OUTLINE

1. Supplement tochapter 10 The Money Supply and the Federal Reserve System OUTLINE Central Bank Independence and Inflation What is Money? How Banks Create Money A Historical Perspective: Goldsmiths The Modern Banking System The Creation of Money The Money Multiplier The Federal Reserve System Functions of the Federal Reserve Expanded Fed Activities Beginning in 2008 The Federal Reserve Balance Sheet How the Federal Reserve Controls the Money Supply The Required Reserve Ratio The Discount Rate Open Market Operations Excess Reserves and the Supply Curve for Money Looking Ahead

2. Central Bank Independence and Inflation

3. What is Money? • Money is anything that is widely accepted in exchange for goods and services in ordinary commercial transactions. • If we all agree something is money, then it can be used to buy stuff. • Paper money (currency) has the advantage of being tangible. • What about balances in checking accounts?

4. Where do Checkable Deposits Come From? • You can’t see, touch, or smell balances in your checking account. • Those deposits only exist as electronic records in the bank’s computers. • Then why should it surprise anyone that the Fed can change the money supply simply by changing some entries in their computers? • Which is exactly what happens …

5. What Backs Up the Money Supply? • Nothing. Nada. Zero. • No developed country (with the possible exception of Switzerland) backs their currency with gold, silver, or anything else. • Central banks can create as much money as they want. • Consider Zimbabwe. • Money supply statistics for Zimbabwe are on the following supply. The source is economist Steven Hanke who has a nice discussion at http://www.cato.org/zimbabwe.

6. Highest Monthly Inflation Rates in History

7. Currency Growth Rate Source: Hanke, Steve H., “Zimbabwe: From Hyperinflation to Growth” (2008). Cato Institute. Available at http://www.cato.org/pubs/dpa/dpa6.pdf. Pay close attention to the vertical scale.

8. Understanding the Money Multiplier

9. An Example • Suppose there is only one bank in an economy, the required reserve ratio is 12%. Further assume that the bank holds no excess reserves. • Suppose the Fed purchases $5 million in securities from the bank. The bank finds itself with $5 million in excess reserves which it promptly lends. The loan becomes a deposit, increasing M1 by $5 million. • Now assume loans are completely deposited with no one taking any cash out of a deposit.

10. The Second and Third “Rounds” • The bank is required to hold 12% of the new deposits as reserves or $600,000. This leaves $4.4 million available for more loans. Those loans are deposited. • The new $4.4 million in deposits requires $528 million in reserves, leaving $3.872 million for still more loans.

11. The Eventual Outcome • On the next few slides I’ll show you why the following is true: • R: Reserves • REQ: Required reserve ratio • For our example, M1 will increase by ($5 million/0.12) = $41.67 million.

12. The Money Multiplier • 1/REQ is called the money multiplier, the increase in M1 that will be caused by a $1 increase in bank reserves (given all the assumptions made earlier). • For the previous example the money multiplier is 1/0.12=8.33. • Let’s derive the money multiplier using supply and demand analysis.

13. Deriving the Money Multiplier • We’ll add currency held by the non-bank public back into the system. Let CU be the fraction of deposits (TDD) the public wants to hold as currency. Let REQ be the fraction of deposits banks “want” to hold as reserves. • M1 = (CU)(TDD)+TDD = TDD(1+CU) • The monetary base is B = (CU)(TDD) + (REQ)(TDD) = TDD(CU+REQ)

14. Deriving the Money Multiplier II • Dividing M1 by B gives us • But M1/B is just the money multiplier since M1=(money multiplier)B.

15. Extending the Earlier Example • The Fed purchases $5 million in securities from the bank. The bank “wants” to hold 12% of deposits as reserves. Suppose people want to hold 26% of deposits as currency. The money multiplier is (1+0.26)/(0.12+0.26)=3.316. • Adding a currency “leakage” from the loan-deposit cycle reduces the numeric value of the money multiplier.

16. Reserve Balances

17. The New Rules of Discount Borrowing

19. The Discount Rate • The Fed changes this rate periodically. Until recently the discount rate was mainly changed to keep up with changes in the Federal Funds rate. • Before 2002, the Fed viewed borrowing at the discount window as a privilege. Banks that visited the window too frequently were viewed with suspicion. Banks believed they were more likely to invite close scrutiny by borrowing reserves from the Fed.

20. New Discount Window Policy • The Fed proposes to set up a new type of discount window credit, to be called primary credit. It would replace adjustment credit, which currently is extended at a below-market rate. • Primary credit would be available for very short terms as a backup source of liquidity to depository institutions that are in generally sound financial condition. It would be extended at a rate that would be above the usual level of short-term market interest rates, including the federal funds rate.

21. New Discount Window Policy: Eligibility • The primary credit program would be broadly similar to mechanisms used by many other major central banks. • The interest rate for primary credit would be set through a procedure identical to that currently used for the basic discount rate. Under the proposal, the interest rate on primary credit would initially be set at 100 basis points above the target federal funds rate. Thereafter, Reserve Banks would set the rate, subject to review and determination by the Board of Governors.

22. New Discount Window Policy: Impact • By restricting eligibility to generally sound institutions and by eliminating the incentive for institutions to borrow to exploit the positive spread of money market rates over the discount rate, the primary credit program should considerably reduce the need for the Federal Reserve to review the funding situations of borrowers. • The Federal Reserve expects that, as a result of this reduced administration, institutions' willingness to use the window when money markets tighten should increase, limiting potential volatility in the federal funds rate.

23. Why Does the Fed Buy the Securities They Buy?

24. Facts About the Fed • When the Fed buys anything with newly-created money the money supply expands. • Historically the Fed has concentrated its purchases on government securities with maturities less than one year. • Today they have strayed a bit, holding about $1 trillion in (most likely toxic) mortgage backed securities.

25. What if the Fed Bought … ? • Shares of Apple stock • Antique Chippendale chairs • Houses and real estate • Or anything else

26. The Fed Buys in Bulk • When the Fed makes a purchase, it’s a big purchase. • They need to buy something that’s available in large quantities and highly liquid. • U.S. government securities qualify on both counts. • The price of anything the Fed buys will rise, perhaps increasing by a large amount.

27. Why the Fed Doesn’t Shop Around • It’s an issue of fairness. • If the Fed bought Apple stock, Chippendale chairs, houses, or anything else, it would push up the price of that item. • The closest the Fed can come to being neutral is to buy U.S. government securities. • As a result the U.S. government pays a somewhat lower interest rate.