macro econ theory

CLASSICAL THEORY: THE ECONOMY IN THE LONG RUN The Monetary System (Ch 4)

• Definition, functions, and types of money

• How banks create money

• What is a central bank and how it controls the money supply

Money

• Definition: Money is the stock of assets that can be readily used to make transactions.

• Functions:

o medium of exchange: it is used to buy goods and services

o store of value: it transfers purchasing power from the present to the future

o unit of account: it is the common unit for measuring prices and values

Types of Money

1. Fiat money

• has no intrinsic value

• Example: paper currency

2. Commodity money

• has intrinsic value

• Examples: gold coins, cigarettes in P.O.W. camps

Money Supply and Monetary Policy

• Money supply is the quantity of money available in the economy

• Monetary policy is the control over the money supply.

• Monetary policy is conducted by a country’s central bank.

• The U.S. central bank is called the Federal Reserve (“the Fed”)

• To control the money supply, the Fed uses open market operations (the purchase and sale of government bonds)

Symbol Assets Amount in December 2016 (billions of dollars)

C Currency 1,419.8

M1 C + demand deposits, travelers' checks, other checkable deposits

3,328.9

M2 M1 + saving deposits (incl. money market deposit accounts), small-denomination time deposits, balances in money market mutual funds

13,184.8

Source: Federal Reserve. Amounts are seasonally adjusted

Banks and the Monetary System

• Money supply equals currency plus demand (checking account) deposits:

M = C + D

• Since the money supply includes demand deposits, the banking system plays an important role

Bank's Balance Sheet

• Bank's assets include reserves, outstanding loans, and financial securities

o Reserves (R) are bank's holdings of deposits in an account with the central bank. Loosely speaking, reserves are deposits that have not been lent

• Bank's liabilities include deposits and borrowings (debt)

• Bank’s equity (i.e., total assets less total liabilities) is called capital. This is the resources the bank owners have put into the bank

Bank's Balance Sheet

Assets Liabilities and Owners' Equity

Reserves Deposits

Loans Debt

Securities Capital

100-percent Reserve Banking vs. Fractional Reserve Banking

• 100-percent-reserve banking: a system in which banks hold all deposits as reserves

• Fractional-reserve banking is a system in which banks hold a fraction of their deposits as reserves.

Imagine three scenarios:

1. No banks

2. 100-percent-reserve banking (banks hold all deposits as reserves)

3. Fractional-reserve banking (banks hold a fraction of deposits as reserves, use the rest to make loans)

In each scenario, assume C = $1 billion

Scenario 1: No banks

C = $1b and D = $0

M = C + D = $1b.

Scenario 2: 100-percent-reserve banking • Initially

C = $1b and D = $0 M = C + D = $1b

• Assume all currency is deposited in a bank (say with owners' capital $0)

Bank's Balance Sheet Assets Liabilities and Owners' Equity

Reserves $1b Deposits $1b

Capital $0

• After the deposit

C = $0 and D = $1b, M = C + D = $1b

• 100%-reserve banking has no impact on money supply

Scenario 3: Fractional-reserve banking

• Assume banks hold 10% of the deposits in reserve, making loans with the rest

• Assume all currency is deposited in Bank 1 (as before, we ignore owners' capital)

• Bank 1 makes $0.9b in loans Bank 1's Balance Sheet

Assets Liabilities and Owners' Equity

Reserves $0.1b

Loans $0.9b

Deposits $1b

Capital $0

• If the borrowers hold $0.9b in currency, then M = C + D = $0.9b + $1b = $1,9b

• In fractional-reserve banking, banks create money

Scenario 3: Fractional-reserve banking (continued) • Assume the borrowers deposit the $0.9b in Bank 2 (alternatively, they can

spend the money to buy something from someone who then deposits the money in Bank 2)

• Bank 2 keeps 10% of the money in reserve and make loans with the rest

Bank 2's Balance Sheet Assets Liabilities and Owners' Equity

Reserves $0.09b

Loans $0.81b

Deposits $0.9b

Capital $0

• If the borrowers hold $0.81b in currency, then M = C + D = $0.81b + $0.9b + $1b = $2,71b

• Then, if $0.81b is deposited in Bank 3, the process goes on.

Scenario 3: Fractional-reserve banking (continued)

• The process can continue forever:

o Let rr be the reserve-deposit ratio, i.e., the proportion of deposits that each bank keeps in reserve.

o In other words, the bank lends a proportion (1 − rr) of its deposits

o In our example, the initial deposit in Bank 1 is $1b and rr = 0.10

o Bank 1 lends (1 − rr) x $1b = (1 − 0.10) x $1b = $0.9b

o Bank 2 lends (1 − rr)2 x $1b = (1 − 0.10) x $0.9b = $0.81b

o and so on

Total money supply =

$1b + $0.9b + $0.81b + $0.729b + ... =

$1b + (1 − 0.10) x $1b + (1 − 0.10)2 x $1b + (1 − 0.10)3 x $1b + ... =

$1b x [1 + (1 − 0.10) + (1 − 0.10)2 + (1 − 0.10)3 + ...] =

$1b x (1 / 0.10) =

$1b x 10 = $10b

Total money supply = Initial deposit / rr

Note: Banks create money, but not wealth. Bank loans give borrowers some new money and an equal amount of new debt.

Bank Capital and Leverage

• Leverage is the use of borrowed money to supplement existing funds for the purposes of investment

• Leverage ratio = bank's assets / bank's capital

• Being highly leveraged makes banks vulnerable.

Remember that bank's capital is bank's assets less bank's liabilities. Say, assets are $1b and liabilities are $0.9b, so bank's capital is $____.

Bank's leverage ratio is ____.

Now, imagine that a recession leads to a 10% decrease in the value of bank’s assets, i.e., bank assets become $____. Assume bank's liabilities stay the same. Then, bank's capital goes down to $____, i.e., decreases by ____%.

Exercise: A bank's leverage ratio is 5. Assume bank's assets change by k percent, while bank's liabilities remain unchanged. What is the percentage change in bank's capital?

Bank Capital and Leverage (continued)

• Example: The 2008-2009 financial crisis

o Losses on mortgages shrank bank capital, slowed lending, and exacerbated the recession.

o The government injected billion dollars of capital into banks to ease the crisis and encourage more lending.

• Capital requirement

o minimum amount of capital mandated by regulators

o intended to ensure banks will be able to pay off depositors

o higher for banks that hold more risky assets

A Model of Money Supply

Exogenous Variables:

• Monetary base, B = C + R

o controlled by the central bank

• Reserve-deposit ratio, rr = R / D

o depends on regulations and bank policies

• Currency-deposit ratio, cr = C / D

o depends on households’ preferences

Solving for the Money Supply

We want to express money supply M as a function of exogenous variables.

Money supply is defined as: M = C + D. We have just defined the monetary base as B = C + R. Then:

= + = + = ++ = ++ = + 1+ ⇒ =

We define the money multiplier as = Then, M = m x B

• The money multiplier is the increase in the money supply resulting from a one-dollar increase in the monetary base

• Example:

Imagine that the monetary base B equals $1b, the reserve-deposit ratio rr is 0.10 and the currency-deposit ratio cr is 0 (households deposit all their currency).

Then, the money multiplier = = . = 10, so the money supply equals 10 x $1b = $10b

M = m x B, where = Note:

• If rr < 1, then m > 1 • If the monetary base changes by ΔB, then ΔM = m × ΔB • If rr decreases, banks make more loans, i.e., create more money for each

dollar in reserves, which increases the money multiplier and so raises the money supply

• If cr decreases, households hold a lower proportion of the monetary base as currency, i.e., they deposit more of their money into the banks, and so banks can make more loans thus creating more money. Therefore, a decrease in cr raises the money multiplier and increases the money supply.

Monetary Policy Instruments

• The Fed can change the monetary base using:

o open market operations (preferred method)  To increase the base, the Fed could buy government bonds,

paying with new dollars

o the discount rate: the interest rate the Fed charges on loans to banks  To increase the base, the Fed could lower the discount rate,

encouraging banks to borrow more reserves.

o other instruments:  Term Auction Facility  Overnight reverse repurchase (repo) agreements (ON RRPs)

conducted by the Open Market Trading Desk

Monetary Policy Instruments (continued)

• The Fed can change the reserve-deposit ratio using

o reserve requirements: Fed regulations that impose a minimum reserve-deposit ratio

 To decrease the reserve-deposit ratio, the Fed could reduce reserve requirements

o interest on reserves: the interest paid on bank reserves deposited with the Fed

 To decrease the reserve-deposit ratio, the Fed could pay a lower interest rate on reserves

Why the Fed can’t precisely control M?

M = m x B, where =

• Households can change the currency deposit ratio (cr) causing m and M to change

• Banks often hold excess reserves (reserves above the reserve requirement). If banks change their excess reserves, then rr would change causing m, and M to change

Quantitative Easing

• Quantitative easing: the Fed bought long-term government bonds instead of T-bills to reduce long-term rates.

• The Fed also bought mortgage-backed securities to help the housing market.

• But after losses on bad loans, banks tightened lending standards and increased excess reserves causing the money multiplier to fall.

• Some economists feared that if banks start lending more as the economy recovered, rapid money growth might cause inflation. To prevent this, the Fed considered various exit strategies.

U.S. Monetary Base and M1

• From August 2008 to August 2011, the monetary base tripled, but M1 grew only by about 40%.

Bank failures in the 1930s

• From 1929 to 1933, over 9,000 banks closed and the money supply fell by 28%

• This drop in the money supply may not have caused the Great Depression, but certainly contributed to its severity

M = m x B, where =

• Loss of confidence in the banks increased cr and thus reduced m

• Banks became more cautious, which increased rr and thus reduced m

August 1929 March 1933 % change

M 26.50 19.00 -28.30 C 3.90 5.50 41.00 D 22.60 13.50 -40.30

B 7.10 8.40 18.30 C 3.90 5.50 41.00 R 3.20 2.90 -9.40

m 3.70 2.30 -37.80 rr 0.14 0.21 50.00 cr 0.17 0.41 141.20

Bank failures in the 1930s: Could this happen again?

• Many policies have been implemented since the 1930s to prevent such widespread bank failures.

• For example, Federal Deposit Insurance to prevent bank runs and large swings in the currency-deposit ratio.