The Fed and Credit

1. The Fed and Credit MSFI535 Week #3 The Fed and Credit Week 3 Lecture Slides

2. The Fed and Credit Lecture Outline • The Fed • Money multiplier • Reserve • Money supply • Monetary Policy • Money supply control • Liquidity • Money creation • The Fed Stance • Policy targets • Credit • Flexibilty The Fed and Credit Week 3 Lecture Slides

3. The Fed The Fed • Through its control of the monetary base (high-powered money), the Fed controls money supply. Money is defined as the sum of currency (CU) and bank deposits (D), that is, M = CU + D • High-powered money is defined as the sum of currency (CU) and bank reserves (R), that is,   H = CU + R • Bank reserves (R) consist of deposits banks hold at the Fed and currency that is held in bank vaults. Total bank reserves are the sum of required reserves (RR) and excess reserves (XR), that is, R = RR + XR The Fed and Credit Week 3 Lecture Slides

4. The Fed Money Multiplier (mm) • If we divide money supply by high-powered money, we can derive the money multiplier as follows: M/H = (CU + D)/(CU + R) = [(CU/D) + (D/D)]/[(CU/D) + (R/D)] = (cu + 1)/(cu + re) Where, cu = CU/D = currency-deposit ratio, and re = R/D = reserve-deposit ratio. • Hence, the money multiplier (mm) is usually greater than 1, which implies that any change in high-powered money will lead to a larger change in total money supply, that is, M = [(1 + cu)/(re + cu)](H) = mm(H). The Fed and Credit Week 3 Lecture Slides

5. The Fed Money Multiplier (mm) • Why is the M1 money multiplier decline close to or below 1 during the current recession? (Hint: Credit Crisis) Note that M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. The Fed and Credit Week 3 Lecture Slides

6. The Fed Reserve (R) • Recall that bank reserves (R) consist of deposits banks hold at the Fed and currency that is held in bank vaults. • Total bank reserves are the sum of required reserves (RR) and excess reserves (XR), that is, R = RR + XR • Given that money multiplier (mm) is [(1 + cu)/(re + cu)], if banks increase their reserve-deposit ratio (e.g. do not lend) then mm declines. • And if mm declines and given M = [(1 + cu)/(re + cu)](H) = mm(H). The overall money supply or M will decline. The Fed and Credit Week 3 Lecture Slides

7. The Fed Money Supply (m) • Recall from Week #2 lecture that the decline in money supply can lead to higher rates on nominal interest rates – assuming the money demand remained unchanged. • What would happen if the declined in money supply is accompanied by the decline in money demand (e.g. due to a recessionary condition or crisis)? The overall interest rate outcome is uncertain. However, the overall real money transaction (supply & demand) will decline. T This will lead to contractions of the real economy of production and consumption activities (e.g. declining GDP). The Fed and Credit Week 3 Lecture Slides

8. Monetary Policy Monetary Policy • As discussed in Week #2 lecture, the Fed can respond to economic contracts by implementing an expansionary monetary policy or increasing the money supply • However, recall that the QTM implies that if V and Q are constant then inflation will equal to the rate of money supply growth as a function of time – in the long run. (More on the implications in Week #5). The Fed and Credit Week 3 Lecture Slides

9. Monetary Policy Money Supply Control • The Fed create high-powered money (H) through open market purchases. In that process, the Fed (its NY Branch) buys government securities (e.g. treasuries) from banks, increasing the reserves of the banking system. R = RR + XR When calculating the change in money supply resulting from a change in the monetary base, the money multiplier (mm) is generally assumed to be constant. M = [(1 + cu)/(re + cu)](H) = mm(H). However, the money multiplier (mm) can change as banks and consumers respond to different market conditions (e.g. the current credit crisis and recession). And… The Fed and Credit Week 3 Lecture Slides

10. Monetary Policy Money Supply Control • And… The payment habits of the public and the convenience and cost of obtaining cash determine how much currency is held relative to bank deposits. Similarly, banking regulations and the trade-off between profitability and safety that banks face, affect the reserve-deposit ratio. It is fairly obvious that the money multiplier increases as the reserve-deposit ratio decreases. M = [(1 + cu)/(re + cu)](H) = mm(H) Where: re = reserve-deposit ratio Thus the Fed controls money supply only indirectly through its control of high-powered money. The Fed and Credit Week 3 Lecture Slides

11. Monetary Policy Liquidity • Based on preceding discussions, it is clear that stability of the money multiplier is crucial to the Fed's ability to control money supply. However, the money multiplier is neither constant nor easily predictable and can be greatly reduced by runs on banks like those that occurred in the Great Depression. Runs on banks or troubled banks also lead to disintermediation, that is, the inability of banks to make loans to businesses or consumers. This results in a contraction of money supply that if severe enough, can easily lead to a recession. But the Fed appears to have learned from its mistake. Right after the stock market crash of 1987, Fed chairman Alan Greenspan immediately assured financial markets that the Fed stood ready to provide needed liquidity. And, in response to the current global credit crisis and “great” recession, Fed Chairman Bernanke has responded aggressively and provided needed liquidity. The Fed and Credit Week 3 Lecture Slides

12. Monetary Policy Liquidity • The Fed is often referred to as the "lender of last resort." In other words, the Fed will always provide liquidity to banks in need if there is a serious risk of instability to the banking system. The Fed has three basic instruments to influence money supply: open market operations, discount rate changes, and changes in the required-reserve ratio. Open market operations take place if the Fed buys or sells government securities to the public (mostly though government securities dealers). The discount rate is the rate that is charged to banks that borrow funds from the Fed. The required-reserve ratio is the percentage of deposits that banks have to keep in reserve (either as vault cash or as deposits at the Fed) and therefore cannot loan out. The Fed and Credit Week 3 Lecture Slides

13. Monetary Policy Money Creation • While the Fed has fairly good control over money supply (since it can change bank reserves), it cannot control the demand for money. Therefore it cannot simultaneously target interest rates and money supply. If the Fed targets interest rates, money supply will fluctuate, but if the Fed targets money supply, interest rates will fluctuate. There is some controversy over which of these two intermediate targets the Fed should choose. This is largely a debate over what the ultimate goal of the Fed should be (full employment or price stability), and from which sector (the money sector or the expenditure sector) most economic disturbances emanate. Interest rate targets work better if most disturbances are arising from shifts in money demand, while money supply targets work better if most disturbances are arising from a change in intended spending or velocity. The Fed and Credit Week 3 Lecture Slides

14. The Fed Stance Policy Targets • The Fed long relied on interest rate targets but began emphasizing monetary targets in 1979 because of high inflation rates. After the recession of 1981-82, the Fed again relied more on interest rates as a guide for monetary policy. Since then, its approach to monetary policy has been fairly eclectic. The Fed and Credit Week 3 Lecture Slides

15. The Fed Stance Credit • The recession of 1990-91 had another interesting feature (which looks and feel similar to the current recession), namely the slow or close to no growth in credit. Bank regulators, worried about the large number of problem banks, tightened standards and banks responded by rationing credit. Credit is rationed when lending institutions limit the amount that firms or consumers can borrow, fearing that irresponsible borrowers may overextend themselves. To avoid the higher risks incurred with such borrowers, banks often limit the amount of credit given to any one customer. When credit rationing occurs, interest rates are not a good guide for monetary policy. In this type of situation, the Fed should consider credit targets instead. The Fed and Credit Week 3 Lecture Slides

16. The Fed Stance Flexibility • Despite their impreciseness, monetary policy targets are needed because the Fed has imperfect knowledge and because monetary policy lags tend to be fairly long. Thus, there is a need for intermediate targets to assess whether policy changes might have the desired effects on the ultimate targets. These intermediate targets may have to be reset occasionally as velocity can easily change. All in all, we can conclude that the Fed must remain flexible enough to decide which targets to follow and when to adjust to changing economic conditions. The Fed and Credit Week 3 Lecture Slides