Chapter Sixteen Monetary Control. Copyright © Houghton Mifflin Company. All rights reserved.16 | 2...

Chapter Sixteen

Monetary Control

Copyright © Houghton Mifflin Company. All rights reserved. 16 | 2

• The Fed does not control the money supply directly, but indirectly through adjustments to its monetary base

• This base supports a larger money supply through the money-multiplier process

• The money supply is a measure of the amount of money held in the economy, such as M1 or M2

Monetary Control


The Money Supply

• Money supply = Money multiplier × Monetary base

• Money supply: M1 or M2 or M3• Monetary base: determined by Federal

Reserve; equal to reserves + currency held by nonbank public

• Money multiplier: depends on decisions by people, banks, and the Fed


• Fed influences money supply by affecting banks’ reserves, mainly through open-market operations

• The Fed’s main asset is its portfolio of securities • Banks create and destroy money by changing

amount of outstanding loans– Money is “created” when more loans are made

available through banks, and destroyed when fewer loans are given

Money Creation and Destruction


Federal Reserve Balance Sheet,

12/31/2004 ($ billions)

Assets Liabilities + Capital

Securities 750.86 Monetary Base

781.55

Discount Loans

0.04 Other Liabilities

9.86

Other 64.05 Capital 23.54

Total 814.95 Total 814.95


• Open-market purchase: Fed buys securities from government securities dealers, adds reserves to bank

• Fed’s assets (securities) increase; monetary base (bank reserves) increase

• Open-market sale: Fed sell securities; gets reserves from banks; Fed assets decline; monetary base declines

Open-Market Operations


1. Fed buys securities in open market

2. First Bank gets reserves and now has excess reserves

3. First Bank makes additional loans

4. Funds go to Second Bank, which now has excess reserves

5. Second Bank makes additional loans

6. Third Bank has excess reserves ...

How Banks Create Money


Effect of $4 Million Open-Market Purchase

Bank New Deposits

Additional Reserves

Loans

Made

First 4.00 0.400 3.60

Second 3.60 0.360 3.24

Third 3.24 0.324 2.92

Fourth 2.92 0.292 2.63

. . . . . . . . .

Total 40.00 4.000 36.00


The Money Multiplier

• The money multiplier is the ratio of the money supply to the monetary base. mm = M ÷ MB


• The multiple amount by which the money supply increases from an open-market purchase of $4 million equals:

1/q = 1/0.1 = 10(q = reserve requirement)

ΔM = mm × ΔMB

if mm is constant

Ex: ΔM = mm × ΔMB = 10 × 4 = 40

Money Multiplier (cont’d)


• Simple examples thus far…i.e., money created by banks and deposited in banks stays in banks

• For a more realistic example examine– How the monetary base is split into reserves and

currency held– How different measures of money are split into their

components– How banks split between required & excess reserves

and required clearing balances.– How people split holdings into different assets

Realistic Money Multipliers


• Monetary base is equal to the amount of reserves held by banks plus the amount of currency held by the nonbank public

MB = R + C• Different measures of the money supply will

have different multipliers.M1 = D + C

Realistic Money Multipliers (cont’d)


• Different measures of the money supply will have different multipliers

M2 = D + C + N + MMF(MMF signifies money market mutual funds.)

• The M2 multiplier is the ratio of M2 to the monetary base:

Mm2 = M2 / MB

Realistic Money Multipliers (cont’d)


• Banks hold reserves both because of reserve requirements and because they may have agreed to hold required clearing balances (RCB) at the Fed

• Required clearing balances help to ensure that banks have plenty of funds at the Fed to cover daily transactions and help check-clearing process run smoothly

Reserves = Required reserves + Excess reserves + Required clearing balances

R = RR + ER + RCB

Bank Reserves


DC

DRCB

DER

DRR

DC

mm

11

DC

DRCB

DER

DRR

DMMF

DN

DC

mm

12

Deriving the Multipliers


• Changes in the multiplier affect the money supply simultaneously

• Who determines multipliers?– People: C/D (the ratio of currency to deposits), N/D

(ration of non-transactions deposits to transaction deposits), MMF/D (money market mutual funds to transaction deposits)

– Banks: ER/D (excess reserves to deposits), RCB/D (required clearing balances to deposits)

– The Fed: RR/D (required reserves to deposits)

How People & Banks Affect the Money Supply


Please insert Table 16.3

How People & Banks Affect the Money Supply (cont’d)


The rate of decline in the M1 multiplier increased in the 1990s with the advent of sweep accounts


Figure 16.1 Money Multipliers


Both components of the M1 multiplier rose rapidly beginning in 1995


Figure 16.2a Components of the Numerator of the M1 Money Multiplier


The components of the M2 numerator also rose sharply after 1995


Figure 16.2b Components of the Numerator of the M2 Money Multiplier


The components of the denominator of the multipliers

Figure 16.3a Components of the Denominator of the Money Multipliers (Other Than C/D)



Movements in the denominator are dominated by movements in the ratio of currency to transactions deposits over time

Figure 16.3b Components of the Denominator of the Money Multipliers



1. Open-market operations

2. Changes in the discount rate

3. Changes in reserve requirements

• Bank’s reserves can be broken down into those borrowed from the Fed:

Monetary base = reserves + currency

The Tools of Monetary Policy


Open-Market Operations

• The most commonly used tool• Example: People demand more money during the

holidays, so the Fed increases the monetary base to prevent the decline in the multiplier from affecting M1

• Defensive open-market operations are undertaken because of seasonal effects or temporary changes in market demand

• Dynamic open-market operations are undertaken when the Fed wants to actively change monetary policy


M = mm × (DL + NBR + C)

• The discount rate is the interest rate banks pay when they borrow from the Fed at the discount window

• When the discount rate is higher, fewer loans are made

• The Fed takes a haircut on loan’s collateral (requires collateral valued at more than the amount of the loan)

Discount Lending


• Primary credit discount loan – requires CAMELS rating of 1, 2, or 3– no questions asked– primary credit discount rate currently set at 1

percentage point above federal funds rate target

• Secondary credit discount loan– CAMELS rating of 4 or 5– questions asked– secondary credit discount rate currently set at ½

percentage point above primary credit discount rate

Discount Lending (cont’d)


• Seasonal credit discount loan– program to lend at the discount window for

small banks – for small banks with seasonal demands for

credit (eg. farm banks)– rate equals ½ average fed funds rate + ½

average rate on negotiable CDs over two-week maintenance period



• How do changes in the discount rate affect the money supply?

• An increase in the amount of discount loans increases the money supply by the amount of the increase in the discount loans times the money multiplier

M = mm × (DL + NBR + C)



M = mm × (DL + NBR + C)

• Increases in the reserve requirements reduce the multiplier because banks hold more reserves and lend less

• Not often used to affect the money supply—too blunt a tool

Reserve Requirements


Please insert Table 16.4

The Tools of Monetary Policy


• Fed intervenes daily in market for bank reserves, so it needs a good model of the reserve market.

• Split reserves into parts– Discount loans that depend on the federal funds rate

(discount loans for profit DL-Profit)– Non-Borrowed Reserves (NBR) supplied by the Fed– Discount loans that do not depend on the federal

funds rate, which include seasonal discount loans + secondary credit discount loans by weak banks with problems + primary credit discount loans by good banks with temporary problems (DL-Business)

The Market for Bank Reserves


• Supply curve for reserves – Vertical segment: NBR + DL-Business– Horizontal segment: DL-Profit

• Horizontal segment starts at primary credit discount rate (d)

• Demand curve for reserves– Downward sloping, as banks desire more reserves,

the cheaper they are

• Equilibrium point determines equilibrium fed funds rate

The Market for Bank Reserves (cont’d)


The demand curve slopes downward because banks want to hold more reserves when the federal funds rate is lower



The supply of reserves is vertical when ffr is less than the primary discount rate, and horizontal when they are equal



Equilibrium in the reserves market occurs at the intersection of supply and demand; in this case there are no primary credit discount loans



The Open-Market Desk’s Job– Daily analysis of the reserves market– Estimates the amount of reserves available in

the market each day– Determine NBR to get ffr* equal to FOMC’s

target rate– Engage in open-market operations each day

based on the current level of NBR and the desired level



When ffr exceeds the Fed’s target, If the Fed engages in purchases in the amount of ∆R, equilibrium ffr will equal the target



If demand for reserves is D2 instead of D1, ffr will rise to equal the discount rate



• Why pay interest on reserves?– Required reserves are higher than banks need, so

they avoid them by sweep accounts, which are costly

– Interest on reserves could increase efficiency; banks would price their services more in line with their economic costs

– Because bank reserves are an asset, their return should be determined by the market

– The Fed would gain an additional policy tool

Should the Fed Pay Interest on Reserves?


• Disadvantages of interest on reserves– Would be costly to the Fed: $700 million to $5

billion per year, depending on the interest rate paid, at current reserve levels

– Payment of interest would lead to more reserves being held, so the amount would be even higher

– The system of required clearing balances implicitly pays interest

Should the Fed Pay Interest on Reserves? (cont’d)

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Chapter Sixteen Monetary Control. Copyright © Houghton Mifflin Company. All rights reserved.16 | 2...

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