Money and Banking Final

6 monetary policy goals of the fed

1. price stability 2. unemployment 3. economic growth 4. stability of financial markets and insitutions 5. interest rate stability 6. forex market stability

post 08 monetary tools

1. QE: goal is to simulate the economy buy buying/selling lg term securities 2. fwd guidance: statements by fomc about how it will conduct policy in future 3. administrative rates 4. quantitively tightening

Economic power w/in the Fed reserve system divided

1. among bankers and business matters 2. among states and regions 3. between gov and private sector

what defines a central bank

1. bankers bank 2. monopoly issuer of currency notes 3. regulator of commercial banks 4. lender of last resort 5. conductor of monetary policy current FED plays all 5 roles

4 groups within fed reserve system

1. fed reserve banks 2. private commercial member banks 3. board of governors 4. FOMC

modern lender of last resort

1. supply additional bank reserves as needed (to keep money supply/total spending from shrinking) 2. announce readiness to do so (helps reduce public demand for cash) do NOT rescue insolvent banks

weak US banking system 1863-1913

1. virtual cap on note-issue led to reserve drains when currency demand peaked ("crop-moving" season) 2. tiered reserve requirements interbank deposits, so reserve drain spread to city banks 3. branching restrictions reduced diversification, so solvency assurances weak - local banks make similar loans contagion effects

what determines nominal money demand

1. volume of planned spending, which depends on nominal income Y 2. interest opportunity cost of holding money: the extra interest you could be earning on non-M1 assets (bonds, MMMFs) 3. the per-transaction cost of shifting funds between M1 and non-M1 assets, which influences

simple deposit multiplier

1/RR Ratio of the amount of deposits created by banks to the amount of new reserves 2 key assumptions: bank hold no excess reserves, nonbank public does not increase holdings of currency

FOMC

12 member fed reserve committee directs open market operations (chair, fed governors, 5/12 fed reserve bank presidents) NY president always a member meet 8 times in DC take formal vote to set target for fed funds rate and summarizes views in public statement of balance of risks between higher inflation and weaker economy formal authority over monetary policy fed sets the range for rate and manager for domestic Open mrkt ops carries out by buying/selling treasuries with primary lenders

Fed reserve act

12 regional banks to furnish an elastic currency act as lenders of last resort Lender of last resort 1. lend freely to all banks that qualify 2. announce readily to lend freely 3. to qualify must be solvent 4. lend at penalty rate the fed failed to do 1&2 during great depression the fed failed at 3&4 in 2008 crisis

fed funds rate target

=current inflation + equilibrium real fed funds rate+ (1/2 * inflation gap) +(1/2* output gap) if inflation> fed target rate--fomc will increase fed funds rate output gap<0 ; real gdp < potential gdp--fomc will decrease target for fed funds rate

aggregate demand curve

A downward-sloping curve because as price level increases expenditure on goods/services decreases equilibrium=real gdp and price level changes in AD: C, I, G, NX

Abundant Reserve System Pros

Administered rates—(RP, IORB, ON RRP—now control i ∗ FFR Fed can engage in LSAP without effecting i ∗ FFR No need to taper before engaging in further policy More tools at Zero Lower Bound (LZB

increase/decrease in Money supply

Money supply increases: if monetary base/multiplier increase increase in (c/d)/req reserves/(ER/D)--> decrease in money multiplier-> decreases in money supply

Banks have Adjusted to New Level of Reserves

Bank Supervisors tell Banks to Hold X amount of Reserves Banks normalize X value X Amount no Longer Feels Like "Extra" Demand for Reserves Increases

Okun's Law

Empirical relationship between unemployment and output. Yt = -2(ut - u ∗ t ) where Y t = Output gap ut = Unemployment rate u ∗ t = Natural rate of unemployment

currency in M1

currency in circulation - vault cash

M1 and monetary base

Currency + deposits base= currency + reserves fed controls the monetary base currency and bank reserve bank determines the volume of checkable deposits per dollar of reserves public determines the split between

propositions to end weak us banking system 1894 (ultimately led to Fed reserve act) ABA

Deregulation was possible remedy 1. Deregulation of note-issue, like Canada (to end seasonal reserve drains) 2. Branch banking, like Canada (reduce interbank deposits, ◦ improve loan diversification, redemption points for any excess notes) reforms proposed by ABA, but not adopted - ABA's "Baltimore Plan" 1894 (emulate Canadian banking) - blocked by small bank lobby: branching a threat to them • Instead the Federal Reserve Act, 1913

real interest rates

Distinction between real and nominal interest rates is important •Real interest rate = Nominal rate - Inflation rate r = i - π High real interest rates discourage borrowing and spending; low rates encourage them

The Standing Repo Facility (SRF)

Established July 2021 Provides a backstop in the money market to help maintain control of the i ∗ FFR Hard ceiling on i ∗ FFR Needed because reserves may not be as abundant as the Fed thought Banks can borrow as much as they want at the Repo Rat

Fed earnings come from

Fed financial independence allows it to resist external pressure contribute to treasury rather than receive funds from treasury earnings come from: interest on securities it holds, interest on discount loans, fees it receives from check-clearing and services

Equilibrium FFR

Occurs where S = D on the Flat Part of the Demand Curve Shifts in Supply: Changes in Reserves by Fed Shifts in Demand: Changes in Administered Rates, Changes in Reserve Requirements ,Changes in Market Conditions

changes in Aggregate demand

affect inflation output and employment

Money supply affects determined by behaviors of 3 groups

affects: i rates, inflation, exchange rates, economy output of G+S 3 groups: Fed reserve, banking system (banks), nonbank public (depositors) fed reserve: control M supply & regulates banking system banks: creates checking accounts components of M1 measure of M supply depositors: how wish to hold their money currency/check account deposits

If M supply> money demanded (MD)

as individuals spend more money to get rid of unwanted M1 prices rise, raising nominal income Y and thereby nominal money demanded will once again rise to gain equilibrium

The feds balance sheet

assets: (most important are treasuries and discount loans) mortgage back sec, repos, loans, gold liab/equity: reserves, fed reserve notes (cash), repos earn i on assets pays i on deposits difference covers expenses left overs remitted to treasury

how the FDIC works

banks pay premiums (taxes) into the FDIC FDIC uses funds to save insolvent banks (pays depositors what the bank cannot) FDIC either liquidates the banks arranges a purchase and assumption liquidation/payout: FDIC pays insured depositors sells assets (uninsured depositors get a haircut) purchase& assumption: FDIC sells the bank as going concern, sells/pays to assume the liabilities (no depositors takes losses) liquidation is cheaper in the long run whole bank purchase and assumption takes less FDIC cash political pressure favors P&A

how the fed changes monetary base

buying/selling treasury securities/ making discount loans to banks adjusting the reserve requirements or i paid on reserves fed has greater control over open market operations than discount loans (banks decide whether to borrow from fed) - has some control bc it sets the discount rate willing to buy/sell at any price to carry out operation successfully

MPC (marginal propensity to consume)

change in consumption/change in income If MPC=0.90 households spending $0.90 if every additional USD they earn

board of directors of fed reserve bank

class a: bankers elected. class b: 3 leaders in industry, commerce and agriculture class c: 3 public interest directors

clean bank/whole bank

clean bank: FDIC retains and sells the banks dubicous assets whole bank-purchaser takes assets as well sometimes with the FDIC value guarantee

direct monetary policy/indirect

direct: making discount loans indirect: membership on fomc

potential benefits/drawbacks of central bank

drawbacks: moral hazard by banks counting on LOLR , poorly run monetary policy (higher inflation, boom-bust cycles, especially a problem in LDCs) benefits: ender of last resort to remedy spillover effects of bank runs, panics, well run monetary policy

goods market

equilibrium= value of goods demanded=value of goods produced value of goods demanded=real GDP AE>real gdp--economy is in expansion AE< Real GDP--economy is in recession

duel mandate of fed

full employment and stable prices full employment (u=u*) stable prices (inflation around 2%) established with the fed reserve reform act 1977 slightly reduced their independence

Shifts in the Phillips Curve

increase in the natural rate of unemployment: Curve shifts up. Decrease in the natural rate of unemployment: Curve shifts down increase in inflation expectations Curve shifts up. Decrease in inflation expectations: Curve shifts down. positive Supply shocks: Curve shifts down. Negative supply shock: Curve shifts up

interest on bank reserves balances as monetary tool

increase on interest it pays on reserves-> increase in reserves->restrains banks ability to lend loans-> increases money supply interest rate fed pays put a floor on short term i rates->banks wont lend lower than fed i rate

shifts in AD curve (left)

increase: household saving rate, income taxes/business taxes

shifts in AD curve (right)

increase: nominal Money supply, households expected future income, expected future profitability of capital, gov purchases, foreign demand for US goods

actions carried out by the "the desk"

info gathering to determine interest rates open market operations quantitive easing/tightening repurchase agreements/reverse repurchase agreements

Channels of Monetary Policy

interest rate channel Bank lending channel (commercial banks) Bank lending channel (shadow banks) Balance sheet channel

3 theories of how the Fed acts

public: central bank decision making that holds that officals act in the best interest of the people principal agent: central bank decision that holds that officials maximize their personal well-being rather than of general public political business cycle: policymakers will urge the fed to lower i rates to stimulate the economy right before an election

output gap

the percentage difference between actual aggregate output and potential output during recession output gap is negative bc real GDP< Potential gdp if ouput gap is negative FOMC will lower target for fed funds rate Positive gap: Actual output > Potential output. Negative gap: Actual output < Potential output

monetary policy

tools-> instruments-> targets-> goals targets: monetary aggregates (base,M1, M2) & Interest rates (fed funds rate, SOFR, risk free rate, mortgage rates) instruments: reserves, fed funds rate, admin rates discount rate, overnight reverse repos)

arguments against independence of fed

undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. too technical counterargument: so is national security and foreign policy which is entrusted to elected officials fed hasn't always used its independence well benefit from coordinating monetary policy with gov tax and spending policy

how the fed is not completely insulated

1. president can exercise control over membership of board of governors 2. fed remains creation of congress--so congress can amend feds charter and power or abolish it entirely 3. require consent of treasury secretary b4 it was able to implement some policy initiatives

money supply curve

M1 determined entirely on the supply side implies a vertical M S curve vertical axis: purchasing power of the money (1/P) or "goods per dollar" horizontal axis: M1 money stock supply

Money supply with 0 required reserve ratio

M= {(C/D)+1/(C/D)+(R/D)}*B fed can set the value of nonborrowed base but behavior of public influences money supply

Aggregate expenditure

The sum of spending by households, planned spending by business firms, the government, and net exports AE=C+I+G+NX

Bank lending channel (commercial banks)

Focuses on bank loans Monetary expansion: increases banks' ability to lend to bank-dependent borrowers, causing aggregate expenditure to increase Monetary contraction: decreases banks' ability to lend to bank-dependent borrowers, causing aggregate expenditure to decrease

Interest rate channel

Focuses on interest rates Monetary expansion: lowers interest rates, causing aggregate expenditure to increase Monetary contraction: raises interest rates, causing aggregate expenditure to decrease

Bank lending channel (shadow banks)

Focuses on the ability of money market mutual funds to purchase commercial paper issued by firms Monetary expansion: lowers interest rates, which may lead investors to sell shares in money funds, thereby reducing the ability of the funds to purchase commercial paper Monetary contraction: raises interest rates, which may lead investors to purchase shares in money funds, thereby increasing the ability of the funds to purchase commercial paper

Balance sheet channel

Focuses on the link between the net worth and liquidity of households and firms and their spending Monetary expansion: increases net worth and liquidity, causing aggregate expenditure to increase Monetary contraction: decreases net worth and liquidity, causing aggregate expenditure to decrease

IS curve

Investment/Spending Curve Shows combinations of interest rates and real GDP that represent equilibria in goods and money market where aggregate expenditure equals real output (AE = Y). • Shows relationship between interest rates and real output Downward sloping in r, Y space: Higher interest rates decrease output; lower rates increase it Changes in the real interest rate move you along the curve Demand shocks shift the curve ◦ Changes in C + I + G + NX

Abundant Reserve System Cons

Large financial footprint Demand for reserves can adjust, causing issues Requires an expansion of counter parties to soak up reserves Larger staff needed to implement Political Economy Concerns (Fed as a "Piggy Bank") Reduction in Market Driven Intermediation Death of Inter-bank Market - Lack of Monitoring

Scarce Reserve System Cons

Limited control at Zero Lower Bound (ZLB) Required tapering to shrink the balance sheet after LSAP

how does the fed help fund gov spending

Open market purchase: decreases publicly held debt and increases monetary base treasury sells new bond: increase publicly held debt, increases gov spending so net of both transactions: increase in gov spending, increase in monetary base

connection to money multiplier

Pre-08: ↑ Base ⇒ ↓ fed funds interest rate & ↑ B ⇒ ↑ M1 Post-08: ↑ Base and ↑ interest on reserve balances ⇒ ↑ excess &↑ Base and ↑ excess ⇒ we dont know what type of change to M1

The MP Curve

Represents the stance of monetary policy. The Fed sets nominal interest rates (via administered rates) The Fed influences real rates by changing nominal rates The Fed aims for a real rate but uses a nominal rate

Okun's Law and the Phillips Curve

Rewriting the Phillips curve with Okun's Law Formula: π = π e + bY t - s • Relates inflation rate (π) to the output gap (Yt ) and supply shocks (s).

Scarce Reserve System Pros

Small Financial Footprint Effective Control of Federal Funds Rate • Small Staff to Operate • Limited Political Economy Concerns ◦ Changes to size of balance sheet impacted economy ◦ Fed could refuse to be a "piggy bank" due to dual mandate • Active Inter-bank Market - Strong Monitoring Incentive

Philips Curve

Theme of trade-offs in economics: Balancing inflation and output π = π e - α(u - u ∗ ) - s π = Inflation rate π e = Expected inflation rate α = Constant (unemployment gap impact on inflation) u = Actual unemployment rate u ∗ = Natural rate of unemployment s = Supply shock Trade-off between inflation and unemployment. Higher-than-expected inflation: Lower unemployment. Lower-than-expected inflation: Higher unemployment. Inflation changes move the economy along the curve.

opportunity cost of holding M1

larger interest differential makes it more costly to hold money, reducing k T-bill interest rate can be regarded as the opportunity cost Thus k, the fraction of a year's income desired to be held in money balances, falls as the interest rate on T-bills rises money demand is interest-sensitive

clearinghouse association pre fed duties

made last resort loans issued additional currency (illegally) coordinated suspensions of convertibility

primary function fo 12 district banks

make discount loans to member banks in its regions loans provide liquidity fulfilling in a decentralized way system role each fed reserve bank is private-gov joint venture other duties: manage check clearing system in pmt system, manage currency in circulation by issuing new fed reserve notes and withdrawing destroyed notes from circulation, supervisory and regulatory functions, serve on FOMC

making an account non-run prone

modify any 1 of the three conditions 1. not debt--equity claim like MMMF "no me first problem" 2. conditional redeemability (notice of w/drawl clause) 3. solvency assurances: adequate capital advertised diversified portfolio

Monetary base and money supply

monetary base= currency in circulation + reserves of banks money supply =monetary base * money multiplier M=m*b M= ((c/d)+1/(c/d)+rr+(ER/d)*B reserve deposits are assets for banks liabilities for fed

national v state banks

national banks: chartered from fed gov were required to join state banks (commercial) charter from state gov were NOT required to join

Dodd-Frank Act

new regulatory responsibilities for the fed restrictions on feds role as lender of last resort created Vice chair for supervision and GAO audit of emergency lending

multiple deposit creation

part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits and an increase in the money supply that is a multiple of the initial increase in reserves

Interbank Loans

possible fix even with run-prone deposit contract need immediate info on whether the borrowing bank is solvent if bank worth saving profit can be made by the lender

sticky prices in short run

prices adjust slowly in response to change in AD firms adjust their production levels to meet new level of D w/out changing their prices increase in price level->increase firm profit in short run->increases output larger proportion of firms in the economy with sticky prices--flatter SRAS curve is

debate over FDIC 1933

pro: remedy to bank runs, argued by weaker rural banks FDIC allows them to compete more easily by making all banks look equally safe to depositors against: moral hazard problem, encourages bad banking

opportunity cost on banks (with joining fed reserve system)

state banks often choose not to join fed reserve system bc costly fed historically didn't pay interest on required reserves seen as tax since banks lost interest they could have earned by lending funds

arguments for independence of fed

subjecting it to more political pressures would impart an inflationary bias to monetary policy. monetary policy is too technical for elections to determine frequency of elections cause politicians to be concerned with short term benefits w/out regard to lg term costs increase likehood of political business cycle fluctuations in MS and irates gov officials pressuring ctrl banks to buy bonds primary cause of inflation

Floor system-post 08

switch from corridor to floor system/abundant reserve system Equilibrium in the Federal Funds Market Determines iFFR - Supply is Abundant • Demand is Flat • Intersection at "Floor" Changes in Balance Sheet ̸= Changes in iFFR Changes in i ∗ FFR are Driven by Changes in the Floor (i IORB)

The Taylor Rule

t = r ∗ + πt + 0.5(πt - π ∗ ) + 0.5(Yt - y ∗ ) it = Nominal interest rate r ∗ = Natural rate of interest πt = Inflation rate π ∗ = Target inflation rate Yt = Real output y ∗ = Target real output

board of governors

the governing board of the Federal Reserve System seven members appointed by the president of the United States headquarter in DC chair: chosen by president serve for 4 years and can be reappointed what they do: administers monetary policy to influence the nations money supply and interest rates through open market operations, reserve requirements and discount lending - influence national/international economic policy decisions advises president and testifies b4 congress on economic matters (unemployment and economic growth) set margin requirements approves bank mergers and determine permissible activities for bank holding companies

Theory of bureaucratic behavior

the objective of a bureaucracy is to maximize its own welfare that is related to power and prestige - Fight vigorously to preserve autonomy Avoid conflict with more powerful groups Does not rule out altruism

Short run aggregate supply

upward sloping shows relationship in sh run between price level and quantity of aggregate output/real gdp changes in SRAS: changes in price level, input prices, long rus AS, supply shocks

Long run Aggregate supply curve

vertical shifts left: increase in labor costs, input costs, expected price level shifts right: increase in capital and labor inputs, and productivity changes in LRAS: resources, etch, institutions

the Cambridge equation

with greater nominal income (Y), proportionally greater M1 balances are desired (other things equal) M D = kY M D is money demand and is measured in $ ◦ k is the fraction of a years income you want to hold in M1 assets, measured in years (typically <1) Y is nominal income, measured in $/yr.