Lecture Notes 22 October 2012



Lecture Notes 22 October 2012My instinct from the last lecture was that the various concepts regarding money supply etc. was somewhat confusing. I’d like to run through some examples before proceeding to anything else. I think we should probably run through an example to get the concepts straight. Recall the Monetary Base is the sum of the cash in circulation, bank reserves and treasury monetary liabilities (coins)M1 – The total amount of cash outside the banking industry plus all demand deposits (checkable deposits)M2 = M1 + most savings accounts, money market accounts and small size time deposits.Money Multiplier = M1/MBRequired Reserves = 10%Let’s go through a simple example:I start with 1000 dollars in cash. There are no deposits in any bank and no excess reserves. Let’s assume that the treasury has no coins etc outstanding.Thus we haveMonetary Base = 1000M1 = 1000 – my cash is not in a bankM2 = 1000 – M2= M1+other thingsMoney Multiplier = M1/MB = 1Let’s assume that I deposit 500 dollars in my checking account.The bank needs to deposit $50 in reserves at the Fed Reserve thus must take $50 dollars of my cash and place it on deposit at the Fed. This also means that $450 is sitting in the vault at the bank.. Thus will reduce the cash in circulation by $50 but leave the Monetary Base unchangedMB = 950 cash in circulation + 50 reserves = 1000M1 = 500 cash outside of banking + 500 in checkable deposits = 1000M2 = M1 + other things = 1000Money Multiplier = M1/MB = 1Let’s assume that I deposit the other 500 dollars in a money market account. This becomes a bit more complicated. The first thing we need to figure out is what happens to MB. In order to do that we need to understand what the money market account does with the dollars. Let’s assume that the money market account is at a bank and the bank simply takes the cash, puts it into a vault and gives an electronic ledger entry in the money market account. Thus we have taken $500 dollars out of M1 as the cash is no longer outside the banking industry and the money has not appeared in a checkable deposit elsewhere. M2 stays unchanged because there is an additional $500 in a money market account.Now we have:MB = 1000M1 = 500M2 =M1 + 500 = 1000Money Multiplier = M1/MB = 0.5Now the bank might take the $950 dollars sitting in its vault and lend it as cash to someone else. There are several options as to how to do this.Version 1:The bank lends cash to someone. The cash in circulation is $950, the reserves is $50 so the monetary base is unchanged at $1000. M1 is changed because we now have $950 in cash outside of the banking system and $500 in a checkable deposit. Therefore:MB = 1000M1 = 950+500=1450M2 = M1+500 = 1950Money Multiplier = M1/MB = 1.45Version 2:The bank lends the money to someone and deposits electronic money into their checking account. In this situation the reserve requirement goes up by $9.50 and the bank will need to return $9.50 in cash back to the Fed in order to satisfy this reserve requirement. Thus the mixture of the monetary base will change. There will be 940.50 of cash in circulation and reserves of $59.50. The monetary base will be unchanged. M1 will change. There is no cash in circulation outside of banks but checkable deposits will have increased to 1450.MB = 1000M1 = 1450M2 = M1 + 500 = 1950Money Multiplier = 1.45Version 3:The bank lends the money to someone and deposits electronic money into their money market account. No new reserves are needed and we find that the monetary base is unchanged, M1 is unchanged but M2 has increased by $950. SoMB = 1000M1 = 500M2 = 1950Money Multiplier = 0.5Do these examples make sense?Let’s go back to the beginning. Someone has $1000 dollars in cash and we haveMB = 1000M1 = 1000M2 = 1000Let’s assume that this person purchases T-bills worth $500 and the treasury takes the cash and deposits it into an account at the Fed. Effectively this is a reserve account so MB = 500 cash + 500 reserve account = 1000M1 = 500M2 = 500There are lots of alternatives to where the treasury might keep its money. It might for example put it into a checking account at a bank; it might buys goods and services from someone. These may have different effects on M1 and M2.Now let’s assume that the Fed buys the T-bills from the person. That person will get a check from the Fed worth $500 which they deposit into their checking account. In this situation the monetary base will now increase by $500 because the Fed will add an additional $500 in reserves to the system (their electronic check will be deposited into the bank’s reserve account. Thus the Monetary Base, M1 and M2 will be increased by $500 MB = 1500M1 = 1000M2 = 1000Now let’s walk through one more example. Let’s start with our original person who had $1000 in cash so MB=M1=M2 = 1000Let’s assume that they are going abroad and decide to transfer $1000 into pounds at an exchange rate of 2 to 1. They go to the bank and exchange the dollars into pounds. This moves dollars into vault cash and takes pounds out of vault cash. Thus MB = 1000M1 = 0M2 = 0The 500 GBP in circulation does not count towards the US version of M1 and M2 only the UK version of this. Does all of this make sense?Goals of Monetary PolicyThe goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.The various goals of monetary policy can be in conflict with one another at given times. Generally speaking though in the long run central banks believe that the goal of stable prices will promote growth in the economy that will in turn increase employment. In addition long-term interest rates are driven in part by inflation expectations. Therefore the best way to moderate long-term interest rates is to control of inflation and to have the market perceive that the Fed will do what it takes to control it.Thus the Fed generally sees price stability as the primary medium to long-term goal of monetary policy.The Fed though has a time inconsistency problem in trying to control inflation. Time inconsistency problems arise when choices that appear optimal today appear sub-optimal once those choices are made. Before we go into how this applies to inflation let’s look at a more straightforward example. Consider a borrower who would like to borrow money to buy a house. Two obvious questions are:1 – would the borrower like to receive the loan to buy the house?2 – would the borrower like to not have to repay the loan?The answer to both of these questions is clearly yes. Now ask a separate question1 – at the time of borrowing would the borrower like there to be an enforcement agency that ensures that the loan is repaid2 – at the time of repayment would the borrower like there to be an enforcement agency that ensures that the loan is repaid.The answer to the second question is probably no as the borrower would prefer not to repay the loan. The answer to the first question is probably yes because it increases the probability that the loan will be made available and probably reduces the cost of the loan. The time-inconsistency is that the borrower changes his opinion about the enforcement agency.Controllng inflation has a similar problem. When the Fed decides that Inflation is too high they will look to target a higher Fed Funds rate:Through what type of open market operation could the Fed attempt to raise the Fed Funds rate?If they decide to raise Fed Funds the economy may suffer as a result of the Fed trying to lower inflation expectations. Thus having decided to control inflation they are creating a situation in which higher Fed funds rates cause a slow-down in the economy and the optimal short-term solution is to lower Fed Funds rates. Inflation TargetingOne of the key ways in which central banks attempt to achieve their long-term goals is through inflation targeting. This was introduced by New Zealand in 1988. Since New Zealand introduced an inflation target it has moved from being one of the worst.Given this experience many other countries have introduced an inflation target – the Fed formally set a public inflation target in January of 2012 at 2%.Advantages of Inflation TargetingIt is readily understood by the publicIncreases accountability of the central bank and places an emphasis on transparency by the Fed. Helps avoid the time-inconsistency problem since the public can hold the central bank accountable.Allows for better private sector planning since the central bank is communicating Inflation goalsRegular measures of inflationHow to achieve the goals given current conditions.Explanations of deviations from targets.Performance has been good.There is a feedback mechanism from the statement of the policy into inflation expectations. Because I know that the Fed is targeting a particular inflation level I can expect that long-term interest rates will reflect this. There may be fluctuations around this level in the short term.Disadvantages of Inflation TargetingIn the short-term inflation is not easily controlled and there is a significant lag between changes in monetary policy and changes in inflation.Too much rigidity. A central bank that pursues a short-term inflation target above all else will cause larger fluctuation in output in order to maintain its target.Low economic growth – during the period of disinflation (the reduction of inflation) one would expect lower than average growth. This might be too big a cost for an economy. For example in the early 1980’s recession the Central Bank was probably a bit fortunate that inflation reduced as significantly as it did in the time it did. Another couple of years of recession might have caused serious questions to be asked about its strategy.The Fed Carries out Monetary PolicyGenerally speaking the central bank controls the tools of monetary policy but first they have to decide what they are looking to target. If the goal of monetary policy is price stability in the medium term then one might consider long-term interest rates or a measure of money supply growth like M2 as the “intermediate target.”The intermediate target is the target that the Fed believes will influence in a predictable way their target. This is a challenge as there is not direct linkage between The intermediate target and the goal. The tool of monetary policy and the intermediate target.Next the Fed has to choose a policy instrument that focuses on their target.Criteria for choosing a policy instrument1 – Observability and Measurability – one of the reasons for this is that the Fed is signaling to the market its policy stance.2 – Controllability – The Fed must be able to exercise effective control over the policy instrument.3 – Predictable effects on goals.Generally the Fed has chosen the Fed Funds rate as the best instrument for setting monetary policy. There are some issues – it’s a nominal rate rather than a real rate. During the Great Depression nominal rates were very low historically but real rates were very high because Right now the Fed has used the interest on reserves to set a lower bound on the Fed Funds rate and has been targeting longer term interest rates through asset purchases.Lender of Last ResortOne of the other key functions of the Fed is as lender of last resort. As I mentioned the discount rate is generally set to a level at which it is un-economic to borrow from the Fed. The facility is used though and is part of the function as a lender of last resort – namely a bank can borrow reserves from the Fed in situations when no one else will lend to them. Let’s go back to our example where we had an individual with $1000 in cash deposited in a checking account and the bank has leant out $500 dollars of this which also sits in a checking account. In this situation the bank has assets and liabilities.Assets|LiabilitiesCash 850Deposits1,500Reserves150Loan500Clearly this bank could be in trouble if both depositors request to take out any amount over $850. Theoretically if the first depositor asked for $1,000 back then the bank could rescind the loan and pay back the $1,000 but this may be very difficult to do on short notice. Generally what the bank might do is borrow reserves from elsewhere in the banking system. Thus the picture would change to:Assets|LiabilitiesCash 850Deposits1,500Reserves650Borrowed Reserves500Loan500They can then turn the excess reserves into cash and pay the depositors the cash that is requested. In the end they will have assets and liabilities that look like:Assets|LiabilitiesCash 0Deposits0Reserves0Borrowed Reserves500Loan500On the other hand if one is worried that the bank is insolvent then other banks will not lend reserves to the bank. Thus the bank would have to go to the Fed Reserve and borrow at the discount window. The effect would be the same but the bank would have significantly greater borrowing costs.Things to know about the lender of last resort function of the Fed Reserve.Financial panics are extremely damaging to an economy. In particular bank runs can cause serious problems. Reserve Banking depends on all depositors not attempting to take their money out at the same time. When there are rumors of a bank insolvency it can actually cause insolvency because of the run. As a depositor you are much better off being first in line to take your money out rather than last in line. The Fed Reserve has not always used the discount window to prevent bank runs – a significant number of banks failed in the 1920’s and this accelerated into the early 1930’s. These runs greatly increased the severity of the ensuing depression.The FDIC should alleviate some but not all risk of bank runs. It is important to recognize that the FDIC insurance fund only covers around 1% of the deposits outstanding and only covers $250K per account holder. In a serious crisis banks might need more support.The Fed Reserve sees this function not only as lender of last resort to the banking industry but lender of last resort to the financial system as a whole. In the 2007 crisis the Fed stepped in to provide this function to money market funds and other types of “deposits” even though these were not explicitly insured. During the recent financial crisis some of the lender of last resort style actions of the Fed were to:Significantly reduce the discount rate from 1% above the Fed Funds target to 0.25% above the target.Extend the length of discount loans from overnight to 90 days.Created a temporary Term Auction Facility to make discount loans to banks. This reduced the stigma of the discount loans. As the crisis worsened the amount outstanding through this facility was greater than $400bn.Extended currency swap lines to foreign central banks. This allowed these banks to extend dollar loans to their domestic banks.Facilitated the purchase of Bear Stearns by JP Morgan.We will hopefully spend some time in the last couple of weeks of the course talking more about the recent financial crisis. ................
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