Monetary Policy

1. Monetary Policy Topic 5

2. What is monetary policy? General definition: A tool used by governments to affect the economy • Monetary policy is geared towards influencing interest rates • If government can affect interest rates, then the government can affect consumer and firm behavior • MRT = the interest rate at which firms can transform inputted capital • MRS = the interest rate at which households will defer current consumption • In equilibrium, MRT=MRS=interest rate, which is what the government would like to affect. • Example: increasing interest rates slows the economy by making funds more expensive to firms, and promotes consumer savings which decreases revenues by firms. • Central Bank (Federal Reserve Bank - Founded 1913) is the central authority appointed by the government to implement monetary policy

3. Monetary Policy and the Federal Reserve Bank Tools used by the FRB (FED) for implementing monetary policy • Open market transactions: Buying and selling of treasury securities changes the money supply in the economy, affecting interest rates • Perhaps the most frequently used tool available by the FED • Decisions are made by the FOMC (Fed Open Market Committee) • Reserve requirements: changes the amount of reserves that banks must hold, affecting the amount of money creation, and thus supply. • Powerful tool, but infrequently used (once a decade or so) because of the disequilibrium that it creates • Discount window lending: Sets the base lending rate among financial institutions • A somewhat imaginary rate since few institutions actually borrow from the Fed, so this requires nothing other than a statement by the Fed Chairman

4. The role of Banks in Monetary Policy Banks can be viewed as counterfeit operations controlled by the government, and are an essential tool in affecting monetary policy • Banks lend money that they don’t have! • Loans made by banks are not backed 100% by reserves, so they are essentially minting their own currency • Reserve requirements set by the government determine the extent to which banks can counterfeit • Fewer required reserves means more counterfeiting and increased money supply (more loans means more available funds) Q: How do banks get away with counterfeiting? A: By use of their reputation. • Customers could bankrupt a bank simply by asking for all of their reserves back, which they can do at any time. • But, customers don’t ask for their money back since counterfeiting is profitable and they earn a part of the returns (interest), but they tolerate the behavior only as long as they believe that the bank is reputable in this activity

5. Historical perspective on depository institutions (banks) • Vault bank: Keep “money” safe. • Goldsmith establishments, Warehouse banks • Merchant Banking: Wealthy families, usually involved in trade, began to offer credit to customers to help them finance their purchases • Fractional Reserve Banking: More formal banks that accepted deposits recognized that the deposits never left the bank, so they began to use the reserves (lending) to earn additional profits, and specializing in: • Maturity intermediation • Asset diversification • Information processing (private information) • Monitoring and enforcement • Monetary policy: Governments use banks to enact monetary policy through control of the money supply.

6. Merchant Banking • Centuries Past: 1500’s Medici Family in Italy, Fuggers in Germany • Wealthy merchants would extend credit to their customers • This activity was in certain cases so profitable that it overshadowed their trading activity and became their main business. • These were private loans, involving only the capital of the merchant (no depositors). • Merchant banks today: Are classically defined at investment banks. • Rothschild is a current example of the classical European merchant bank (rare) • In the U.S., investment banks started in this same vein, such as JP Morgan, Goldman Sachs, Morgan Stanley, and these investment houses used their own capital or that borrowed from others to finance corporate underwriting. • Merchant/Investment banks were organized as partnerships, they did not enter the commercial mainstream and general populous. • Today, many investment banks are public firms, so they now risk outside investor money (although not depositors) • Value of Reputation: Merchant banks are successful only as far as their reputation • Credit only works if counterparties are credible • Credit markets prefer reputations with longer life than an individual, hence the family unit • Today, longer lived reputations include corporations and government entities

7. Fractional Reserve Banking • Since the bulk of deposits never leave the bank, warehouse banks recognized • that they could lend out excess deposits and earn interest on those loans. • Depositors receive a paper claim to their deposit, and this paper claim can be used as a from of payment if the institution banking the claim is reputable. • Banks receipts are a form of “money”, which is just a store of value (eg. U.S. dollar). • A warehouse can “create” new receipts in excess of their reserves, and as long as the bank maintains enough in reserve to meet depositor demands, they can lend these receipts and earn interest (this is counterfeit!) • Since these banks do not hold 100% of their reserves, they are referred to as “fractional” reserve banks.

8. Fractional Reserve Banking • Problems with Fractional Reserve banking: These banks only work if they are able to meet redemption requirements, and if their customers are confident that this is true. • Fractional reserve banks have the ability to create money by issuing new receipts, but using these receipts as money in the economy is limited by they reputation of the issuer • Some famous families (merchants) of history had the reputation to do so, but even so, their ability to create excess notes was limited • Eventually, the end user of the note would choose to convert it to gold or an equivalent store of value backing the note. • The fractional reserve “counterfeiting” operation is threatened by: • Reputation of the note – the institution backing the promise. • Increased likelihood of note redemption (a function of issuer reputation) • An increase in the note float (decrease in the proportion of reserves held to notes issued)

9. The central bank • Central Bank: A bank with supreme reputation and credibility, created to mitigate the risks associated with fractional reserves. • Bankers realized that it was in their interest to cartelize the industry to mitigate these risks. A reputation greater than any one individual or family was needed • While it is possible for a cartel of banks to organize and support each other, a government is best suited for this task. Governments generally have more longevity than institutions, individuals or families in developed economies. • The Bank of England (1690) is the first modern Central Bank, and until this century, was privately owned. • The Federal Reserve Bank in the U.S. was founded in 1913 in response to the contagious bank runs of 1910 (bank runs are failures of fractional reserve banking)

10. Federal Reserve Bank • Governance of the U.S. Central Bank: • The U.S. has 12 Federal Reserve Banks managed by 7 governors appointed by the President and confirmed by congress to 14 year terms, one expiring every two years • Each district represent a geographical area of the U.S. which formerly were operated with considerable autonomy. Early American were skeptical of a central bank head-quartered back east. • Each federal reserve bank operates as a depository institution for banks in its area. The NY Fed is generally considered the most important since most large banks are head-quartered there too. • Each district banks has a 9 member board comprised of 3 appointments from Washington and 6 from the local banking community • The Chairman of this committee serves four year terms, and is considered one of the most powerful positions affecting world economies •  Ben Bernanke replaces Alan Greenspan

11. Federal Reserve Districts Source: http://www.federalreserve.gov/otherfrb.htm

12. Money creation through fractional reserves • The Federal Reserve and other regulatory arms charter member banks and delegate the task of money creation, using the government’s reputation as certification of the process • The money creation process: Making one loan, creates the opportunity to make another loan, a process which continues in perpetuity. • Step 1: Bank issues a promissory note for which there is no “direct” reserve. (ie. the bank makes a loan and gives the borrower a receipt against that banks reserves) • Step 2: This receipt (loan) is traded for a good or service (promissory note is passed on to a new holder) • Step 3: The promissory note is deposited back into a bank by the new holder, creating a new deposit (bank liability). • Step 4: The promissory note is available once again to be loaned.

13. Money Creation Example A bank that receives $100 Million in deposits and keeps $20 million in reserve while loaning the rest. But the $80M in loans returns to the banking system somewhere else, if not this bank, the second Generation Bank The third generation bank receives $64 million of new loan deposits, allowing another $51.2 million in loans

14. Money creation in perpetuity Monetary base = $100 million (reserves) Total quantity of money = $500 million

15. The money multiplier • Money Multiplier: The extent to which “money” can be created through fractional reserve banking is as follows: • Total Quantity of Money = Money Multiplier * Monetary base • Money Multiplier = (1 + c) / (r + c) • r: reserve requirement • c: measure of money escaping the banking system (assumed to be 0 in our example) • MM = (1 + 0) / (.2 + 0) = 5  $100M *5 = $500M • Monetary Base: The amount of definitive money in the economy • Gold Standard: Prior to 1933, The U.S. Dollar was fully convertible into gold, From 1933 to 1971, it was partially convertible into Gold. • Leaving the Gold Standard: After 1971, the monetary base in the U.S. was no longer based on gold. Definitive money is now “Fed” money.

16. Different types of money • Different Types of Money: Money is a generic term to describe a store of value, and serves as a numeraire, or unit of account for wealth. World currencies like the U.S. dollar, Euro, Swiss Franc, Yen etc. are familiar medium of exchanges that serve this purpose • In calculating the monetary base in the U.S., we have different classifications: • M1: Instruments that serves as a medium of exchange (Approximately $809 Billion) • Currency in circulation • Demand accounts – those which are loanable through the banking system • M2: Includes substitutes for money (Approximately $3,272 Billion) • All M1 • Time and savings deposits • Money market funds • M3: Liquid assets (Approximately $4,066 Billion) • All M2 • Long-term time deposits • Commercial paper

17. Money & Faith Q: What makes a dollar worth a dollar? A: Confidence…in the U.S. government • The monetary base is no longer gold, and money is defined by M1, M2 or M3 • The monetary base is determined by how much money the Government wants to print, or how many loans banks are allowed to make…all backed by faith. • If there were no confidence in the U.S. dollar, then it would only be worth the paper that it is printed on (nothing). •  U.S. monetary policy requires the same level of confidence that drivers of opposing directions have with each other on narrow two lane highways. •  U.S. monetary policy is akin to the double yellow stripe that separates drivers…it isn’t a physical barrier, but it is a barrier that nonetheless facilitates driving.

18. Relative Size of Economy Approximate measures of various markets (changes can be significant) • M1 Money: $0.81 Trillion • M2 Money: $3.27 Trillion • M3 Money: $4.1 Trillion • Mutual Funds: $7 Trillion (2004) • Hedge Funds: $1 Trillion (2004) • Market Value of NYSE & NASDAQ $17 Trillion (2004) • Corporate bond market (2002): $4.1 Trillion • Mortgage market (2004): $10.5 Trillion

19. i: interest rate S Increase in money supply through FED action 4% 3.6% D $ of lending Interest Rates and Money Supply • Changes in money supply affect interest rates • An increase in money supply makes the economy feel wealthier by putting more money in the hands of consumers • An increase in money supply decreases interest rates When interest rates are attractive to consumers and firms, they borrow & buy, hence increasing money supply increases economic activity

20. FED Monetary Policy Tools and Interest rates • The Federal Reserve induces interest rate changes by changing the money supply • If more money is injected into the economy, then there is an increase in loanable funds, and rates drop. • When the FED tightens monetary policy, money supply drops, interest rates increase and consumers feel less wealthy. • The Fed affects money supply through all three monetary policy tools • Reserve requirements – affects the level of loans banks are able to make • Open market transactions – changes the amount of “money” in the economy • Discount window – guides markets towards the “appropriate” rate • The Fed Open Market Committee (FOMC) • The major monetary policy-making body of the FR System • Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade • Open market operations: the purchase and sale of U.S. government and federal agency securities • Sets ranges for growth of monetary aggregates and directs the FR in foreign exchange markets

21. Reserve Requirements • If the Fed increases the reserve requirement from 10 to 12%, then banks would have to recall loans to the extent that is necessary to meet reserve requirements • Consider this affect on a monetary base of $1,000 billion, assuming that no “money” leaves the banking system (all loans return as deposits) • Money Supply with: • 10% reserve requirement: $1,000B*(1+0)/(.1+0) = $10,000 billion • 12% reserve requirement: $1,000B*(1+0)/(.12+0) = $8,333 billion • The change in total quantity of money (supply) is $1,667 billion or 17% • Change in reserve requirements affect M1 money, and the FED has the flexibility to move rates between 8% and 14% per the limits set by Congress • In reality, the reserve requirement rarely change and is not an instrument that the FED uses for short-term policy implementation. It can take months for the equilibrium money supply to settle after a change in reserve requirements.

22. Open Market Transactions • Open Market Transactions: The Federal Reserve buys and sells government securities issued by the U.S. Treasury, done in the liquid Treasury bill market so that prices aren’t affected • Open market Buy order: increases the money supply and lowers rates • Federal Reserve Bank buys securities from the open market (banking sector) • Federal Reserve creates new Fed money to make payment, crediting the seller with dollars at the Federal Reserve Bank • This new money is simply the government creating a new receipt. • This new receipt is now expanded through the depository system by the money multiplier. The treasury seller now has a liability which can be used by the banking system to create new loans.4 Federal Reserve Bank Banking System Banking system sells $500 Million of treasuries Fed buys $500 Million in treasuries Fed creates $500 Million liability, bank deposit at FED Bank receives payment through new deposit This is new “cash” available for loans

23. Open Market Transactions • Open market Sell order: The Federal Reserve decreases the money supply and increases rates • Federal Reserve destroys Fed money when it sells treasuries on the open market. The revenue generated by the sell simply disappears into the vast depths of the Federal Reserve Bank, with ownership of the liability no longer assigned to a consumer or commercial claimant (The government owns it) • This destroyed money unravels the effect of the money multiplier. • If a bank buys the security, then the “cash” used is no longer available for a “money creating” loan • If a firm or consumer buys the security, they no longer holds a liability in the banking system (it is replaced with a government security), and the banking system must increase reserves to account for the redeemed (lost) liability, thus decreasing loanable funds • Scarcer loanable funds increases the interest rate required to borrow.

24. Are all loans equal w.r.t. Money creation? Q: What if GM or Ford, and not a bank, initiates a loan with consumers through its auto loan programs? Does this change the money supply? A: No! Inter firm/household loans do not affect the money supply. They simply rearrange the liabilities held at commercial banks Banking System Checking Deposits GM: - $25,000 HH: + $ 25,000 GM Loans money to household  debit GM liability Household receive loan  Credit HH liability