Chapter 14

1. Chapter 14 Monetary Policy and the Federal Reserve System

2. Chapter Outline • Principles of Money Supply Determination • All currency • All reserve • Fractional reserve • Tools • Monetary Control in the United States • The Conduct of Monetary Policy: Rules Versus Discretion (skip)

3. Principles of Money Supply Determination • Three groups affect the money supply • The central bank is responsible for monetary policy • Depository institutions (banks) accept deposits and make loans • The public (people and firms) holds money as currency and coin or as bank deposits

4. Principles of Money Supply Determination • The money supply in an all-currency economy • A trading system based on barter is inconvenient • The creation of a central bank to print money can improve matters • Central bank: buy (sell) assets to increase (decrease) money supply • Public: use money as legal tender • In an all-currency economy, the money supply equals the monetary base • Monetary base = currency (no bank deposit) in all-currency economy • Monetary base: most liquid and can be used to “create” money

5. Principles of Money Supply Determination • The money supply under fractional reserve banking • The currency that banks hold is called bank reserves • Bank reserves = vault cash + reserves at the central bank • When bank reserves are equal to deposits, the system is called 100% reserve banking • To make money, banks would have to charge fees for deposits, since they earn no interest on reserves (changed now!) • When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking • Banks have incentive to lend out part of deposits. • But face potential Bank runs. (a large scale, panicky withdrawal of deposits)

6. Principles of Money Supply Determination • The money supply under fractional reserve banking • When all the banks catch on to this idea, they will all make loans as the economy undergoes a multiple expansion of loans and deposits • How it works in a no-cash economy? • Suppose monetary base increases by 1b through bank A • Suppose reserve-deposit ratio is 25% and people don’t hold currency. • The 1b increase can create 3b more money supply, altogether 4b money supply (deposits). • 1+3/4+3/4*3/4+3/4*3/4*3/4+…=4 • Money supply = Monetary Base/(reserve-deposit ratio)

7. Principles of Money Supply Determination • The money supply under fractional reserve banking • Notation: • M money supply, • BASE monetary base, high-powered money (M0) • Currency held by public (CU) and bank reserves (RES) • DEP bank deposits, • RES bank reserves, • res banks’ desired reserve-deposit ratio (RES/DEP) • How much money can be created by monetary base? • Money multiplier

8. Principles of Money Supply Determination • The money supply with both public holdings of currency and fractional reserve banking • If there is both public holding of currency and fractional reserve banking, the picture gets more complicated • The money supply consists of currency held by the public and deposits, so M = CU + DEP (14.4) • The monetary base is held as currency by the public and as reserves by banks, so BASECURES (14.5)

9. Principles of Money Supply Determination • The money supply with both public holdings of currency and fractional reserve banking • Taking the ratio of these two equations gives M/BASE (CU+DEP)/(CU+RES) (14.6) • This can be written as M/BASE [(CU/DEP) + 1]/[(CU/DEP) + RES/DEP)] (14.7) • The currency-deposit ratio (CU/DEP, or cu) is determined by the public • The reserve-deposit ratio (RES/DEP, or res) is determined by banks

10. Principles of Money Supply Determination • The money supply with both public holdings of currency and fractional reserve banking • Rewrite Eq. (14.7) as M [(cu + 1)/(cu + res)]BASE (14.8) • The term (cu + 1)/(cu + res) is the money multiplier • The money multiplier is greater than 1 for res less than 1 (that is, with fractional reserve banking) • If cu 0, the multiplier is 1/res, as when all money is held as deposits • The multiplier decreases when either cu or res rises • Look at U.S. data to illustrate the multiplier (Table 14.1)

11. Table 14.1 The Monetary Base, the Money Multiplier, and the Money Supply in the United States

12. Principles of Money Supply Determination • Three tools: • Open-market operations • The most direct and frequently used way of changing the money supply is by raising or lowering the monetary base through open-market operations • Discount window lending • Reserve requirements

13. Principles of Money Supply Determination • Application: The money multiplier during the Great Depression • The money multiplier is usually fairly stable, but it fell sharply in the Great Depression • The decline in the multiplier was due to bank panics, which affected the multiplier in two ways • People became mistrustful of banks and increased the currency-deposit ratio (text Fig. 14.1) • Banks held more reserves, in anticipation of bank runs, which raised the reserve-deposit ratio

14. Figure 14.1 The currency-deposit ratio and the reserve-deposit ratio in the Great Depression

15. Principles of Money Supply Determination • Application: The money multiplier during the Great Depression • Even though the monetary base grew 20% from March 1930 to March 1933, the money supply fell 35% (text Fig. 14.2) • As a result, the price level fell sharply (nearly one-third) and there was a decline in output (though attributing the drop in output to the decline in the money supply is controversial)

16. Figure 14.2 Monetary variables in the Great Depression

17. Monetary Control in the United States • (READ) History, Organization, Balance Sheet • http://www.federalreserveeducation.org/fed101/ • Tools for Monetary Control • Targets (Ultimate and Intermediate) • Reality (practice)

18. The Federal Reserve System • The Fed began operation in 1914 for the purpose of eliminating severe financial crises • There are twelve regional Federal Reserve Banks (Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco), which are owned by private banks within each district (text Fig. 14.3)

19. Figure 14.3 Location of the Federal Reserve Banks

20. Monetary Control in the United States • The Federal Reserve System • The leadership of the Fed is provided by the Board of Governors in Washington, D.C. • There are seven governors, who are appointed by the president of the United States, and have fourteen-year terms • The chairman of the Board of Governors has considerable power, and has a term of four years

21. Monetary Control in the United States • The Federal Reserve System • Monetary policy decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven governors plus five presidents of the Federal Reserve Banks on a rotating basis (with the New York president always on the committee) • The FOMC meets eight times a year • It may meet more frequently if economic developments warrant

22. Monetary Control in the United States • The Federal Reserve’s balance sheet and open-market operations • Balance sheet of Fed (text Table 14.2) • Largest asset is holdings of Treasury securities • Also owns gold, makes loans to banks, and holds other assets including foreign exchange and federal agency securities • Largest liability is currency outstanding • Some is held in bank vaults and is called vault cash • The rest is held by the public • Another liability is deposits by banks and other depository institutions • Vault cash plus banks’ deposits at the Fed are banks’ total reserves (RES)

23. Table 14.2 The Balance of the Federal Reserve System (Billions of Dollars)

24. Figure 14.4 Components of the monetary base

25. Monetary Control in the United States • Means of controlling the money supply • The primary method for changing the monetary base is open-market operations (by FOMC) • Reserve requirements (Board of Governors) • The Fed sets the minimum fraction of each type of deposit that a bank must hold as reserves • An increase in reserve requirements forces banks to hold more reserves, thus reducing the money multiplier • Discount Window Lending

26. Monetary Control in the United States • Discount window lending (Board of Governors) • Discount window lending is lending reserves to banks so they can meet depositors’ demands or reserve requirements • The interest rate on such borrowing is called the discount rate • The Fed was set up to halt financial panics by acting as a lender of last resort through the discount window • A discount loan increases the monetary base • Increases in the discount rate discourage borrowing and reduce the monetary base • The Fed modified the discount window in 2003 • The Fed funds rate is a market rate of interest, determined by supply and demand while the discount rate is set by the Fed • Under the new procedure, the Fed sets the discount rate (primary and secondary) above the Fed funds rate (Fig. 14.5)

27. Figure 14.5 The discount rate and the Fed funds rate, 1979-2006

28. What are the new changes during the credit crunch? • August 17, 2007: • 50bps cut from 6.25% • 30-day loan vs. overnight • Spread 50 bps vs. 100 bps • March 16, 2008 (Bear Stearns) • From 30 days to 90 days • From 50 bps to 25 bps spread

29. Summary 19

30. Monetary Control in the United States • Ultimate targets: price stability and economic growth • Intermediate targets • Variables the Fed can’t directly control but can influence predictably • Most frequently used are monetary aggregates such as M1 and M2, and short-term interest rates, such as the Fed funds rate

31. Monetary Control in the United States • Intermediate targets • The Fed cannot target both the money supply and the Fed funds rate simultaneously • Suppose both the money supply and the Fed funds rate were above target, so the Fed needs to lower them • Since a decrease in the money supply shifts the LM curve up (to the left), it will increase the Fed funds rate • In recent years the Fed has been targeting the Fed funds rate (Fig. 14.6)

32. Figure 14.6 Interest rate targeting

33. Monetary Control in the United States • Intermediate targets (targeting the Fed funds rate) • This strategy works well if the main shocks to the economy are to the LM curve (shocks to money supply or money demand) • The strategy stabilizes output, the real interest rate, and the price level, as it offsets the shocks to the LM curve completely • But NOT ALWAYS WORK WELL • If other shocks to the economy (such as IS shocks) are more important than nominal shocks, the policy may be destabilizing, unless the Fed changes the target for the Fed funds rate

34. Monetary Control in the United States • Intermediate targets • Suppose a shock (increase in exports demand) shifts the IS curve to the right (Fig. 14.7) • If the Fed were to maintain the real interest rate, it would increase the money supply, thus making output rise even more, which would be destabilizing (and a higher price/inflation) • Instead, the Fed needs to raise the real interest rate to stabilize output

35. Figure 14.7 Interest rate targeting when an IS shock occurs

36. Monetary Control in the United States • Making monetary policy in practice • The IS-LM model makes monetary policy look easy—just change the money supply to move the economy to the best point possible • In fact, it isn’t so easy because of lags in the effect of policy and uncertainty about the ways monetary policy works • Lags in the effects of monetary policy • It takes a fairly long time for changes in monetary policy to have an impact on the economy • Interest rates change quickly, but output and inflation barely respond in the first four months after the change in money growth (Fig. 14.8)

37. Figure 14.8 Responses of output, prices, and the Fed funds rate to a monetary policy shock

38. Monetary Control in the United States • Making monetary policy in practice • Tighter monetary policy causes real GDP to decline sharply after about four months, with the full effect being felt about 16 to 20 months after the change in policy • Inflation responds even more slowly, remaining essentially unchanged for the first year, then declining somewhat • These long lags make it very difficult to use monetary policy to control the economy very precisely • Because of the lags, policy must be made based on forecasts of the future, but forecasts are often inaccurate • The Fed under Greenspan has made preemptive strikes against inflation based on forecasts of higher future inflation

39. Monetary Control in the United States • Making monetary policy in practice • The channels of monetary policy transmission • The interest rate channel: as seen in the IS-LM model, a decline in money supply raises real interest rates, reducing aggregate demand, leading to a decline in output and prices • The exchange rate channel: in an open economy, tighter monetary policy raises the real exchange rate, reducing net exports, and thus aggregate demand • The credit channel: tighter monetary policy reduces both the supply and demand for credit (READ Box 14.1) • IS curve shifts to the left • Loose monetary policy (ease credit) by Greenspan partially contributes to the credit crunch.

40. Monetary Control in the United States • Making monetary policy in practice • The channels of monetary policy transmission • How important are these different channels? • Suppose real interest rates are high(easy), but the dollar has been falling(tight); is monetary policy tight or easy? It depends on the relative importance of the different channels • Or suppose real interest rates are low(tight), but borrowing and lending are weak(easy) • Monetary policy: art or science?

41. A Review of Credit Crisis • Overview: • Huge percentage of subprime mortgages default • Hundreds of billions of mortgage-related investments collapsed • High profiled investment banks (GS, MS) either change to commercial banks or go bankrupt (BS, LB) • 700-billion bail-out plan • Origins • Late 90’s: tech bubble burst and in 2000 a sharp decline in stock market  recession  cut interest rate (see chart) • Cheap mortgages and loose regulation on mortgage lending

42. Fed Funds Target Rate Rate cut: 1/3/2001 Rate cut: 6/25/2001 Rate cut: 10/29/2008

43. Origins • Origins (cont.) • Default/Delinquency rose in 2006, and didn’t stop increase in mortgage lending • Banks create CDO’s and CDS and other credit derivatives to transfer (at least they thought so) credit risks. (repackage good and bad loans and sell to mutual/hedge funds) • Housing prices (see chart for Miami) start to drop, no equity can be taken out (refinancing doesn’t work), foreclosure rises… • EVERYTHING BAD starts to roll…

44. Miami Housing Price Index 6/2006

45. Victims (on the record) • Bear Stearns: two hedge funds that directly invested in subprime mortgage markets wend under… and eventually the whole firm was sold to JP Morgan on March 17 ($2 vs. $170 a year ago). • Fannie Mae and Freddie Mac: September 7, taken over by the government • Leman Brothers: September 12, went bankruptcy • Merrill Lynch: September 14, sold to BOA • AIG: September 16, bailed out by the Fed ($85billion) • WaMu: September 25, sold to JP Morgan • Wachovia: October 9, acquired by Wells Fargo

46. What is wrong? Everything! • Mortgage industry: lack of regulation/supervision • As long as one can make money, nobody cares about the default. ARM (adjustable rate mortgages) • Rating agency: • Official #1: Btw (by the way) that deal is ridiculous. • Official #2: I know right ...model def (definitely) does not capture half the risk. • Official #1: We should not be rating it. • Official #2: We rate every deal. It could be structured by cows and we would rate it. • Regulator: • Low interest for long (Fed) and oversight of credit derivatives • Deregulation of banks • Politicians: affordable housing?

47. What is wrong? (cont.) • Banks: • Highly leveraged and actively involved in mortgage-related investments (EASY MONEY) • Although they might know the high housing value is unsustainable, they are probably too greedy to get out. • Not like dotcom bubble, then banks were not holding large percentage of tech stocks (who holds? Average joe). • Bad risk management, modeling of default • Defaults highly correlates. • Historical data underestimate default ratio.

48. Solutions • Key is to restore confidence • $700 billion Bail-out plan (directly injecting money to commercial banks and helping deal with distressed mortgage-related securities) • Extend credits to investment banks, insurance companies • Buy commercial papers (short-term financing for payroll…) • Careful Regulations (especially hedge funds)

49. Your essay? (Due 12/1) • Approach I • Pick any topic • Historical background: • For instance, deregulation of credit derivatives, deleveraging • Why is this happening from the specific perspective? • What can be done to reduce the chance of happening again? • Approach II • Relating finance to macroeconomics • Think of the channels that Wall street affects Main street • How to make them work together? • Approach III: anything that can employ macro analysis