CHAPTER 17 MONEY SUPPLY

CHAPTER 17MONEY SUPPLY MONEY SUPPLY AND THE BANKING SYSTEM

Functions of money: • - means of exchange • - store of value • - unit of account • M1: currency + checkable deposits • M2: M1 + savings + small-denomination time deposits • M3: M2 + large-denomination time deposits Money: Definition

Federal Reserve System: 12 regional banks + Board of Governors (located in Washington). • Board of Governors: 7 governors (including 1 chairman) appointed by President for a 14-year term. • Federal Open Market Committee: 12 voting members = 7 governors + 5 regional Federal Reserve bank presidents (by rotation except president of New York Fed). • Open Market Operation: buys and sells government securities in the open market by the Fed The Federal Reserve System

sets legal reserve requirement on deposits • Fed’s liabilities (which is controllable) include currency + bank reserve deposits = monetary base = money supply • Fed’s Tools: • Open Market Operations – Fed buys bonds, increase Ms • The Discount Rate – interest rate charged to banks • The Required Reserve Ratio – % deposits as reserves Fed Controls Money Supply

Commercial Bank Balance Sheet: • Assets: Reserves, Loans, Securities • Liabilities: Deposits (checkable, time, savings) • Deposit creation begins when one bank converts its excess reserve (less required reserve) into loans: • individual A sells bond to the Fed, receive $1000 then deposits $1000 into Citibank • at rr = 10%, Citibank gives out $900 loan to individual B • who buys a boat and $900 check is deposited into Bank of America • at rr = 10%, BofA gives out $810 loan to individual C … Reserves and Deposits

increase in required reserves • = reserve ratio x change in deposits = rrdΔD • increase in reserves = increase in required reserves • ΔR = rrdΔD • if change in reserves = 1000 and rrd = 0.1, then total change in deposit is 1000 = 0.1 ΔD • ΔD = 1000 / 0.1 = 10000. • deposit multiplier = increase in deposits per unit increase in bank reserves = Deposit Multiplier

monetary base = currency held by public + bank reserves • assume public currency holding is constant, then • change in monetary base = change in bank reserves ΔMB = ΔR • change in money supply = change in bank deposits ΔMs = ΔD • then money multiplier (an increase in money supply per unit increase in monetary base): • assuming public currency holding constant, • money multiplier = deposit multiplier Money Multiplier

for narrowly defined money supply (M1), the money multiplier will depend on additional factors: • i) public holding of currency/deposit ratio, CU/D • example: if individual A sells bond and receive $1000, but prefers to hold $200 in currency, then will only deposit $800. CU/D = 0.25 • ii) bank’s desired excess reserve/deposit ratio, ER/D • example: as deposits increase, public’s tendency to hold currency grow faster than increase in bank’s excess reserves M1 as Money Supply

broad definition of money supply m = m (rrd) • narrow definition of money supply m = m (rrd, CU/D, ER/D) • factors: required reserve ratio • public currency/deposit ratio • bank excess reserve/deposit ratio • since change in money supply (ΔMs) is a result of change in monetary base (ΔMB) x money multiplier (m), then at a given level of monetary base, a money supply function: • Ms = m x MB (all will negatively affect money multiplier) Money Multiplier Function

Ms0 Ms1 Interest rate, r r1 r* Interest Rate vs Money Supply Md1 money, M Md0 M* M1 Failure to control money supply may be due to economic variables such as interest rate. Due to conflict in objectives, in the case of increasing money demand, the central bank may be willing to increase money supply in order to maintain a lower interest rate. Then money equilibrium ≠ M*.

Short-run: central bank may not be able to control Ms effectively due to uncertainty of money multiplier which is affected by public behavior and the banking system. • Long-run (>6 months): central bank becomes more effective because overall growth aims at average money growth, not monthly growth rate specifically. • Example: Central bank aims for a 5% money growth but if money growth is only at 1% in January, then money multiplier decreases and central bank will aim to achieve >5% money growth in subsequent months. Who Controls Money Supply?

Money serves as a medium of exchange, store of value and unit of account. There are 3 measurements of money: M1, M2, M3. • The Federal Reserves System involves 12 regional central banks, Board of Governors, Federal Open Market Committee. • The Fed controls its liabilities of bank reserve deposits through open market operations, discount rate and required reserve ratio. • Deposit creation is made possible by excess reserves. Deposit multiplier = money multiplier = f(rr). Money multiplier for narrow money is f(rr, CU/D, ER/D). Money supply function is Ms = m x MB. • Conflict of objectives in policy to change interest rate or money supply when there is a shock in money demand. Long-run Ms targeting is more effective given the short-term instability of m. Conclusion

CHAPTER 17 MONEY SUPPLY