Maclachlan, Money & Banking Fall 2006

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The Money Supply Processand Monetary Policy Tools

Week 9

Maclachlan, Money & Banking Fall 2006

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Consider the narrowest definition of money: M1. Consists of …

currencycheckable depositstravelers checks

Maclachlan, Money & Banking Fall 2006

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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

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Bank reserves consist of ….

Vault cash (includes cash in ATM’s).Deposits at the Fed.

Maclachlan, Money & Banking Fall 2006

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Government securities

Discount loans

Fed notes in circulation

Deposits of member banks

Fed Assets Fed Liabilities

Maclachlan, Money & Banking Fall 2006

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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

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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

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Deposit Creation

Maclachlan, Money & Banking Fall 2006

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Deposits at Failed Banks: 1929–33

Maclachlan, Money & Banking Fall 2006

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e, c: 1929–33

Maclachlan, Money & Banking Fall 2006

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Money Supply and Monetary Base: 1929–33

Maclachlan, Money & Banking Fall 2006

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Monetary Policy

Maclachlan, Money & Banking Fall 2006

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Three Tools of Monetary Policy

• Open market operations

• Discount rate

• Reserve requirements

Maclachlan, Money & Banking Fall 2006

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Open Market Operations2 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

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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

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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

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Discount Policy

Advantages1. Lender of Last Resort Role

Disadvantages1. Confusion interpreting discount rate

changes2. Fluctuations in discount loans cause

unintended fluctuations in money supply3. Not fully controlled by Fed

Maclachlan, Money & Banking Fall 2006

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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

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Goals of Monetary Policy

Goals

1.High Employment2.Economic Growth3.Price Stability4.Interest Rate Stability5.Financial Market Stability6.Foreign Exchange Market StabilityGoals often in conflict

Maclachlan, Money & Banking Fall 2006

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Money Supply Target

1. M d fluctuates between M d' and M d''

2. With M-target at M*, i fluctuates between i' and i''

Maclachlan, Money & Banking Fall 2006

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Interest Rate Target

1. M d fluctuates between M d' and M d''

2. To set i-target at i* Ms fluctuates between M' and M''

Maclachlan, Money & Banking Fall 2006

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Criteria for Choosing Targets

1. Measurability2. Controllability3. Ability to predictably affect goalsInterest rates aren’t clearly better than Ms on criteria 1 and 2 because hard to measure and control real interest rates