1

Money and the Federal Reserve Bank

The objective is to understand the actions of the Central Bank and its impact on the economy

2

Overview

• What is Money?

• The Fed and Monetary Policy

• Money and Inflation---Long Run

• The Money Multiplier and Bank Runs

3

Abel/Bernanke, Macroeconomics Update, © 2003 Pearson Education, Inc. All rights reserved

Chapter 7 Table 1 U.S. Monetary Aggregates (January 2002)

Note that the use of credit cards does not eliminate the use of money, as money is often used to pay off a credit card balance. Credit cards simply delay the payment of a good.

Money’s primary purpose is to serve as a medium of exchange and thereby to facilitate transactions.

What is Money?

4

The Fed and Monetary Policy in the Short Run

5

What does the Fed Do?It controls monetary aggregates to affect the economy and financial markets

Board Room at the Federal Reserve Board

Federal Reserve Board, Washington, DC

6

Fed Actions

The Fed manages the economy by managing

– The interest rate---the Federal Funds (FF) Rate

– Regulate the banking system

NB: The SEC is supposed to regulate Investment Banks.

7

Federal Funds Rate

Federal Reserve Sets the Target Federal Funds RateThe Federal Funds Rate (FF) is the rate banks charge each other for borrowing reserves overnight

8

Federal Funds Rate Drives all Interest rates

Fed FundsT-Bill

30 yr Mortgage

9

Recent Federal Funds Rate

10

Supply of Money and Open Market Operations

Open Market Purchase: When the Fed buys T-bills, it credits the reserve account of the selling Financial Institution (Bank) by the amount of the purchase, thereby increasing the amount of money in circulation

Supply ofmoney

C.B. pays Cash or makes Deposits in the account of the financial institution at

the Fed

Fin. Institution delivers T-bills or Bonds to Central Bank

Central Bank Financial Institutions

How Does the Fed Manage the Fed Funds Rate?

11

Supply of Money

• M is the nominal supply of money

• Then M/P is the real supply of money where P is the aggregate nominal price level (CPI)

12

Demand for Money

Why hold money?

– Liquidity

– Money is the most liquid asset and is needed for transactions

13

Demand for Money

• The demand for Real Money Balances:

• y is real GDP and P is the price level or CPI

• Less money is demanded when the nominal interest rate is higher.

),( ed

ryLP

M

14

Demand and Supply of Money

The demand for money• Falls as interest rate

increases• Falls as expected

inflation rises.

• Falls if the real interest rate rises.

• Rises as real GDP increases

The supply of money• Determined by the Fed

15

The Money Market

•Real Money Demand = Real Money Supply

• This market clearing condition determines the nominal interest rate --- the Fed funds rate.

Real Money Demand

Real Money SupplyNominal interest rate, R

R*

M/P(M/P)*

),( eryL

P

M

16

Effect of Open Market Purchase

Increase of currency in circulation via an open market purchase lowers the Fed funds rate

Money Demand

Fed funds rate

R

R’

M/P M/P(M/P)’

17

Empirical Evidence: Effects of 60 Basis Points Rise in FF Rate

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48

Real GDP Price level (GDP deflator)

months

% change

Empirical evidence shows that a rise in the Fed Funds Rate brings down Prices and Real GDP in subsequent periods at horizons of 18 months.

Why Is the Fed so Important?

18

Short Run Effects on the Economy

The Short Run Impact of a Federal Funds-rate cut

Real GDP

Growth Employment

Investment Real Wages

Stock Prices Bond Prices

FF Rate Cut is designed to cut real interest rates and stimulate investment demand

19

Long Run Effects on the Economy

• A policy of keeping the Fed Funds Rates low may require the central bank to continuously increase the supply of money

In the long run this leads to inflation

20

Money and Inflation: Long Run

21

Long Run Effect of Increasing Money Supply

Increase of currency in circulation via an open market purchase lowers the Fed funds rate

Money Demand

Fed funds rate

R

R’

M/P M/P(M/P)’

Only effect is to increase the price level

22

Money and HyperinflationAustrian Hyperinflation

100

5,100

10,100

15,100

20,100

25,100

30,100Ja

n-21

Mar

-21

May

-21

Jul-

21

Sep-

21

Nov

-21

Jan-

22

Mar

-22

May

-22

Jul-

22

Sep-

22

Nov

-22

Jan-

23

Mar

-23

May

-23

Jul-

23

Sep-

23

Nov

-23

Jan-

24

Mar

-24

May

-24

Time

Pric

e le

vel

1,000,000

1,001,000,000

2,001,000,000

3,001,000,000

4,001,000,000

5,001,000,000

6,001,000,000

7,001,000,000

8,001,000,000

9,001,000,000

Mon

ey s

uppl

y

CPI Money supply

Money supply is Austrian Crowns in circulation

23

Other Hyperinflations

24

Why is high inflation bad?

• With high inflation people want to economize on holding money

• High inflation and price uncertainty makes it difficult to evaluate the profitability of projects

25

Policy Trade-off

• In Recession: Fear of rising unemployment and falling income leads the Fed to lower the Fed Funds rate

• Cost of this Policy : Greater inflation in the long run

• In Economic Booms: Fear of Inflation, so raise interest rates

• Cost of this policy: Lower Economic Growth

26

Money and Banking

Money Multiplier and Bank Runs

27

Reserve Requirements

• Required Reserves – Specified percentage of commercial bank deposits

(checking deposits) must be held as reserves (vault cash or deposit at the Central Bank)

• Excess Reserves– Typically, to meet withdrawals of cash, banks

hold more reserves than what’s required

28

Invisible Money Creation: Money Multiplier10 percent reserve requirement

Deposit Reserves Loans

1st Round $100 $10 $90

2nd Round $90 $9 $81

3rd Round $81 $8.10 $72.90

4th Round $72.90 $7.29 $65.61

…

Total $1000 $100 $900

29

The Money Multiplier

• Money available in the economy is currency held by the public, CU plus bank deposits DEP

M = CU+DEP

• The Monetary Base is currency held by the public, CU plus reserves, RES held by banks

MB= CU +RES

30

The Money Multiplier

• The Money Multiplier can be expressed as

11

/ /1 /

rescucu

DEPRESDEPCUDEPCU

MBM

MBrescu

cuMB

MB

MM

1

• Money, the Monetary Base, and the Money Multiplier

31

The Money Multiplier and Bank Runs

What if households decide to withdraw their deposits and hold more currency per dollar of bank deposit?---cu rises

• The bank would use the reserves to return the Deposits

• Less money would be loaned out

• Money Supply will fall

What if banks become conservative and hold more reserves per dollar of deposit?----res rises

• Less money would be loaned out

• Money Supply will fall

32

The Money Multiplier and Bank Runs

• In may cases, households may fear that banks don’t have adequate assets to cover their liabilities (demand deposits)

– They may want to withdraw their deposits and hold cash

• What if banks start running out of reserves

– Loans have to be liquidated at significant losses

– Sudden loan liquidation may not be enough to cover all the deposit withdrawals

– The fear of depositors that they may loose their bank deposits causes a run on the bank

• Implication-----cu rises, money supply falls, and banks fail.

33

Monetary Variables in the Great Depression

•Consumers Shift to holding Currencycurrency/deposit ratio rises•Banks become more conservative and hold more reservesreserve/deposits rise

34

Great Depression

• Central Bank provides more money (liquidity) Monetary Base rises

• Money Multiplier falls due to rise in cu and res

35

Monetary Variables in the Great Depression

• Due to the fall in the money multiplier, despite the increase in the Monetary Base, the Money Supply falls

• This is similar to the current financial crises in the US, in which households and banks become more conservative (banks freeze their lending), so the money multiplier falls.

36

CPI in the Great Depression

Goods Prices fall as money supply falls

37

The Money Multiplier

38

The Monetary Base

39

The Money Supply: M1