978-0132992282 Chapter 14 Lecture Note Part 1

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2. Depository institutions (banks) accept deposits and make loans

3. The public (people and firms) holds money as currency and coin or as bank deposits

B. The central bank (the Federal Reserve Bank in the United States) has a balance sheet showing

1. The sum of reserve deposits and currency (held by the nonbank public and by banks) is

called the monetary base or high-powered money.

2. Banks hold liquid assets called bank reserves

a. When bank reserves are equal to deposits, the system is called 100% reserve banking

b. But banks lend out some of their deposits, as only a fraction of reserves are needed to

meet the need for outflows

1. The most direct and frequently used way of changing the money supply is by raising or

lowering the monetary base through open-market operations

2. To increase the monetary base, the central bank prints money and uses it to buy assets in the

market; this is an open-market purchase

3. If the central bank wants to decrease the monetary base, it uses an open-market sale

Policy Application

Most of the use of open-market operations turns out not to be related to changes in monetary

policy at all, but rather to changes in money demand. There’s a seasonal component to money

1. The relationship between the monetary base and the money supply can be shown

algebraically

2. Let M  money supply, BASE  monetary base, DEP  bank deposits, RES  bank reserves,

CU = currency held by nonbank public, res  banks’ desired reserve-deposit ratio

3. The money supply consists of currency held by the public and deposits, so

M  CU  DEP (14.1)

4. The monetary base is held as currency by the public and as reserves by banks, so

BASE  CU  RES (14.2)

5. Taking the ratio of these two equations gives

M/BASE  (CU  DEP)/(CU  RES) (14.3)

6. This can be written as

M/BASE  [(CU/DEP)  1]/[(CU/DEP)  (RES/DEP)] (14.4)

7. The currency-deposit ratio (CU/DEP, or cu) is determined by the public

8. The reserve-deposit ratio (RES/DEP, or res) is determined by banks

9. Rewrite Eq. (14.4) as

M  [(cu  1)/(cu  res)]BASE (14.5)

10.The term (cu  1)/(cu  res) is the money multiplier

a. The money multiplier is greater than 1 for res less than 1 (that is, with fractional

11. The monetary base is called high-powered money because each unit of the base that is issued

leads to the creation of more money

1. If people think a bank won’t be able to give them their money, they may panic and rush to

withdraw their money, causing a bank run

2. To prevent bank runs, the FDIC insures bank deposits, so that depositors know their funds

are safe, and there will be no need to withdraw their money

1. The money multiplier during the Great Depression

a. The money multiplier is usually fairly stable, but it fell sharply in the Great Depression

b. The decline in the multiplier was due to bank panics, which affected the multiplier in two

ways

(1) People became mistrustful of banks and increased the currency-deposit ratio

2. The money multiplier during the financial crisis of 2008

a. The worldwide financial panic in fall 2008 caused the money multiplier to decline

sharply, especially because of a sharp rise in the reserve-deposit ratio (text Figure 14.3)

b. Banks wanted to hold more reserves because the Fed began paying interest on reserves

and because the Fed increased the monetary base significantly and banks had few good

1. The Fed began operation in 1914 for the purpose of eliminating severe financial crises

2. There are twelve regional Federal Reserve Banks (Boston, New York, Philadelphia,

Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and

San Francisco), which are owned by private banks within each district (text Figure 14.5)

Policy Application

What do the twelve Federal Reserve Bank do? First, they clear checks between banks and supply

3. The leadership of the Fed is provided by the Board of Governors of the Federal Reserve

System in Washington, D.C.

a. There are seven governors, who are appointed by the president of the United States,

and have fourteen-year terms

b. The chairman of the Board of Governors has considerable power, and has a term

4. Monetary policy decisions are made by the Federal Open Market Committee (FOMC),

which consists of the seven governors plus five presidents of the Federal Reserve Banks

on a rotating basis (with the New York president always on the committee)

a. The FOMC meets eight times a year

1. Balance sheet of Fed (text Table 14.2)

a. Largest asset is holdings of Treasury securities

b. Also owns mortgage-backed securities, federal agency debt, and gold, makes loans to

banks, and holds other assets including foreign exchange

2. The monetary base equals banks’ reserves plus currency held by the nonbank public

(text Figure 14.6)

3. The primary method for changing the monetary base is open-market operations

Policy Application

The FOMC generally votes on three options concerning immediate changes in policy: option A

to ease policy, option B to maintain the current policy stance, or option C to tighten policy. In

1. The Fed sets the minimum fraction of each type of deposit that a bank must hold as reserves

2. An increase in reserve requirements forces banks to hold more reserves, thus reducing the

money multiplier

Policy Application

Changes in reserve requirements are such a powerful tool that they aren’t used much. A small

1. Discount window lending is lending reserves to banks so they can meet depositors’

demands or reserve requirements

2. The interest rate on such borrowing is called the discount rate

Policy Application

3. The Fed was set up to halt financial panics by acting as a lender of last resort through the

discount window

4. A discount loan increases the monetary base

5. Increases in the discount rate discourage borrowing and reduce the monetary base

6. The Fed modified the discount window in 2003

a. Previously, the Fed discouraged banks from borrowing from the Fed and encouraged

them to borrow from each other in the Federal funds market

b. The interest rate in the Federal funds market is the Fed funds rate

c. The Fed funds rate is a market rate of interest, determined by supply and demand

1. In the financial crisis that began in 2008, the Fed began paying interest to banks on their

reserves held on deposit at the Fed

2. The interest rate paid on reserves is now a tool that the Fed can use to affect the amount of

reserves that banks hold and the money supply

1. An increase in res, cu, reserve requirements, or the interest rate on reserves has no effect on

the monetary base, decreases the money multiplier, and decreases the money supply

2. An open-market purchase, an increase in discount window borrowing, or a decrease in the

discount rate increase the monetary base, have no effect on the money multiplier, and

increase the money supply

Policy Application

The Fed has two other instruments, though they are seldom used. The Fed can set margin

1. The Fed uses intermediate targets to guide policy as a step between its tools or instruments

(such as open-market purchases) and its goals or ultimate targets of price stability and stable

2. Intermediate targets are variables the Fed can’t directly control but can influence predictably,

and they are related to the Fed’s goals

3. Most frequently used are monetary aggregates such as M1 and M2, and short-term interest

rates, such as the Fed funds rate

4. The Fed cannot target both the money supply and the Fed funds rate simultaneously

a. Suppose both the money supply and the Fed funds rate were above target, so the Fed

5. In recent years the Fed has been targeting the Fed funds rate (Figure 14.1; like

text Figure 14.8)