Agenda
• Principles of Money Supply Creation
Monetary Policy and the
Federal Reserve System,
Part 1
• The Federal Reserve System
• Monetary Policy Tools
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Money Creation
Money Creation
• Three groups affect the money supply:
• A central bank can print money:
¾ Central bank can print money to buy real assets
from the public.
¾ The central bank conducts monetary policy.
• This is how money gets into circulation.
¾ Depository institutions (banks) accept deposits
and make loans.
• People accept money if they believe other people will
accept it in exchange.
¾ The public (people and firms) holds money as
currency and coin and as bank deposits.
• The government usually decrees that the paper money is
legal tender.
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Money Creation
Money Creation
• A central bank can print money:
• Required conditions for money creation:
¾ The central bank’s assets are the real assets it buys
from the public.
¾ The equivalence of cash and deposits.
¾ The central bank’s liabilities are the money it
issued to the public.
¾ The redeposit of loan proceeds.
¾ The holding of (fractional) cash reserves.
• That money is called the monetary base, or highpowered money
¾ The presence of willing borrowers.
¾ The presence of willing lenders.
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Components of the monetary base
The Monetary Base
• Definitions:
¾ BASE = CU + RES,
where
• BASE = Monetary Base,
• CU = Currency held by the non-bank public, and
• RES = Reserves held by banks.
¾ Required reserves.
¾ Excess reserves.
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Currency
Bank Reserves
• Definitions (continued):
• Definitions (continued):
¾ CU = cuDEP,
¾ RES = resDEP + exDEP,
where
where
• DEP = deposits and
• DEP = deposits and
• 0 < cu < 1 and is determined by the public.
• 0 < res < 1 and is determined by the central bank.
¾ Reserve requirement ratio, the legal minimum.
¾ Currency held is a fraction of deposits.
• 0 < ex < 1 and is determined by commercial banks.
¾ Excess reserve ratio, reserves above the legal minimum.
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¾ Reserves held are a fraction of deposits.
The Monetary Base
The Money Supply
• Relationships:
• Definitions (continued):
¾ BASE = CU + RES
¾ M = CU + DEP,
¾ BASE = cuDEP + resDEP + exDEP
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where
• M = Money supply
¾ BASE = (cu + res + ex)DEP
¾ M1 = currency + checking deposits.
¾ M2 = M1 + savings deposits.
¾ M3 = M2 + institutional deposits (no longer published).
• or
¾ DEP = BASE/(cu + res + ex)
• If cu + res + ex < 1, then DEP > BASE.
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The Money Supply and the Monetary Base
The Money Supply and the Monetary Base
• Relationships (continued):
• Relationships (continued):
¾ If
¾ M = CU + DEP
M = (1 + cu)DEP
¾ M = cuDEP + DEP
and
DEP = BASE/(cu + res + ex),
¾ M = (1 + cu)DEP
then:
¾ M = (1 + cu)BASE/(cu + res + ex)
¾ M = [ (1 + cu)/(cu + res + ex) ] * BASE
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The Money Supply and the Monetary Base
The Monetary Base & the Money Multiplier
• Each unit of the monetary base allows
• The term:
(1 + cu)/(cu + res + ex)
(1 + cu)/(cu + res + ex)
units of money to be created.
is called the money multiplier.
¾ The monetary base is called high-powered money
because each unit of the base that is issued leads to
the creation of more than one unit of money.
¾ As long as res + ex < 1, then the money multiplier
will be > 1.
¾There is a different money multiplier for each
definition of money.
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Monetary Base, Money Multiplier, and Money Supply
Money Creation
• Peculiarities:
¾ Gold discoveries.
• and BASE.
¾ Bank panics.
• and cu.
¾ Credit crunches.
• and ex.
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The Federal Reserve System
The Federal Reserve System
• Created by an Act of Congress.
• Consists of:
¾ on December 23, 1913.
¾ The nation’s central bank.
¾ Board of Governors
• In Washington, DC
• Responsibilities:
¾ 12 regional Federal Reserve Banks
¾ Functions as the government’s bank.
¾ Regulates and supervises banks and thrifts.
¾ Acts as lender of last resort.
¾ Implements monetary policy.
• Located throughout the country
¾ Federal Open Market Committee (FOMC)
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The Federal Reserve System
The Federal Reserve System
• The Board of Governors:
• Regional Bank Presidents:
¾ 7 members with overlapping 14-year terms.
¾ Appointed by regional Federal Reserve Bank’s
Board of Directors.
• Appointed by the President.
• Confirmed by the Senate.
• Renewable 5-year terms.
¾ Chairman and Vice Chairman with 4-year terms.
¾ Approved by the Board of Governors.
• Designated by the President.
• Confirmed by the Senate.
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The Federal Reserve System
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The Federal Reserve System
• Independent within the Government.
¾ Independent:
• Appointment of Governors.
• Appointment of Bank Presidents.
• Financed from its own resources.
¾ Surplus turned over to Treasury.
¾ Within the government:
• Ultimately responsible to Congress.
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Federal Open Market Committee
Federal Open Market Committee
• Created by an Act of Congress.
• Consists of 12 voting members:
¾ 7 members of the Board of Governors.
¾ President of the New York Federal Reserve Bank.
¾ On March 1, 1936.
¾ Primary decision-making body for monetary
policy.
• Has operational responsibility for open market operations.
¾ 4 other regional Federal Reserve Presidents.
• Serve on an annually rotating basis.
• And 7 non-voting members:
¾ The other regional Federal Reserve Presidents.
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Federal Open Market Committee
Federal Open Market Committee
• Chairman:
• Meetings:
¾ Traditionally the Chairman of the Board of
Governors.
¾ 8 per year at 5 – 8 week intervals.
• Minimum of 4 meetings per year.
• Also have conference calls if economic development
warrant.
• Vice Chairman:
¾ Provides direction for open market operations to
the New York Federal Reserve Bank.
¾ Traditionally the President of the New York
Federal Reserve Bank.
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Federal Open Market Committee
Federal Open Market Committee
• Meetings (continued):
• Meetings (continued):
¾ Issues a policy statement following the conclusion
of each meeting announcing.
• Any policy action taken.
¾ Releases minutes 3 weeks following the meeting.
¾ Releases semi-annual Monetary Policy Report:
• Typically, in February and July.
• Presented by Chairman to Congress.
• The policy directive.
¾ Symmetrical.
¾ Asymmetrical.
¾ Releases meeting transcripts after a 5-year lag.
» Economic strength/weakness
» Inflation
• The vote.
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The Federal Reserve’s balance sheet
The Federal Reserve’s balance sheet
• The Federal Reserve’s balance sheet:
• The Federal Reserve’s balance sheet:
¾ Liabilities:
¾ Assets:
• Currency outstanding.
• U.S. Treasury securities
– Some is held in bank vaults and is called vault cash
– The rest is held by the public
• Federal agency securities
• Deposits by depository institutions.
• Gold
• Loans to depository institutions
¾ Addendum: Banks’ reserves are vault cash plus
• Other assets (mostly foreign exchange reserves)
banks’ deposits at the Fed.
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The Balance of the Federal Reserve System
Monetary Policy Tools
• The Federal Reserve can change the monetary
base, and therefore the money supply, through
one of 3 monetary policy tools:
¾ Open Market Operations
¾ Discount Window Lending and the Discount Rate
¾ Reserve Requirements
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Monetary Policy Tools
Monetary Policy Tools
• Open Market Operations:
• Open Market Operations:
¾ When the central bank buys U.S. government
securities in the open market, it will increase
money in circulation, expand the monetary base
and, therefore, increase the money supply.
¾ The primary method for changing the monetary
base and the money supply is through openmarket operations.
¾ Open market operations involve the central
bank’s buying and selling of U.S. government
securities in the open market.
• This is an open-market purchase.
• By increasing RES, the BASE increases, and this
increases Ms through the money multiplier, and reduces
the federal funds rate.
• Conducted by the New York Federal Reserve Bank.
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Monetary Policy Tools
Monetary Policy Tools
• Open Market Operations:
• The Federal Funds Rate:
¾ When the central bank sells U.S. government
securities in the open market, it will reduce money
in circulation, decrease the monetary base and,
therefore, reduce the money supply.
¾ The interest rates that banks pay to each other to
borrow excess reserves.
• Very closely influenced by the Federal Reserve.
¾ While the fed funds rate is not a particularly
important influence on the economy by itself,
movements in the funds rate (and expectations
about future funds rates encouraged by any
change) influence the broad spectrum of interest
rates and financial asset prices in the economy.
• This is an open-market sale.
• By decreasing RES, the BASE decreases, and this
decreases Ms through the money multiplier, and
increases the federal funds rate.
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Monetary Policy Tools
Monetary Policy Tools
• Discount Lending and the Discount Rate:
• Discount Lending and the Discount Rate:
¾ Discount window lending is the central bank
lending reserves to banks to meet reserve
requirements.
¾ Discount window lending was set up to halt
financial panics by acting as a lender of last resort
through the discount window.
¾ The discount rate is the interest rate banks pay on
borrowings from the Federal Reserve.
• Set by the Board of Governors based on requests from
the Boards of Directors from the regional Federal
Reserve Banks.
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Monetary Policy Tools
Monetary Policy Tools
• Discount Lending and the Discount Rate:
• Discount Lending and the Discount Rate:
¾ A discount window loan increases the monetary
base and, through the money multiplier, increases
the money supply.
¾ Discount window lending and the discount rate
are now relatively unimportant.
• Because such borrowings are bank initiated, the central
bank acts in a relatively passive manner.
¾ An increase in the discount rate would discourage
discount window borrowing, reduce the monetary
base and, through the money multiplier, decrease
the money supply.
• In addition, banks rarely use the discount window.
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Monetary Policy Tools
Monetary Policy Tools
• Reserve Requirement Ratio:
• Reserve Requirement Ratio:
¾ The reserve requirement ratio is the legal
minimum fraction of each type of deposit that
must be held by depository institutions as cash
reserves.
¾ An increase in the reserve requirement ratio
forces depository institutions to hold more
reserves, which reduces the money multiplier, and
shrinks the money supply for any given monetary
base.
• Set by the Board of Governors.
• This is for required reserves.
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Factors affecting the money supply
Monetary Policy Tools
• Reserve Requirement Ratio:
¾ Although a theoretically powerful way to change
the money supply, in practice the reserve
requirement ratio is relatively unimportant.
• Because they are rarely changed.
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The Money Supply
The Money Supply
• Why the Fed Can’t Control Ms Exactly
• Why the Fed Can’t Control Ms Exactly
¾ The Fed doesn’t control Ms directly but indirectly
through its influence on:
¾ The public determines cu.
• Bank reserves, RES, and
• Fed must forecast cu, then adjust BASE (and/or res) to
accommodate.
• The reserve requirement ratio, res.
• Sometimes it is difficult to predict cu.
¾ Seasonal patterns.
¾ The influence of foreigners.
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The Money Supply
The Money Supply
• Why the Fed Can’t Control Ms Exactly:
• Why the Fed Can’t Control Ms Exactly:
¾ Commercial banks and borrowers determine exc.
¾ Multiple definitions of money:
• M1
• M2
• Fed must forecast ex, then adjust BASE (and/or res) to
accommodate.
• Sometimes it is difficult to predict ex.
¾ The influence of deposit shifts between reserve categories.
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