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1. Austrian Macroeconomics
Lecture 4

2. The Fed’s Tools of Monetary Control
• Earlier, we learned
money supply = money multiplier × bank reserves
• The Fed can change the money supply by changing
bank reserves or
changing the money multiplier.

3. How the Fed Influences Reserves
• Open-Market Operations (OMOs):
the purchase and sale of U.S. government
bonds by the Fed.
– If the Fed buys a government bond from a bank, it
pays by depositing new reserves in that bank’s
reserve account.
With more reserves, the bank can make more
loans, increasing the money supply.
– To decrease bank reserves and the money supply,
the Fed sells government bonds.

4. How the Fed Influences Reserves
• The Fed makes loans to banks, increasing their
reserves.
– Traditional method: adjusting the discount rate—the
interest rate on loans the Fed makes to banks—to
influence the amount of reserves banks borrow
– New method: Term Auction Facility—the Fed chooses
the quantity of reserves it will loan, then banks bid
against each other for these loans.
• The more banks borrow, the more reserves they have
for funding new loans and increasing the money
supply.

5. 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 the
minimum amount of reserves banks must hold against
deposits.
Reducing reserve requirements would lower the
reserve ratio and increase the money multiplier.
• Since 10/2008, the Fed has paid interest on reserves
banks keep in accounts at the Fed.
Raising this interest rate would increase the reserve
ratio and lower the money multiplier.

6. Problems Controlling the Money Supply
• If households hold more of their money as
currency, 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, the Fed can compensate for household
and bank behavior to retain fairly precise control
over the money supply.

7. Bank Runs and the Money Supply
• A run on banks:
When people suspect their banks are in trouble, they
may “run” to the bank to withdraw their funds,
holding more currency and less deposits.
• Under fractional-reserve banking, banks don’t have
enough reserves to pay off ALL depositors, hence
banks may have to close.
• Also, banks may make fewer loans and hold more
reserves to satisfy depositors.
• These events increase R, reverse the process of money
creation, cause money supply to fall.

8. How Well Has the Fed Performed?

9. The Fed Dollar Vs the Gold Dollar 1
• $22.57 in the year 2012 has the same "purchasing power" as
$1 in the year 1914 (the year the Fed began operating)
• $17.23 in the year 2012 has the same "purchasing power" as
$1 in the year 1933 (the year the U.S. abandoned the
domestic gold standard)
• $5.67 in the year 2012 has the same "purchasing power" as
$1 in the year 1971 (the year that the U.S. closed the “gold
window” on foreign governments and central banks)
• $2.23 in the year 2012 has the same "purchasing power" as
$1 in the year 1984 (the year the enlightenment of central
banks and the “Great Moderation” began).

10. The Fed Dollar Vs the Gold Dollar 2
• $0.80 in the year 1914 had the same "purchasing power" as
$1 in the year 1800.
• $0.67 in the year 1896 (the year of new gold discoveries in
South Africa) had the same "purchasing power" as $1 in the
year 1800.
• $0.82 in the year 1896 had the same "purchasing power" as
$1 in the year 1880 (period of greatest rate of growth in U.S.
history).
• $1.19 in the year 1914 had the same "purchasing power" as
$1 in the year 1896 (the year of new gold discoveries and
period of “Great Inflation”).

11. Capital and the Structure of
Production

12. Production and Time Preference
• Production takes time and takes place in
stages
• Law of Time Preference:
– Time is scarce and so individuals prefer to achieve
their goals sooner rather than later, all other
things equal.
– Everyone values a good (or satisfaction or sum of
money) available in the present to the same good
available in the future.

13. The Nature of a Loan Transaction
Borrower’s value scale Lender’s value scale
$10,000 present $11,000 future
$11,000 future $10,000 present
Worker Payday Lender
$244 present $280 future
$280 future $244 present

14. Time Preference Defined
• An individual’s time preference (t.p.) is expressed in his or her
consumption/saving ratio: C/S
• Example:
Assume persons A and B both earn income of $1,000 per month.
A: C/S = $800/$200 = 4/1
B: C/S = $500/$500 = 1/1
• A higher C/S ratio indicates a relatively higher t.p. because a
greater proportion of income is spent on present
consumption. A lower C/S ratio indicates a relatively lower
t.p. because a lower proportion of income is spent on present
consumption and a relatively larger proportion is saved for
spending on future consumption.

15. Changes in Time Preference
• A person’s t.p. is not constant. It varies with income,
age and other circumstances. Different people will have
different t.p. even in the same circumstances.
• Examples:
– Typical t.p. life cycle: children; young adults; middle age;
old age
– Criminals; lottery winners; undeveloped countries;
immigrants versus playboys; preventive medical care
– Announcements: a) a new drug will double the average
human lifespan; b) a meteor will crash into Earth in a year.

16. Laws of Human Action
1. All people prefer a greater quantity of goods to a smaller
quantity of goods, all other things equal. (Law of Total
Utility)
3 DVDs > 2 DVDs > 1 DVD
2. All people value a quantity of goods available sooner more
highly than an equal quantity of goods available later, all
other things equal. (Law of Time Preference)
IPhone (today) > IPhone (in 2 yrs.) > IPhone (in 5 yrs.)
3. Some longer processes of production are more productive
than shorter processes of production.

17. Law of Human Action cont’d
3. Example: You can catch more fish per day with the same
number of workers by first building a boat and a net than
by making fishing poles and having the laborers fish off
the dock.
4. Some highly valued goods can only be produced with
longer processes of production, e. g, automobiles,
laptops, MRI machines, etc. Therefore:
5. People will only use longer processes of production if
they are sufficiently more productive (that is, yield either
a greater quantity of the same goods or new goods that
cannot be produced with shorter processes) to overcome
their t.p. in waiting a longer time for the goods.

18. Choosing Production Processes
More Productive Less Productive
Shorter All Some
Longer Some None

19. Choosing Production Processes
• People will always chose the shorter and most
productive processes first, because of the laws of
time preference and maximizing utility.
• No one will choose the longer less productive
processes of production when they can get an equal
or greater quantity of goods from the shorter
processes.
• People will only choose longer more productive
processes if there are sufficient savings available to
produce the necessary capital goods.