Chapter 5 Money and Inflation - Pennsylvania State University



Chapter 5 Money and Inflation

• Money: assets that are widely used and accepted as payment (a medium of exchange)

• Money = currency + demand deposits

• The cost of holding money is the nominal interest income forgone

• Over half the US currency is held abroad – most likely due to its stability and its good store of value

3 Functions of Money:

1. Medium of Exchange

a. Definition: device for making transactions

b. Allows us to specialize

c. Results in a more efficient use of scarce economic resources

2. Unit of Account

a. Basic unit for measuring economic value

b. This simplifies the comparison among different goods

3. Store of Value

a. Money is a way of holding wealth

b. Any asset can be a store of value and money is typically not considered as a good store of value (i.e., we assume a zero nominal return on money and thus, the actual return on money is negative the rate of inflation). Bonds and Stocks and other non-monetary assets (e.g., real estate) are usually thought of being a ‘better’ store of value than money.

c. Money’s usefulness as a medium of exchanges is why people choose to use it as a store of value (vs. stocks, bonds, etc.) even though the return is less

Monetary Aggregates

• M1 includes

a. Currency

b. Checkable deposits

c. Traveller’s cheques

• M2 includes M1 +:

a. Savings Deposits

b. Money market mutual funds and deposit accounts

c. Small denomination time deposits

The Market for overnight reserves - the federal funds market - this model applies up until the Fed received the authority to pay interest on reserves in October of 2008.

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Example - a $1000 open market purchase by the Federal Reserve (Federal Funds Trading Desk at the FRBNY).

Define money as below:

1) M = C + D where C = currency (cash) and D = demand deposits (checking accounts)

The Fed has pretty good control over what is referred to as the monetary base (MB) (also referred to as high powered money since changes in MB due to open market operations result in high powered effects, via the money multiplier, on the money supply). Define MB as follows with C = currency as before, R equals total reserves, a combination of required reserves (RR) and excess reserves (ER).

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What are the implicit assumptions with regard to bank behavior and household behavior?

A more realistic money multiplier

1) M = C + D

2) MB = C + R

Divide 1) by 2)

3) M/MB = (C + D)/(C + R)

Now a “trick” – divide the numerator and denominator of the RHS (right hand side) of 3) by D

4) M/MB = (C /D+ D/D)/(C/D + R/D)

Let’s do a few things to 4) – a) get MB on RHS, b) D/D = 1, and c) R = RR + ER

5) M = [(C /D+ 1)/(C/D + RR/D + ER/D)] MB

The term in brackets is referred to as the money multiplier, which is a little different than our simple money multiplier. Equation 5) implies that the money multiplier is influenced by household behavior via C/D, which is determined by us. C/D is simply the currency to deposit ratio. For example, if you typically carry $100 in cash and you have $1000 in a demand deposit, then your C/D is 0.1.

Equation 5) also implies that bank behavior influences the money multiplier via ER/D. Even though banks tend to get rid of excess reserves (ER) since they earn zero interest, sometimes they hold on to them.

The last player that has influence over the money multiplier is the Fed themselves via RR/D which is simply the reserve requirement ratio. Note that if we let C/D and ER/D equal zero, the money multiplier collapses to 1/(RR/D) which is the ‘simple’ money multiplier that we derived above.

Specifics on the money multiplier: If ER/D or RR/D go up, then the multiplier falls. This is important, because if MB remains constant, the money supply will fall along with the multiplier. We will now use an example that is a simplified version of what happened during the great depression.

Graphical Analysis, connecting the reserve market to the money market.

Initial Conditions

Let C/D = .2 , RR/D = .1 and ER/D = 0

Money Multiplier = (.2 +1)/ (.2 + .1 + 0) = 4

What does this mean?

A couple things: first, suppose the MB is $ 100 billion ; M = $ 400 billion

Second, a 10 billion dollar open market purchase will result in a $40 billion increase in the money supply (remember high powered money!) See the two graphs below.

The Great Depression – an Example

The Fed is blamed by some for causing the great depression or at the very least, failing to respond appropriately as in they should of conducted more open market purchases! Of course hindsight is 20/20.

What will a bank run do to C/D ratios?

So C/D rose dramatically as people were trying to get their cash – remember, there was no FDIC insurance back then.

ER/D also rose for two reasons – one, banks were keeping ER to meet the liquidity needs of their customers and two, had no one to lend to – banks are reluctant to make loans in such a dismal environment (i.e., the default risk of the borrower is naturally high in such a dismal environment).

Ironically, RR/D went up as well. The Fed was young, less than 20 years in existence and felt that raising the required reserve ratio would make banks more sound as well as giving the public more confidence so that they would not run on banks – in hindsight, raising the required reserve ratio was a mistake!

All three components of money multiplier rose during the great depression – impact on money multiplier?

Recall Money Multiplier equals:

[(C /D+ 1)/(C/D + RR/D + ER/D)]

Initially, let C/D = .2 , RR/D = .1 , and ER/D = 0

With numbers:

[(.2+ 1)/(.2 + .1 + 0)] = 4

Now account for changes in C/D, RR/D, ER/D

Let C/D up to .5, RR/D up to .2, ER/D up to .3

[(.5+ 1)/(.5 + .2 + .3] = 1.5

NEW Multiplier = 1.5

With numbers – before the great depression

M = ( 4 ) MB

If MB = $ 100 billion ; M = $ 400 billion

Now great depression hits and the multiplier falls to 1.5

MB still at $100 billion – M = 150 billion

Targeting the growth rate of money and the quantity theory of money - this was very relevant for monetary policy during the 1970s and 1980s..

MV = PY

use the space below to show why targeting the growth rate of money makes sense, under certain conditions.

Explain what an intermediate target is and the characteristics of a 'good one.'

Now explain what happened to money as an intermediate target.

Back to the market for overnight reserves and targeting the federal funds rate.

Practice problem......Suppose you are the manager the trading desk back when the fed was in the old system of targeting the federal finds rate. It is morning and your staff estimates reserve demand to be

Rf = 60 - 5 iff and the target for the funds rate is 4% (use 4 in calculations)

assuming you have perfect control over the amount reserves.

a)(5 points) How many reserves are needed to hit the target established by the FOMC (all numbers are in $ billion)?

b)(5 points) How do you control the amount of reserves in the system? Be specific. Who do you deal with?

In the space below, draw a graph of the reserve market and label this as point A.

10 points for correct and completely labeled graph

The next morning, your staff realizes that a shock occurred overnight and they now estimate reserve demand to be:

Rf = 70 - 5 iff and the target for the funds rate is still 4%

c) (5 points) What do you instruct the desk (the traders) to do and how would they do it? Depict this new point as point B.

The Federal Reserve received the authority to pay interest on reserves in October of 2008 and since then, most everything has changed in the overnight market for reserves (the federal funds market)

Notes and other resources will be used to explain this new regime.

Practice Questions for Exam 2

1. Explain what happened to the money multiplier and why during the Great Depression - be sure to write out expression for money multiplier and discuss what happened to its components and why. Then discuss what happened to the money multiplier as soon as the Fed got the authority to pay interest on reserves in October 2008.

b) (10 points) Many criticize the Fed for not reacting appropriately during the Great Depression. Explain these criticisms and if the Fed would have it to do over again, what would they do exactly? Be sure to support your answer by using the definition (expression) of the money supply.

3) (35 points) We discussed in detail how the Fed has managed its balance sheet in recent years in conjunction with why the Fed wanted to pay interest on reserves. Using the balance sheet below, answer the following questions:

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a) (10 points) We discussed the concepts of sterilization and unlimited balance sheet capacity. On the graphic above, locate (mark on the graphic) the period of sterilization and explain exactly what sterilization is and why and under what conditions, central banks practice sterilization. Why was the Fed practicing sterilization during this period and what exactly was the concern about this sterilized intervention? (more room next page)

b) (10 points) The Fed pleaded with Congress to push up the date in which the Fed would be granted the authority to pay interest on reserves. Why was the Fed pleading for this authority, when did they get the authority, and what did they do as soon as they got the authority? Please mark on your diagram the date that the Fed received this authority. Finish your essay by answering the following questions: What exactly does 'unlimited balance sheet capacity' mean? What happened to excess reserves and the money multiplier as soon as the Fed was granted the authority to pay interest on reserves? Please use an expression for the money multiplier to support your answer.

c) (5 points) Using the table below, calculated the percent change in money supply (MS) between June 2008 (2008-06-01) and June 2010 (2010-06-01) and compare it to the percent change in the money supply if the Fed acted the same way but did not get the authority to pay interest on reserves. That is, the monetary base changed as it did but the money multiplier remained constant as it is in June 2008.

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MB

MB’

MB

110

100

i

Ms’

Ms

400

M

440

i

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