Chapter 14
Monetary Policy and
the Federal Reserve
System
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Chapter Outline
• Principles of Money Supply Determination
–
–
–
–
All currency
All reserve
Fractional reserve
Tools
• Monetary Control in the United States
• The Conduct of Monetary Policy: Rules Versus
Discretion (skip)
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Principles of Money Supply Determination
• Three groups affect the money supply
– The central bank is responsible for monetary policy
– Depository institutions (banks) accept deposits and make
loans
– The public (people and firms) holds money as currency and
coin or as bank deposits
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Principles of Money Supply Determination
• The money supply in an all-currency economy
– A trading system based on barter is inconvenient
– The creation of a central bank to print money can improve matters
• Central bank: buy (sell) assets to increase (decrease) money supply
• Public: use money as legal tender
– In an all-currency economy, the money supply equals the
monetary base
• Monetary base = currency (no bank deposit) in all-currency economy
• Monetary base: most liquid and can be used to “create” money
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Principles of Money Supply Determination
• The money supply under fractional reserve banking
– The currency that banks hold is called bank reserves
• Bank reserves = vault cash + reserves at the central bank
• When bank reserves are equal to deposits, the system is called
100% reserve banking
• To make money, banks would have to charge fees for deposits,
since they earn no interest on reserves (changed now!)
– When the reserve-deposit ratio is less than 100%, the
system is called fractional reserve banking
• Banks have incentive to lend out part of deposits.
• But face potential Bank runs. (a large scale, panicky
withdrawal of deposits)
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Principles of Money Supply Determination
• The money supply under fractional reserve banking
– When all the banks catch on to this idea, they will all make
loans as the economy undergoes a multiple expansion of
loans and deposits
– How it works in a no-cash economy?
• Suppose monetary base increases by 1b through bank A
• Suppose reserve-deposit ratio is 25% and people don’t hold
currency.
• The 1b increase can create 3b more money supply, altogether
4b money supply (deposits).
• 1+3/4+3/4*3/4+3/4*3/4*3/4+…=4
– Money supply = Monetary Base/(reserve-deposit ratio)
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Principles of Money Supply Determination
• The money supply under fractional reserve banking
• Notation:
• M  money supply,
• BASE  monetary base, high-powered money (M0)
– Currency held by public (CU) and bank reserves (RES)
• DEP  bank deposits,
• RES  bank reserves,
• res  banks’ desired reserve-deposit ratio (RES/DEP)
• How much money can be created by monetary base?
– Money multiplier
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Principles of Money Supply Determination
• The money supply with both public holdings of currency
and fractional reserve banking
– If there is both public holding of currency and fractional
reserve banking, the picture gets more complicated
– The money supply consists of currency held by the public
and deposits, so
M = CU + DEP
(14.4)
– The monetary base is held as currency by the public and as
reserves by banks, so
BASE  CU  RES
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(14.5)
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Principles of Money Supply Determination
• The money supply with both public holdings of currency
and fractional reserve banking
– Taking the ratio of these two equations gives
M/BASE  (CU + DEP)/(CU + RES)
(14.6)
– This can be written as
M/BASE  [(CU/DEP) + 1]/[(CU/DEP) + RES/DEP)] (14.7)
– The currency-deposit ratio (CU/DEP, or cu) is determined by
the public
– The reserve-deposit ratio (RES/DEP, or res) is determined
by banks
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Principles of Money Supply Determination
• The money supply with both public holdings of currency
and fractional reserve banking
– Rewrite Eq. (14.7) as
M  [(cu + 1)/(cu + res)]BASE
(14.8)
– The term (cu + 1)/(cu + res) is the money multiplier
• The money multiplier is greater than 1 for res less than 1 (that
is, with fractional reserve banking)
• If cu  0, the multiplier is 1/res, as when all money is held as
deposits
• The multiplier decreases when either cu or res rises
• Look at U.S. data to illustrate the multiplier (Table 14.1)
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Table 14.1 The Monetary Base, the Money Multiplier,
and the Money Supply in the United States
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Principles of Money Supply Determination
• Three tools:
– Open-market operations
• The most direct and frequently used way of changing the money supply is by
raising or lowering the monetary base through open-market operations
– Discount window lending
– Reserve requirements
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Principles of Money Supply Determination
• Application: The money multiplier during the Great
Depression
– The money multiplier is usually fairly stable, but it fell sharply
in the Great Depression
– The decline in the multiplier was due to bank panics, which
affected the multiplier in two ways
• People became mistrustful of banks and increased the
currency-deposit ratio (text Fig. 14.1)
• Banks held more reserves, in anticipation of bank runs, which
raised the reserve-deposit ratio
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Figure 14.1 The currency-deposit ratio and the
reserve-deposit ratio in the Great Depression
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Principles of Money Supply Determination
• Application: The money multiplier during the Great
Depression
– Even though the monetary base grew 20% from March 1930
to March 1933, the money supply fell 35% (text Fig. 14.2)
– As a result, the price level fell sharply (nearly one-third) and
there was a decline in output (though attributing the drop in
output to the decline in the money supply is controversial)
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Figure 14.2 Monetary variables in the Great
Depression
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Monetary Control in the United States
– (READ) History, Organization, Balance Sheet
• http://www.federalreserveeducation.org/fed101/
– Tools for Monetary Control
– Targets (Ultimate and Intermediate)
– Reality (practice)
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The Federal Reserve System
– The Fed began operation in 1914 for the purpose of
eliminating severe financial crises
– There are twelve regional Federal Reserve Banks (Boston,
New York, Philadelphia, Cleveland, Richmond, Atlanta,
Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and
San Francisco), which are owned by private banks within
each district (text Fig. 14.3)
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Figure 14.3 Location of the Federal
Reserve Banks
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Monetary Control in the United States
• The Federal Reserve System
– The leadership of the Fed is provided by the Board of
Governors in Washington, D.C.
• There are seven governors, who are appointed by the
president of the United States, and have fourteen-year terms
• The chairman of the Board of Governors has considerable
power, and has a term of four years
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Monetary Control in the United States
• The Federal Reserve System
– Monetary policy decisions are made by the Federal Open
Market Committee (FOMC), which consists of the seven
governors plus five presidents of the Federal Reserve Banks
on a rotating basis (with the New York president always on
the committee)
• The FOMC meets eight times a year
• It may meet more frequently if economic developments warrant
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Monetary Control in the United States
• The Federal Reserve’s balance sheet and open-market operations
– Balance sheet of Fed (text Table 14.2)
• Largest asset is holdings of Treasury securities
• Also owns gold, makes loans to banks, and holds other assets
including foreign exchange and federal agency securities
• Largest liability is currency outstanding
– Some is held in bank vaults and is called vault cash
– The rest is held by the public
• Another liability is deposits by banks and other depository institutions
• Vault cash plus banks’ deposits at the Fed are banks’ total reserves
(RES)
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Table 14.2 The Balance of the Federal Reserve
System (Billions of Dollars)
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Figure 14.4 Components of the monetary
base
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Monetary Control in the United States
• Means of controlling the money supply
– The primary method for changing the monetary base is
open-market operations (by FOMC)
– Reserve requirements (Board of Governors)
• The Fed sets the minimum fraction of each type of deposit that a
bank must hold as reserves
• An increase in reserve requirements forces banks to hold more
reserves, thus reducing the money multiplier
– Discount Window Lending
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Monetary Control in the United States
– Discount window lending (Board of Governors)
• Discount window lending is lending reserves to banks so they can
meet depositors’ demands or reserve requirements
• The interest rate on such borrowing is called the discount rate
• The Fed was set up to halt financial panics by acting as a lender of
last resort through the discount window
• A discount loan increases the monetary base
• Increases in the discount rate discourage borrowing and reduce the
monetary base
– The Fed modified the discount window in 2003
• The Fed funds rate is a market rate of interest, determined by
supply and demand while the discount rate is set by the Fed
• Under the new procedure, the Fed sets the discount rate
(primary and secondary) above the Fed funds rate (Fig. 14.5)
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Figure 14.5 The discount rate and the Fed
funds rate, 1979-2006
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What are the new changes during the credit crunch?
•
•
August 17, 2007:
– 50bps cut from 6.25%
– 30-day loan vs. overnight
– Spread 50 bps vs. 100 bps
March 16, 2008 (Bear Stearns)
– From 30 days to 90 days
– From 50 bps to 25 bps spread
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Date
Discount rate
(change)
Fed funds rate
(change)
August 17, 2007
5.75% (-50bp)
5.25% (no
change)
September 18,
2007
5.25% (-50bp)
4.75% (-50bp)
October 31, 2007 5.00% (-25bp)
4.50% (-25bp)
December 11,
2007
4.75% (-25bp)
4.25% (-25bp)
January 22, 2008 4.00% (-75bp)
3.50% (-75bp)
January 30, 2008 3.50% (-50bp)
3.00% (-50bp)
March 16, 2008
3.25% (-25bp)
3.00% (no
change)
March 18, 2008
2.50% (-75bp)
2.25% (-75bp)
April 30, 2008
2.25% (-25bp)
2.00% (-25bp)
October 8, 2008
1.75% (-50bp)
1.50% (-50bp)
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Summary 19
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Monetary Control in the United States
• Ultimate targets: price stability and economic growth
• Intermediate targets
– Variables the Fed can’t directly control but can influence
predictably
– Most frequently used are monetary aggregates such as M1
and M2, and short-term interest rates, such as the Fed
funds rate
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Monetary Control in the United States
• Intermediate targets
– The Fed cannot target both the money supply and the Fed
funds rate simultaneously
• Suppose both the money supply and the Fed funds rate were
above target, so the Fed needs to lower them
• Since a decrease in the money supply shifts the LM curve up
(to the left), it will increase the Fed funds rate
– In recent years the Fed has been targeting the Fed funds
rate (Fig. 14.6)
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Figure 14.6 Interest rate targeting
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Monetary Control in the United States
• Intermediate targets (targeting the Fed funds rate)
– This strategy works well if the main shocks to the economy
are to the LM curve (shocks to money supply or money
demand)
– The strategy stabilizes output, the real interest rate, and the
price level, as it offsets the shocks to the LM curve
completely
– But NOT ALWAYS WORK WELL
• If other shocks to the economy (such as IS shocks) are more
important than nominal shocks, the policy may be destabilizing,
unless the Fed changes the target for the Fed funds rate
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Monetary Control in the United States
• Intermediate targets
– Suppose a shock (increase in exports demand) shifts the IS
curve to the right (Fig. 14.7)
• If the Fed were to maintain the real interest rate, it would
increase the money supply, thus making output rise even more,
which would be destabilizing (and a higher price/inflation)
• Instead, the Fed needs to raise the real interest rate to stabilize
output
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Figure 14.7 Interest rate targeting when an IS
shock occurs
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Monetary Control in the United States
• Making monetary policy in practice
– The IS-LM model makes monetary policy look easy—just
change the money supply to move the economy to the best
point possible
• In fact, it isn’t so easy because of lags in the effect of policy
and uncertainty about the ways monetary policy works
– Lags in the effects of monetary policy
• It takes a fairly long time for changes in monetary policy to
have an impact on the economy
• Interest rates change quickly, but output and inflation barely
respond in the first four months after the change in money
growth (Fig. 14.8)
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Figure 14.8 Responses of output, prices, and
the Fed funds rate to a monetary policy shock
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Monetary Control in the United States
• Making monetary policy in practice
– Tighter monetary policy causes real GDP to decline sharply after
about four months, with the full effect being felt about 16 to 20
months after the change in policy
– Inflation responds even more slowly, remaining essentially
unchanged for the first year, then declining somewhat
– These long lags make it very difficult to use monetary policy to
control the economy very precisely
– Because of the lags, policy must be made based on forecasts of
the future, but forecasts are often inaccurate
– The Fed under Greenspan has made preemptive strikes against
inflation based on forecasts of higher future inflation
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Monetary Control in the United States
• Making monetary policy in practice
– The channels of monetary policy transmission
• The interest rate channel: as seen in the IS-LM model, a
decline in money supply raises real interest rates, reducing
aggregate demand, leading to a decline in output and prices
• The exchange rate channel: in an open economy, tighter
monetary policy raises the real exchange rate, reducing net
exports, and thus aggregate demand
• The credit channel: tighter monetary policy reduces both the
supply and demand for credit (READ Box 14.1)
– IS curve shifts to the left
– Loose monetary policy (ease credit) by Greenspan partially
contributes to the credit crunch.
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Monetary Control in the United States
• Making monetary policy in practice
– The channels of monetary policy transmission
• How important are these different channels?
– Suppose real interest rates are high(easy), but the dollar has
been falling(tight); is monetary policy tight or easy? It depends on
the relative importance of the different channels
– Or suppose real interest rates are low(tight), but borrowing and
lending are weak(easy)
• Monetary policy: art or science?
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A Review of Credit Crisis
• Overview:
– Huge percentage of subprime mortgages default
– Hundreds of billions of mortgage-related investments
collapsed
– High profiled investment banks (GS, MS) either change to
commercial banks or go bankrupt (BS, LB)
– 700-billion bail-out plan
• Origins
– Late 90’s: tech bubble burst and in 2000 a sharp decline in
stock market  recession  cut interest rate (see chart)
– Cheap mortgages and loose regulation on mortgage lending
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Fed Funds Target Rate
Rate cut: 1/3/2001
Rate cut: 6/25/2001
Rate cut: 10/29/2008
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Origins
• Origins (cont.)
– Default/Delinquency rose in 2006, and didn’t stop increase in
mortgage lending
– Banks create CDO’s and CDS and other credit derivatives to
transfer (at least they thought so) credit risks. (repackage
good and bad loans and sell to mutual/hedge funds)
– Housing prices (see chart for Miami) start to drop, no equity
can be taken out (refinancing doesn’t work), foreclosure
rises…
– EVERYTHING BAD starts to roll…
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January 1998
April 1998
July 1998
October 1998
January 1999
April 1999
July 1999
October 1999
January 2000
April 2000
July 2000
October 2000
January 2001
April 2001
July 2001
October 2001
January 2002
April 2002
July 2002
October 2002
January 2003
April 2003
July 2003
October 2003
January 2004
April 2004
July 2004
October 2004
January 2005
April 2005
July 2005
October 2005
January 2006
April 2006
July 2006
October 2006
January 2007
April 2007
July 2007
October 2007
January 2008
April 2008
July 2008
Miami Housing Price Index
300.00
6/2006
250.00
200.00
150.00
100.00
50.00
0.00
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Victims (on the record)
• Bear Stearns: two hedge funds that directly invested in
subprime mortgage markets wend under… and
eventually the whole firm was sold to JP Morgan on
March 17 ($2 vs. $170 a year ago).
• Fannie Mae and Freddie Mac: September 7, taken over
by the government
• Leman Brothers: September 12, went bankruptcy
• Merrill Lynch: September 14, sold to BOA
• AIG: September 16, bailed out by the Fed ($85billion)
• WaMu: September 25, sold to JP Morgan
• Wachovia: October 9, acquired by Wells Fargo
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What is wrong? Everything!
• Mortgage industry: lack of regulation/supervision
– As long as one can make money, nobody cares about the
default. ARM (adjustable rate mortgages)
• Rating agency:
•
•
•
•
Official
Official
Official
Official
#1: Btw (by the way) that deal is ridiculous.
#2: I know right ...model def (definitely) does not capture half the risk.
#1: We should not be rating it.
#2: We rate every deal. It could be structured by cows and we would rate it.
• Regulator:
– Low interest for long (Fed) and oversight of credit derivatives
– Deregulation of banks
• Politicians: affordable housing?
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What is wrong? (cont.)
• Banks:
– Highly leveraged and actively involved in mortgage-related
investments (EASY MONEY)
• Although they might know the high housing value is
unsustainable, they are probably too greedy to get out.
• Not like dotcom bubble, then banks were not holding large
percentage of tech stocks (who holds? Average joe).
– Bad risk management, modeling of default
• Defaults highly correlates.
• Historical data underestimate default ratio.
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Solutions
• Key is to restore confidence
– $700 billion Bail-out plan (directly injecting money to
commercial banks and helping deal with distressed
mortgage-related securities)
– Extend credits to investment banks, insurance companies
– Buy commercial papers (short-term financing for payroll…)
• Careful Regulations (especially hedge funds)
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Your essay? (Due 12/1)
• Approach I
– Pick any topic
– Historical background:
• For instance, deregulation of credit derivatives, deleveraging
– Why is this happening from the specific perspective?
– What can be done to reduce the chance of happening
again?
• Approach II
– Relating finance to macroeconomics
• Think of the channels that Wall street affects Main street
• How to make them work together?
• Approach III: anything that can employ macro analysis
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