PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 15 (LECTURES 35 - 38)
Dec. 6-10, 1999

[These lectures focus on money and monetary policy. They include a makeup lecture for the canceled class on Wed., Dec. 1. The corresponding chapters in McConnell's textbook are 13, 14, and 15.  These notes were last revised at 1:15 a.m. on Sun., Dec. 12.]

LECTURE 35
Mon., Dec. 6, 1999

Today: Money and monetary policy (continued)
I.   The 3 uses of money
II.  Money supply, money demand, and the equilibrium interest rate
 

I. THE THREE USES OF MONEY

We have already gone over how money, as macroeconomists use the term, means something different from "income" or "wealth." Money is defined as anything that is generally accepted as payment or, in a word, as liquidity. Since having liquidity is a much smaller priority for most people than earning a high income or becoming wealthy is, we need to figure out what it is that money is good for. Economists have identified three main functions of money:
1. Medium of exchange - money "greases the wheels of commerce," by making it much easier for people to exchange the goods and services they produce for the goods and services that they want. Having a generally accepted currency eliminates the need for barter (trading), and makes the volume of transactions a lot larger than it would otherwise be.
2. Unit of account - having a standard monetary unit, like the dollar, allows us to price individual goods and services, putting a single price on each item instead of having to compute a different exchange price for every different pair of commodities (e.g., 1 cup of coffee = 2 newspapers = 6 minutes of office work as a temp = 3 minutes of my teaching services).
3. Store of value - money has some use as an asset, because it holds its nominal value over time and, unlike stocks or bonds, its value does not fluctuate from day to day. Unlike stocks or bonds, there is no risk that dollars will suddenly become worthless. In sum, money is a virtually riskless asset. It is also a very liquid (convertible into cash; spendable) asset, which is another desirable quality.
 

II. MONEY SUPPLY, MONEY DEMAND, AND THE EQUILIBRIUM INTEREST RATE

Defn. INTEREST RATE -- the annual interest payment on a loan expressed as a % of the loan. It is equal to the amount of interest received per year divided by the amount of the loan. It is the "price" of money, or rather the price of borrowing someone else's money.
-- Ex.: If you borrow $100 and must pay $105, int. rate = (5%). (We don't count the repayment of the original $100, which is called the principal on the loan. The interest rate is the net payment you make; we say that the gross interest rate = 105%, but that usage is uncommon.)
-- Which interest rate are we talking about here? There are many interest rates in the economy or even at a single bank. But, they do tend to move together and, for the sake of simplicity, we will talk as if there is only one interest rate ("the interest rate").

One of the best ways to understand movements in interest rates is through the money market - a representation of the supply and demand of money and the resulting equilibrium point. So the money market is just another supply-and-demand diagram, with the price of money on the vertical axis, the quantity of money on the horizontal axis, and a downward-sloping money-demand curve.
- [Refer to Figure 13-2, panel (c), on p. 273 of McConnell's textbook.]
- The only variations on the usual supply-and-diagram are that:

Q: Considering that money earns a lower rate of return (0%) than virtually every other asset there is, why hold money at all? Even when i is low, as long as it's greater than 0, holding money means that you are losing out on the interest that you could be earning on bonds, CDs (certificates of deposit), or savings accounts, not to mention the positive returns you could be earning on things like stocks or real estate.

A: There are at least four good MOTIVES FOR HOLDING MONEY. They are:

(1.) Transactions demand (the most obvious motive) -- We need it to buy things, since money is the universal medium of exchange.
-- Corollary: the more you earn, the more money you'll demand.

-- The greater your income and wealth, the greater your consumption will be, hence the greater your transactions demand for money will be.

(2.) Precautionary demand ("save it for a rainy day")
-- Ex.: Say I normally spend ~$20/day --> then if I go to the bank every 5 days, I should withdraw $100 every time, right? Not necessarily -- even though $100 is what I'd need on average, I might have some abnormal expenses -- unexpected emergencies, bills, great sales, etc. So I might withdraw more than $100.
-- Money is the most liquid of assets, thus you might want to set some aside to be ready for any emergencies that might arise.

(3.) Avoid transactions costs of bank trips (ATM fees, time and inconvenience of trips to the bank). Because of those costs, it is often desirable to make very large withdrawals of cash when you visit the bank, so that you won't have to visit the bank again for a long while. The larger your average bank withdrawal, the greater your money demand. Putting those two observations together, money demand will be greater when the transactions costs of bank trips are high.

(4.) Asset demand - money is a riskless asset and is extremely liquid. Thus, money is somewhat useful as a store of value.

Despite all of these good reasons to hold money, it's still true that money earns a lower rate of return than bonds and other interest-bearing assets, so people will try to economize on their holdings of money somewhat, by keeping only small amounts of money as cash or in their checking accounts, while keeping the rest of their unspent income in bonds or other assets that earn competitive rates of interest. People will hold even less money when the interest rate is high - in other words, the demand curve for money slopes downward.

The intersection of the money demand and (vertical) money supply curves is the equilibrium in the money market and determines the equilibrium interest rate. (The equilibrium quantity of money, by the way, is always equal to the supply of money -- since the money supply curve is vertical, the equilibrium quantity of money will not be affected by shifts in the demand curve for money.)

***

PRINCIPLES OF MACROECONOMICS
WEEK 15, LECTURE 36
Wed., Dec. 8, 1999

Today: Monetary policy
I.     Bank balance sheets, in brief
II.   Tools of monetary policy
III.  How money affects output
 

I.  BANK BALANCE SHEETS, IN BRIEF

The standard accounting tool for listing a bank's assets and liabilities is called a T-account, so named because it's a table that you begin by drawing a big letter "t." A bank's balance sheet is just a listing of the bank's assets and liabilities. Assets (how the bank uses its funds; what the bank OWNS) go on the left side, while liabilities (sources of funds, or how the bank gets its funds, or what the bank OWES) go on the right side.

The first rule of accounting is that both sides add up to the same amount; in other words, the two sides of the balance sheet must balance. Yet a bank whose assets and liabilities are exactly equal would not be a very healthy bank - a bank likes to have some kind of cushion of funds so that a sudden dip in its assets doesn't make it insolvent. So a bank wants to have more assets than liabilities, but the balance sheet must balance. The way we make it balance is to add the bank's net worth (assets minus liabilities) to the liabilities side, as in the balance sheet below. So remember:

Assets - Liabilities = Net Worth (or Bank Capital);

Assets = Liabilities + Net Worth

The following table, showing the combined balance sheet of all U.S. banks and noting the relative share of each item in the totals, will be familiar to anyone who's taken accounting:
 

ASSETS  LIABILITIES + NET WORTH 
Reserves  5% Deposits  66%
Securities (T-bills, etc.)  21% Borrowings (loans from others)  26%
Loans to firms, individuals, other banks, etc.  68% Net worth 8%
Other assets (physical capital...)  6%
TOTAL ASSETS  100% TOTAL LIABILITIES  100%

(Total bank assets/liabilities are about $5 trillion.)

The first item on a bank's balance sheet is reserves, which banks keep to meet deposit outflows (withdrawals, checks drawn on the bank, etc.) and because they're required to do so by the Federal Reserve.

Banks are required by the Fed to hold a certain proportion of their deposits as reserves, mainly to guard against "runs on the bank" and to allow the Fed to manipulate the money supply. Reserves can be held either as cash or in accounts at the Fed. Currently, the required reserve ratio (RRR) is 10% on checking accounts and zero on savings and money-market accounts.

The difference between a bank's total reserves and its required reserves is its excess reserves:
             excess reserves (ER) = actual reserves - required reserves
                                                  = actual reserves - (.10)(checking deposits)

Excess reserves are mainly kept by banks as a precaution. In good times, banks generally try to keep as few excess reserves as possible, since they earn no interest on them. The Fed's reserve requirements are typically much higher than what banks actually need in order to be able to handle deposit outflows.
 

II.   HOW MONEY AFFECTS OUTPUT (THE MONETARY TRANSMISSION MECHANISM)

Monetary policy affects the economy because changes in the money supply affect interest rates, and interest rates affect aggregate demand (AD) by affecting C, Ip, and net X; and the level of AD affects real GDP (Q), the unemployment rate, the price level (P), and the inflation rate
- Changes in monetary policy cause the AD curve to shift. They do not cause the AS curve to shift.

Monetary policy can be:

The step-by-step process by which changes in monetary policy affect real GDP and the price level is as follows, considering first the case of an expansionary monetary policy:

(1)  The Fed increases the level of bank reserves, using one of its three tools of monetary policy.
-> (2) Banks loan out their excess reserves to firms (planned investment increases) and households (consumption increases, especially durable goods consumption).
-> (3) As loans are redeposited back into bank accounts (usually after the loan money is spent - i.e., money loaned for the purchase of a new car is deposited by the car dealer into his bank account), the money supply increases, since the money supply is cash plus bank accounts. The bank will loan out most of the new deposits, and those loan monies will be redeposited somewhere else, and the cycle of reserves->loans->deposits->reserves will continue. Eventually the money supply will increase by a multiple of the original increase in reserves.
-> (4) The increase in the money supply (Ms) causes the equilibrium interest rate to fall.
---- increase in Ms --> i falls
---- [Refer to Figure 13-3 on p. 275 of McConnell's textbook. Note how when the money supply curve shifts out, the equilibrium interest rate falls.]
-> (5) With lower borrowing costs, and a lower opportunity cost of spending one's money, planned I and durable-goods consumption both increase ( lower i --> Ip, Cdurables both increase). Aggregate demand (AD) increases, since C and I are two key components of aggregate demand.
-> (6) Real GDP (Q) and the price level (P) both increase, since the AD curve shifts out, in most cases moving along the upward-sloping portion of the AS curve (since that's where the economy usually is).

In sum:

            increased reserves -> Ms increases --> i falls --> I, C both rise --> Q rises, P rises             decreased reserves -> Ms falls --> i rises --> I, C fall --> Q falls, inflation falls
 

III.  TOOLS OF MONETARY POLICY

When the Fed conducts monetary policy, it directly affects the level of bank reserves, causing banks to have either excess reserves (which they loan out) or a reserve deficiency (which causes them to call in loans). In either case, the supply of money changes by a multiple of the original change in reserves.
-- money multiplier = (change in money supply)/(change in bank reserves) = 1/RRR

The Fed has three tools that it uses to conduct monetary policy:
(1) changes in the required reserve ratio (RRR), i.e. of the fraction of deposits that banks must keep as cash
(2) changes in the discount rate, i.e. of the interest rate at which the Fed makes loans to commercial banks
(3) open market operations (OMO) -- when the Fed buys and sells government bonds on the open market
---- The Fed uses OMO to affect the federal funds rate, which is its mostly widely watched interest-rate target.

***

PRINCIPLES OF MACROECONOMICS
WEEK 15, LECTURE 37
Fri., Dec. 10, 1999

[Today was essentially a review session, in which we went over the third exam and I discussed what to expect on the final. To repeat, the final will be all multiple-choice, with 60 questions followed by four extra-credit questions. Just as the course can be divided into four quarters - first exam, second exam, third exam, and the monetary policy material we did over the last couple weeks - so can the final exam, which will drawn on those four quarters about equally. The four extra-credit questions at the end will all be based on the material in the makeup lecture (Lecture 38) that appears at the end of this week's notes.]

***

LECTURE 38
MAKEUP LECTURE FOR WED., DEC. 1, 1999

In this lecture:


I.  THE THREE TOOLS OF MONETARY POLICY, EXPLAINED

(1) Changes in banks’ required reserve ratio (RRR)
 —  The required reserve ratio (RRR) is now 10% of banks’ checking deposits.
 —  It was lowered from 12% in early 1990's.
 —  The RRR on savings account, CD’s, and money-market deposit accounts is zero.
 —  Changes in the RRR have large effects on money supply: increasing RRR causes a decrease in banks’ excess reserves and a decrease in the money multiplier (1/RRR), so the money supply decreases by a lot.
  –> Because this tool’s effects are so powerful as to preclude “fine tuning” (making small changes in monetary policy as needed), it is rarely used.

(2) Changes in the discount rate
 – The Fed controls the discount rate, i.e. the interest rate at which it loans money to banks.
 – When the Fed lowers the discount rate, bank reserves will increase, because banks will take advantage of the lower rates by borrowing more reserves from the Fed (and then loaning those reserves out).
 – Although the Fed is officially a “lender of last resort” to banks, to be used only when banks are in desperate situations, when it lowers the discount rate it is generally signaling a relaxation of that rule, i.e. an increased willingness to make ordinary loans to banks in order to expand the volume of money and credit.

* (3) Open market operations (OMO)
 —  In OMO, the Fed buys or sells bonds, usually from the banks, in order to affect the level of bank reserves and the federal funds rate (the interest rate at which commercial banks loan each other money, usually in the form of reserves, on an overnight basis).  In turn, the money supply and other interest rates will be affected, too.
 -- OMO is the Fed’s most important and most-used policy tool.
 – How OMO works: when the Fed buys or sells securities (government bonds) from banks, it makes or collects the payment for those bonds by crediting or debiting the banks’ reserve accounts at the Fed and thereby changing the level of bank reserves, which changes the money supply in the same direction.  These operations are carried out solely by the regional Fed bank of New York.
  -- Expansionary monetary policy calls for open-market purchases: Fed buys securities, pays by crediting banks’ reserve accounts --> money supply expands, interest rates fall.
  -- Contractionary monetary policy:  open-market sales: Fed sells securities, collects payment by debiting banks’ reserve accounts --> money supply shrinks, interest rates rise.
 -- The Fed uses OMO to affect the federal funds rate.  Open-market purchases and sales by the Fed affect the federal funds rate because they affect the supply of bank reserves.  An increase in the supply of bank reserves (expansionary OMO) reduces the federal funds rate; a decrease in the supply of bank reserves (contractionary OMO) increases the federal funds rate.
  -- Imagine (or, better yet, draw) a supply-and-demand diagram of the federal funds market, with the quantity of bank reserves on the horizontal axis, the interest rate (price) on borrowed bank reserves on the vertical axis, an upward-sloping supply curve, and a downward sloping demand curve.  If the Fed makes an open-market purchase of a security from a bank, for example, it pays for the security by crediting the bank’s reserve account at the Fed; thus it is adding to the total supply of reserves.  That addition corresponds to an outward shift of the supply curve of federal funds, which will cause the interest rate on reserves (i.e., the federal funds rate, or the “price” of borrowing reserves) to fall.
 

II.  AN EXAMPLE OF MULTIPLE DEPOSIT CREATION

Let us consider an example of an expansionary monetary policy move by the Fed.  Suppose that the Fed conducts expansionary OMO by making an open-market purchase of securities.  Specifically, the Fed buys $100 in securities from the First National Bank.  (The required reserve ratio, RRR,  for checking deposits is 10%.  We will assume that First National and all other banks initially have zero excess reserves.  Also assume that all loans get redeposited into checking accounts at First National.)  The Fed pays for the securities by crediting First National’s reserve account at the Fed with $100.  We would like to know: What is the ultimate change in the money supply, after the entire chain of deposit creation has run its course?

Fast-forwarding a bit, we can answer that question right now, because we know the initial change in reserves (+$100) and can compute the money multiplier (1/RRR = 1/.10 = 10).  The ultimate change in the money supply will be:
     {increase in money supply} = {increase in reserves} * {money multiplier}
                                               = ($100) * (10)
                                               = $1000.

To see just how we got from an initial increase in reserves of $100 to a cumulative increase in the money supply of $1000, we can look at the changes in First National’s balance sheet.  The initial change in First National’s balance sheet is:

 FIRST NATIONAL BANK

Assets                        | Liabilities
---------------------- | -----------------------
Reserves  +$100        |
Securities - $100        |

First National now has excess reserves of $100.

First National will loan out those excess reserves — say, to me.  I use that $100 to buy something (say, $100 worth of compact discs), and the CD merchant will either deposit that $100 in the banking system or spend it himself; either way, someone will eventually deposit that $100 cash in the banking system — if not at First National, then at some other bank.  With that new deposit the (cumulative) change in the banking system’s balance sheet is as follows:

 Assets                   | Liabilities
 ------------------  | ----------------------------
 Reserves  + $100  | Checking deposits    +$100
 Securities -  $100  |
 Loans  + $100       |

The money supply has expanded by $100, since the money supply includes checking deposits.  The money-creation process will continue because the bank that received the $100 cash deposit now has excess reserves ( = actual reserves - required reserves ) of
                       $100 - (.10)($100) = $100 - $10 = $90.

The bank will loan out that $90 and it, too, will eventually be redeposited as cash in the banking system.  Now the cumulative change in the banks’ balance sheet is:

 Assets                   | Liabilities
------------------- | -----------------------------------
 Reserves  + $100  | Checking deposits       +$190
 Securities -  $100  |
 Loans  + $190      |

The banks have excess reserves of $81 ( = $100 - (.10)($190) = $100 - $19 ).  They will loan them out and the money will be redeposited in the banking system, increasing checking deposits by another $81 dollars.  Then 90 percent of that will be loaned out and redeposited, and 90 percent of that will be loaned out and redeposited, etc.  The total increase in bank deposits (and hence in the money supply) will be:

         $100 + $90 + $81 + ($81)(.90) + ($81)(.902) + ...
      = $100 + ($100)(.90) + ($100)(.902) + ($100)(.903) + ($100)(.904) + ...

This seemingly endless sum, just like the chain of consumption in the multiplier model, is a geometric series, and is solvable as

         $100 * 1/(1-.90) = $100 * (1/.10) * $100 * 10 = $1000,

which is where the money multiplier (1/RRR) comes from.  Thus total bank deposits increase by $1000, as does the money supply.  The total change in the banking system’s balance sheet, when there are no more excess reserves remaining, is:

 Assets                   | Liabilities
 ------------------- | ------------------------------
 Reserves  + $100  | Checking deposits      +$1000
 Securities -  $100  |
 Loans  + $1000    |

That $1000 increase in checking deposits all came about as the result of an initial increase in reserves of $100.  Thus the total amount of deposits has expanded by a multiple (ten) of the original change in reserves.

To review:
*  In this example, the Fed injects $100 in reserves into the banking system, by purchasing a $100 security from the First National Bank.  To see how that increases the money supply, we need to keep track of the increase in checking deposits.  After the Fed’s purchase, First National has $100 in excess reserves.  They loan those reserves out as $100 cash, and that $100 cash gets redeposited into a checking account at the bank.  Then the bank has $100 in reserves again, and $90 of that is excess reserves (the remaining $10 has to be kept to meet their 10% reserve requirement on checking deposits; they can loan out 90% of any increase in cash deposits, so they loan out .90*$100 = $90).  They loan out those excess reserves -- $90 cash -- and that $90 gets redeposited.  They can lend out 90% of that (.90*.90*$100 = $81), and it will be redeposited.  And so on.
*  The sum of all these additional checking deposits is a geometric sum, which means that we have a simple formula for finding the total increase in deposits:
                                            total increase in deposits = initial increase in deposits * (1/RRR)
*  The initial increase in reserves of $100 ultimately leads to a $1000 increase in checking deposits, or a $1000 increase in the money supply.