Desk is on the 8th oor of the New York Fed This is where the trading in government securities actually occurs The traders take their orders from the FOMC and carry them out An Open Market Operation impacts the banking system by changing bank reserves initially and ultimately the money supply Let s look at an example of an Open Market Purchase Suppose the Fed purchases 100 million of government securities from commercial banks How does the banking system and the economy adjust First let s stop to think of where the money comes from Where does the Fed get the 100 million to purchase the government debt The answer may surprise you The Fedreal Reserve System is offbudget meaning that it generates its own operating revenue In fact the Fed makes such a pro t that it gives billions of dollars back to the US Treasury each year The money for its open market operations comes from computer terminals The money is completely quotelectronicquot But once the money is there on the computer it is as real as a dollar bill Now let39s answer our original question as to the effects of the 100 Open Market Purchase To see the effects we must examine our bank balance sheets again in Figure 2 When the Fed purchases 100 million in government bonds from banks it simultaneously puts 100 million of reserves in the hands of banks as they exchange their stocks of government securities for the reserves Total Reserves 100 Required Reserves Excess Reserves 00 Figure 2 Since the 100 million are not deposits the entire 100 million becomes excess reserves Banks can begin lending out the 100 million which leads to the money expansion we looked at earlier The money creation process might generate a maximum of Change in M1 1 10 X 100 million 1000 million T001 2 Change in the Discount Rate Sometimes banks need liquidity That is bank operations may be sound but heavy withdrawals or unexpected delay of payments by customers leave the bank without enough cash to meet its reserve requirements A bank in this Figure 3 situation has two primary sources to turn in order to borrow funds One place is the federal funds market Other banks who have excess reserves can lend their reserves to those banks who are short of their reserves The interest rate that is charged when one bank lends reserves to another is called the federal funds rate A bank needing reserves could also turn to the Federal Reserve39s discount window If the Fed decides to lend to the bank the Fed charges interest also This interest rate charged is called the discount rate The discount rate is the interest rate at which the Federal Reserve lends funds to banks It is the only interest rate that the Fed sets directly The Federal Reserve controls the discount rate in order to in uence the supply of money in the economy If the Federal Reserve lowers the discount rate it is signaling that it is loosening the money supply and consequently banks will be more willing to make loans to customers and make up any shortage in reserves by borrowing from the Fed Conversely if the Fed raises the discount rate it is signaling that monetary policy is tightening and banks had better make sure they have enough reserves on hand Lowering the discount rate increases the money supply raising the discount rate contracts the money supply Let s look at an example Suppose the Fed decreases the discount rate by one percentage point This induces banks to borrow 5 million more in reserves from the Fed The 5 million is an asset that goes in the bank39s reserves but it is simultaneously a liability that is a loan from the Fed However the loan from the Fed carries no reserve requirements The bank is free to lend out the entire 5 million provided that it has enough reserves to meet its required ratio This scenario is charted if Figure 3 below Reserves 5 E Change in reserves Required Reserves T001 3 Change in the Required Reserve Ratio The last tool of monetary policy is to change the required reserve ratio Currently the required reserve ratio is 10 percent If the Federal Reserve lowers the required reserve ratio then a bank has to hold fewer reserves on a given amount of deposits For example ifa bank has deposits of 100000 and a required reserve ratio of 125 percent then it has to hold 12500 as reserves If the Fed lowers this to 10 percent then the bank only has to hold 10000 as reserves Therefore 2500 in excess reserves are created RRR125 RRR10 Total Deposits 100000 100000 Reserves on hand 12500 12500 Reserves 12500 10000 Excess Reserves 0 2500 Figure 4 The Federal Reserve does not use this tool often because banks must constantly estimate their reserves to make sure they meet the required level and if the rules of the game keep changing for banks then it makes it much more difficult for banks to manage their assets The Fed prefers to use Open Market Operations Summary of Monetary Policy Tools Tool Expansionary C ontracti ortary OMO Purchase Sale Discount Rate Lower Raise RRR Lower Raise Figure 5 Impacts of Monetary Policy on the Economyl 1 Note that even though monetary policy may stimulate a struggling economy a quick rebound may not happen for a number of reasons Businesses may not jump back with both feet and start investing in new equipment until they see definite signs that things are turning around again Longstruggling Japan for example slashed interest rates to near zero in 2000 and 2001 Despite the desperate measure that effectively amounts to throng money out of airplanes to get the Japanese to spend and stimulate the economy there is no proof that the policy is working Second It takes up to a year for the Fed39s policy shift to filter through the economy And business expansion is also a long and costly process It includes opening plants buying inventories of raw materials and hiring and training people It can take up to a yearfor new investments to bene t the economy This section establishes the link between monetary policy and the behavior of the economy We explain how Federal Reserve actions impact the behavior of output in ation and unemployment Monetary Policy works by changing the level of demand for goods and services in the economy When the Fed expands the money supply banks have more reserves to lend out They will usually quotsellquot these reserves to the public by lowering the interest rate and prompting more borrowers to come forward The lower interest rate will induce higher levels of investment and will lead to more demand for goods and services boosting the economy39s level of output The Loanable Funds Market We best illustrate the impacts of monetary policy by examining the loanable funds market Demand for loanable funds comes from anyone wishing to borrow money whether it be to buy a home or go to college As the interest rate falls the cost of borrowing funds falls so more potential borrowers want funds Therefore the demand curve is downward sloping Draw the Figure here The supply of loanable funds comes from anyone wishing to lend money whether it be a bank or an individual As the interest rate rises the profit opportunity for lending funds rises so more people wish to lend their funds Therefore the supply curve is upward sloping Equilibrium occurs where demand and supply for loanable funds are equal as illustrated in Figure 4 This determines the equilibrium interest rate and the quantity of loanable funds in the economy Monetary Policy and Interest Rates When the Fed conducts expansionary contractionary monetary policy it is giving banks more less funds to lend out Thus the supply of loanable funds shifts to the right left This lowers raises interest rates and increases decreases the amount of loanable funds In Figure 5 we move from point A to point B and interest rates in the economy fall So expansionary monetary policy lower interest rates while contractionary monetary policy raises interest rates Figure 5 Expansionary monetary policy will shift the AD curve to the right The Impact of Monetary Policy on the Economy How does all this impact the economy So far we have not discussed any changes in prices output or employment Let s examine expansionary monetary policy speci cally an open market purchase When interest rates fall due to the increase in loanable funds expenditures on investment and consumption items that are sensitive to the interest rates rise Recall that investment and the interest rate are inversely related Figure 6 For example if mortgage rates fall demand for new houses will increase Demand for cars might also increase as the interest payments fall People may buy more items on credit if credit card rates are reduced and so on Therefore expansionary monetary policy increases Aggregate Demand as illustrated by the rightward shift in Aggregate Demand in Figure 6 When demand for goods and services increases more production must occur to meet the demand This creates jobs and lowers the unemployment rate Notice too that the Price Level increases Other things equal expansionary monetary policy will increase GDP employment and in ation The reverse is also true Contractionay monetary policy shifts the Aggregate Demand curve to the left resulting in lower levels of GDP and employment and a lower in ation rate Monetary policy is an extremely powerful tool with profound effects on the economy By changing interest rates the Federal Reserve can cause an economic expansion or contraction that in uences millions of people in the United States and around the world CHAPTER 13 MONEY AND BANKING Note this chapter is almost complete Chapter Outline Money De nition and Measurement Measuring the Quantity ofMoney Financial Intermediaries and their roles Financial Regulation Deregulation and Innovation Banking The Fractional Reserve System Dangers of a Fractional Reserve System Bank Bookkeeping Money Creation by Banks The Money Multiplier Money De nition and Measurement What is money Money is anything that is acceptable in exchange for goods and services In the past there are many kinds of money that have been used The main kinds of money that we countries used and are using include 1 Fiat Money money that is declared as money by the government This is includes coins and currency Fiat money is the circulating debt of the Federal Reserve Fiat money has its own advantages and disadvantages Advantages 1 It is cheap to produce and hence is used as a source of revenue for the government called seignorage 2 it is easy to carry Disadvantages 1 Because it is cheap to produce there is a strong temptation to print more2 It is susceptible for counterfeiting 2 Commodity Money includes gold silver and other precious metals Advantages can be used be used for other purposes than money earrings necklaces etc Disadvantages 1 it could be a victim of Gresham s lawi bad money drives out good money That is people may try to give up only debased mutilated money and hence the ones circulating could be these quotbadquot monies 2 it is heavy to carry 30 it is susceptible for counterfeiting as well 3 Bank Money are deposits in checking accounts Advantages less susceptible for counterfeiting 2 easier to use for transactions A barter system is one in which goods and services are exchanged directly for goods and services It requires a double coincidence of wants For example if I decide that I want a cow I must nd someone who has one and she must be willing to trade the cow for something that I have For example I might have a that the cow owner wants We can then exchange the cow for the horse Such transactions are difficult and clumsy We can ease the transition process by using a monetary system A monetary system uses some universally recognized currency to facilitate transactions Now if I wish to acquire a cow I simply go to the owner of the cow and pay money for the cow I do not need to have something of equal value that the cow owner wishes to have The double coincidence of wants is unnecessary We need to carefully define quotmoneyquot In common usage the terms money income and wealth are often used interchangeably But to an economist money and income are very different things Income is the ow of revenue over a particular time period For an income measurement to make sense one must define it in terms of a particular time period For example I earn 8 per hour or my salary is 1800 per month or my income is 23000 per year Without a time qualification income could refer to almost anything Few of you think of yourselves as millionaires but in your lifetimes you will indeed earn income over 1000000 Wealth is the value of your stock of assets at a particular point in time Your assets are things of value that you own For example your house stocks car and funds in your savings account are all part of your wealth Wealth is a stock it can be added up at any moment in time Functions of Money Money is something that serves these th purposes First it is a medium of exchange or a means for making transactions Second it is a unit of account or a standard unit for quoting prices Third it is a store of value a means to store wealth from one time period to the next You can put your money under your mattress and it will be there next month Lots of things can be used as money In much of our history we used gold and silver Some places use rocks to trade goods During wars cigarettes and chocolates are often used As long as the commodity serves the three purposes described above it can be money In today39s world we use fiat money or paper money The money is inherently worthless except for the purchasing power that we trust it will bring Without trust the paper money becomes useless pieces of paper Supply and 39 of Money Money is measured in terms of its liquidity how easily it can be converted to cash Currency by de nition is highly liquid because it is already cash Checking accounts are liquid because one can write checks as a way to carry out transactions Houses and cars however are not nearly as liquid The narrowest measure of money which includes only the most liquid assets is called M1 M1 includes Currency Demand Deposits nointerest checking accounts Other Checkable Deposits and Traveler s Checks bP Nt M2 is a slightly broader de nition of money that includes less liquid assets M2 includes M 1 plus Savings Deposits plus SmallTime Deposits less than 100000 plus Money market Mutual Funds MMMF and Money Market Deposit Accounts MMDA eP NEE The distinction between M1 and M2 has been narrowing due to advances in banking M2 is much more liquid than it used to be Currently we have nearly 13 trillion in M1 in the economy and over 37 trillion in M2 The role of W 39 Intermediaries Defn Financial intermediaries are 1 commercial banks 2 thrift institutions such as saving and loan associations mutual savings banks credit unions and 3 money market mutual funds such as retirement funds and insurance companies These financial intermediaries have four economic functions a They provide liquidity by borrowing short and lending long They stand to repay loans on short notice On the other hand they make loans available for a long time 15 20 years of a mortgage is an example b They minimize the cost of borrowing by bringing lenders and borrowers together If you want to run a business and you are short of funds in millions of dollars you just need The Value of Money It depends on to go the nancial intermediary to get the necessary funds that hundreds and possibly thousands of people have deposited They reduce cost of monitoring borrowers by investigating the creditworthiness of individuals and companies By depositing your money with your nancial intermediary you avoid the cost of losing your assets if you were to lend it to rm who could have defaulted on its loans Banks monitor each borrower before and after the loans are provided to the individual or form Risk pooling They do this by being able to lend to a large number of borrowers in which some may be risky borrowers If the majority of borrowers are less risky and only a few may default the bank may still come out ahead The default is spread across all depositors and individual depositors avoid the risk of losing all of their assets Banks bring together diversi ed group of borrowers They create money via the fractional reserve system and multiple creation of deposits see Figures 142 and 143 in this chapters and therefore are responsible in the creation of part of the money supply About 65 of the money circulation is bank money called Ml which is basically deposit on checking accounts 1 Acceptability 2 legal Tender 3 Relative Scarcity The Demand for Money 1 Transaction Demand 2 Asset Demand 3 Total Demand Combining the Demand and Supply of Money show graphically about here The Federal Reserve System Brief History Financial Regulation Deregulation and Innovation Banks make money by providing loans And this is their major source of income There is a builtin temptation to loan out every penny they have But there is also a danger for banks to run out cash and face a bank run As a result nancial intermediaries are heavily regulated They are regulated especially in four balance sheet regulations which are a Capital requirements the minimum amount of an owner39s own nancial resources that must be kept into an intermediary This is done to discourage nancial intermediaries from making loans that are too risky b Reserve Requirements rules setting out the minimum percentages of deposits that must be held in currency or other safe liquid assets b Deposit Rules restrictions on the different type of deposits that an intermediary can accept For example commercial banks in the past provided to checking accounts while others were only allowed to provide saving accounts These have changed after the 1980s and 1990s nancial deregulations c Lending rules in the past SampLs were allowed only to provide mortgage loans while commercial banks were allowed to provide commercial loans These have changed after the 1980s and 1990s nancial deregulations How Banks Create Money The Fractional Reserve System Our banking system is called a Fractional Reserve System which means that banks must only keep a fraction of the deposits they hold on hand The rest can be loaned out For example suppose banks are required to keep 10 of deposits on hand This is called the Required Reserve Ratio RRR For every 100 of deposits only 10 must be held by the bank De ning the required reserve ratio in percentage terms RRR required reserves total deposits X 100 or required reserves RRR X total deposits 100 Banks are in business like any other private company to make a pro t They earn pro ts primarily on the spread between the rate they must pay for funds and the rate they charge for lending funds Dangers of a Fractional Reserve System There are at least two problems with a fractional reserve system First the nancial system is susceptible to bank runs If depositors lose faith in their banks they run to the banks to withdraw the funds This happened on a large scale during the Great Depression Since banks have only a fraction of the deposits actually on hand at the bank only the first customers to get in line will receive their money The second problem with a fractional reserve system is the possibility of bank failures Since banks are in business to make a profit they can make poor management decisions by making risky loans Depositor funds are at risk We have developed partial solutions to these problems over the years particularly in the years following the Great Depression To prevent bank runs we have implemented a system of deposit insurance Most banks are members of FDIC the Federal Deposit Insurance Corp This is an insurance system that banks pay funds into in order to cover depositors funds if the bank fails This helps to avoid widespread bank runs because depositors are assured of the security of their deposits However this also leads to an incentive system in which depositors do not care how a bank is managed There is no consumer regulation on quality of banks39 operations Even when Savings and Loans were going bust in the late 1980s depositors kept putting their money in them To reduce the likelihood of bank failure and bad or corrupt management practices we have developed an extensive system of bank regulation Banks are probably the most regulated companies in the Us They are subject to frequent audits to make sure loan portfolios are sound and that all activities are legal The system is far from perfect however given the recent wave of bank failures and corruption Commercial Banks and Bank Bookkeeping Capital Assets Liabilities Reserves are funds that the bank keeps on hand to meet depositor demands for funds and to satisfy the minimum reserve requirements set by the Federal Reserve Reserves can consist of either vault cash or funds held by the Fed for the bank Many banks especially those in large cities prefer the Fed to hold onto the cash for them The funds can be withdrawn at any time