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Introduction to Money Supply

Introduction to Money Supply. The market for money. The Money Supply The relationship between the quantity of money supplied and nominal interest rate i . On any given day, the quantity of money is fixed independent of interest rate i .

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Introduction to Money Supply

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  1. Introduction to Money Supply The market for money • The Money Supply • The relationship between the quantity of money supplied and nominal interest rate i. • On any given day, the quantity of money is fixed independent of interest rate i. • The quantity of money supplied is determined by bank lending and the Fed. Money MS i0 M0

  2. Introduction to Money Supply • The market for money • Equilibrium • Money supplied is fixed in the short-run. • i is determined by the intersection of MS and MD • Interest Rate Adjustment • When the interest rate is above its equilibrium level, the quantity of money supplied exceeds the quantity of money demanded (or needed). • People hold too much money, so they try to get rid of it by buying other financial assets. • The demand for financial assets increases, the prices of these assets rise, and the interest rate falls. Money MS i1 i0 MD M1 M0

  3. Introduction to Money Supply • The market for money • Equilibrium • Money supplied is fixed in the short-run. • i is determined by the intersection of MS and MD • Interest Rate Adjustment • When the interest rate is below its equilibrium level, the quantity of money demanded (or needed) exceeds the quantity of money supplied. • People are holding too little money, so they try to get more money by selling other financial assets. • The demand for financial assets decreases, the prices of these assets fall, and the interest rate rises. Money MS i0 i1 MD M1 M0

  4. Money Supply and Banks • Banks as financial intermediaries • What role do banks play in the creation of the supply of money? • Commercial banks bring savers and investors together • Banks use checking and savings deposits to make loans • balance sheet for a bank • balance sheet has two sides: • Liabilities – the source of the funds for the bank • checking accounts • savings accounts • Assets (generate income for banks via interest payments) • Mortgages • car loans • US Treasury Bonds • required reserves • excess reserves (big withdrawal insurance) • Net worth = assets – liabilities

  5. Money Supply and Banks • Banks as financial intermediaries • Example: Balance for a bank • Assets Liabilities • 300 req’d reserves 3000 deposits • 50 excess reserves • 900 US T-bonds • 2000 car loans250 net worth • 3250 3250 • Reserves: assets not lent out by banks • Banks are Required to hold a fraction of Reserves (RR) • Reserves in Excess of RR are called excess reserves (RE) • If r = 10%, the bank holds RR = 3000 X 0.1 = 300, • R = RR + RE = $350

  6. Money Supply and Banks • The process of money creation • Example: banks role in determining the supple of money • You walk into Bank 1 and deposit $1000 into your checking account • MS does not change because currency held by the public and in checking accounts are both part of the MS • If the r = 10%, Bank 1 holds $100 of the $1000 deposit as RR & lends $900 to George. • George uses the $900 to buy a TV from BuyMart • BuyMart deposits the $900 into its account at Bank 2 • MS does not change because currency held by the public and in checking accounts are both part of the MS • Since the r = 10%, Bank 2 holds $90 of the $900 deposit as RR & lends $810 to Jill • Yada yada yada… The original deposit of $1000 is used to create money via lending: • 1000 + 900 + 810 + 729 + 656.1 + . . . . . = 10,000 • Increases in bank deposits creates money in the economy via increased bank lending even though the actual number of bills in the economy has not changed!

  7. Money Supply and Banks • The process of money destruction • Example: banks role in determining the supple of money • You withdrawal $1000 from your checking account at Bank 1 • MS does not change because currency held by the public and in checking accounts are both part of the MS • If the r = 10%, Bank 1 holds $100 less in RR and lends out $900 less. • Bank 1 cannot lend George the $900 he needs to buy a TV. • George does not spend the $900 at BuyMart • BuyMart deposits $900 less in its account at Bank 2. • Since the r = 10%, Bank 2 holds $90 less in RR and does lends out $810 less. • Yada yada yada.. Hence, the original withdrawal $1,000 destroys money via less lending: • Withdrawals collapse the money in an economy via less bank lending even though the actual number of bills in the economy has not changed!

  8. Money Supply and the Fed • Demand for reserves • Example: Suppose r = 0.1, D = 50 (billion $), and demand for excess reserves is given by • Derive reserves demand. Federal Funds Market iff 5 2 DR DER 20 23 25 28 Q

  9. Money Supply and the Fed • Supply of reserves • A bank that can’t meet its reserve requirement (RR) borrows from a bank that has excess reserves in the federal funds market and QS remains unchanged. • The vertical part of reserves supply curve is the amount of reserves the Fed supplies to the federal funds market. • When banks borrow from the Fed, discount loans rise, borrowed reserves (RB) increase, the quantity of reserves supplied increases. • When banks sell US Treasury securities to the Fed, non-borrowed reserves (RN) increase, which increases the quantity of reserves. • Hence, the supply of reserves is the sum • The horizontal part of the reserves supply curve is the discount rate (id) • If the federal funds rate is less than the discount rate (iff < id), banks will not borrow from the Fed because • “Insurance” purchased from the Fed is more expensive than from other banks • If the federal funds rate is more than the discount rate (iff > id), banks will want to borrow from the Fed instead of other banks • “Insurance” purchased from other banks is more expensive than from the Fed.

  10. Money Supply and the Fed • Supply of reserves • Example: Suppose RB = 0 (billion $), RN = 28 (billion $) and id = 3 (percent). Graph the supply of reserves in the figure below. • Vertical part: • RB + RN = 0 + 28 = 28 • Horizontal part: • id = 3 Federal Funds Market iff 3 SR 28 Q

  11. Money Supply and the Fed • Federal funds market equilibrium • If demand for reserves intersects the vertical section of the supply of reserves, then • The federal funds interest rate is less than the discount interest rate (iff < id ) • A bank would rather borrow from other banks • The quantity of reserves equals RN + RB • If demand for reserves intersects the horizontal section of the supply of reserves, the federal funds interest rate equals the discount interest rate (iff = id ) • A bank is indifferent between borrowing from other banks or the Fed • However, the bank borrows from the Fed because something (a crisis) has dried up all of the excess reserves held by banks. • The equilibrium quantity of reserves exceeds RN + RB • The difference between equilibrium quantity of reserves and RN + RB is the quantity of discount loans made by the Fed

  12. Money Supply and the Fed Federal funds market equilibrium • Example:Suppose r = 0.1, D = 50, RB = 0, RN = 28, id = 3, and excess reserves demand is Graph the reserves supply and demand. Vertical part: RN + RB = 28 Horizontal part: id = 3 Federal Funds Market iff 5 3 SR Equilibrium 2 DR 25 28 Q

  13. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose the Fed increases the discount rate to 4 (percent). Show the effect of this policy change in the figure below. Federal Funds Market The horizontal section id = 4 iff The vertical section no change SR 4 3 SR Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target 2 DR 28 Q

  14. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. Federal Funds Market iff 4 The new equilibrium: iff = 3 3 SR 2 DR DR 28 29 Q

  15. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. In the past, the Fed has tried slowing the economy by increasing r. Doing this creates a big collapse in bank lending to businesses and consumers. In addition, the Fed has to make $1 billion in discount loans to banks because REdried up. So even though total reserves have increased via discount lending ($1 billion in the diagram above), this cash is sitting idle. The effect is a reduction in money supply. Federal Funds Market iff 3 SR DR 28 29 Q

  16. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead the Fed increases the required reserve ratio to 14%. Show the effect of this policy change in the figure below. Money MS’ MS This increases r provided inflation remains unchanged. i1 i0 MD M1 M0

  17. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead the Fed increases the required reserve ratio to 14 (percent). Show the effect of this policy change in the figure below. Higher r decreases I, but also reduces net exports. These collapse AD. This results in lower prices and real GDP. In the past, small increases in r have put a “hot” economy (one that is growing too fast) into a recessionary gap. The Fed has not changed the r since 1992 AD-AS-YFE AS PL0 PL1 AD AD’ Y1 YF Y0

  18. Money Supply and the Fed • Open Market Operations • The Fed conducts an Open Market Purchase (OMP) by buying Treasury bonds from banks • Cash flows from the Fed to Banks • The quantity of reserves in the federal funds market rises • The federal funds interest rate declines • This is an exPansionary monetary policy • The Fed conducts an Open Market Sale (OMS) by selling Treasury bonds to banks • The Fed has bonds to sell because it purchased them directly from • Treasury in the primary market (this is called monetizing the debt) • Banks in the secondary market in a previous OMP • Banks give cash (reserves) to the Fed in exchange for Treasury bonds • The quantity of reserves in the federal funds market declines • The federal funds interest rate increases • This is a reStrictive monetary policy

  19. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead of changing id or r the Fed performs an OMP by buying a half of a billion dollars worth of bonds from banks (RN = 28 + .5 = 28.5). Show the effect of this policy change in the figure below. Federal Funds Market The horizontal section no change iff The vertical section RN + RB = (28 + .5) + 0 = 28.5 3 SR SR 2 New equilibrium 1.5 DR 28 28.5 Q

  20. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Federal Funds Market Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target. iff 3 SR SR 2 1.5 DR 28 28.5 Q

  21. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Federal Funds Market Starting on 1/1/03 the Fed began setting the discount rate 100 basis points (1%) above its federal funds rate target. So the Fed lowers the discount rate to 2.5 iff 3 SR SR 2.5 SR 1.5 DR 28 28.5 Q

  22. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Money Increased RN means banks have more cash to lend to consumers and business. The money supply increases via increased lending If inflation remains unchanged,r will fall too, increasing I (and X). MS MS’ i0 i1 MD M0 M1

  23. Money Supply and the Fed Federal funds market equilibrium • Example(continued): Suppose instead of changing id or r the Fed performs an OMP by buying a half (billion $) worth of bonds from banks. Show the effect of this policy change in the figure below. Lower r increases I, but also increases net exports. These increase AD. This results in higher GDP, lower unemployment, and higher prices AD-AS-YFE AS PL1 PL0 AD’ AD Y0 YF

  24. Money Supply and the Fed • Federal funds market equilibrium • Example(continued): Suppose instead the Fed performs an OMS by selling a half of a billion dollars worth of bonds to banks (RN = 28 - .5= 27.5) . Explain how this policy change affects the economy. • An OMS is the opposite of an OMP. • If the Fed sells0.5 (billion $) in US Treasury securities to banks, then 0.5 (billion $) in US Treasury securities leaves the Fed’s vault while 0.5 (billion $) in cash from member banks enters the Fed’s vault. • This decreases RN by 0.5 (billion $) and total reserves from 28 to 27.5 (billion $), decreasing reserves supply. • The equilibrium federal funds interest rises while MS falls. • i rises, which raises r if inflation does not change. • Hence, I and X decline, decreasing AD • Lower AD results in less output and lower prices.

  25. Money Supply and the Financial Crisis Interest on Reserves—the new tool • The Fed’s rescue of the financial system in 2008-2009 included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market iff DR Crisis mode To prevent this in October of 2008, the Fed began paying Interest on Reserves (IOR), which is currently about 0.25% id SR iff IOR 0 Q -iff

  26. Money Supply and the Financial Crisis Interest on Reserves—the new tool • The Fed’s rescue of the financial system in 2008-2009 included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market iff DR This allows the Fed to buy id SR IOR 0 Q

  27. Money Supply and the Financial Crisis Interest on Reserves—the new tool • The Fed’s rescue of the financial system in 2008-2009 included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market iff DR This allows the Fed to buy or sell as many securities as it wants without changing the federal funds rate. id SR IOR 0 Q

  28. id SR IOR Money Supply and the Financial Crisis Interest on Reserves—the new tool • The Fed’s rescue of the financial system in 2008-2009 included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market iff DR The federal reserve can also raise and lower the federal funds rate by simply raising IOR and id simultaneously. 0 Q

  29. Money Supply and the Financial Crisis Interest on Reserves—the new tool • The Fed’s rescue of the financial system in 2008-2009 included purchasing enough securities to increase the supply of reserves so much that it would drive the federal funds rate negative. Federal Funds Market iff DR The Fed will need to conduct several controlled OMS while carefully raising IOR to reduce its $2-3 trillion balance while keeping a eye on inflation. id SR iff 0 This should hopefully return the federal funds market to its pre-crisis state. Q

  30. Money Supply Growth and Inflation • Money Supply growth is the percent change in the stock of money • Inflation is the percent change in the Price Level (PL) from one year to the next. • Hyperinflation is really high inflation • How high is really high? • It’s a judgment call • Usually we talk about ridiculously high examples. • Compounding is important to remember. • Examples of Hyperinflation • YouTube inflation video 1 • YouTube inflation video 2

  31. Money Supply Growth and Inflation Hyperinflation in the Weimar Republic (Germany, post WWI) Feb., 1920 March,1922 Nov.,1922 Feb., 1923

  32. Money Supply Growth and Inflation Hyperinflation in the Weimar Republic (Germany, post WWI) July, 1923 Sept., 1923 Oct., 1923 • Why did this happen? • In Nov. of 1918, there were 29,200,000,000 paper marks in circulation • A year later, 497,000,000,000,000,000,000 paper marks in circulation • That was a massive increase in the money supply, an increase of 1,702,054,794,421%

  33. Money Supply Growth and Inflation Yugoslavia had inflation problems in the 1980’s, but in 1993 things really got bad. $1 = 900 Dinar (1/1/93) $1 = 2,000,000 Dinar (11/12/93) $1 = 13,000,000 Dinar (11/23/93) $1 = 64,000,000 Dinar (11/31/93 ) $1 = 6,400,000,000 Dinar (12/15/93) PRICES WERE DOUBLING EVERY DAY $1 = 12,000,000,000,000,000,000,000 Dinar (1/24/94)

  34. Keynes vs. Hayek Keynes: advocate of proactive government intervention • Budget deficits in recessions • Surpluses in economic expansions • Both can be used to manage AD, ensuring full employment Hayek: advocate of economic freedom • Government intervention results in less economic freedom • Economic efficiency • "The problem was that under central planning, there was no economic calculation--no way to make a rational decision to put this resource here or buy that good there, because there was no price system to weigh the alternatives." • “Socialism told us that we had been looking for improvement in the wrong direction.“ • The thesis in The Road to Serfdom is • Government intervention leads to more intervention • Each intervention has unintended consequences, which distort markets • Unintended consequences of well-intentioned policy generates the need for more interventions because consequences need to be corrected. • It is this dynamic that leads society down the road to serfdom. The tree and western wild fire analogies

  35. Keynes vs. Hayek Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps. Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices.

  36. AS AD Keynes vs. Hayek Keynesians intervene in the short-run to steer the economy back to full-employment. They pursue policies that close short-run recessionary and inflationary gaps. Hayekians are not concerned with short-run fluctuations, advocating instead for pro-growth, free-market (not pro-business) polices. Watch the “Fear the boom and bust” video on YouTube AD-AS-YFE PL Hayek Keynes Y

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