The Federal ReserveAnd the Money Supply

Printing Money and Spending it.

This is the equation of exchange, which defines V and hence always holds true.

MV=PQ

Md=kPQ=(1/V)PQ?

The demand for money (Md) is some proportion (k) of the expenditures (PQ) that people expect to be making.

k=(1/V)?

MsV=PQ

MsV=PQThe M in the equation exchange is

the money supply, i.e., Ms.

Md=kPQ=(1/V)PQ?

Hence, k = 1/V only when Ms = Md. If people are demanding more money than currently exists then Ms < Md.

k=(1/V)?

M = C + D

The Money Supply

Where C is currency and coin

And D is checking account balances

M = C + D

The Money Supply

C = is currency and coin

Currency is produced by the Bureau of Engraving and Printing:

Washington, D. C., and Fort Worth

M = C + D

The Money Supply

C = is currency and coin

Coins are produced by the U.S. Mints:

Philadelphia and Denver

San Francisco and West Point

M = C + D

The Money Supply

R = rDWhere R is total bank reserves, The coefficient r is the reserve ratio,and rreq is the required reserve ratio.

M = C + D

The Money Supply

D = R/rM = C + R/r

M = C + R/r

Suppose that at some future date:

C = $800 billion;

R = $240 billion;

and rreq = 20%, or 0.20.

How large would the money supply be?

M = C + R/r

Assume the banks are “fully loaned up,” and plug the numbers into the equation:

M = C + R/r

M = $800 + $240/0.20

M = $800 + $1200

M = $2000

C = $800 R = $240 r = 0.20

M = C + R/r

What would happen to the money supply if the reserve requirement were cut in half (i.e., from 0.20 to 0.10)?

C = $800 R = $240 r = 0.20

M = C + R/r

Plug the numbers into the equation:

M = C + R/r

M = $800 + $240/0.10

M = $800 + $2400

M = $3200So, D doubles (from $1200 to $2400) increasing M from $2000 to $3200.

C = $800 R = $240 r = 0.10

What would happen to the money supply if the reserve requirement were cut in half (i.e., from 0.20 to 0.10)?

Ultimately, C would be doubled from $800 to $1600, so that M would be doubled from $2000 to $4000.

r R()=

C

+

M

Can you rearrange these symbols to produce an equation that expresses the money supply M as a function of C, R, and r?

And why isn’t D included in the mix?D

FEDERAL RESERVE POLICY TOOLS:

Required Reserve Ratio: “rreq” –which determines the maximum volume of demand deposits that can be supported by a given level of reserves.

( )M=C+ Rr

Required Reserve Ratio

( )M=C+ Rr

Required Reserve Ratio

FEDERAL RESERVE POLICY TOOLS:

Required Reserve Ratio: “rreq” –which determines the maximum volume of demand deposits that can be supported by a given level of reserves.

Discount Policy (Primary Credit Policy): “id”which encourages (or discourages) borrowing from the Fed to meet the reserve requirement, thus increasing (or decreasing) R.

( )M=C+ Rr

Discount Policy

( )M=C+ Rr

Discount Policy

The Primary Credit Rate

a.k.a. the Discount Rate

is an administered rate.

0.750000000000000000000000000000000000%0.75%

The “Required Reserve Ratio” is a blunt policy tool. Even a small change in “r” can cause large and abrupt changes in the money supply. And besides, changing “r” attracts press attention.

“Discount Policy” caters to overly aggressive banks. It encourages banks to get caught short of reserves and have to borrow from the Federal Reserve. Better to use the discount rate, a.k.a, the “Primary Credit Rate” for dealing with troubled banks.

Is there some other way of increasing Reserves generally (and daily) without attracting press attention and without putting those reserves in the hands of overly aggressive or troubled banks?

Open Market Operations“Open Market Operations” is a term that refers to the Fed’s buying Treasury bills from commercial banks as a means of directly increasing the level of reserves.

Treasury bills in the portfolio of a commercial bank represent “funds lent out.” That is, when the bank bought the Treasury bill (i.e., the IOU) from the Treasury, it lent funds to the Treasury.

When the Fed buys the Treasury bill from the bank, it replaces “funds lent out” with Reserves, which enables the bank to engage in further lending.

FEDERAL RESERVE POLICY TOOLS:

Required Reserve Ratio: “rreq” –which determines the maximum volume of demand deposits that can be supported by a given level of reserves.

Discount Policy (Primary Credit Policy): --“id” which encourages (or discourages) banks from borrowing from the Fed to meet the reserve requirement, thus increasing (or decreasing) R.

Open Market Operations: “T-bills” –which the Fed can buy from banks (or sell to banks), directly affecting R.

The Federal Reserve’s buying of Treasury bills has an effect on the rate of return that holders of those bills receive.

More significantly, the Fed’s buying of T-bills has a direct effect on the total amount of bank reserves and hence on the interest rate (the federal-funds rate) at which banks can borrow from one another.

The Fed can increase the money supply by buying T-bills, and can gauge the magnitude of the increase by watching the federal funds rate. This is called “interest rate targeting.”

Q

D

S

Pri

ce o

f T-b

ills

Market for Treasury Bills

Q

D

SS’

Market for Reserves

D’

fed

-fu

nd

s r

ate

S + M

New money is lent into existence. It enters the economy through the market for loanable funds.

Query: How does the increased investment (the I) show up in the monetarists’ equation of exchange?

I

( )M=C+ Rr

Required Reserve Ratio

Discount Policy

Open Market Operations

( )M=C+ Rr

Required Reserve Ratio

Discount Policy

Open Market Operations

( )M=C+ Rr

Open Market Operations

Required Reserve Ratio

Discount Policy

Effective Federal Funds Rate:

2006-2011

Press Release March 15, 2011

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

….the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

Bank Reserves:1959-2011Pre-crisis level: $45

billionCurrent level: $1,263 billionPercentage increase: $1,263/$45 = 28.1 = 2810%

Feb 2008: r = 43.4 / 291.5 = 14.9 %Feb 2011: r = 1,263 / 537 = 235 %

Deposits:2005-2011

The Fed increased the required reserve ratio in 1937-38

The Fed increased the required reserve ratio in 1937-38

According to the Fed’s “Regulation Q,” which was imposed on the banking system from the mid 1930s until the early 1980s, no bank account could be both checkable and interest bearing.

Checking accounts, i.e., demand deposits can bear no interest.

Savings accounts bear interest but are not checkable.

In the early 1980s---after a bout with double-digit inflation, “Regulation Q” was phased out, after which the distinction between checking accounts and saving accounts was blurred.

Checking accounts, i.e., demand deposits can bear no interest.

Savings accounts bear interest but are not checkable.

In the early 1980s---after a bout with double-digit inflation, “Regulation Q” was phased out, after which the distinction between checking accounts and saving accounts was blurred.

Checking accounts, i.e., demand deposits can now bear interest.

Savings accounts bear interest and are effectively checkable.

In the early 1980s---after a bout with double-digit inflation, “Regulation Q” was phased out, after which the distinction between checking accounts and saving accounts was blurred.

Well, we just

don’t know what

money is,

anymore.

The equation of exchange was most useful when most US dollars were in the US.

$$$$$

$$

$$

$$

$$

$$

Even if the Fed knew just how much money it had created, it wouldn’t know where in the world it all is.

$$$$$

Printing Money and Spending it.The Federal Reserve

And the Money Supply