Transcript 6% - Spring Branch ISD

Monetary Policy
the “Fed”
Alan Greenspan
How Banks Create
Money
The Monetary Multiplier:
• The monetary multiplier is similar in concept to the
spending-income multiplier (expenditure multiplier).
• The expenditure multiplier exists because the expenditures of
one person becomes the income of someone else. So the
multiplier magnifies the initial change in spending into larger
changes in GDP.
MPC 1/MPS
= M
.90 1/.10
= 10
.80 1/.20
= 5
.75 1/.25
= 4
.60 1/.40
= 2.5
.50 1/.50
= 2
Since the expenditure multiplier is determined by
how much new income is consumed (MPC), it is the
reciprocal of MPS, the smaller MPS the greater the
expenditure multiplier.
Inverse relationship between MPS & Multiplier
MPS
Multiplier
• In contrasts, the monetary multiplier exists because the
reserves and deposits loaned out by one bank are received by
another bank and then loaned out again. So it magnifies loan
able funds (excess reserves) into a larger creation of
checkable-deposit money.
1/RR
1/.10
1/.20
1/.25
1/.40
1/.50
= M
= 10
= 5
= 4
= 2.5
= 2
Since the monetary multiplier is determined by
how much new deposits are loaned out, it is the
reciprocal of the required reserve ratio, the smaller
the RR the greater the monetary multiplier.
Inverse relationship between RR & Mm
RR
Multiplier
The monetary multiplier represents the
maximum amount of new checkable- deposit
(DD) money that can be created by a single
dollar of excess reserves.
Mm
=
1
RR
By multiplying the excess reserves by the monetary
multiplier we can find the maximum amount of new
checkable-deposit money (DE) that can be created by
the banking system.
Maximum
checkabledeposit
expansion
= ER x M
m
Practice;
Suppose Mr. Walton deposits $100 into his banking
account (his paycheck), also assume that the
required reserve ratio is 20%. What will be the
maximum checkable-deposit expansion (DE)?
Mm = 5 (1/.20 = 5)
ER = $80 (100 – 20 = 80)
DE = $400 (80 x 5 = 400)
The new money supply = DE + DD (So the money
supply will grow by a multiple of 5).
Practice;
Suppose Mr. Walton deposits $500 into his banking
account (sold his liver), also assume that the
required reserve ratio is 25%. What will be the
maximum checkable-deposit expansion (DE)?
Mm = 4 (1/.25 = 4)
ER = $375 (500 – 125 = 375)
D = $1500 (375 x 4 = 1500)
The new money supply = DE + DD (So the money
supply will grow by a multiple of 4).
by Brian [MS=Currency+DD of Public]
$1,000$1,000 DD Sherri
(1)
BANK
(2)
New Deposits
(new reserves)
DD
(3)
NEW REQUIRED
RESERVES
(4)
D D CREATED By
NEW LOANS
RR = 2 0 %
(equal to new ER)
A
$1 ,0 0 0 .0 0
$1,000.00
$ 2 0 0 .0 0
B
8 0 0 .0 0
800.00
16 0 .0 0
C
640.00
6 4 0 .0 0
12 8 .0 0
Dell
6 4 0 .0 0
640.00
Sam’s
D
5 1 2 .0 0
512.00
10 2 .4 0
E
4409.60
0 9 .6 0
8 1.9 0
________
Totals
_____________
_____________
$5
,0 0 0
5,000.00
$ 1,0 0 0
Canon
Target
$1 ,0 0 0
PM C in Ban k in g Sys
+
$4 ,0 0 0
512.00
5 1 2 .0 0
409.60
4 0 9 .6 0
3 2 7 .7 0
327.70
______________
$4 ,0 0 0
4,000.00
(rounded)
DD b y Sherri
L in d say
800.00
$8 0 0 .0 0
TM S in Ban k in g Sys
=
$5 ,0 0 0
MS grows by
a multiple of 5
MULTIPLE DEPOSIT EXPANSION PROCESS
RR= 20%
Bank
Acquired reserves Required
and deposits
reserves
Excess
reserves
Amount bank
can lend - New
money created
$80.00
A
$100.00
$20.00
$80.00
64.00
B
80.00
16.00
64.00
51.20
C
64.00
12.80
51.20
40.96
D
51.20
10.24
40.96
32.77
E
40.96
8.19
32.77
26.22
F
32.77
6.55
26.22
Mrs. Walton
20.98
G
26.22
5.24
20.98
16.78
H
20.98
4.20
16.78
I’m doing
13.42
the econ
I
16.78
3.36
13.42
rap.
10.74
J
13.42
2.68
10.74
8.59
K
10.74
2.15
8.59
Ronald McDonald L
6.87
8.59
1.72
6.87
5.50
M
6.87
1.37
5.50
4.40
N
5.50
1.10
4.40
17.57
Other banks 21.97
4.40
17.57
Potential Money Creation in the banking system (DE) = $400.00
Manuel Labor
TMS = $500.00
Monetary policy; the deliberate changes in
the money supply to influence interest rates
and thus the total level of spending in the
economy.
Only “fiscal or monetary
policy” can get me back on
my feet and allow “Sam” to
get back up.
Goals of
Monetary Policy
Maintain;
• price-level
stability
• Fullemployment
• Economic
growth
“Help”
“When the economy is partying hard
(inflation), it’s the job of the Fed to take away
the punch bowl.”
When the economy is not partying at all
(recession), the Fed job is to
“spike the punch.”
ASSETS of the Fed;
• Securities; government bonds that
are part of the public debt (money
borrowed by the government).
Securities account for 90% of the
Fed’s assets
• Loans to Commercial Banks; IOUs of
commercial banks that are claims
against the assets of commercial
banks.
LIABILITIES of the Fed;
• Reserves of Commercial Banks; the Fed
requires banks to hold reserves against
their checkable deposits. These reserves
are stored in Federal Reserve Banks.
• Treasury Deposits; the U.S. Treasury keeps
deposits in the Fed and draws checks on
them to pay its obligations.
• Federal Reserve Notes; money in
circulation is a claim against the assets of
Federal Reserve Banks. 90% of the Fed’s
liabilities are reserve notes.
Three Tools Of Monetary Policy
1. Open Market Operations
- This is the main tool of monetary policy.
- It consists of the buying and selling of
government securities.
Open-Market Operations:
 When the Fed buys bonds from commercial
banks, banks give up some of their
securities and the Fed pays money for those
securities. Thus they increase the excess
reserves of the commercial banks by the
amount of the purchase. Commercial banks
are then able to loan out more money from
their excess reserves.
 When the Fed buys bonds from the public, the
public gives up the securities and the Fed gives
them money. Some of this increased wealth is
consumed (MPC) and some is saved (MPS).
The amount that is saved is deposited in
commercial banks, which increase the bank’s
excess reserves inversely to the required
reserve ratio.
 So when the Fed buys securities in the open
market from commercial bank excess reserves
are increased, more loans are made, and Ig
increases.
 Also when the Fed buys securities in the open
market from the public, DI increases, and more
consumption and savings occurs.
 Both actions will lead to increased aggregate
demand.
2. The Reserve Ratio
- The most powerful & seldom used
- It affects money creation by changing ER and
the multiplier
RR - Atomic Bomb of Monetary Policy
The Reserve Ratio:
Lowering the reserve ratio transforms required
reserves into excess reserves and enhances the
ability of banks to create new money by lending.
RR - Atomic Bomb of Monetary Policy
Atomic Bomb of Monetary Policy
Suppose the banking system has $500 billion in DD.
The RR is 12% & TR is $60 billion. There are no ER
in this system, thus no new loans can be made
(500 x .12 = 60).
Now, what if the Fed lowers the RR to 10%, what
would be the affect on the banking system?
Banks will have to keep $50 billion in reserve, so ER will
increase from zero to $10 billion, and more new loans will be
made.
Atomic Bomb of Monetary Policy
Why is it called the atomic bomb of
monetary policy?
Because changing the RR will also changes the Mm.
In the example at 12% RR, the Mm equaled 8.33, but
when the Fed changed the RR to 10% the Mm
increased to 10. So not only did the Fed increase ER
for loans, it also increased the multiple by which
those loans will increase the money supply.
3. The Discount Rate
- emergency loans that Federal Reserve Banks
make to commercial banks. The Fed charges an
interest rate called the discount rate.
Discount Rate:
In providing loans, the Federal Reserve Bank
increases the reserves of the borrowing
commercial bank. Since required reserves do
not need to keep against loans, all Fed loans
increase excess reserves.
A lowering of the discount rate encourages
commercial banks to increase excess
reserves by borrowing from the Fed. These
excess reserves are then loaned out and
increases the money supply.
Easy money Policy:
When the economy faces a recession and
unemployment, the Fed will decide to
increase the money supply in order to
increase aggregate demand. To do this the
Fed will either;
• Lower the reserve ratio; changing required reserves to
excess reserves.
• Lower the discount rate; enticing borrowing to increase
excess reserves.
• Buy securities; increasing excess reserves and the
DI of the public. Fed will do this 9-10 times!
DI
MS MS2
Real Interest Rate
1
10%
10
8%
8
6%
6
Price level
0
DM
Money Market
AD
AD
1
2
P
P2
Investment
Demand
0
QID1 QID2
AS
E2
E1
1
Real GDP
Buy
Bonds
MS
YR
I.R.
Y*
QID
AD
Y/Emp/PL
Tight money Policy:
When the economy is in an inflationary spiral,
the Fed will decide to decrease the money
supply in order to decrease aggregate
demand, which will decrease demand-pull
inflation. They will do this by;
• Increasing the reserve ratio; changing excess reserves to
required reserves.
• Raise the discount rate; discouraging borrowing to increase
excess reserves.
• Sell securities; decreasing excess reserves and the
DI of the public. The Fed will do this 9-10 times.
Dm
MS2MS1
Real Interest Rate
10
10%
8
6%
Money Market
AS
0
Price level
AD1
P1
Investment
Demand
8%
6
0
Di
AD2
P2
QID2 QID1
E1
E2
Y* YI
Sell
Bonds
MS
I.R.
QID
AD
Y/Empl./PL
9%
9%
6%
6%
3%
3%
0
Dm
$100 120 140
Money Market
AD3
DI
MS1 MS2 MS3
0
AD1
AD
I=$60
I=$50] 2
I=$70
A
S
PL3
PL2
PL
1
$50 $60 $70 QID
Investment Demand
YR
Y* YI RDO
The ideal economy is AD2, with I.R. at 6% & Ig at $60
billion. The I.R. will be in equilibrium with Dt at $120 billion
What if the economy is only at $100 billion?
1. Give the proper Fed action
2. Analyze and diagram the affect of that policy.
DI
MS1 MS2
9%
9%
6%
6%
AD1
AD
I=$60
I=$50] 2
A
S
PL2
PL
Dm
0
$100 120
Money Market
0
1
$50 $60
QID
Investment Demand
YR
Y*
RDO
1. The economy must be experiencing substantial
unemployment, so the Fed will institute an easy money
policy.
2. Increasing the MS from $100 to $120, will lower the IR from
9% to 6%, which will increase QID from $50 to $60 billion,
which will increase AD from AD1 to AD2.
9%
9%
6%
6%
3%
3%
0
Dm
$100 120 140
Money Market
AD3
DI
MS1 MS2 MS3
0
AD1
AD
I=$60
I=$50] 2
I=$70
A
S
PL3
PL2
PL
1
$50 $60 $70 QID
Investment Demand
YR
Y* YI RDO
What if the economy is at $140 billion?
1. Give the proper Fed action
2. Analyze and diagram the affect of that policy.
AD3
DI
MS2 MS3
AD
I=$60
2
6%
6%
PL3
3%
3%
PL2
0
Dm
$120 140
Money Market
0
$60 $70 QID
Investment Demand
I=$70
A
S
Y*YI RDO
1. To rein in spending, the Fed will institute a tight
money policy.
2. Decreasing the MS from $140 to $120, will
increase IR from 3% to 6%, which will decrease QID
from $70 to $60, which decreases AD from AD3 to
AD2.
Strengths of Monetary Policy
1. Speed and flexibility –Compared to fiscal policy
monetary policy can be quickly altered. The
buying & selling of bonds can occur on a daily
basis.
2. Isolation from political pressures – because the
Board of Governors serve 14 year terms.
They can enact unpopular
policies which
might get a member of Congress fired, but is
best for our economy’s health.
3. Success since the 1980s – a tight money
policy helped bring inflation from 13.5% in 1980
to 3.2% in 1983. An easy money policy helped
the economy recover from the 2000 recession.
Shortcomings of Monetary Policy
Kiss my tail! I wont
drink!
Cyclical Asymmetry “You can lead a horse
To water but you can’t make him drink”
An easy money policy during depression does
not guarantee that banks will give out loans if
people don’t have jobs.
Velocity of money “number of times per
year the average dollar is spent”
During inflation, when the Fed restrains
the money supply, velocity may increase.
During a recession, when the Fed increases the money supply, the
public may hold more money due to lower interest rates & fear.
Less Control by the Fed
Banking reforms make it easier to move near-money to checking accounts
and vice versa. Also increased global banking may led to policies that are
inappropriate for domestic monetary policy.
The End