Transcript Money in the Economy - Kennesaw State University

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.
Bank Reserves
• Total Reserves = Required reserves plus
excess reserves.
– Required reserves = Deposits times reserve
requirement.
– Excess reserves = Total reserves minus
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.
– 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: 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
Required Reserves
Excess Reserves
$100
$ 90
$ 81
$ 72.90
$ 65.61
$10.00
$ 9.00
$ 8.10
$ 7.29
$ 6.51
$100
$ 90
$ 81
$ 72.90
$ 65.61
$ 59.05
$1,000
$100
$900
New Loan
$100
$ 90
$ 81
$ 72.90
$ 65.61
$ 59.05
$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.
dD = 1/r x dR
The Multiplier
• The simple deposit expansion multiplier is
1/r or 1/reserve requirement.
– r is a leakage out 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 Multiplier
• The real world multiplier is smaller than our
1/r because….
– Banks hold idle excess reserves and…
– People hold and use cash.
• The real world multiplier is:
1 + c
r+c+e
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.
– 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.
• 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.
Discount Loans
• When the Fed makes a discount loan to a
bank, the bank is credited with an increase
in reserves.
• When a bank repays the Fed, the bank’s
reserves are debited.
Reserve Requirements
• If the Fed increases reserve requirements,
banks have fewer excess reserves to lend,
causing the expansion of deposits to
decrease.
• If the Fed decreases or eliminates reserve
requirements, banks have more excess
reserves to lend, permitting the expansion of
deposits to increase.
Excess Reserves and Currency
Drains
• 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.
Excess Reserves and Currency
Drains
• 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.
Central Bank Policy Channels
Policy
Tools
Level & Growth
Bank Reserves
Cost & Availability
of Credit
Size and Growth
Rate of Money
Supply
Market Value
of Securities
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 different ways money can
cause changes in economic activity.
Interest Rate Channel
Change in
Money Supply
Change in
Interest Rates
Change in
GDP
Change in
Exchange
Rates
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.
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 relative 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.
Interest Rate Parity: Example
• 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 it to
depreciate.
Monetary Policy, Exchange Rates
and GDP
• Let the Fed raise interest rates
– As interest rates increase, exchange rates
increase, causing net exports (X - M) and
GDP to fall.
• GDP = C + I + G + (X - M)
– As the value of the dollar increases, we export fewer
goods and import more.
Monetary Policy, Exchange Rates
and GDP
• Let the Fed decrease interest rates
– As interest rates decrease, exchange rates
decrease, causing net exports (X - M) and
GDP to rise.
• GDP = C + I + G + (X - M)
– As the value of the dollar decreases, we export more
goods and import fewer.
Early Monetarist View
• 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
Early Monetarist View: 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
Early Monetarist View: The
Equation of Exchange
• Given a fixed V,
– If the Fed increases M, PY must increase.
– If the Fed decreases M, PY must decrease.
MV = PY
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
Monetary Policy in the AD/AS
Model
Expansionary Monetary Policy
Expansionary monetary policy
shifts the AD curve from AD1 to AD2.
LRAS
P
SRAS
But as Y rise, interest rates rise,
causing investment and net exports
to rise by smaller amounts. As Y rises,
competition for resources causes
other prices to rise.
P2
P1
0
If prices do not rise, the monetary
stimulus causes Y to rise to Y3.
Y1 Y2* Y3
AD2
AD1
Y
Equilibrium Y occurs at Y2 and P2.
National income rises from Y1
to Y2. Prices rise from P1 to P2.
Contractionary Monetary Policy
Contractionary monetary policy
shifts the AD curve from AD1. to AD2
LRAS
P
SRAS
But as Y falls interest rates fall,
causing investment and net exports
to fall by smaller amounts. As Y falls,
less competition for resources causes
other prices to fall.
P1
P2
0
If prices do not fall, the monetary
contraction causes Y to fall to Y3.
Y3 Y2 Y1
AD1
AD2
Y
Equilibrium Y occurs at Y2 and P2.
National income falls from Y1
to Y2. Prices fall from P1 to P2.