Eco 342 Fall 2011 Chris SimsWhat is Money? What determines prices?September 19, 2011c2011by Christopher A. Sims. This document is licensed under theCreative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported LicenseWhat is money? I.e. what is this course about?• Old answer: medium of exchange, unit of account, store of value.• Newer answer: An information-conservation and anonymity-preservingdevice.1What determines the price level?• Old answer: MV = P Y .• Newer answer: The government’s balance sheet.2How to measure M?• Central to determining P in the old view.• (How to measure P ? CPI, PCE deflator, “core” vs. non-core)• Currency is certainly part of M. Traditionally, also demand deposits atbanks. Sum = M1.• Used to be that demand deposits were uniquely checkable, and paid nointerest.• In the current period, most deposits pay very little interest, and manyassets (e.g. money market mutual funds) are checkable.3Measuring M, continued• M2, which includes MM mutual funds and other deposits that aren’tstrictly “demand” drew more attention in the 1970’s when high interestrates led to the invention of money market mutual funds. But itillustrates ambiguity in the dividing line betseen the transactions balancesin MV = P Y and other assets that are more purely stores of value.• Electronic payments, credit cards? Aren’t they “means of payment”?(Ball argues that “economists” think credit cards aren’t.)• Why this is important: If institutional and technological innovation caninduce substantial changes in V and/or the definition of M, controllingP by controlling M may be difficult.4Illustration: Liquidity in the recent crisis• Nobody would argue that mortgage-backed securities, even those ratedAAA, were part of M.• Nonetheless, large financial institutions were treating them as “near-cash”.• They could be “repo”’d overnight in thick markets, yet paid a nice return.(define “repo” and “thick”)• One element of the crisis was that rather quickly these assets ceasedfunctioning as near-cash.• A deflationary effect understandable with MV = P Y , except that noneof this was in M.5Controlling M• Even leaving aside “transactions balances” that aren’t in anyone’sstandard definition of M, the old story about how policy controls Mdoesn’t work.• The old story (simplified): Banks’ liabilities are deposits, D. They investdeposits in interest bearing loans, L. They are legally required to holda proportion α of their deposits in non-interest-bearing “reserves”, F —deposits with the Federal Reserve system and vault cash.• Since reserves pay no interest, while loans do, banks keep reserves asclose as possible to the legal minimum αD.6• The Federal Reserve system can control reserves F . D = F/α, the“money multiplier”.• M = C + D. C not controlled, responds passively, but by controlling D,the Fed can control M.7Currency drain in the Great Depression• In the Depression, and in earlier contractions, public worries about thesafety of bank deposits would lead to withdrawals from banks, increasingthe ratio of C to D.• The Fed’s own balance sheet has currency and reserves (C and F ) asliabilities. If a “currency drain” occurs, C increases and banks’ requiredreserves shrink.• Say D declines by 100, C increases by 100. Required F drops by 100α.Thus if total M = C + D remains constant, the Fed’s total liabilitiesincrease by (1 − α) · 100.8• This requires the Fed to purchase assets to increase the size of its balancesheet to offset the contractionary effect of the currency drain. Otherwise,if F + C rather than F/α + C remains constant, an increase in C of 100makes M decrease by 100(1/α − 1)9The Friedman-Schwartz critique• Milton Friedman and Anna Schwartz used the MV = P Y frameworkand the money multiplier idea to argue that the Fed in the 1930’s failedto understand the need to expand its balance sheet in the face of bankingsystem contraction, and that this led to the severity of the depression.• In the recent crisis, there was no substantial currency drain and in theUS banks subject to reserve requirements were not initially a main focusof financial stress. Nonetheless the Fed intervened, having learned theFriedman-Schwartz lesson, but wisely casting MV = P Y thinking aside.10What’s wrong with the old story?• As part of the TARP legislation that in late 2008 authorized $700 billionin “bailout” funds, the Federal Reserve was given the right to pay intereston reserves, and it now does so.• The approximate ratio of actual to required reserves today: 18.• The interest rate on reserves: 0.25%. The interest rate on US 30-dayTreasury bills: 0.01%.• So the notion that banks should be eager to keep reserve balances closeto the minimum required level no longer applies. There is no