1

Money and the Central Bank

The objective is to understand inflation and interest rates and their relation to real GDP and the supply of money.

2

Overview

• What is Money?

• The Fed and Monetary Policy--Short Run

• Money and Inflation--Long Run

• The Money Multiplier, Bank Runs, and Financial Crisis

3

Abel/Bernanke, Macroeconomics Update, © 2003 Pearson Education, Inc. All rights reserved

Chapter 7 Table 1 U.S. Monetary Aggregates (January 2002)

Note that the use of credit cards does not eliminate the use of money, as money is often used to pay off a credit card balance. Credit cards simply delay the payment of a good.

Money’s primary purpose is to serve as a medium of exchange and thereby to facilitate transactions.

What is Money?

4

What does the Fed Do?Fed controls monetary aggregates and the Federal Funds rate

Fed regulates banks and the SEC regulates Investment Banks

Board Room at the Federal Reserve Board

Federal Reserve Board, Washington, DC

Bernanke sits here

5

Federal Funds Rate

Federal Reserve sets the Federal Funds rateThe Federal Funds Rate (FF) is the rate banks charge each other for borrowing reserves overnight

6

Federal Funds Rate Drives all Interest Rates

Fed Funds

T-Bill

30 yr Mortgage

7

Supply of Money and Open Market Operations

Open Market Purchase of Securities: Fed buys T-bills from a bank, thereby increasing the amount of money in circulation

Open Market Sale of Securities: Fed sells T-bills to a bank, thereby decreasing the amount of money in circulation

Supply ofmoney

Central Bank pays cash for the T-bill

Bank delivers T-bills to Central BankCentral BankCommercial Bank

How Does the Fed Manage the Fed Funds Rate?

8

Supply of Money

• Ms is the nominal supply of money

• Then Ms /P is the real supply of money where P is the aggregate nominal price level (CPI)

9

Demand for Money

• The (transactions) demand for Real Money Balances

y is real GDP and R is the nominal interest rate

• More money is demanded when real GDP is higher (captures the volume of transactions)

• Less money is demanded when the nominal interest rate is higher (captures the cost of holding money)

),( RyLP

M d

10

Demand and Supply of Money

The demand for money• Falls as interest rate

increases• Falls as expected

inflation rises.

• Falls if the real interest rate rises.

• Rises as real GDP increases

The supply of money• Determined by the Fed

11

The Money Market

• Real Money Demand = Real Money Supply

• In the short run, this market clearing condition determines the nominal interest rate --- the Fed funds rate.

Real Money Demand =

Real Money SupplyNominal interest rate, R

R*

Real Money Balances, M/P(M/P)*

),( RyL

P

M s

12

Effect of Open Market Purchase(short-run, before goods prices adjust)

Liquidity effect of open-market operations:• Open-market purchase increases money held by banks as reserves• Banks lower interest rate to encourage money to be loaned out

Real Money Demand

Fed funds rate

R

R’

M/P M/P(M/P)’

Real Money Supply

13

Empirical Evidence: Effects of 60 Basis Points Rise in FF Rate

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48

Real GDP Price level (GDP deflator)

months

% change

Empirical evidence shows that a rise in the Fed Funds Rate brings down Prices and Real GDP in subsequent periods at horizons of 18 months or more.

Why Is the Fed so Important?

14

Short Run Effects on the Economy

The Short Run Impact of a Federal Funds-rate cut

Real GDP

Growth Employment

Investment Real Wages

Stock Prices Bond Prices

FF Rate Cut is designed to cut real interest rates and stimulate investment demand

15

Long Run Effect of Increasing Money Supply

Increase of currency in circulation via an open market purchase initially lowers the Fed funds rate, but this effect is temporary

Money Demand

Fed funds rate

R

R’

M/P M/P(M/P)’

Only long-run effect is to increase the price level

16

Long Run Effects on the Economy

A policy of attempting to keep the Fed Funds Rates low may require the central bank to continuously

increase the supply of money

In the long run this leads to inflation

17

Money and Inflation: Long Run

18

Policy Trade-off

• In Recession: Fear of rising unemployment and falling income leads the Fed to lower the Fed Funds rate

• Cost of this Policy : Greater inflation in the long run

• In Economic Booms: Fear of Inflation, so raise interest rates

• Cost of this policy: Lower Economic Growth

19

Fed’s Reaction Function• In the US, the Fed seems to set the Fed funds rate using the following

rule (Taylor rule)

R = 1.5*π + 0.5*ydev + 1.0

– R is the Fed funds rate– π is the rate of inflation over the preceding four quarters– ydev is the percentage deviation of output from the trend real GDP

• If the real GDP is below the trend line (ydev less than zero) then the Fed will lower the Fed funds rate

• If π continues to rise, then the Fed will increase the Fed funds rate

20

21

The Money Multiplier and the Endogenous Creation of Money by the

Private Sector

22

Money with Commercial Banks

• Money available in the economy is currency held by the public, CU, plus bank deposits, DEP

M = CU+DEP

• The Monetary Base is currency held by the public, CU, plus currency held by banks, RES (i.e., bank reserves)

MB= CU +RES

23

Bank Reserves

• Required Reserves – a percentage of commercial bank deposits

(checking deposits) must be held as reserves (vault cash or deposit at the Central Bank)

• Excess Reserves– Typically, to meet withdrawals of cash, banks

hold more reserves than what’s required

24

Money Creation in a Fractional Reserve Banking System10 percent reserve requirement

Deposit Reserves Loans

1st Round $100 $10 $90

2nd Round $90 $9 $81

3rd Round $81 $8.10 $72.90

4th Round $72.90 $7.29 $65.61

…

Total $1000 $100 $900

25

The Money Multiplier• The Money Multiplier, m, is the relation between M and MB

M = m*MB

• The Money Multiplier can be expressed as

• A rise in cu or a rise in res lowers the multiplier m

11

/ /

1 /

rescu

cu

DEPRESDEPCU

DEPCU

MB

Mm

26

The Money Multiplier, Currency, and Reserves

What if households decide to withdraw their deposits and hold more currency per dollar of bank deposit?---cu rises

• The bank would use the reserves to return the Deposits

• Less money would be loaned out

• Money Supply will fall

What if banks become conservative and hold more reserves per dollar of deposit?----res rises

• Less money would be loaned out

• Money Supply will fall

27

The Money Multiplier and Bank Runs

• Sometimes households fear that banks don’t have adequate assets to cover their liabilities (demand deposits)

– They may want to withdraw their deposits and hold cash

• What if banks start running out of reserves

– Loans have to be liquidated at significant losses

– Sudden loan liquidation may not be enough to cover all the deposit withdrawals

– Note that the first to withdraw receive the full value of their deposits, which causes a bank run

• Implication-----cu rises, money supply falls, and banks fail.

28

Monetary Variables in the Great Depression

•Consumers Shift to holding Currencycurrency/deposit ratio rises•Banks become more conservative and hold more reservesreserve/deposits rise

29

Great Depression

• Central Bank provides more money (liquidity) Monetary Base rises

• Money Multiplier falls due to rise in cu and res

30

Monetary Variables in the Great Depression

• Due to the fall in the money multiplier, despite the increase in the Monetary Base, the Money Supply falls

• This is similar to the recent financial crises in the US, in which households and banks become more conservative (banks freeze their lending), so the money multiplier falls.

31

CPI in the Great Depression

Goods Prices fall as money supply falls

32

The Money Multiplier

33

The Monetary Base

34

The Money Supply: M1

35

Recent U.S. Financial Crisis

Mortgages are now mostly market-based and not bank-based.

GSE = government sponsored enterprise

ABS = asset back security

Source: Adrian and Shin, “Money, Liquidity and Monetary Policy,” NY Fed Staff Report, January 2009.

36

Recent U.S. Financial Crisis

Credit Crunch

37

Recent U.S. Financial Crisis

Non-bank lenders contracted during the recent financial crisis

38

Recent U.S. Financial Crisis

When your home value rises, your leverage ratio falls. The opposite is true for Investment Banks. Why?

39

Recent U.S. Financial Crisis

Haircut is the difference between the market value of a security and the price at which it is sold in the repo market (for later repurchase). A rise in the haircut leads to a fall in

leverage.

7 8

Security Apr-2007 Aug-2008

40

Recent U.S. Financial Crisis

Leverage peaks on the onset of a crisis.