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W12 C1 (19th Jan, 2009)

Money Market

Monetary Policy

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Money is a generic term to describe a store of value orunit of account for wealth.

For example, in calculating the monetary base in theU.S., there are different classifications:

M1: Instruments that serves as a medium ofexchange (Approximately $809 Billion) e.g.Currency in circulation, current accounts

M2: Includes substitutes for money (Approximately$3,272 Billion) e.g. All M1, Time and savings

deposits, Money market fundsM3: Liquid assets (Approximately $4,066 Billion) e.g.All M2, Long-term time deposits, Commercial paper

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General definition: A tool used by governments to affect theeconomy

Monetary policy is geared towards influencing interest rates. If

government can affect interest rates, then the governmentcan affect consumer and firm behavior.

Central Bank (Federal Reserve Bank - Founded 1913) is thecentral authority appointed by the government to implementmonetary policy.

Example: increasing interest rates slows the economy bymaking fundsmore expensive to firms, and promotes consumer savings

which decreasesrevenues by firms.

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Tools used by the Central bank for implementingmonetary policy

Open market transactions:

Buying and selling oftreasury securities changes the moneysupply in the economy, affecting interest rates. This is the most

frequently used tool available to the central bank.

Reserve requirements:This involves changing the amount of reserves that banks must

hold, affecting the amount of money creation, and thus supply.This is a powerful tool, but infrequently used (once a decade orso) because of the disequilibrium that it creates.

5. Discount window lending:

Sets the base lending rate among financial institutions. Asomewhat imaginary rate since few institutions actuallyborrow from the central bank, so this requires nothing other

than a statement by the central bank chairman.

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Banks can be viewed as counterfeit operations (bank maintainsenough in reserve to meet depositor demands, they can lend thesereceipts and earn interest) controlled by the government, and arean essential tool in affecting monetary policy

Loans made by banks are not backed 100% by reserves, so they areessentially minting their own currency.

Reserve requirements set by the government determine the extentto which banks can counterfeit. Fewer required reserves meansmore counterfeiting and increased money supply (more loans

means more available funds)

Q: How do banks get away with counterfeiting? A: By use of their reputation. Customers could bankrupt a bank

simply by asking for all of their reserves back, which they can do atany time. But, customers dont ask for their money back since

counterfeiting is profitable and they earn a part of the returnsinterest but the tolerate the behavior onl as lon as the

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Since the bulk of deposits never leave the bank, warehousebanks recognized that they could lend out excess depositsand earn interest on those loans.

Since these banks do not hold 100% of their reserves, they

are referred to as fractional reserve banks.

Fractional reserve banks have the ability to create money bylending loans, but the ability to do this is limited by thereputation of the bank and requirements of central Bank.

The fractional reserve counterfeiting operation isthreatened by:

1. Reputation of the note the institution backing the promise

2. Increased likelihood of note redemption (a function of issuerreputation)

3. An increase in the note float

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Central Bank: A bank with supreme reputation andcredibility, created to mitigate the risks

associated with fractional reserves.4. Bankers realized that it was in their interest to cartelize the

industry to mitigate these risks. A reputation greater than any oneindividual or family was needed.5.While it is possible for a cartel of banks to organize and supporteach other, a government is best suited for this task. Governmentsgenerally have more longevity than institutions, individuals or

families in developed economies.6.The Bank of England (1690) is the first modern Central Bank, anduntil this century, was privately owned.7.The Federal Reserve Bank in the U.S. was founded in 1913 inresponse to the contagious bank runs of 1910 (bank runs are

failures of fractional reserve banking)

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The central bank delegate the task of money creation to banks.

The money creation process: Making one loan, creates theopportunity to make another loan, a process which continues in

perpetuity.Step Description

1 Bank issues a promissory note for which there is nodirect reserve. (i.e. the bank) makes a loan and givesthe borrower a receipt against that banks reserves

2 This receipt (loan) is traded for a good or service(promissory note is passed on to a new holder)

3 The promissory note is deposited back into a bank by thenew holder, creating anew deposit (bank liability).

5 The promissory note is available once again to be loaned

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A bank that receives $100 Million in deposits and keeps $20 million inreserve while loaning the rest.

But the $80M in loans returns to the banking system somewhere else, ifnot this bank, the second Generation Bank

The third generation bank receives $64 million of new loan deposits,allowing another $51.2 M in loans

Assets Liabilities

Portion held in reserve: $20 M Deposits: $100 M

New loan issued without reserve: $80 M

Assets Liabilities

Reserve: $16 M Dep. of loan from 1st bank: $80 M

Loans from new deposit: $64 M

Assets Liabilities

Reserve: $12.8 M Dep. Of loan from 2nd bank: $64 M

Loans from new deposit: $51.2 M

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The money multiplier:The extent to which money can becreated through fractional reserve banking is as follows:

Total Quantity of Money = Money Multiplier * Monetary base

Money Multiplier = (1 + c) / (r + c)

r: reserve requirement

c: measure of money escaping the banking system (assumed

to be 0 in our example)

MM = (1 + 0) / (.2 + 0) = 5 -> $100M *5 = $500M

Monetary Base: The amount of definitive money in the

economy

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Changes in money supply affect interest rates

1. An increase in money supply makes the economy feelwealthier by putting more money in the hands ofconsumers

2. An increase in money supply decreases interest rates

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The central bank induces interest rate changes by changing themoney supply.Main responsibilities of central bank are to formulate policiesto promote full employment, economic growth, price stability,

and a sustainable pattern of international trade.

1. If more money is injected into the economy, then there is anincrease in loanable funds, and rates drop.

2. When the central bank tightens monetary policy, money

supply drops, interest rates increase and consumers feelless wealthy.

The central bank affects money supply through all threemonetary policy tools

6. Reserve requirements affects the level of loans banks areable to make

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If the central bank increases the reserve requirement from 10to 12%, then banks would have to recall loans to the extentthat is necessary to meet reserve requirements.

Consider this affect on a monetary base of $1,000 billion,

assuming that no money leaves the banking system (allloans return as deposits)

Money Supply with: 10% reserve requirement: $1,000*(1+0)/(.1+0) = $10,000

billion 12% reserve requirement: $1,000*(1+0)/(.12+0) = $8,333

billion The change in total quantity of money (supply) is $1,667

billion or 17%

Change in reserve requirements affect money, and thecentral bank has the flexibility to move rates between 8% and

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Open Market Transactions: The Federal Reserve (monitoredthrough central bank) buys and sells government securitiesissued by the government Treasury.

Open market Buy Order: increases the money supply andlowers rates

Federal Reserve Bank buys securities from the open market(banking sector). Federal Reserve creates new Fed money to makepayment, crediting the seller with dollars at the Federal ReserveBank

This new money is simply the government creating a new receipt. This new receipt is now expanded through the depository system

by the money multiplier. The treasury seller now has a liabilitywhich can be used by the banking system to create new loans.

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Open market Sell order: The Federal Reservedecreases the money supply and increases rates.Federal Reserve destroys Fed money when it sellstreasuries on the open market. The revenue generated by

the sell simply disappears into the vast depths of theFederal Reserve Bank, with ownership of the liability nolonger assigned to a consumer or commercial claimant(The government owns it).

This destroyed money unravels the effect of the moneymultiplier.

If a bank buys the security, then the cash used is nolonger available for a money creating loan.

If a firm or consumer buys the security, they no longer holdsliability in the banking system (it is replaced with a

government security), and the banking system must increase