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2. Depository Institutions
these are the banks that accept deposits and make loans
1
Now we see that this is not true; a central bank cannot directly
control either the actions of depository institutions or the actions
of the non-banking public.
so DEP = 0
the central bank uses the currency it prints to buy real assets
from the public
but the public will accept this paper currency only as long it
believes that other people will accept it in exchange
2
liabilities of a central bank → the paper currency it has issued
(the currency is an I.O.U. that must be re-paid in the future)
MS = BASE
this is the other extreme, where the public holds no currency and
keeps all money as bank deposits
3
so CU = 0
1. The currency that banks hold for the public is called “bank
reserves”
(if a bank does decide to keep 100 percent reserves, so that RES
= DEP, this is called “100 percent reserve banking”)
4
ROUND 1: checking account balances ↑ $ 100; banking
required reserves ↑ $ 10; banking excess reserves ↑ $90
...
→ [1 / 0.10] * $ 100
→ $ 1000
How do we know that this is the equation for the final change in
deposits?
→ 100 [1 / 0.10]
→ 100 [10]
Δ DEP = $ 1000
(1) banks get rid of all excess reserves because they are costly to
hold; so excess reserves = 0
(2) households do not hold any currency; if they did, the money
multiplier would die out quickly
STEP II: Banks hold reserves equal to (res * DEP) which must
equal the currency distributed by the central bank
7
STEP III: Solve for DEP and substitute
D. Bank Runs
1. Banks assume they will never have to pay out more than the
amount of their required reserve holdings
in the federal funds market, banks buy the required reserves they
are short, and other banks sell the excess reserves they are long
8
this is one contributing factor to the “credit freeze” of 2008:
banks no longer trusted each other and preferred to hold on to
excess reserves rather than risk lending them out
9
MS = the nominal money supply (M1)
MS = CU + DEP
BASE = CU + RES
10
4. To find the relationship between these two variables, we
algebraically manipulate the two equations
where
11
NOTE: As mentioned above, we usually assume er = 0, so this
term disappears from the denominator. While this has been true
historically, it no longer strictly applies. In the aftermath of the
Great Recession, banks now hold substantially higher levels of
excess reserves than they did prior to 2008.
and here we see that even though the central bank can directly
control the monetary base, because of the money multiplier it
cannot directly control the actual money supply in this type of
economy
12
(2) when cu = 0, the multiplier becomes [1 / res], the simple
money multiplier from before when all money is held as
deposits
F. Open-Market Operations
14
but this time, it fell because res ↑
one reason banks held more excess reserves (↑ res) is that the
Fed implemented a new policy: paying interest on reserves
SHOW SLIDES
1. History
the First Bank of the United States (1791) failed due to public
fears of centralized government power
15
the Second Bank of the United States failed on September 10,
1816, when President Andrew Jackson let its charter expire (this
was for political reasons: he and Nicholas Biddle, the Bank’s
President, hated each other)
2. Locations
16
the Federal Reserve System is divided into twelve geographic
regions
3. Responsibilities
4. Differences
New York Fed and Boston Fed lean much more toward
Keynesian views
18
years (which always expires mid-way through a U.S. President’s
term—far from election day)
policy “tools” are means through which the Fed can manipulate
the monetary base and/or the money supply
19
1. Open-Market Operations
(2) option B: maintain current policy stance (keep fed funds rate
at its current level)
2. Reserve Requirements
the Fed sets the minimum fraction of each type of deposit that a
bank must hold as reserves
this is a very powerful tool, and it is rarely ever used (only in the
event of a structural change in the banking system)
20
3. Discount Window Lending
the Fed uses the discount window to fill its role as Lender of
Last Resort
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(1) banks in good condition: they can take out a “primary credit
discount loan”
no questions asked
(2) banks not in good condition: they can take out a “secondary
credit discount loan”
this is a rare policy tool the Fed learned from Japan’s liquidity
trap of the 1990s
QE can only be used when the usual nominal interest rate target
is already at—or is very close to—the zero interest rate lower
bound
22
or, in more colorful language, when the Fed’s primary policy
tools are impotent
(1) the central bank can increase the amount of assets on its
balance sheet by printing significant amounts of (new) money
and buying securities in the open market
(2) the central bank can begin purchasing assets other than short-
term government bonds
in the United States since 2008, Ben Bernanke’s Fed is using all
three methods simultaneously
23
it’s still too early for us to see if this aggressive attempt at QE
policy was successful at reducing the severity of the Great
Recession
5. Other
this is a new tool that evolved from the financial crisis in 2008
the interest rate paid on reserves is a new tool that the Fed can
use to affect the amount of reserves that banks hold (and thus
affect the money supply)
(3) the Fed can impose credit controls on credit cards and
consumer loans
24
1. Intermediate targets, therefore, are variables the Fed cannot
directly control but that it can influence predictably
3. The Fed must choose only one target! The Fed cannot target
both the money supply and the fed funds rate simultaneously
why?
suppose that both the money supply and the fed funds rate were
too high (above target)
25
the Fed can either set a target of MS = $ 900b or a target of r = 5
percent, but it cannot have both because then the money market
would not be in equilibrium
4. Inflation Targeting
%ΔM+%ΔV=%ΔP+%ΔY
27
let’s assume that π = 2 % and growth = 3 % (their theoretically
“optimal” levels)
if they did this, then the Fed is forced to give up all discretionary
policy
(i) Find both real money demand and nominal money demand.
28
According to the quantity theory, (MD / P) = (Y / V), where (MD /
P) is real money demand. So, the real demand for money is
given by
MD = 2 * 2000 = 4000.
(ii) Suppose that the Federal Reserve sets the nominal money
supply at 6000. Using the quantity equation, what is the new
price level? Suppose now the money supply increases to 8000.
What is the new price level?
(MS / P) = (Y / V).
6000 / P = 12,000 / 6
P = 6000 / 2000 = 3.
8000 / P = 12,000 / 6
P = 8000 / 2000 = 4.
29
(iii) Suppose the quantity theory of money holds. If the growth
rate of real GDP is 3 percent per year, and the growth rate of the
nominal money supply is 10 percent per year, what is the rate of
inflation in this economy?
(Δ MS / MS) – (Δ P / P) = (Δ Y / Y) – (Δ V / V).
(Δ P / P) = 0.10 – 0.03
= 0.07
this is, in fact, the variable the Fed has targeted since the late
1980s
if the Fed picks a target range for the nominal (or real) interest
rate, then it manipulates the nominal money supply to hit the
target
the Fed follows this strategy when the main shocks in the
economy are “nominal” shocks
30
this means shocks to the LM curve via either the money supply
curve or money demand curve
why? because the Fed will have to continually change its target
for the Fed funds rate
31
while interest rates can change quickly, output (GDP) and
inflation barely respond during the first four months after the
change in money growth
the “interest rate channel,” the “exchange rate channel,” and the
“credit channel”
too many banks were lying about their losses (and their
holdings) on mortgage-backed securities
the result of this was that the IS curve kept shifting down and to
the left—again and again and again
33
this makes the “rules” of the central bank slightly more flexible
by allowing the central bank to respond to actual economic
conditions
where
34