The Money Supply and Monetary Policy - Lecture Notes | ECO 2013, Study notes of Introduction to Macroeconomics

Download The Money Supply and Monetary Policy - Lecture Notes | ECO 2013 and more Study notes Introduction to Macroeconomics in PDF only on Docsity! Fall 2001 ECO 2013 Cobbe Ch 12 Page 1 of 8 CHAPTER 12: The Money Supply and Monetary Policy CHAPTER CHECKLIST 1. Explain how banks create money by making loans. 2. Explain how the Fed controls the quantity of money. < How Banks Create Money < How the Fed Controls the Money Supply 12.1 HOW BANKS CREATE MONEY <Creating a Bank To see how banks create money, we’ll work through the process of creating a bank and see how our new bank creates money. There are eight steps: • Obtain a license to operate a commercial bank • Raise some financial capital • Buy some equipment and computer programs • Accept deposits • Establish a reserve account • Clear checks • Buy government securities • Make loans 12.1 HOW BANKS CREATE MONEY Obtaining a Charter Apply to the Comptroller of the Currency Raising Financial Capital Virtual College Bank creates 2,000 shares, each worth $100, and sells these shares in your local community. Balance sheet A statement that summarizes assets (amounts owned) and liabilities (amounts owed). 12.1 HOW BANKS CREATE MONEY Table 12.1 shows Virtual College Bank’s balance sheet #1. This balance sheet is in the form of what is called a T-account [because the shape is like a T]. The key thing to remember about book-keeping is that the two sides of the T always have to add to the same amount. 12.1 HOW BANKS CREATE MONEY Buy some equipment and computer programs Buy some office equipment, a server, banking database software, and a high-speed Internet connection. These items cost you $200,000. Table 12.2 shows Virtual College Bank’s Balance Sheet #2 Fall 2001 ECO 2013 Cobbe Ch 12 Page 2 of 8 12.1 HOW BANKS CREATE MONEY Accepting Deposits Your bank offers the best terms available and the lowest charges on checkable deposits. Deposits begin to roll in. You have accepted $120,000 of deposits. 12.1 HOW BANKS CREATE MONEY Table 12.3 shows Virtual College Bank’s Balance Sheet #3. Note how both assets and liabilities have increased by $120,000. 12.1 HOW BANKS CREATE MONEY Establishing a Reserve Account Establish a reserve account at local Federal Reserve Bank. Table 12.4 shows Virtual College Bank’s Balance Sheet #4 12.1 HOW BANKS CREATE MONEY Reserves: Actual and Required A bank’s required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Suppose that the required reserve ratio is 25 percent of total deposits. A bank’s required reserves are equal to its deposits multiplied by the required reserve ratio. So Virtual College Bank’s required reserves are: Required reserves = $120,000 x 25 ÷100 = $30,000. 12.1 HOW BANKS CREATE MONEY Actual reserves minus required reserves are excess reserves. Virtual College Bank’s excess reserves are: Excess reserves = $120,000 - $30,000 = $90,000. Reserves earn no income or revenue for the bank; therefore banks tend not to hold excess reserves, but to convert them into something that will earn them income, like loans. Whenever banks have excess reserves, they can make loans. 12.1 HOW BANKS CREATE MONEY Clearing Checks Virtual College Bank’s depositors want to be able to make and receive payments by check. Funds must move from an account at your bank to an account at another bank. In the process, one bank loses reserves and the other bank gains reserves. Figure 12.1 on the next slide shows how a bank clears a check. Suppose one of Virtual College Bank’s customers, Jay, writes a $20,000 check to someone [“Hal’s PCs”] who banks with First American Bank: Fall 2001 ECO 2013 Cobbe Ch 12 Page 5 of 8 12.1 HOW BANKS CREATE MONEY Table 12.7 shows Virtual College Bank’s Balance Sheet #7 The deposits that Virtual College created are now at some other banks in the system. 12.1 HOW BANKS CREATE MONEY <Limits to Money Creation When Virtual College creates money and its customers spend the new money, other banks receive reserves and have excess reserves. These banks now create money just like Virtual College did. At each stage the amount of new loans get smaller. 12.1 HOW BANKS CREATE MONEY When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. The amount loaned becomes a new deposit at another bank. The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves. At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits. Figure 12.3 on the next slide shows the multiple creation of bank deposits. 12.1 HOW BANKS CREATE MONEY 12.1 HOW BANKS CREATE MONEY <The Deposit Multiplier The number by which an increase in bank reserves is multiplied to find the increase in bank reserves. It is one divided by the required reserve ratio, because for that is the number of dollars in deposits that one dollar of reserves allows. Deposit multiplier = 1 Required reserve ratio 12.2 FED CONTROL OF MONEY SUPPLY In theory, the Fed has three tools for controlling the money supply: • Required reserve ratios • Discount rate • Open market operations Fall 2001 ECO 2013 Cobbe Ch 12 Page 6 of 8 12.2 FED CONTROL OF MONEY SUPPLY <How Required Reserve Ratios Work When the Fed increases the required reserve ratio, the banks must hold more reserves. To increase their reserves, the banks must decrease their lending, which decreases the quantity of money. When the Fed decreases the required reserve ratio, the banks may hold fewer reserves. To decrease their reserves, the banks increase their lending, which increases the quantity of money. Reality check … <The Fed does not use changes in the required reserve ratio as a tool of monetary policy in practice. <Why? Because it is too much of a “blunt instrument” – the changes it would induce would be too discontinuous and large, and would disrupt financial markets. E.g., if we go from say a 25% required reserve ratio to a 20% one, we change the amount of deposits permitted for each dollar of reserves from $4 [1/.25] to $5 [1/.2] – a sudden 20% increase, not a good idea. <Some other industrialized countries no longer bother with required reserve ratios at all; banks are not likely to want to run out of reserves – it would not be good for business – so their central banks just control total reserves available and regulate bank capital. 12.2 FED CONTROL OF MONEY SUPPLY <How The Discount Rate Works When the Fed increases the discount rate, the banks must pay a higher price for any reserves that they borrow from the Fed. Faced with a higher cost of reserves, the banks are less willing to borrow reserves. The banks must decrease their lending to decrease their borrowed reserves. So when the discount rate increases, the quantity of money decreases. 12.2 FED CONTROL OF MONEY SUPPLY When the Fed decreases the discount rate, the banks pay a lower price for any reserves that they borrow from the Fed. Faced with a lower cost of reserves, the banks are willing to borrow more reserves and increase their lending. The quantity of money increases. Reality check …. <We already saw [the Fed’s Balance Sheet] that in practice banks hardly borrow from the Fed at all – the amount of loans to banks on the Fed’s balance sheet is almost negligible. Banks don’t borrow from the Fed largely because the Fed is the ‘lender of last resort’ – one of the traditional roles of a central bank – so markets interpret a bank borrowing from the Fed as meaning nobody else will lend to it, that bank is in trouble. <Why then does the Fed bother to change the discount rate? Partly because it is a traditional means of signaling what the Fed wants to have happen to interest rates, partly to maintain the discount rate at the normal level compared to the Federal Funds Rate [half a point lower]. 12.2 FED CONTROL OF MONEY SUPPLY <How An Open Market Operation Works This is the Fed’s major policy tool, the one that really drives monetary policy. When the Fed buys securities in an open market operation, it pays for them with its IOU’s, newly created bank reserves and money. The banks can use their new reserves to create even more money. When the Fed sells securities in an open market operation, people pay for them with money and reserves, which are Fed IOU’s, so when the Fed gets them they disappear as reserves. Fall 2001 ECO 2013 Cobbe Ch 12 Page 7 of 8 12.2 FED CONTROL OF MONEY SUPPLY The Fed Buys Securities Suppose the Fed buys $100 million of U.S. government securities in the open market. What is going to happen is that the total quantity of reserves available to the banking system is going to increase by $100 million. The seller might be: • A commercial bank • The non-bank public 12.2 FED CONTROL OF MONEY SUPPLY Figure 12.4 shows what happens when the Fed buys securities from a bank. 12.2 FED CONTROL OF MONEY SUPPLY Figure 12.5 shows what happens when the Fed buys securities from the public. 12.2 FED CONTROL OF MONEY SUPPLY The Fed Sells Securities Suppose the Fed sells $100 million of U.S. government securities in the open market. This is the reverse of the Fed buying securities; when the Fed gets paid for the securities it has sold, the money [currency or commercial bank reserves] it is paid for them ceases to exist, and both assets and liabilities of the Fed decrease by the amount of securities it sold [which were initially an asset of the Fed]. The monetary base decreases. The reserves of the banking system decrease. 12.2 FED CONTROL OF MONEY SUPPLY <The Multiplier Effect of an Open Market Operation An open market purchase that increases bank reserves also increases the monetary base. The increase in the monetary base equals the amount of the open market purchase, and initially, it equals the increase in bank reserves. 12.2 FED CONTROL OF MONEY SUPPLY If the Fed buys securities from the banks, the quantity of deposits (and quantity of money) does not change. If the Fed buys securities from the public, the quantity of deposits (and quantity of money) increases by the same amount as the increase in bank reserves. Either way, the banks have excess reserves that they now start to lend.