Intermediate Macroeconomic Theory
Topic Six
Review of Money and the FED
Money:
Barter:
Who Invented Money?
Spontaneous Evolution of Commodity Money:
Characteristics of a “good” money:
Functions of money:
Commodity Money vs. Fiat Money:
1. The central bank is responsible for monetary policy
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
A trading system based on barter is inconvenient – commodity money emerges
Fiat money emerges from commodity money and then a central bank comes along (the last is not a spontaneous process, but a political one):
The central bank uses money it prints to buy real assets from the public; this gets money in circulation
People accept the paper money if they believe other people will accept it in exchange
The government often decrees that the paper money is legal tender, so that it can be used to pay off debts and the government will accept it for tax payments
The central bank's assets are the real assets it buys from the public; its liabilities are the paper money it issued
That money is called the monetary base, or high-powered money
In an all-currency economy, the money supply equals the monetary base
1. As an economy becomes more sophisticated financially, banks develop
2. If currency is easily lost or stolen, people may want to hold all their money in bank deposits and none in currency
3. The currency that banks hold is called bank reserves
When bank reserves are equal to deposits, the system is called 100% reserve banking
To make money, banks would have to charge fees for deposits, since they earn no interest on reserves
4. Rather than holding reserves that earn no interest, suppose a bank lent some of the reserves
It could do this, since the flow of money in and out of the bank is fairly predictable and only a fraction of reserves are needed to meet the need for outflows
f the bank needs to keep only 25% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 75%
The reserve-deposit ratio would be 25%
When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking
5. When all the banks catch on to this idea, they will all make loans as the economy undergoes a multiple expansion of loans and deposits (money multiplier)
6. The money multiplier depends on the reserve ratio to deposits and the currency ratio to deposits:
a. The currency-deposit ratio (CU/DEP, or cu) is determined by the public
b. The reserve-deposit ratio (RES/DEP, or res) is determined by banks. The multiplier decreases when either cu or res rises.
.
1. The Fed began operation in 1914 for the purpose of eliminating severe financial crises (lender of last resort)
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)
3. The leadership of the Fed is provided by the Board of Governors in Washington, D.C.
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)
The FOMC meets eight times a year
It may meet more frequently if economic developments warrant
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.
a. If the central bank wishes to increase the money supply by 15%, it purchases 15% more assets and its liabilities increase by 15%, which is the currency it issues
b. To decrease the monetary base, the central bank sells assets in the market and retires the money it receives; this is an open-market sale
c. For a constant money multiplier, the decline or fall in the monetary base of 15% is matched by a decline or fall in the money supply of 15%
2. Reserve requirements
The Fed sets the minimum fraction of each type of deposit that a bank must hold as reserves
An increase in reserve requirements forces banks to hold more reserves, thus reducing the money multiplier
3. Discount window lending
Discount window lending is lending reserves to banks so they can meet depositors' demands or reserve requirements
The interest rate on such borrowing is called the discount rate
The Fed was set up to halt financial panics by acting as a lender of last resort through the discount window
A discount loan increases the monetary base
Increases in the discount rate discourage borrowing and reduce the monetary base
The Fed discourages banks from borrowing from the discount window frequently
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 economic growth
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. In recent years the Fed has been targeting the Fed funds rate
1. The AD/AS model makes monetary policy look easy—just change the money supply to move the economy to the best point possible
In fact, it isn't so easy because of lags in the effect of policy and uncertainty about the ways monetary policy works
2. Lags in the effects of monetary policy
It takes a fairly long time for changes in monetary policy to have an impact on the economy
Interest rates change quickly, but output and inflation barely respond in the first four months after the change in money growth
These long lags make it very difficult to use monetary policy to control the economy very precisely
Because of the lags, policy must be made based on forecasts of the future, but forecasts are often inaccurate
The Fed under Greenspan has made preemptive strikes against inflation based on forecasts of higher future inflation
3. The channels of monetary policy transmission
Exactly how does monetary policy affect economic activity and prices?
1. The interest rate channel: a decline in money supply raises real interest rates, reducing aggregate demand, leading to a decline in output and prices
2. The exchange rate channel: in an open economy, tighter monetary policy raises the real exchange rate, reducing net exports, and thus aggregate demand
3. The credit channel: tighter monetary policy reduces both the supply and demand for credit
Monetarists and classical macroeconomists advocate the use of rules. According to Monetarists:
Rules make monetary policy automatic, as they require the central bank to set policy based on a set of simple, pre-specified, and publicly announced rules
Examples of rules
Increase the monetary base by 1% each quarter
Maintain the price of gold at a fixed level
The rule should be simple; there shouldn't be much leeway for exceptions
The rule may also permit the Fed to respond to the state of the economy
Discretion means the central bank looks at all the information about the economy and uses its judgment as to the best course of policy
Discretion gives the central bank the freedom to stimulate or contract the economy when needed; it is thus called activist
Since discretion gives the central bank leeway to act, while rules constrain its behavior, why would anyone suggest that the central bank follow rules?
Milton Friedman has argued for many years (since 1959) that the central bank should follow rules for setting policy
Friedman's argument for rules comes from four main propositions
Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the longer run, however, changes in the money supply have their primary effect on the price level
Proposition 2: Despite the powerful short-run effect of money on the economy, there is little scope for using monetary policy actively to try to smooth business cycles
Proposition 3: Even if there is some scope for using monetary policy to smooth business cycles, the Fed cannot be relied on to do so effectively
Proposition 4: The Fed should choose a specific monetary aggregate (such as M1 or M2) and commit itself to making it grow at a fixed percentage rate every year
Inflation targeting
Since 1990, some countries have switched from targeting money growth to targeting inflation
New Zealand was the pioneer, announcing explicit inflation targets that had to be met or else the central bank's governor could be fired
Canada, the U.K., Sweden, Australia, Spain, and others followed with some version of inflation targeting
The new European Central Bank uses a method of inflation targeting that retains a role for money-growth targets
Under inflation targeting, the central bank announces targets for inflation over the next 1 to 4 years
Advantages of inflation targeting over money-growth targeting
It avoids the problem of instability in money demand
It's easy to explain inflation targets to the public (since they understand what inflation is) than money-growth targeting (which most people don't understand)
Better communication of the central bank's goals will reduce uncertainty about what the central bank will do and may increase the bank's accountability
Disadvantages of inflation targeting relative to money-growth targeting
Inflation responds to policy actions with a long lag, so it's hard to judge what policy actions are needed to hit the inflation target and hard for the public to tell if the central bank is doing the right thing
(Thus central banks may miss their targets badly – creating more problems for the economy.
The Case for NOT having a Central Bank:
There are economists who don’t believe a central bank is necessary or even desirable. That central banks have caused more harm than good – even depressions.
Alternatives:
Free Banking (Competing Currencies)
The Gold Standard