Transcript Money in the Economy

Money in the Economy
Mmmmmmm,
money!
The Money Supply
• M1:Currency + travelers checks + checkable
deposits
• M2:M1 + small time deposits + overnight
repurchase agreements + overnight
Eurodollars + money market mutual fund
balances
• M3:M2 + large denomination time deposits +
term repurchase agreements + term
Eurodollars + institutions only money market
fund balances
The Creators of Money
• The three major players whose decisions and
actions determine the rate of growth in the
money supply are:
– The Federal Reserve (Fed)
– The Commercial Banking System
– The Non-Bank Public
Money Creation
• Banks create money in their normal, day-today profit seeking activities
• Banks do not try to create money
• Money creation occurs because we have a
fractional reserve commercial banking
system.
– Banks must hold a fraction of their deposits idle
as reserves. They may lend the remainder.
• As they make loans, new deposits are created,
causing the money supply to expand.
Bank Reserves: Definitions
• Total Reserves = Required reserves plus excess
reserves
– Required reserves = Deposits X reserve
requirement
– Excess reserves = Total reserves - required
reserves
Money Creation: Assumptions
• Assumptions:
–
–
–
–
Banks lend all their excess reserves
The non-bank public does not use cash
Only demand or checkable deposits exist
The required reserve ratio is 10%
Money Creation: Step 1
• Assume the Federal Reserve injects $100 into
the banking system by granting a loan.
– Excess reserves increase by $100 in Bank #1
• Banks do not face reserve requirements on injections
of reserves by the Fed
• Bank #1, therefore, has $100 to lend
Money Creation: Step 2
• Let Bank #1 make a $100 loan to a member of
the non-bank public
– It does this by crediting the borrower’s checking
account with $100.
• Let the borrower spend the money.
• Let the recipient of the money bank at Bank #2
• When Bank #1 honors the check, Bank #1’s
deposits and reserves fall by $100.
Money Creation: Bank #1
Bank # 1
Assets
Reserves
100
Liabilities
Discount Loan
100
Loan
Reserves
100
(100)
Demand Deposit
Demand Deposit
100
(100)
Loan
100
Discount Loan
100
Money Creation: Step 3
• A second bank, Bank #2, has received a new
deposit of $100.
– Its total reserves increase by
• Its required reserves increase by
• Its excess reserves increase by
– Bank #2 may now make a loan of
?
?
?
?
Money Creation: Step 4
• Bank #2 makes a loan of $90 in the form of a
new demand deposit.
– When the money is spent and Bank #2 honors the
check, deposits and reserves at Bank #2 fall by $90
• But Bank #3 now has a new deposit of $90 and
may make a loan equal to
?
Money Creation: Summary
New Deposit
Req Res
Ex Res
New Loan
$100
$ 90
$ 81
$ 72.90
$ 65.61
$10
$ 9.00
$ 8.10
$ 7.29
$ 6.51
$100
$ 90
$ 81
$72.90
$65.61
$59.05
$100
$ 90
$ 81
$ 72.90
$ 65.61
$ 59.05
$1,000
$100
$900
$900
Some Simple Formulas
• Note that in our simple example, demand
deposits are a multiple of required reserves
–
–
–
–
–
Let R = required reserves
Let r = % reserve requirement
Let D = demand deposits
R=rxD
or
D = 1/r x R
• A change in deposits will be a multiple of the
change in reserves
– /\D = 1/r x /\R
The Multiplier
• The simple deposit expansion multiplier is 1/r or
1/reserve requirement
– r is a leakage of the lending process
• If r gets bigger, expansion of deposits gets smaller
because banks have fewer excess reserves to lend.
• If r gets smaller, expansion of deposits gets larger
because banks have more excess reserves to lend.
• The real world multiplier is smaller than our 1/r
because
– Banks hold idle excess reserves
– People hold and use cash
The Fed and the Money Supply
Process
Control of the Money Supply
• The Fed controls the money supply with...
– Open Market Operations
• Purchases and sales of government securities by the Fed
on the open market
– Discount Window
• Loans made by the Fed to banks
• The Fed influences the multiplier with
– Changes in the reserve requirement
Open Market Operations
Fed Bank
Presidents
Federal Open
Market Comm.
Fed Board of
Governors
Securities
Dealers
Federal Reserve
Bank of New York
Commercial
Banks
Change
in
Reserves
Change in
Money
Supply
Open Market Operations
• When the Fed buys Treasury bonds from a
bank, it pays for the bonds by crediting the
bank with an increase in reserves.
– Banks can now make more loans.
• When the Fed sells Treasury bonds to a bank,
it accepts payment for the bonds by debiting
the bank’s reserve position at the Fed
– Banks can now make fewer loans.
Discount Loans
• When the Fed makes a discount loan to a bank,
the bank is credited with an increase in
reserves.
– Banks can now make more loans.
• When a bank repays the Fed, the bank’s
reserves are debited.
– Banks can now make fewer loans.
Reserve Requirements
• If the Fed increases reserve requirements,
banks have fewer excess reserves to lend,
causing the expansion of deposits to decrease.
– Banks can made fewer loans.
• If the Fed decreases or eliminates reserve
requirements, banks have more excess reserves
to lend, permitting the expansion of deposits to
increase.
– Banks can make more loans.
Excess Reserves
• Banks determine the level of excess reserves
– Increases in excess reserves diminish the
expansion of deposits.
– Decreases in excess reserves increase the
expansion of deposits
Currency Changes
• Members of the non-bank public determine
currency in circulation
– Increases in currency drains from the banking
system, diminish the expansion of deposits
– Decreases in currency drains from the banking
system, increase the expansion of deposits
Monetary Policy
I see rates rising;
no, falling; no
rising; no --
Monetary Policy
• A tool of macroeconomic policy under the
control of the Federal Reserve that seeks to
attain stable prices and economic growth
through changes in the rate of growth of the
money supply.
Monetary Policy Channels
Policy
Tools
Level & Growth
Bank Reserves
Size and Growth
Rate of Money
Supply
Volume
and
Growth
of
Borrowing
and
Spending
by the
Public
Full
Employment
Growth
Price
Stability
Monetary Transmission Mechanism
• A monetary transmission mechanism describes
the chain of events that occur in an economy
as a result of a change in the rate of growth in
the money supply.
• Good monetary policy decisions depend on
understanding the way money can cause
changes in economic activity.
Monetary Policy Transmission
Mechanism: Interest Rates
Change in
Money Supply
Change in
Interest Rates
Change in Interest
Sensitive Spending
Change in
Exchange Rates
Change in
GDP
Change in
Net Exports
Monetary Policy, Interest Rates
and GDP
• Let the Fed raise interest rates
–
As interest rates increase, the cost of
borrowing increases, causing investment (I),
consumer durables (C), and GDP to fall.
• Let the Fed decrease interest rates
– As interest rates decrease, the cost of
borrowing decreases, causing investment (I),
consumer durables (C), and GDP to rise.
Monetary Transmission
Mechanism: Exchange Rates
Change in
Money Supply
Change in
Interest Rates
Change in
Exchange Rates
Change in
GDP
Explaining Exchange Rates
with Interest Rates
• The exchange rate is the price of a currency
expressed in terms of another currency.
• The exchange rate and the interest rate are
positively related.
– The higher domestic real rates of interest are
compared to foreign real interest rates, the
higher will be the foreign exchange rate for the
domestic economy.
Interest Rate Parity
• Interest rate parity says that the interest rate
differential between any two countries is equal
to the expected rate of change in the exchange
rate between those two countries.
Interest Rate Parity: Example
• Assume that U.S. real interest rates are
higher than those in other countries.
– The high rates of return on U.S. assets will
attract foreign buyers, but in order to buy
U.S. financial assets, foreigners must first
buy dollars.
• The demand for dollars increases in the global
marketplace, causing the dollar to appreciate.
• The supply of the other currency increases in the
global marketplace, causing the other currency
to depreciate.
Monetary Policy, Exchange Rates
and GDP
• Let the Fed raise short-term interest rates
– As interest rates increase, exchange rates increase,
causing net exports (X - M) and GDP to fall.
• As the value of the dollar increases, we export fewer
goods and import more.
Monetary Policy, Exchange Rates
and GDP
• Let the Fed decrease short-term interest rates
– As interest rates decrease, exchange rates decrease,
causing net exports (X - M) and GDP to rise.
• As the value of the dollar decreases, we export more
goods and import fewer.
Modeling Monetary Policy
Money Market Model
• Interest rates are determined in the money
market through the interaction of money
supply and money demand.
Money Supply
• The real money supply is assumed to be fixed
in supply and invariant with respect to the
interest rate.
– The supply of real money balances is defined as
the ratio of nominal money balances and the price
level.
• Real money supply = MS/P
Money Supply
MS
Interest
Rate
The money supply is shown as a
vertical line because we are
assuming that it does not change
as interest rates increase or
decrease.
0
Money
Money Demand and Interest Rates
• Money demand is assumed to be determined by
both interest rates and the level of income.
– MD = L(i, Y).
• The interest rate is the cost of holding money.
– As i rises, the opportunity cost of holding money
rises so people hold less money and more interest
bearing assets.
– As i falls, the opportunity cost of holding money
falls so people hold more money and fewer interest
bearing assets.
Money Demand
i
Money demand is drawn as a
downward sloping line.
i2
Note that at high rates of interest
people do not want to hold very
much money, but at low rates of
interest they are willing to hold
higher money balances.
i1
MD
0 MD
1
MD2
Money
Money Demand and Income
• Money demand is also assumed to be determined
by the level of income.
– MD = L(i, Y).
• People hold money to make transactions.
– Higher levels on Y are associated with more
transactions. Money demand increases.
– Lower levels of Y are associated with fewer
transactions. Money demand decreases.
Money Demand
i
Increases in Y from Y1 to Y3 shift
money demand to the right.
Decreases in Y from Y3 to Y2 shift
money demand to the left.
MD(Y3)
MD(Y2)
MD(Y1)
0
Money
The Money Market
The equilibrium rate of interest is
determined by the intersection of
money demand and money supply.
i
Money supply is vertical because it
does not vary with the interest rate by
assumption.
ie
MD
0
MS
Money
Money demand slopes down because
the opportunity cost of holding money
rises and falls with i.
The Money Market: Shifts
Increases in the money supply
shift the MS line to the right.
i
i3
Decreases in the money supply
shift the MS line to the left.
i2
i1
0
MD
MS1
MS2 MS3
Money
Note that increases in the money supply
cause the equilibrium rate of interest to
decrease while decreases in the money
supply cause the equilibrium rate of
interest to increase.
Money Demand
Increases in Y shift money demand
to the right.
i
Decreases in Y shift money demand
to the left.
MD3
0
MD1
MS
MD2
Money
Note that an increase in money
demand causes the equilibrium
rate of interest to increase while
a decrease in money demand causes
the equilibrium rate of interest
to decrease.
The Money Market: Monetary
Policy
Contractionary monetary policy shifts
MS to the left, increasing the
equilibrium interest rate.
i
i3
Expansionary monetary policy shifts
MS to the right, decreasing the
equilibrium interest rate.
i2
i1
MD
0
M1 M2 M3
Money
i
i
1
i1
3
i3
1
i1
3
i3
Investment
MD(Y1)
0
0
MS1 MS2
I1
AS
AE
AE3 (i3)
3
AE1 (i1)
Expansionary Monetary
Policy: Step 1
1
0
Y1
Y3
Y
I3
Expansionary Monetary Policy:
Transmission Mechanism: Step 1
• An increase in the money supply, other things
remaining the same, causes interest rates to
fall.
– As interest rates fall, interest sensitive spending
and net exports increase.
– As spending increases, the aggregate
expenditure line shifts up to AE3
• Inventories fall, inventories are replaced
• Y rises, consumption rises, inventories fall, etc.
– Y begins to rise towards Y3, BUT……..
Expansionary Monetary Policy:
Transmission Mechanism: Step 2
• As Y rises, money demand rises
– The increase in money demand puts upward
pressure on interest rates causing some
investment spending
– And net exports to be crowded out
• As interest sensitive spending and net exports
fall we more toward Y2.
i
i1
i2
i3
i
1
2
MD(Y2)
MD(Y1)
3
0
1
i1
i2
i3
2
3
Investment
0
MS1 MS2
I1 I2 I3
AS
AE
3
2
Expansionary Monetary
Policy: Step 2.
AE4 (i3)
AE3 (i2)
AE1 (i1)
1
0
Y1
Y2
Y3
Y
AE
AS
AE3(P1)
AE2(P2)
2
AE1(P1)
3
Y1
Y2
Y3
Aggregate demand shifts from AD1 to
AD2 and Y rises toward Y3.
Y
AS
At point 2, AD > AS*. As the price
level rises, AD decreases along the
aggregate demand curve.
3
P2
P1
2
1
AD2
AD1
0
Y1
To close the gap, the government
engages in expansionary monetary
policy.
The decrease in interest rates causes
aggregate expenditures to increase
from AE1 to AE3.
1
0
P
We begin at Y1, where AD< AS*. The
economy is in a recessionary gap.
Y2
Y3
Y
The rising price level causes AE3 to
shift down to AE2. Equilibrium is
established at Y2 and P2.
Fiscal Policy, One More Time
• An increase in government spending or a
decrease in taxes causes aggregate
expenditures to rise.
– The shift up in AE sets off the multiplier
process, causing Y to rise.
– As Y rises, money demand rises, causing
interest rates to rise.
– As interest rates rise, some investment and net
exports are crowded out.
i
i
2
i3
i1
0
2
i3
1
i1
1
MD(Y2)
MD(Y1)
Investment
0
MS1
I3
AS
AE
Expansionary fiscal policy
with money demand
and money supply
3
AE3 (i1)
AE2 (i3)
AE1 (i1)
Y3
Y
2
1
0
I1
Y1
Y2
I
Expansionary Fiscal Policy with
Rising Interest Rates
• Transmission mechanism:
– G up or T down, AE shifts up to AE3, inventories
fall, production increases, Y rises, consumption
rises, inventories fall, etc. Y moves toward Y3.
– As Y rises MD shifts up to MD2, causing interest
rates to rise.
– As interest rates rise, investment spending and net
exports decrease so AE shifts down to AE2.
– Equilibrium occurs at Y2.
Combining Expansionary Fiscal
and Monetary Policy
• Transmission mechanism:
– But if as interest rates rise, the Fed increases the
rate of growth in the MS from MS1 to MS2,
interest rates do not rise and investment and net
exports are not crowded out
– If investment and net exports are not crowded out
or less investment and net exports are crowded
out, the expansion of Y is larger. Y moves toward
Y3.
i
i
2
i3
1
i1
0
2
i3
3
1, 3
i1
MD(Y2)
MD(Y1)
Investment
0
MS1 MS2
I3
AS
AE
3
Expansionary Fiscal
and Monetary Policy
2
AE3 (i1)
AE2 (i2)
AE1 (i1)
1
0
I1
Y1
Y2
Y3
Y
I
Money and Inflation
The Equation of Exchange
The Equation of Exchange
• Early Monetarist View: MV = PY
– A change in the money supply accompanied by no
change in the velocity of money leads to an equal
change in nominal GDP.
– Fact: Velocity is not a constant and, since the
deregulation of the banking system in the 1980s, is
increasingly unpredictable
The Equation of Exchange
• MV = PY
where
– M = Money supply
– V = Velocity of money
• The number of times the money supply turns over
purchasing a given GDP
– P = Price level
– Y = Output
• PY = Nominal GDP
The Equation of Exchange
• Given a fixed V,
– If the Fed increases M, PY must increase
– If the Fed decreases M, PY must decrease
• If V is not fixed, however, changes in the
money supply will not have a predictable
effect on PY.
The Equation of Exchange
• Given a fixed Y,
– If the Fed increases M, P must increase
– If the Fed decreases M, P must decrease
• In the long-run, Y is fixed. If the Fed increases
the money supply when Y cannot respond, the
inflation rate rises.
• This is why economists say that inflation is
always a monetary phenomenon.
Monetary Transmission
Mechanisms
Keynesian: The Interest Rate Channel
Change in the
Money Supply
Change in
Interest Rates
& Exchange Rates
Change in
Spending
Change in
GDP
Monetarist: The Asset Price Channel
Change in the
Money Supply
Change in
Spending
Change in
GDP
i
i
i1
Investment
MD1
0
0
MS1
I1
AS
AE
AE1
0
Y1
Y
i
i
i1
i1
Investment
MD1
0
0
0
MS1
I1
AS
AE
AE1
0
Y1
Y