The Money Supply Process and Monetary Policy Tools

1. The Money Supply Processand Monetary Policy Tools Week 9 Maclachlan, Money & Banking Fall 2006

2. Consider the narrowest definition of money: M1. Consists of … • currency • checkable deposits • travelers checks Maclachlan, Money & Banking Fall 2006

3. How do banks create new deposits? • They must have excess reserves. • When they make a loan with the excess reserves, a new deposit is created. Maclachlan, Money & Banking Fall 2006

4. Bank reserves consist of …. • Vault cash (includes cash in ATM’s). • Deposits at the Fed. Maclachlan, Money & Banking Fall 2006

5. Fed Assets Fed Liabilities Government securities Discount loans Fed notes in circulation Deposits of member banks Maclachlan, Money & Banking Fall 2006

6. Monetary Base (aka High Powered Money) Currency in circulation + Bank Reserves = Fed notes and coins in circulation + vault cash + bank deposits at Fed Maclachlan, Money & Banking Fall 2006

7. Money Supply Process: Simple Model Assumptions: • 10% required reserve ratio. • Banks hold no excess reserves. • No currency. What happens to the money supply when the Fed purchases $100 of Treasury securities? Maclachlan, Money & Banking Fall 2006

8. Deposit Creation Maclachlan, Money & Banking Fall 2006

9. Deposits at Failed Banks: 1929–33 Maclachlan, Money & Banking Fall 2006

10. e, c: 1929–33 Maclachlan, Money & Banking Fall 2006

11. Money Supply and Monetary Base: 1929–33 Maclachlan, Money & Banking Fall 2006

12. Monetary Policy Maclachlan, Money & Banking Fall 2006

13. Three Tools of Monetary Policy • Open market operations • Discount rate • Reserve requirements Maclachlan, Money & Banking Fall 2006

14. Open Market Operations 2 Types 1. Dynamic: Meant to change MB 2. Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1. Fed has complete control 2. Flexible and precise 3. Easily reversed 4. Implemented quickly Maclachlan, Money & Banking Fall 2006

15. Discount Loans 3 Types 1. Primary Credit 2. Secondary Credit 3. Seasonal Credit Lender of Last Resort Function 1. To prevent banking panics FDIC fund not big enough Example: Continental Illinois 2. To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident Maclachlan, Money & Banking Fall 2006

16. How Primary Credit Facility Puts Ceiling on iff Rightward shift of Rs to Rs2 moves equilibrium to point 2 where i2ff = id and discount lending rises from zero to DL2 Maclachlan, Money & Banking Fall 2006

17. Discount Policy Advantages 1. Lender of Last Resort Role Disadvantages 1. Confusion interpreting discount rate changes 2. Fluctuations in discount loans cause unintended fluctuations in money supply 3. Not fully controlled by Fed Maclachlan, Money & Banking Fall 2006

18. Reserve Requirements Advantages 1. Powerful effect Disadvantages 1. Small changes have very large effect on Ms 2. Raising causes liquidity problems for banks 3. Frequent changes cause uncertainty for banks 4. Tax on banks Maclachlan, Money & Banking Fall 2006

19. Goals of Monetary Policy Goals 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict Maclachlan, Money & Banking Fall 2006

20. 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i'' Money Supply Target Maclachlan, Money & Banking Fall 2006

21. 1. M dfluctuates between M d' and M d'' 2. To set i-target at i* Ms fluctuates between M' and M'' Interest Rate Target Maclachlan, Money & Banking Fall 2006

22. Criteria for Choosing Targets 1. Measurability 2. Controllability 3. Ability to predictably affect goals Interest rates aren’t clearly better than Ms on criteria 1 and 2 because hard to measure and control real interest rates Maclachlan, Money & Banking Fall 2006