Fall Semester ’10-’11 Akila Weerapana

Lecture 8: The Federal Reserve and the Monetary System

I. INTRODUCTION
• In today’s class, we will take a closer look at another key macroeconomic variable - the money supply. We will look at what economists mean when they talk about the “money supply”. We will also discuss the monetary system in the United States, in particular the roles played by the Federal Reserve and by the banking system. • Understanding the basics of the Fed and the banking system will prepare us for (eventually) doing a more sophisticated analysis of recent monetary policy decisions taken by the Fed as well as the widespread bank failures associated with the financial crisis in 2008. • After establishing the importance of money in the economy, we will (in the next lecture) provide a cautionary tale about how we can have too much of a good thing - in other words how can printing too much money be bad for the economy.

II. WHAT IS MONEY?
• Money can be anything that is widely accepted for conducting economic transactions, i.e. anything that eliminates the double coincidence of wants. Therefore the dollar bills in your wallet, gold, the stone money of Yap, cigarettes in WW II POW camps etc. are all considered to be forms of money. • Money is generally assumed to serve three functions in an economy. Money provides a 1. Store of value: butter or eggs would be a bad way to accumulate wealth! One of the primary advantages of metal coinage was the fact that they were long lasting with very limited wear and tear. 2. Medium of exchange: eliminates double coincidence of wants, i.e. the need for me to want what you have and for you to want I have. 3. Method of account: easier to price goods and services in terms of a single unit. Although this seems to serve the same purpose as the medium of exchange there are times when the two differ. One example is in countries with extremely high inflation: Chile had 2 currencies for a while, one of which was used as the unit of account and the other was used as the medium of exchange. Another example was during the transition to EMU when prices were denominated in Euros even though most countries still had their existing currencies. • A good used as money that also has an intrinsic value is known as commodity money: silver, gold, salt and cigarettes fall into this category. • Over time, we have moved away from commodity money to paper money. Paper money is easier to transport and were not subject to the vagaries of supply and demand of a particular commodity.

• Prior to the 20th century, paper money was by law linked to gold (the gold standard). Governments would specify a rate at which all paper money could be converted to gold. Increases in the stock of paper money could occur only with increases in government gold holdings. During the Civil War and the World Wars, more paper money was issued than could be backed by existing holdings of gold and the world has gradually moved away towards having currencies that are no longer commoditized. • If you look at a dollar bill notice that there is nothing that says it has any inherent value, e.g. that it is convertible to gold or silver or anything with intrinsic value. Instead it says that the note is “legal tender for all debts, public and private”. In other words, the U.S. dollar is valued simply because of its transactions use. • In today’s economy the definition of money is a fluid one, changing with innovations to the financial system. Even though you may think that “money” and “currency” (i.e. the notes in your wallet) are the same, the definition of money is broader than that. Typically economists refer to currency + bank deposits as money. This narrowest categorization of money is termed M1: categorized as currency (coins and dollar bills) and checking account balances held in banks by the public and by firms (traveler’s checks belong to this category but are very rarely used and hence constitute a very small portion of M1. • A somewhat broader measure of money is M2: which consists of M1 + savings deposits, time deposits (like CD’s which can not be accessed for a specific period of time) and other deposits where check writing is limited. Intuitively, the additional items in M2 are liquid (can be easily accessed and used for conducting transactions) but not quite as liquid as M1. Notice again that financial innovation is blurring the line between what is M2 and what is M1. • Currency is about 50% of M1 and a little over 10% of M2.

III. THE FEDERAL RESERVE
• The supply of paper money (currency) is controlled by governments, typically through an institution known as the central bank. In the United States, the Central Bank is the Federal Reserve. Even though newspapers couch the policy decisions of the Fed in terms of changes in interest rates, in reality, the Fed what the Fed really controls is the supply of money in the economy. • When the Fed wants to change interest rates, it does so by changing the supply of money in order to bring about the desired changes to the interest rate - this mechanism is not something we focus on in today’s class. We will defer that discussion to later in the semester. • The core of the Federal Reserve is the Federal Reserve Board also known as the Board of Governors which is located in Washington, D.C. The Board of Governors consists of 7 individuals, appointed to serve non-renewable 14-year terms by the President (with Senate confirmation). • The most important person on the Board of Governors is the Chairman of the Federal Reserve, who is appointed to a renewable 4-year term as Chair. The current Chair is Ben Bernanke, whose name is very prominent in the media. • In addition to the Board of Governors, there are a dozen regional Federal Reserve Banks located all around the country. The regional Feds are located in Atlanta, Boston, Chicago,

Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco and St. Louis. These Federal Reserve banks are each assigned a district - an area of the country it has responsibility over (in terms of monitoring economic conditions and regulating banks) • The primary entity within the Fed responsible for changing monetary policy is known as the Federal Open Market Committee (FOMC). The FOMC consists of the 7 members of the Board of Governors, the President of the New York Fed, and 4 other members chosen from the chairs of the regional Federal Reserve banks. • The FOMC meets about 6 times a year and these meetings are among the most eagerly awaited events of the year: many people on Wall Street can make or lose millions of dollars depending on the decisions of the Fed and they need to keep a close eye and try to predict what the policy actions of the Fed are likely to be. • In addition to changing the money supply, the Fed plays a critical role in the banking sector. First, it acts as a bank for banks: all banks are required to keep a certain fraction of their customer’s deposits at the Federal Reserve. This fraction is known as the required reserve ratio. Banks are also allowed to borrow from the Fed if they need money for some reason, such as an unexpected increase in customer withdrawals. The rate at which the Fed lends money to banks is known as the discount rate. • The Fed also acts as a clearing house for checks: when you write a check on your Bank of America account and the recipient deposits it into their Citibank account, it is the Fed that debits Bank of America’s account at the Fed and credits Citibank’s account. • The primary method that the Fed uses to change the money supply is through Open Market Operations: decisions to buy or sell government bonds. If the Fed wants to increase the money supply it will print up some currency and use the currency to buy government securities. If the Fed wants to decrease the money supply it will sell government securities from its existing collection in exchange for cash and pull that money out of circulation from the economy. • Even though open market operations are the primary tool via which the Fed can increase the money supply, there are two other strategies it can follow. One is by reducing the required reserve ratio: this will require banks to keep fewer reserves at the Fed and allow them to make more loans which, as we will soon see, will increase the amount of money circulating in the economy. • Lowering the discount rate is the third way the Fed can increase the money supply because this can make it easier for banks to borrow money from the Fed and make loans or to repay depositors.

IV. THE ROLE OF BANKS
• So the Fed can change the money supply in three ways: open market operations (the most common), changes in the reserve ratio and changes in the discount rate. All three policies change the quantity of reserves held by banks at the Fed, and lead to a change in the supply of money in the economy. • Recall that currency (which the Fed injects into or retracts from the economy) is only a relatively small part of the money supply. In order to influence the money supply, Fed

decisions to increase or decrease reserves have to affect the amount of deposits held in the banking sector as well. Banks play a critical role in how changes in reserves are transmitted through to deposits and by extension to the overall economy. • Banks are firms that act as financial intermediaries between savers (people who want to earn interest on the money they do not intend to use currently for consumption) and investors/borrowers (people who are willing to pay interest to borrow money to undertake spending projects that they do not currently have enough funds for). Banks make money by charging investors/borrowers a higher interest rate than they pay to the savers (also called depositors). • To understand the functioning of a bank, we need to think about its balance sheet. While recent examples have shown that bank balance sheets are notoriously opaque even for their own executives and board members, we will focus on very simple balance sheets to illustrate how policy decisions get transmitted to the economy. • The balance sheet is broken up into two sections: assets and liabilities. Assets are what the bank owns or is owed to banks, liabilities are what the bank owes to someone else. A simple bank balance sheet for Bank Alpha is given below. Bank Alpha’s Balance Sheet Assets Liabilities Loans 70 Deposits 100 Bonds 20 Reserves 10 • Note that the bank has taken in $100 of deposits, of which it has to hold $10 in reserves at the Fed. The banks assets are distributed across loans ($70), bonds ($20), and the reserves it holds at the Fed. • Now consider what happens when the Fed conducts an open market operation whereby it buys $10 in bonds from Bank Alpha in exchange for $10 put into the reserve account of Bank Alpha. • Bank Alpha’s balance sheet becomes Bank Alpha’s Balance Sheet Assets Liabilities Loans 70 Deposits 100 Bonds 10 Reserves 20 • However, Bank Alpha does not need to keep $20 in reserves at the Fed because it is only required to keep $10. This is especially the case since the Fed typically pays no interest on reserves. So it will turn around and make $10 more in loans to someone else in the economy. • Now, Bank Alpha’s Balance Sheet will be

Bank Alpha’s Balance Sheet Assets Liabilities Loans 80 Deposits 100 Bonds 10 Reserves 10 • The person who took out the $10 in new loans will use that money to purchase something, so that money will end up as a deposit at another bank, let’s call it Bank Beta. What will Bank Beta do with the $10 extra in deposits, well it will put $1 more into reserves and lend out the remaining $9 in loans. This $9 will become a deposit at Bank Chi, who will put $0.09 into reserves and lend out the remaining $0.81 and so on ad infinitum. • The end effect can be summarized by the following Table Deposit Expansion Bank Name Deposit Loans Bank Alpha 0 10 Bank Beta 10 9 Bank Chi 9 8.10 Bank Beta 8.10 7.20 . . . . . . . . . Overall Effect 100 100

Reserves 0 1 0.90 0.80 . . . 10

• So the overall impact of an open market operation that increases reserves by $10 is to raise deposits by $100. Notice that we can derive this mathematically as follows: the sum of a series, where the initial number is denoted by A and each subsequent number is some fraction α of the number before it, can be derived as follows by using a little mathematical trick. Let S denote this sum that we are trying to find

S = ( A) + ( α ∗ A) + ( α 2 ) ∗ A + ( α 3 ∗ A) + · · · Multiply both sides by α α ∗ S = ( α ∗ A) + ( α 2 ∗ A) + ( α 3 ∗ A) + ( α 4 ∗ A) · · · Subtract second series from the first S−α∗S = A ⇒ S (1 − α) = A ⇒S = A 1−α

• If we define rr to be the reserve ratio, in the above numerical example, at every stage when the bank received an additional dollar of deposits, it held on to a fraction rr and lent out a fraction (1 − rr). So each deposit was a fraction (1 − rr) of the preceding deposit, or equivalently α = (1 − rr). So subbing in we see that when the bank increases reserves by A, A A 1 then the money supply should increase by 1− α ≡ 1−(1−rr) ≡ rr .

• The magnitude of the increase in the money supply for each dollar increase in reserves is known as the money multiplier. In this example, where all new deposits are lent out as loans, and all new loan-financed expenditure ends up being deposited into a bank, the value 1 of the money multiplier is rr . • Note that in my simple set up, all the loans were being deposited into banks at each stage (i.e. no one was holding on to a fraction of the loans as currency), and banks always preferred to make loans rather than keep money in reserve. This is not always the case when there is turmoil in the financial markets and banks are unsure of who’s a credit risk and who is not. In such a case people may hold onto currency instead of depositing that currency into a bank, and banks may hold onto deposits in their reserve accounts rather than lending all the new deposits out. These would result in a smaller multiplier. This is a topic we will explore in much more detail later but its good to take note of now. • With a reserve ratio of 0.10, this implies that every $1 worth of open market operations will increase the amount of deposits by $10 and the amount of loans by $10. The magnitude of the increase in the money supply for each dollar increase in reserves is known as the money multiplier. In this example, the value of the money multiplier is 10. Thus the Fed can have a very large impact on the money supply via open market operations that change the quantity of reserves. Similarly, since banks are reluctant to hold non interest earning reserves, they are likely to make more loans with the excess reserves, which in turn helps stimulate economic activity as people use the loans they take out from banks to buy houses, vehicles, college degrees etc. • The bottom line is that money plays an important role in the economy by serving as a medium of exchange for economic transactions. The supply of money is influenced by two important entities, the Federal Reserve and the banks. The Federal Reserve can increase or decrease the supply of money by influencing the amount of reserves in the economy, typically via an open market operation but also by changing the required reserve ratio or by changing the discount rates. The banking sector, by adjusting their loans in response to the increases or decreases in reserves will end up affecting the overall money supply by an amount greater than the original change in reserves.

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