Austrian Macroeconomics, Lectures 3, 5, & 6 with Joe Salerno - Mises Academy
The Money Supply-Demand DiagramValue ofMoney, 1/PPriceLevel, PQuantity ofMoney1 1¾ 1.33½ 2¼ 4As the value ofmoney rises, theprice level falls.
The Money Supply-Demand DiagramValue ofMoney, 1/PPriceLevel, PQuantity ofMoney1¾½¼11.3324MS1$1000The Fed sets MSat some fixed value,regardless of P.
The Money Supply-Demand DiagramValue ofMoney, 1/PPriceLevel, PQuantity ofMoney1¾½¼11.3324MD1A fall in value of money(or increase in P)increases the quantity ofmoney demanded:
MS1$1000Value ofMoney, 1/PPriceLevel, PQuantity ofMoney1¾½¼11.3324The Money Supply-Demand DiagramMD1P adjusts to equatequantity of moneydemanded withmoney supply.eq’mpriceleveleq’mvalueofmoneyA
MS1$1000The Effects of a Monetary InjectionValue ofMoney, 1/PPriceLevel, PQuantity ofMoney1¾½¼11.3324MD1eq’mpriceleveleq’mvalueofmoneyAMS2$2000BThen the valueof money falls,and P rises.Suppose the Fedincreases themoney supply.
A Brief Look at the Adjustment ProcessHow does this work? Short version:– At the initial P, an increase in MS causesexcess supply of money.– People get rid of their excess money by spending iton g&s or by loaning it to others, who spend it.Result: increased demand for goods.– But supply of goods does not increase,so prices must rise.(Other things happen in the short run, which we willstudy in later chapters.)Result from graph: Increasing MS causes P to rise.
Monetary Adjustment Process• Excess Supply of Money• MS > MD → ↑DG → ↑P → ↓PPM → ↑Qdm→ MS = MD• Excess Demand for Money• MS < MD → ↓DG → ↓P → ↑ PPM → ↓Qdm→ MS = MD
The Proper Supply of Money• For centuries economists debated the question“What is the optimal supply of money?”• Why should economists discuss this question,when they would never ask what the “optimal”supply of pizzas, iPads or automobiles should be?• Most economists agree that the proper suppliesof goods and services should be determined bythe price system and profit-and-loss test of themarket.
Difference between Money and Other Goods• Capital goods resources are used up or wornout in the process of producing consumergoods.• Consumer goods are typically destroyed byconsumption.• Money is the general medium of exchangeand in performing this function it is not usedup or destroyed but is transferred from onecash balance to the other.
Ricardo’s Law• An increase in the money supply confers nobenefit on society, because the purchasingpower of money is always adjusted by themarket to permit all exchanges to occur thatare mutually beneficial.• Therefore: any supply of money is sufficient toyield the full social benefits of a medium ofexchange.
The Angel Gabriel (or Helicopter) Model• Benevolent but economically ignorant angeldoubles everyone’s cash balances overnight.– The effect on the purchasing power of money.– The effect on the real supply M/P (example: M=$1,000; P=$10/pizza → M/P = 100 pizzas).– The effect on the distribution of income.
Bank Reserves• In a fractional reserve banking system,banks keep a fraction of deposits as reservesand use the rest to make loans.• The Fed establishes reserve requirements,regulations on the minimum amount of reserves thatbanks must hold against deposits.• Banks may hold more than this minimum amountif they choose.• The reserve ratio, R= fraction of deposits that banks hold as reserves= total reserves as a percentage of total deposits
Bank T-Account• T-account: a simplified accounting statementthat shows a bank’s assets & liabilities.• Example:FIRST NATIONAL BANKAssets LiabilitiesReserves $ 10Loans $ 90Deposits $100 Banks’ liabilities include deposits,assets include loans & reserves. In this example, notice that R = $10/$100 = 10%.
Banks and the Money Supply: An ExampleSuppose $100 of currency is in circulation.To determine banks’ impact on money supply,we calculate the money supply in 3 different cases:1. No banking system2. 100% reserve banking system:banks hold 100% of deposits as reserves,make no loans3. Fractional reserve banking system
Banks and the Money Supply: An ExampleCASE 1: No banking systemPublic holds the $100 as currency.Money supply = $100.
Banks and the Money Supply: An ExampleCASE 2: 100% reserve banking systemPublic deposits the $100 at First National Bank (FNB).FIRST NATIONAL BANKAssets LiabilitiesReserves $100Loans $ 0Deposits $100FNB holds100% ofdepositas reserves:Money supply= currency + deposits = $0 + $100 = $100In a 100% reserve banking system,banks do not affect size of money supply.
Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemDepositors have $100 in deposits,borrowers have $90 in currency.Money supply = C + D = $90 + $100 = $190 (!!!)FIRST NATIONAL BANKAssets LiabilitiesReserves $100Loans $ 0Deposits $100Suppose R = 10%. FNB loans all but 10%of the deposit:1090
Banks and the Money Supply: An ExampleHow did the money supply suddenly grow?When banks make loans, they create money.The borrower gets– $90 in currency—an asset counted in themoney supply– $90 in new debt—a liability that does not have anoffsetting effect on the money supplyCASE 3: Fractional reserve banking systemA fractional reserve banking systemcreates money, but not wealth.
Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for SNB, it will loan all but 10% of the deposit.SECOND NATIONAL BANKAssets LiabilitiesReserves $ 90Loans $ 0Deposits $ 90Borrower deposits the $90 at Second National Bank.Initially, SNB’sT-account lookslike this: 981
Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for TNB, it will loan all but 10% of the deposit.THIRD NATIONAL BANKAssets LiabilitiesReserves $ 81Loans $ 0Deposits $ 81SNB’s borrower deposits the $81 at Third NationalBank.Initially, TNB’sT-account lookslike this: $ 8.10$72.90
Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemThe process continues, and money is created with eachnew loan.Original deposit =FNB lending =SNB lending =TNB lending =...$ 100.00$ 90.00$ 81.00$ 72.90...Total money supply = $1000.00In thisexample,$100 ofreservesgenerates$1000 ofmoney.
The Money Multiplier• Money multiplier: the amount of money thebanking system generates with each dollar ofreserves• The money multiplier equals 1/R.• In our example,R = 10%money multiplier = 1/R = 10$100 of reserves creates $1000 of money
A More Realistic Balance SheetMORE REALISTIC NATIONAL BANKAssets LiabilitiesReserves $ 200Loans $ 700Securities $ 100Deposits $ 800Debt $ 150Capital $ 50Leverage ratio: the ratio of assets to bank capitalIn this example, the leverage ratio = $1000/$50 = 20Interpretation: for every $20 in assets,$ 1 is from the bank’s owners,$19 is financed with borrowed money.
Leverage Amplifies Profits and Losses• In our example, suppose bank assets appreciate by 5%,from $1000 to $1050. This increases bank capital from$50 to $100, doubling owners’ equity.• Instead, if bank assets decrease by 5%,bank capital falls from $50 to $0.• If bank assets decrease more than 5%, bank capital isnegative and bank is insolvent.
Central Banks & Monetary Policy• Central bank: an institution that oversees thebanking system and regulates the moneysupply• Monetary policy: the setting of the moneysupply by policymakers in the central bank• Federal Reserve (Fed): the central bank of theU.S.
The Structure of the FedThe Federal Reserve Systemconsists of:– Board of Governors(7 members),located in Washington, DC– 12 regional Fed banks,located around the U.S.– Federal Open MarketCommittee (FOMC),includes the Bd of Govs andpresidents of some of the regional Fed banksThe FOMC decides monetary policy.Ben S. BernankeChair of FOMC,Feb 2006 – present
The Fed’s Tools of Monetary Control• Earlier, we learnedmoney supply = money multiplier × bank reserves• The Fed can change the money supply by changingbank reserves or changing the money multiplier.
How the Fed Influences Reserves• Open-Market Operations (OMOs):the purchase and sale of U.S. governmentbonds by the Fed.– If the Fed buys a government bond from a bank, itpays by depositing new reserves in that bank’sreserve account.With more reserves, the bank can make moreloans, increasing the money supply.– To decrease bank reserves and the money supply,the Fed sells government bonds.
How the Fed Influences Reserves• The Fed makes loans to banks, increasing theirreserves.– Traditional method: adjusting the discount rate—theinterest rate on loans the Fed makes to banks—toinfluence the amount of reserves banks borrow– New method: Term Auction Facility—the Fed choosesthe quantity of reserves it will loan, then banks bidagainst each other for these loans.• The more banks borrow, the more reserves they havefor funding new loans and increasing the moneysupply.
How the Fed Influences the Reserve Ratio• Recall: reserve ratio = reserves/deposits,which inversely affects the money multiplier.• The Fed sets reserve requirements: regulations on theminimum amount of reserves banks must hold againstdeposits.Reducing reserve requirements would lower thereserve ratio and increase the money multiplier.• Since 10/2008, the Fed has paid interest on reservesbanks keep in accounts at the Fed.Raising this interest rate would increase the reserveratio and lower the money multiplier.
Problems Controlling the Money Supply• If households hold more of their money ascurrency, banks have fewer reserves,make fewer loans, and money supply falls.• If banks hold more reserves than required,they make fewer loans, and money supply falls.• Yet, Fed can compensate for householdand bank behavior to retain fairly precise controlover the money supply.
Bank Runs and the Money Supply• A run on banks:When people suspect their banks are in trouble, theymay “run” to the bank to withdraw their funds, holdingmore currency and less deposits.• Under fractional-reserve banking, banks don’t haveenough reserves to pay off ALL depositors, hence banksmay have to close.• Also, banks may make fewer loans and hold morereserves to satisfy depositors.• These events increase R, reverse the process of moneycreation, cause money supply to fall.
The Federal Funds Rate• On any given day, banks with insufficient reserves canborrow from banks with excess reserves.• The interest rate on these loans is the federal fundsrate.• The FOMC uses OMOs to target the fed funds rate.• Changes in the fed funds rate cause changes in otherrates and have a big impact on the economy.
The Fed Funds rate and other rates, 1970–2012051015201970 1975 1980 1985 1990 1995 2000 2005 2010(%)Fed Funds3 Month T-BillPrimeMortgage
Monetary Policy and the Fed Funds RateTo raise fed fundsrate, Fed sellsgovt bonds (OMO).This removesreserves from thebanking system,reduces supply offederal funds,causes rf to rise.rfFD1S23.75%F2S1F13.50%The FederalFunds marketFederal funds rateQuantity offederal funds