EK 3301 Monetary Economics
Lecture notes to accompany Mishkin's Chapter 13
Multiple Deposit Creation and the Money Supply Process
MULTIPLE DEPOSIT CREATION
Recall: money supply = cash in circulation + bank deposits
Bank deposits, not cash, account for the vast majority of the money supply. This
is the case even though cash deposits, and cash reserves, are the foundation of
the banking system. The reason why the volume of bank deposits is so much
larger than the total amount of cash is that banks practice FRACTIONAL
RESERVE BANKING: when cash is deposited into a bank, the bank keeps
only a small fraction of that cash as reserves and loans the rest of it out,
at interest.
-- Fractional reserve banking is closely related to the phenomenon of
MULTIPLE DEPOSIT CREATION: when cash is deposited into a bank, the
bank loans out most of that money, and most of the money loaned gets
redeposited into the banking system, and gets mostly loaned out again,
and redeposited, and so on. The chain of deposit creation -- excess reserves
(ER) being loaned out and redeposited in the banking system -- continues until
the banks have basically no more excess reserves.
Multiple deposit creation can also be understood as follows: When the Fed
creates an additional $1 in bank reserves, total bank deposits (and hence
the money supply) increase by a multiple of that amount.
-- The multiplication of an initial change in reserves into a much larger change in
bank deposits occurs because of the chain of deposit creation, in which excess
reserves are loaned out and redeposited ad infinitum.
In its simplest form, the deposit-creation process involves two key assumptions:
(1) the banks loan out 100% of their excess reserves;
(2) all loans get redeposited into the banking system.
simple deposit multiplier =
{ultimate change in checking deposits}/{change in bank reserves} = 1/RRR
-- If RRR = 10%, then the simple deposit multiplier, or simple money
multiplier, is 10.
---- Ex.: An increase in bank reserves of $1 million would ultimately cause both
checking deposits and bank loans (and the money supply) to increase by ten
times that amount, or $10 million.
1
Multiple deposit destruction: When the Fed destroys an additional $1 in
bank reserves, total bank deposits (and hence the money supply)
decrease by a multiple of that amount.
-- Multiple deposit destruction is assumed to work like this: In equilibrium, banks
hold no excess reserves (ER=0). When the Fed decreases the level of bank
reserves (say, by selling a bond to a bank and collecting payment by debiting
the bank's reserve account), the banking system will have negative excess
reserves, or a reserve deficiency, and any bank with a reserve deficiency will
call in loans for repayment, and their creditors will repay the loans by drawing
down their checking accounts. So the volume of loans and the volume of
checking deposits will shrink at the same time. Since the banks cannot create
reserves themselves, the only way to restore equilibrium is for the volume of
checking deposits to shrink by exactly 10 times the change in reserves.
---- Ex.: An decrease in bank reserves of $1 million would ultimately cause both
checking deposits and bank loans (and the money supply) to decrease by ten
times that amount, or $10 million.
The T-account framework is helpful in illustrating how the deposit-creation
process works.
EXAMPLE: The Fed buys $100 in securities from the First National Bank. (The
required reserve ratio for checking deposits is 10%. We will assume that First
National and all other banks initially have zero excess reserves. Also assume
that all loans get redeposited into checking accounts in U.S. banks.) The Fed
pays for the securities by crediting First National's reserve account at the Fed
with $100. We would like to know, What is the ultimate change in the money
supply, after the entire chain of deposit creation has run its course?
First, the change in the Fed's balance sheet is as follows:
FEDERAL RESERVE SYSTEM
Assets
Liabilities
Securities +$100
Banks' deposits at the Fed +$100
The initial change in First National's balance sheet is:
2
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
+$100
Securities
-$100
First National now has excess reserves of $100 (ER = $100).
We can fast-forward to the answer to our question -- What is the ultimate
change in the money supply, after all excess reserves have been loaned out
and redeposited again and again?
The answer is simply:
{Total change in money supply} = {Initial change in reserves} * {Money
multiplier}
= { + $100 } * {10}
= + $1000
The simple deposit multiplier is 10, because the RRR is 10%, or .10, so,
plugging that into the formula for the simple deposit multiplier, we get:
simple deposit multiplier = 1/RRR = 1/.10 = 10
Let's step back and see how that $1000 increase in the money supply comes to
be. First National will loan out its excess reserves of $100. Say it loans them out
to me. I use that $100 to buy something (say, $100 worth of compact discs),
and the CD merchant will either deposit that $100 in the banking system or
spend it himself; either way, someone will eventually deposit that $100 cash in
the banking system -- if not at First National, then at some other bank. With that
new deposit the (cumulative) change in the banking system's balance sheet is
as follows:
Assets
Liabilities
Reserves
+ $100
Securities
- $100
Loans
+ $100
Checking deposits + $100
The money supply has expanded by $100, since the money supply includes
checking deposits. The money-creation process will continue because the bank
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that received the $100 cash deposit now has excess reserves ( = actual
reserves - required reserves) of
$100 - (.10)($100) = $100 - $10 = $90.
The bank will loan out that $90 and it, too, will eventually be redeposited as
cash in the banking system. Now the cumulative change in the banks' balance
sheet is:
Assets
Liabilities
Reserves + $100
Checking deposits + $190
Securities - $100
Loans
+ $190
The banks have excess reserves of $81 ( = $100 - (.10)($190) = $100 - $19 ).
They will loan them out and the money will be redeposited in the banking
system, increasing checking deposits by another $81. Then 90 percent of that
will be loaned out and redeposited, and 90 percent of that will be loaned out and
redeposited, etc. The total increase in bank deposits (and hence in the money
supply) will be:
$100 + $90 + $81 + ($81)(.90) + ($81)(.902) + ...
= $100 + ($100)(.90) + ($100)(.902) + ($100)(.903) + ($100)(.904) + ...
This seemingly endless sum is a geometric series, and is solvable as
1
1
$100 * --------- = $100 * ----- = $100 * 10 = $1000
1 - .90
.10
Thus total bank deposits increase by $1000, as does the money supply. The
total change in the banking system's balance sheet, when there are no more
excess reserves remaining, is:
Assets
Liabilities
Reserves + $100
Checking deposits + $1000
Securities - $100
Loans
+ $1000
4
That $1000 increase in checking deposits all came about as the result of an
initial increase in reserves of $100. Thus the total amount of deposits has
expanded by a multiple (ten) of the original change in reserves.
To review:
* In our example, the Fed injects $100 in reserves into the banking system, by
purchasing a $100 T-bill from the First National Bank. To see how that
increases the money supply, we need to keep track of the increase in checking
deposits. After the Fed's purchase, First National has $100 in excess reserves.
They loan those reserves out as $100 cash, and that $100 cash gets
redeposited into a checking account at the bank. Then the bank has $100 in
reserves again, and $90 of that is excess reserves (the remaining $10 has to be
kept to meet their 10% reserve requirement on checking deposits; they can loan
out 90% of any increase in cash deposits, so they loan out .90*$100 = $90).
They loan out those excess reserves -- $90 cash -- and that $90 gets
redeposited. They can lend out 90% of that (.90*.90*$100 = $81), and it will be
redeposited. And so on.
* The sum of all these additional checking deposits is a geometric sum, as
explained in the previous lecture, meaning that we have a simple formula for
finding the total increase in deposits:
total increase in deposits = initial increase in deposits * (1/RRR)
* The initial increase in reserves of $100 ultimately leads to a $1000 increase in
checking deposits, or a $1000 increase in the money supply. Thus the total amount of
deposits has expanded by a multiple (ten) of the original change in reserves. That
multiple is called the simple deposit multiplier.
simple deposit multiplier
= total change in deposits per dollar increase in reserves
= 1/(1-percent loaned out) = 1/(percent not loaned out) = 1/(percent kept as
reserves)
= 1/RRR
So far we have assumed that all excess reserves are loaned out, and all loans
are redeposited in full in the banking system. Neither of those assumptions
(especially the second one) is very realistic. In fact, banks do hold some excess
reserves, and some of the money that banks loan out is held by the public as
currency. Both of those factors are "leakages" from the stream of deposit
creation; and, as a result, the result that the "real world" money multiplier is
considerably smaller than 10 (i.e., 1/RRR) -- it's actually about 2.
5
EK3301 Monetary Economics
Lecture notes to accompany Mishkin's Chapter 14
("Determinants of the Money Supply")
I. THE REAL-WORLD MONEY MULTIPLIER
The simple money multiplier, or simple deposit multiplier, is very simple indeed.
You just calculate 1/RRR; since RRR is now 10%, then the simple money
multiplier is 1/.10 = 10.
But, as noted above, it is not very realistic, since banks do hold some excess
reserves (though not much) and, especially, because a sizeable fraction of
money loaned out does not get redeposited into bank accounts. (In fact, about
two-thirds of the U.S. currency that's officially "in circulation" is not even held in
this country; many people in other countries, especially third-world countries,
hold dollars as a hedge against inflation in their own currency, since the dollar
right now is a much better store of value than, say, the Russian ruble.)
To the extent that banks hold onto some of their excess reserves, those
reserves don't get loaned out and don't get redeposited into the banking
system; thus excess reserves do not increase the money supply at all. So an
excess reserves ratio (the ratio of excess reserves to checking deposits, or
ER/D) above zero will cause the money multiplier to be less than 1/RRR.
When cash loaned out continues to be held as cash, instead of redeposited into
bank accounts, those holdings of currency are still counted as part of the money
supply, but there is no multiple expansion of deposits (and hence of the money
supply) associated with currency. Instead, every dollar that the public holds as
currency is a dollar that doesn't get redeposited in the banks and therefore is
not available to be loaned out and to contribute to further expansion of the
money supply.
If we dig up information on banks' actual holdings of excess reserves and the
fraction of loan amounts that people hold as currency (instead of redepositing it
into bank accounts), we can get a much more realistic estimate of the money
multiplier. We will call that realistic estimate the real-world money multiplier,
or just the money multiplier.
Why we care about the real-world money multiplier: Because the Fed seeks to
control the money supply in order to influence interest rates, and yet the Fed
does not control the money supply directly. Instead, it controls the monetary
base, which is the sum of bank reserves and currency in circulation.
Notationally:
monetary base = reserves + currency
MB
=
R
+ C
6
The money supply (Ms) is equal to the monetary base (MB) times the money
multiplier (m):
Ms = m x MB
So the Fed needs to know what the money multiplier is in order to be able to
control the money supply effectively.
We can derive the real-world money multiplier m with a little mathematical
manipulation. Rearranging the above equation, we get
Ms
m = ----- ,
MB
which we can calculate if we are given the Ms and the MB. For the Ms, we
normally use M1, which is roughly defined as Currency in circulation (C) plus
checking Deposits (D). Notationally, then, M1 = C + D.
Breaking the MB down into required reserves and excess reserves (ER) and
recalling that required reserves are RRR * checking deposits, we get:
MB = RRR*D + ER + C
With just a little mathematical manipulation (done in class and in Mishkin, p.
415), we can express the real-world money multiplier (m) as a function of the
required reserve ratio (RRR), the excess-reserves ratio (ER/D), and the
currency-deposit ratio (C/D):
1 + [C/D]
m = -----------------------------RRR + [ER/D] + [C/D]
To find m, all we need are the values of the C/D and ER/D ratios. (We already
know that RRR = .10, or 10%.) Alternatively, we could compute m with values
for C, D, and ER. (The ratios are somewhat more stable than the absolute
numbers of C, D, and ER, however.) Some not-completely-off-base numbers for
those variables are:
C = currency held by the public = $400 billion
D = checking deposits = $800 billion
ER = excess reserves = $0.8 billion
M1 = narrowest measure of money supply = C + D = $1200 billion
Plugging those numbers into our formula for m, the money multiplier, m is:
1 + [400/800]
1 + 0.5
1.5
m = ------------------------------------- = ----------------------- = --------- = 2.496
0.10 + [0.8/800] + [400/800] 0.1 + 0.001 + 0.5
0.601
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The real-world money multiplier is roughly 2.5. [Right now, using the actual
numbers for C, D, and ER in the year 2002, it was actually about 1.7, but this is
not too far off.]
If the money multiplier changes, the Fed needs to make offsetting changes in
the monetary base so as to keep the money supply stable.
Historical note on the Great Depression:
C/D and ER/D both tend to increase during major recessions and depressions,
because the public may view banks as unsafe and banks are more likely to be
pessimistic about borrowers' creditworthiness. During the Great Contraction of
1929-33, both of those ratios skyrocketed, and the money supply fell by about
25%, the most it has ever fallen. The drop was because of the increases in
those ratios, which dramatically shrunk the money multiplier. A related reason
was the huge number of bank failures, caused in large part by the many runs on
the bank by depositors, who were trying to covert their deposits into cash (C/D
was rising). Those bank failures directly and severely reduced the level of bank
deposits, the key component of M1.
II. THE REAL-WORLD MONEY MULTIPLIER AND THE SIZE OF THE
MONEY SUPPLY
The money multiplier is important because the Fed needs to keep the money
supply in balance with money demand -- which fluctuates a lot -- in order to
keep interest rates stable, and the Fed can't control the money supply
effectively unless it knows what the money multiplier (m) is. The Fed's control
of the money supply (M1) is indirect, because the Fed directly controls only the
monetary base (MB, = reserves + currency in circulation), whereas the money
supply (M1) is equal to the monetary base (MB) times the money multiplier (m):
M1 = m x MB
The Fed can influence the size of m by changing the RRR, but it can't control
C/D or ER/D, which depend on the behavior of banks and their borrowers and
depositors. If and when m changes, the Fed needs to make offsetting changes
in the monetary base so as to keep the money supply stable.
When we looked at the money market earlier in this course, in the way of an
explanation of interest-rate movements, we simply assumed that the money
supply was fixed by the Fed and did not depend at all on the interest rate. That
assumption is not realistic. Let's look at all the players who jointly determine
the size of the money supply (remember: Ms = MB x m):
Player
Variable
Ms response
Reason
to an
increase in
8
that variable
The Fed
Banks
RRR
less multiple-deposit expansion (m
shrinks)
decreases
MB (through R) increases
more reserves mean more loans (and
redeposits)
discount rate
fewer bank reserves --> MBdecreases
decreases
supply of loan
monies
(ER/D
increases
decreases if
banks are
looking to make
more loans)
Depositors C/D
m increases
less multiple-deposit expansion (m
shrinks)
decreases
expected
deposit
outflows (ER/D
Depositors
decreases
increases if
and banks
banks are
expecting a lot
of these)
Borrowers
m shrinks
banks can now make more (safe)
loans at the same or a higher interest
rate, so they loan out more of their
excess reserves (ER/D falls) ==>
money multiplier becomes larger. If
those higher interest rates allow banks
to attract new deposits away from
competitors like MMF's, then MB
becomes larger, too.
demand for
loans (ER/D
increases
decreases if
demand for
loans increases)
Unlike the simple deposit multiplier (1/RRR), which is very stable because the
Fed almost never changes the RRR, the real-world money multiplier m can vary
quite a bit from year to year. (In the past year, for example, m fell from about 1.9
to about 1.7.) m is sensitive to changes in the business cycle and to changes in
interest rates.
m is procyclical (m rises in economic upswings; m falls in recessions).
-- Why:
9
* the excess reserves ratio (ER/D) tends to rise during recessions, as
banks tend to view loans as risky during recessions. In an economic slump,
businesses and households may be more likely to default on their debts. So
banks may hold a lot of excess reserves because they think holding onto their
reserves is a lot safer than loaning them out. An example was the "credit
crunch" during the 1990-92 recession.
* the currency-deposit ratio (C/D) tends to rise during recessions, as
people may start to view bank deposits as risky (if their banks are in danger of
failing. This was a bigger problem back before federal deposit insurance was
established in 1933; it is not really a big deal today).
---- Since ER/D is in the denominator of that ratio formula for m, an increase in
ER/D will reduce m.
---- Although C/D appears as a term in both the numerator and denominator of
that formula for m, it's added to a much larger number (+1) in the numerator
than in the denominator (where it's added to the RRR and the ER/D, which
together add to about 0.11 or less), so an increase in C/D enlarges the
denominator more than it enlarges the numerator, causing their ratio (m) to
decrease.
m is also affected by changes in interest rates.
-- Why:
* higher interest rates will induce banks to loan out more of their excess
reserves, causing ER/D to decrease, which causes m to become larger.
* higher interest rates will induce people to carry less cash (C) and keep
more in interest-earning checking account deposits (D), so C/D will
decrease, too, causing m to become larger.
---- Since both of those changes make m larger, then they'll also cause the
money supply (= m * MB) to become larger. So, when we draw the money
market as a supply and demand diagram (where Qm is the quantity of money
and the nominal interest rate, i, is the price of money), the supply-of-money
curve should be upward-sloping, not vertical.
10
EK3301 Monetary Economics
Lecture notes to accompany Mishkin's Chapter 15
TOOLS OF MONETARY POLICY
The Fed has three main policy tools, which it uses to influence the level of
bank reserves and the monetary base, and through them the money supply and
interest rates and the economy:
(1) changes in banks' required reserve ratio
(2) discount loans / changes in the discount rate
(3) open market operations
A. CHANGES IN BANKS' REQUIRED RESERVE RATIO (RRR)
-- The required reserve ratio (RRR) is now 3% of each bank's first $50 million in
checking deposits, 10% of the rest of their checking deposits. It was lowered
from 12% in early 1990's.
-- The RRR on savings account, CD's, and money-market deposit accounts is
zero.
-- Changes in the RRR have large effects on money supply: increasing RRR
causes decrease in m, decrease in money supply. Because this tool's effects
are so powerful as to preclude "fine tuning" (making small changes in monetary
policy as needed), it is the Fed's least-used policy tool.
-- A key disadvantage of changing reserve requirements as a policy tool: it is
too blunt a policy instrument, since it has such a dramatic effect on the
money supply (by changing the money multiplier). It is also not practical, due to
administrative costs and the problems it creates for banks (ex.: 1936, when a
doubling of bank reserve requirements hammered the banks and induced a
severe recession).
-- A number of people advocate abolishing bank reserve requirements (i.e.,
setting RRR at zero), just like many other industrialized countries (Canada,
Switzerland, Australia) have done. The rationale for this is that having to keep
10% of deposits as reserves hurts the competitiveness and profitability of
American banks, since they only need to keep about 1-2% of deposits as
reserves to meet deposit outflows. If RRR were set to zero, banks would still
hold some excess reserves, but could loan out more of their deposits and reap
higher profits.
B. DISCOUNT LOANS / CHANGES IN THE DISCOUNT RATE
Discount loans: loans (of reserves) made by regional Fed banks to
commercial banks.
-- An increase in discount loans increases bank reserves (and the MB) and
increases the money supply
-- A decrease in discount loans decreases bank reserves (and the MB) and
11
decreases the money supply
The Fed controls the discount rate, i.e. the interest rate at which it loans
money to banks.
-- The Fed also controls the volume, or quantity, of discount loans, since its
regional banks have discretion over whether to grant or deny any particular
discount-loan request
-- Discount loans are the essence of the Fed's lender of last resort
function.
---- They were originally envisioned as the Fed's main policy tool, back when the
Fed was chartered in 1913. (More recently, OMO has overtaken discount loans
in importance.) The Fed can help prevent financial and bank panics by
providing reserves.
C. OPEN MARKET OPERATIONS (OMO)
In OMO, the Fed buys or sells bonds, usually from the banks, in order to affect
the level of bank reserves and the federal funds rate (the interest rate at which
commercial banks loan each other reserves, on an overnight basis). In turn, the
money supply and other interest rates will be affected, too.
-- OMO is the Fed's most important and most-used policy tool.
-- Depending on whether the Fed is trying to conduct an expansionary monetary
policy or a contractionary monetary policy, it will use one of the following types
of OMO:
---- (1) open-market purchases - when the Fed buys securities from banks
and pays for them by crediting the banks' reserve accounts at the Fed,
thus creating reserves -> reserves increase, MB increases -> money supply
increases, i decreases (expansionary monetary policy).
---- (2) open-market sales - when the Fed sells securities to banks and
collects payment by debiting the banks' reserve accounts at the Fed, thus
destroying reserves -> reserves decrease, MB decreases -> money supply
decreases, i increases (contractionary monetary policy).
There are two basic types of OMO (aside from the purchases-vs.-sales
distinction):
(1) DYNAMIC OMO: change MB, change money supply, interest rates
---- goes with a definite shift in Fed policy (e.g., a decision to lower interest
rates). Dynamic OMO can be either expansionary or contractionary.
------ (a) EXPANSIONARY OMO: goal is to stimulate the economy and reduce
unemployment. Sequence:
Fed makes open-market purchases of bonds from banks, pays for them
by crediting banks' reserve accounts at the Fed --> reserves increase, MB
increases --> money supply increases, interest rates fall --> business
investment and household consumption rise --> real GDP and
employment rise.
12
------- (b) CONTRACTIONARY OMO: goal is to reduce inflation by slowing
down the economy. Sequence:
Fed makes open-market sales of bonds to banks, collects payment by
debiting banks' reserve accounts at the Fed --> reserves fall, MB falls -->
money supply decreases, interest rates increase --> business investment
and household consumption fall --> real GDP and employment fall (or grow
more slowly) --> inflation rate falls.
(2) DEFENSIVE OMO: offset other factors affecting bank reserves (e.g.,
stock market crash of 1987); maintain current federal funds rate
---- does not go with any major policy shift; Fed conducts defensive OMO nearly
every day
OMO directly influences the FEDERAL FUNDS MARKET (the market where
banks loan their excess reserves to each other, usually on an overnight
basis), by affecting the supply of bank reserves. The federal funds rate, which
is the interest rate that banks charge each other on loans of reserves, is the
equilibrium interest rate in the federal funds market, so it is determined by the
intersection of the supply and demand curves for reserves.
-- [See Mishkin's Chapter 15, Figure 1, "Equilibrium in the Market for
Reserves."]
---- Open-market purchases increase the supply of bank reserves, causing the
supply curve for reserves to shift out and the federal funds rate to decrease. In
the case of expansionary OMO, the Fed conducts open-market purchases
on a large scale, in order to decrease the federal funds rate.
---- [See Mishkin's Chapter 15, Figure 2, "Response to an Open Market
Operation..."]
---- Open-market sales decrease the supply of bank reserves, causing the
supply curve for reserves to shift in and the federal funds rate to increase. In
the case of contractionary OMO, the Fed conducts open-market sales on a
large scale, in order to increase the federal funds rate.
------ [The graph is like Mishkin's Chapter 15, Figure 2, but with the supply curve
of reserves shifting inward, or leftward.]
---- In the case of defensive OMO, the Fed tries to keep the federal funds rate
constant by (1) making open-market purchases to offset an increase in banks'
demand for reserves, or (2) making open-market sales to offset a decrease in
banks' demand for reserves.
Q: What kind of bonds should the Fed buy and sell in its OMO?
A: Treasury bills are ideal -- they have high liquidity, and they are such a highvolume market that the Fed's OMO does not distort the market much. Also,
unlike corporate securities, exchanges of Treasury bills do not create any
possible conflicts of interest (or the appearance thereof) for the Fed.
-- The Federal Open Market Committee (FOMC) makes the decisions (note:
13
Federal Open Market Committee, Open Market Operations).
-- The Federal Reserve Bank of New York conducts OMO, via its Trading Desk
Advantages of OMO:
* has a precise impact on the MB, leaving it completely in the Fed's control
* flexible and easily reversed
* quickly implemented
14
EK 3301
Monetary Economics
Lecture notes to accompany Mishkin's Chapter 16
What Should Central Banks Do? Monetary Policy Goals,
Strategy and Tactics
I. GOALS OF MONETARY POLICY
The Fed's charter, as revised in 1946, pledges it to pursue "price stability" and
"maximum sustainable employment." Those two goals are, to some extent,
mutually exclusive, since literal price stability -- a zero inflation rate -- would
almost surely require a recession to get there. Recall, from introductory macro,
the Phillips Curve tradeoff:
* A lower inflation rate comes at the price of higher unemployment.
* A lower unemployment rate comes at the price of higher inflation.
More realistically, the Fed's goals are a low (not zero) and stable inflation rate
and an acceptably low unemployment rate. The target rate of unemployment is
the non-accelerating-inflation-rate of unemployment (NAIRU), the lowest
unemployment rate consistent with a stable, non-increasing rate of
inflation. According to the prevailing belief among Fed policymakers, an
unemployment rate below this rate (roughly 4%) would cause the rate of
inflation to accelerate -- that is, to increase and keep on increasing.
-- When the inflation rate accelerates, or when people come to expect a
higher rate of inflation, the Phillips Curve shifts up, thereby making the
Phillips Curve tradeoff worse, since every possible unemployment rate would
be associated with a higher inflation rate than before.
-- The Phillips Curve can also shift down, if people come to expect a lower
rate of inflation -- this occurred in the 1980s and 1990s, when unemployment
and inflation both fell.)
-- To reduce inflation, the Fed needs to pursue contractionary policies that raise
unemployment and reduce output, so as to reduce inflationary pressures in the
labor and product markets. If the contractionary policies go on for a long time
and inflation is low for a long time, then the Phillips Curve will likely shift down,
yielding a lower inflation rate for any given level of unemployment. Thus a
contractionary monetary policy, if successful in reducing people's expectations
of inflation, could conceivably be a case of "short-term pain for long-term gain."
The Fed pursues those goals of low inflation and low unemployment by
controlling the level of the money supply.
-- If inflation is too high, the Fed practices contractionary monetary policy:
it reduces the money supply, which causes the equilibrium interest rate to
go up, which causes investment and consumer-durables spending to fall,
causing the economy (real GDP) to contract, which in turn causes the
inflation rate to fall.
-- If unemployment is too high, the Fed practices expansionary monetary
15
policy: it increases the money supply, which causes the equilibrium
interest rate to fall, which stimulates investment and consumer-durables
spending, thereby raising GDP and lowering unemployment.
While keeping inflation and unemployment low are the Fed's principal goals, the
Fed has six basic goals in all:
(1) high employment
(2) economic growth
(3) price stability
(4) interest rate stability
(5) financial market stability
(6) stability of the foreign exchange rate
Let us review each of those goals, and what they mean to the Fed, one by one.
(1) high employment
The Employment Act of 1946 commits the Fed to "maximum sustainable
employment at stable prices." The term "maximum sustainable employment"
(or "full employment" or "high employment") really means the NAIRU (nonaccelerating-inflation rate of unemployment) -- the lowest unemployment
rate that is consistent with a stable rate of inflation. If the unemployment
rate is kept below the NAIRU, the inflation rate will rise and will keep on rising
for as long as the unemployment rate stays below the NAIRU. If the
unemployment rate is persistently above the NAIRU, the inflation rate will fall
and will continue to fall for as long as the unemployment is higher than the
NAIRU -- that's why recessions and high unemployment are indispensable to an
all-out war on inflation, such as the Fed conducted in the early 1980s.
The NAIRU is currently about 4.0-4.5%, or so we think -- nobody really knows
for sure. For years economists believed the NAIRU was about 6%, but the
unemployment rate fell as low as 4.0% (and even a bit less) in the late 1990s
without triggering any sign of accelerating inflation. It appears that the NAIRU
fell sharply during the 1990s.
(2) economic growth
This goal would seem to be the same as high employment, since strong
economic growth creates jobs and reduces unemployment. We should,
however, distinguish between short-term growth (such as when the economy is
recovering from a recession and has room to grow very fast) and long-term
growth (which is slower than that, typically about 3% per year real GDP
growth). The Fed has far more control over the economy's short-term growth
than over its long-term growth, which is driven by more fundamental factors like
the supply of labor, capital, land, and technology. But Fed policies do have
some influence over the economy's long-term growth -- lower real interest rates
promote business investment and capital formation; and lower inflation rates
help to provide a more stable economic environment and remove some of the
economic inefficiencies inherent in inflation, and hence also tend to raise the
economy's productive potential.
16
(3) price stability
The U.S. economy does not seem to function well under high inflation, as we
learned in the inflationary decade of the 1970s. Inflation is particularly costly for
those living on fixed incomes or long-term fixed interest payments. Inflation also
makes it difficult for people to make correct judgments about how relative prices
have changed -- when people mistake absolute price changes for relative price
changes (as would be the case if, say, a 3% rise in the cost of beans when the
general inflation rate is also 3% led you to stop buying beans), they commit the
error of "money illusion," which can be costly.
-- Literally, price stability would mean 0% inflation. Alan Greenspan has said
that is his goal and that he wants the Fed's charter to be changed so that the
Fed can concentrate on price stability instead of also having to pursue
"maximum sustainable employment," but that change is not likely to occur. The
public is simply a lot more concerned about unemployment than central bankers
usually are.
(4) interest rate stability
Volatile interest rates can be extremely damaging to banks. If the current
interest rate shoots up, banks that are holding mostly fixed-rate, long-term
assets will see the resale value of those assets plummet and could face
insolvency. Businesses that rely heavily on borrowing will see a sharp rise in
their costs. If the current interest rate falls sharply, banks that are holding mostly
variable-rate assets (like adjustable-rate mortgages) will see a sharp decline in
their interest income and might also face insolvency. For consumers, volatile
interest rates increase the riskiness of decisions about whether or when to buy
a house or a car or any other durable good that necessitates a series of
installment payments.
-- On a day-to-day basis, however, the Fed mainly just tries to keep the federal
funds rate constant. Many other interest rates, like the prime interest rate (and,
to a lesser extent, mortgage rates), tend to move in tandem with the federal
funds rate.
(5) financial market stability
In a financial crisis, credit intermediation, the process by which financial
institutions channel funds from savings to productive investment, tends to break
down. People tend to hoard currency (C/D rises) and banks tend to hoard
reserves (ER/D rises), thereby shrinking the money multiplier, the money supply
and the volume of productive loans and business investment. Anything the Fed
can do to promote a stable financial system -- serving as a lender of last resort,
keeping interest rates stable -- will generally be good for the economy.
-- The Fed does not try to iron out fluctuations in the stock and bond markets,
since those markets are inherently quite volatile and neither the Fed nor anyone
else can make them perfectly stable. The Fed does, however, try to nip
financial crises in the bud, as it did immediately after the 1987 stock-market
crash, when Greenspan announced that the Fed stood ready to make massive
amount of discount loans to banks that loaned money to brokers (who were
obviously feeling the pinch of the crash).
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(6) stability of the foreign exchange rate
First, let's review a couple definitions:
* The dollar APPRECIATES (or RISES) when it becomes more expensive in
terms of foreign currency.
--> American exports become more expensive abroad; foreign imports become
cheaper here
---- good for American consumers and American tourists abroad
---- helps keep inflation low, because the imports we buy are now cheaper
---- bad for American exporters and American producers who compete with
imports.
* The dollar DEPRECIATES (or FALLS) when it becomes cheaper in terms of
foreign currency.
--> American exports become cheaper abroad; foreign imports become more
expensive here
---- bad for American consumers and American tourists abroad
---- tends to increase inflation, because the imports we buy are now pricier
---- good for American exporters and American producers who compete with
imports
The Fed will often try to prevent either a major appreciation or a major
depreciation of the dollar, since either can be problematic.
-- A severe depreciation of the dollar helps American exporters but hurts
American consumers (and American firms that purchase materials and parts
from abroad) by raising import prices; the increase in prices is also inflationary,
by definition.
-- A major appreciation of the dollar helps American consumers but hurts our
trade balance by making foreign imports cheaper and U.S. exports more
expensive. Since the trade balance, or net exports, is part of GDP, then a rapid
appreciation of the dollar will tend to hurt economic growth and employment,
thus working against the Fed's first two goals.
The Fed's six goals, then, are closely related but often in conflict. For example,
a strong dollar (i.e., a high foreign exchange price for the dollar) helps keep
inflation at bay but hurts American exports, GDP, and jobs. The Fed can help
bring down the dollar's exchange rate by reducing interest rates, which reduces
international demand for dollars and thereby causes the dollar to depreciate, but
too large a reduction in interest rates would be inflationary and would add to the
volatility of interest rates. With so many different goals, the Fed's optimal
solution is something of a compromise solution. No single goal is so important
as to override all the others.
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II. TARGETS OF MONETARY POLICY
You know the Fed's tools (OMO, discount loans, RRR). You know the Fed's
goals. Getting from tools to goals is where the targets of monetary policy come
in.
TOOLS -- OPERATING_TARGETS-- INTERMEDIATE_TARGETS GOALS
>
>
->
the Fed's
things the Fed affects fairly things the Fed affects more
decision
directly
indirectly
variables
(OMO,
discount
loans,
RRR)
high
employment,
price stability,
and the other
four on the list
(reserves, monetary base, (M1, M2, M3, prime interest
federal funds rate)
rate, long-term interest rates)
The big question for Fed policy-makers: Which target should the Fed use?
Interest rates or a monetary aggregate?
Why this matters: If you target (or "peg") the interest rate, the money supply
may fluctuate wildly, perhaps causing inflation. If you target the money supply,
interest rates may fluctuate wildly. The reason in both cases is that money
demand -- the public's demand for currency and checking deposits -- can be
highly variable.
The Fed's usual target has been the interest rate, instead of the money
supply. At one extreme, in WWII the Fed pegged the interest rate at 1%, holding
it absolutely constant despite rapidly rising GDP growth. (That policy would
have been inflationary if not for wartime wage and price controls.) The Fed did
the same in the 1960's, while the government ran big deficits, and the result
was rising inflation. The only time the Fed has exclusively targeted a monetary
aggregate was at the beginning of Paul Volcker's term, in 1979-82, when the
Fed's War on Inflation revolved around drastically slowing the growth rate
of reserves (to be precise, non-borrowed reserves, which are bank reserves
minus discount loans). Interest rates soared, and fluctuated greatly. (Mishkin
speculates that the Fed's stated emphasis on a monetary aggregate was
probably just shrewd political strategy, since a deliberate and massive increase
in interest rates would have been extremely unpopular. The Fed's real
dedication was to stamping out inflation, even at the cost of a recession, not to
slavishly obeying monetary targets. But it's not politically acceptable to say
you're going to induce a recession.)
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EK 3301
Monetary Economics
Lecture notes to accompany Mishkin's Chapter 17
The Foreign Exchange Market
I. INTRODUCTION TO THE FOREIGN EXCHANGE MARKET
Most countries have their own currencies, and when people in different
countries do business with each other, an exchange of currencies must take
place. For example, suppose you're vacationing in London and you walk into a
pub and order a pint of ale. No bartender in Britain is going to let you pay your
tab in dollars -- you're going to have to get a hold of some British pounds
sterling. More generically, you're going to have to get a hold of some foreign
exchange.
FOREIGN EXCHANGE: all currencies other than the domestic currency(in
our case, all currencies other than the dollar). The foreign exchange market
refers to any and all places where different currencies are traded for one
another.
EXCHANGE RATE: the price of one country's currency in terms of another
country's currency; the rate at which two currencies are traded for
another.
-- Exchange rates for all of the world's major currencies are listed daily in the
Wall Street Journal.
---- [We saw an overhead of the "CURRENCY TRADING" table from a recent
Wall Street Journal. It showed exchange rates between the dollar and about fifty
different foreign currencies.]
---- Ex.: On March 17, 2003, the U.S.-Canadian exchange rate was .6757 U.S.
dollars per Canadian dollar (i.e., a Canadian dollar costs you 67.57 cents), or
1.4799 Canadian dollars per U.S. dollar.
A note on usage: The term "exchange rate" has probably generated more
confusion than any other term in economics (no small feat). When economists
talk of "the exchange rate," it's never completely clear which exchange rate
they're talking about. To be more precise about it, identify what currency you're
talking about:
* the dollar's exchange rate (E$ ) = price of a dollar in terms of a foreign
currency
* the foreign exchange rate (Eforeign) = price of a foreign currency in terms
of dollars = 1/E$
-- Note that each one is the reciprocal (1/X) of the other
A still-better idea is to avoid the term "exchange rate" altogether. Instead, we
can talk of currency appreciation and depreciation. Namely,
20
* A currency APPRECIATES when it increases in value
(i.e., it becomes more expensive, it purchases more foreign currency).
* A currency DEPRECIATES when it decreases in value
(i.e., it becomes cheaper, it purchases less foreign currency).
To further avoid vagueness, don't say "the exchange rate appreciates" -- say
"the dollar appreciates."
II. CURRENCY CONVERSIONS
To know how much an item produced in one country will cost in another
country's currency (i.e., as an import or to a tourist), you need to change the unit
of account (e.g., dollars, francs) by performing a currency conversion.
For any good or service produced outside the U.S., the price in dollars is:
Pin dollars = Pin foreign currency units * (1/E$)
= Pin foreign currency units * dollars/(unit of foreign currency)
For any good or service produced in the U.S., the price in terms of foreign
currency is:
Pin foreign currency units = Pin dollars* E$
= Pin dollars * (units of foreign currency)/dollar
The key is to get it into the right unit of account -- on the right-hand side of the
equation, the other currency units should cancel out.
-- Ex.:
(Suppose the dollar trades for 0.6847 British pounds, and 1 British pound trades
for 1.4606 dollars.)
Q: How much would a Cadbury chocolate bar (made in Britain) that sells for one
British pound go for in U.S. dollars?
A: Pin dollars = Pin pounds * dollars/pound = 1 pound * 1.4606 dollars/pound =
1.4606 dollars (or $1.4606)
---- (Note how the pound units just drop out of the equation, as the units term
becomes [pound*dollar]/pound = dollar.)
-- Ex.:
Q: How much would a $10 bottle of California wine cost in Japan?
A: (From the "Currency Trading" table, we can see that 1 dollar trades for
118.46 Japanese yen, and 1 Japanese yen trades for .008442 dollars. Now we
just need to plug the appropriate one of those numbers -- the yen-per-dollar
ratio -- into the formula.)
Pin yen = Pin dollars* yen/dollar = 10 dollars * 118.46 yen/dollar = 1184.6 yen
---- (Note how the dollar units drop out of the equation.)
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III. RETURNS ON INTERNATIONAL ASSETS
When international investors consider whether to invest in one country or
another, they must take into account not only the nominal returns on
investments in the different countries, but also the exchange rates and how they
might change over time.
--> The relevant return (RET) for an international investor is the
(real, after-tax) return after all currency exchanges have taken place.
|
(So as not to complicate this lecture unnecessarily, we will ignore the effect of
inflation and taxes on RET in all the equations and examples that follow.)
-- For U.S. holders of foreign assets, RET is higher if the foreign currency
appreciates against the dollar.
RET on foreign asset held by an American
= nominal RET on asset + appreciation of foreign currency
= nominal RET on asset - appreciation of U.S. dollar
-- For foreign holders of U.S. assets, RET is higher if the dollar
appreciates against the foreign currency.
RET on U.S. asset held by a foreigner
= nominal RET on asset + appreciation of U.S. dollar
= nominal RET on asset - appreciation of foreign currency
The rate of appreciation of a currency is calculated as a percent change.
The dollar's rate of appreciation, for example, would be:
(New Pdollar) - (Old Pdollar)
appreciation of dollar = ---------------------------------- * 100%
Old Pdollar
{ New Pdollar
}
= {---------------- - 1 } * 100%
{ Old Pdollar
}
Ex.:
At its inception in January 2000, the euro traded at a rate of 1.15 U.S. dollars
per euro. Now, in March 2003, it costs 1.10 U.S. dollars per euro. The euro's
total rate of appreciation
{ 1.10
}
= {------ - 1 } * 100% = (.957-1) * 100% = (-.043) * 100% = -4.3%
{ 1.15
}
If an American purchased Volkswagen (German) stock in January 2000 and
earned 15% (in euro terms) between then and now, his total return, net of
currency exchanges, would be
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RET = 15% + (-4.3%) = 10.7%,
which is somewhat less. For American holders of foreign assets, the real return is less
if the foreign currency depreciates against the dollar.
(Aside: You could calculate the annualized, or yearly, rate of appreciation of the
euro by taking that first ratio (the euro's new exchange price divided by its old
exchange price) to the power of 1/n, where n is the number of intervening
years. In this case, it's been 3 years and 2 months, so n = 3 + 2/12 = 3.17.
-- Formula:
annualized appreciation of euro = {[(New Peuro)/(Old Peuro)]^(1/n) - 1} *
100%
-- Applied to above example:
annualized appreciation of euro = {[(1.10/1.15)^(1/3.17)-1} =
{(.957)^(1/3.17)-1} = .986-1 = -.014 = -1.4%)
IV. UNDERSTANDING EXCHANGE RATES: SUPPLY & DEMAND IN THE
FOREIGN EXCHANGE MARKET
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