© 1999-2003 Douglas A. Ruby Revised: 06/23/2003 Financial Markets and Instruments Macroeconomic Policy Macroeconomic Principles Macroeconomic Theory |
and Interest Rate Determination Money can be narrowly defined as anything that may be used for purchasing goods and services or more broadly to include anything of value that may be used for trade. Changes to the the money stock in an aggregate economy can occur for any of several reasons:
To best understand how these changes occur, it is useful to look at the
basic components of the balance sheets of the non-bank public, the commercial
banks, and the central bank (i.e., the Federal Reserve):
In the above example, C represents currency in
circulation -- an asset of the non-bank public and a liability of the central bank.
DD refers to demand deposits,
TD to time deposits
-- assets of the
non-bank public and an liabilities of commercial banks.
rR (required reserves), xR (excess reserves), and their sum R
represent reserves and are non-income producing assets of the commercial banks and a liability of the central bank respectively.
L refers to loans outstanding -- a liability of the non-bank public a
and an income-producing asset for the commercial banks. Finally S
is a reference to securities, specifically government securities (treasuries), that are liabilities of the
Federal Government.
M1 = [1 + (C/DD)](DD)where rd represents the reserve requirement on demand deposits. Rearranging, we can write: DD = B / [rd + (xR/DD) + (C/DD)]thus M1 = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]}Bor MS = M1 = mm (B)where mm = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]} This money multiplier represents the ability of a fractional-reserve banking system to create money within the economy, that is, for each dollar of reserves; the money supply is some multiple of that value. Increasing the reserve requirements (rd) will reduce the value of the money multiplier and thus when holding the monetary base constant, reduce the money supply. Increases to the excess reserve-demand deposit ratio 'xR/DD' (pessimism among bank management) will have a similar affect on the money supply. Finally, changes in the currency-demand deposit ratio 'C/DD' will directly affect the money multiplier -- holding more cash in relative terms will reduce the money supply. Open market operations, one policy tool available to central banks, will affect the monetary base. If the central bank
chooses to pursue an expansionary monetary policy, they would begin to
buy government securities from the commercial banks. Payment for
these securities would be in the form of reserves credited to the commercial
bank's account with the central bank. Thus there is a change in the composition
of assets within the commercial bank's balance sheet -- a change that
lead to fewer income producing assets (securities) and more non-income
producing assets (excess Reserves). Banks will attempt to convert some
or all of these excess reserves to new loans by lowering the interest
rate that they charge on these loans.
As the non-bank public takes out these new loans, they convert these funds into new deposits at the same or other banks in the commercial banking system. Demand deposits expand as does the money supply. Thus this particular type of open market operations (buying securities) leads to more reserves, expansion in the money supply and lower interest rates. Contractionary monetary policy would do just the opposite. The central bank would sell government securities to the commercial banks, removing reserves from the system, causing these banks to curtail their loan activity and raising the interest rates charged on loans. You can experiment with the money multiplier process using the interactive table below:
Reserve-Demand Deposit Ratio (R/DD), or Currency-Demand Deposit Ratio (C/DD) by clicking on the boldfaced numbers in the appropriate number box. Just click on any of these three numbers and enter a new value. 2) Note the following:
4) Press Reset to start over. The Federal Reserve System and Central Banking The Federal Reserve System, the Central Bank of the United States, was created by an act of Congress in 1913. Originally, the 'Fed' was designed as a decentralized Central Bank with 12 District banks located throughout the U.S. and the Board of Governors 'BOG' located in Washington D.C. However, over time the development and direction of monetary policy has migrated from these District banks to the BOG. Also by design, the Fed is both a quasi-public / quasi-private institution. Public in that the 7 members of the BOG are appointed by the President to staggered single 14 year terms and confirmed by Congress. Private in that the assets of the Fed are privately owned through stock owned by commercial banks as ownership shared in their local District bank. The Fed is a system composed of roughly 3000 member commercial banks (nationally chartered banks must be a member of the Federal Reserve System - State chartered banks have the option of joining), 12 District Banks and 25 Branch District Banks, the seven-member Board of Governors and a twelve member (the 7 Governors, 4 District Bank presidents serving on a rotating basis, and the President of the N.Y. District Bank) Federal Open Market Committee - the FOMC. It is the FOMC that is responsible for providing directives guiding Open Market Operations. The Fed has four main responsibilities:
Open market operations as described above is to most common tool used in the implementation of monetary policy. For example, if the goal is to fight inflation, the Fed will set a target of a higher Federal Funds rate (the directive will be to buy and, more likely, sell securities on the open market to achieve this target rate). A higher Federal Funds rate will be an indication of less liquidity in the banking system and thus higher interest rates charged by these banks to their customers. With higher borrowing rates, certain investment projects will become less profitable and thus investment spending will decline. With the reduction in this investment spending, aggregate expenditure (Nominal GDP) should also decline. Less spending in the demand-side of the economy should eliminate any upward pressure on prices that may exist. Equilibrium in Financial MarketsThe functional form for money demand (as derived from the Inventory Theoretic Model) is: Md = f[Y , i ]In equilibrium Md = Ms or: Md = M/Pwhere M/P represents the purchasing power of available money balances (the money supply). Holding the price level constant (no supply-side constraints), changes in purchasing power will only result via changes in the money supply. Additionally, if the price level is unchanging then nominal measures of income are the same as real income measures. figure 2, An increase in the Money Supply An increase in the Money Supply (Real money balances) shifts the MS function to the right. This is often a deliberate policy action (via open-market operations) intended to stimulate aggregate demand. The result is an Excess Supply of Money (specifically excess reserves and thus loanable reserves) such that interest rates charged to their borrowing customers and on overnight loans to other commercial banks (the Federal Funds Rate) will fall. This is shown in figure 2 to the right figure 3, An increase in Income 'Y'An increase in Income 'Y' leads to an outward shift in Money Demand 'Md (due the the need to support a greater level of transactions). This shift leads to an Excess Demand for Money where individuals will begin to make portfolio adjustments (selling bonds and securities thus Pbonds decline, Ψbonds increase) putting upward pressure on the whole structure of nominal interest rates. This is shown in figure 3 to the left. Interest rates thus act as a barometer of changing expectations, reaction to new information about economic events and of changes in monetary policy In addition interest rates provide the linkage between financial markets and the real economy. Changes in the money supply, the buying and selling of financial assets in secondary markets, or the issue and acquisition of financial assets in primary markets all affect returns to lenders and more importantly the cost of borrowing. It is these borrowing costs that affect investment spending decisions and thus real economic activity. Concepts for Review:
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