THE FEDERAL RESERVE AND THE MONEY SUPPLYThe Federal Reserve is America’s central bank. It has theunique right to create U.S. dollars. Counterparts abroad: theBank of Japan, the Bundesbank, the Bank of England, etc..Jan. 1 the Bundesbank, Banque de France, Banca d’Italiawill cede their roles to the new European Central Bank.A central bank’s balance sheet (simplified):Assets LiabilitiesGovernment bonds MoneyIn an open-market operation the CB prints money to buymore bonds, putting more money into circulation – or sellsbonds to withdraw money from circulation. This affects theinterest rate – and because the interest rate affects spending,it affects the economyDETERMINATION OF THE INTEREST RATETwo ways to think about it:1. i must be such as to make supply and demand for moneyequal. Reason: if people regard their money holdings asinadequate, they will try to sell bonds (or borrow). Butyou can’t have sellers without buyers: price of bonds willfall (interest rate rise) until no net selling. Andconversely if people are holding more money than theywant.2. i must be such as to make supply and demand for bondsequal. This is equivalent!Usually thinking in terms of money is more convenient.FORCES THAT CHANGE INTEREST RATES:1. Changes in money demand: most important are changesin Y and changes in price level. We leave P on one side,to return later (crucial role in long run). But other thingsequal, higher Y leads to higher money demand (moretransactions), and hence to higher interest rate. This isthe LM relationship.2. Changes in money supply: basically under control ofcentral bank. Higher M implies lower i.Interest rate matters to economy, because high i means lowspending (housing and other investment), low i highspending.MONEY SUPPLY: SOME MORE DETAILActually a two-tier structure: Federal Reserve plus privatebanks:FedAssets LiabilitiesBonds Monetary base (aka High- powered money)BanksAssets LiabilitiesReserves Bank depositsLoansBondsMonetary base = reserves + currencyHOW AN OPEN MARKET OPERATION WORKS(simplified case: no currency, banks hold constantproportion of deposits as reserves – say, 0.2)1. Fed buys $100 million in bonds from banks2. Banks lend out $100 million; it must return as deposits.3. Banks lend out $80 million; this must return as deposits.4. Banks lend out $64 million ....Eventual money multiplier is 1 + 0.8 + 0.64 + ... = 5In general, in economy with no currency, money multiplieris 1/d, where d is reserve/deposit ratio.In economy with currency (most US monetary base is, infact, currency), also need to know currency/deposit ratio.Formula is:When it matters: when banks are in trouble (US 1930-31,Japan now)MONETARY POLICY:1. Money supply can be changed at short notice – all ittakes is a phone call to banks.2. The Fed actually sets a target range for short-terminterest rate, which is revised roughly every 6 weeks.3. Most advanced countries have found it a good idea togive the central bank a lot of independence. (Otherwisetemptation to politicize policy – e.g., print a lot of moneyin run-up to elections).4. Why can’t anyone understand what Alan Greenspan
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