W12 C1 (19th Jan, 2009)

Money Market
Monetary Policy
 Money is a generic term to describe a store of value or
unit of account for wealth.
 For example, in calculating the monetary base in the
U.S., there are different classifications:
M1: Instruments that serves as a medium of
exchange (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 funds
M3: Liquid assets (Approximately $4,066 Billion) e.g.
All M2, Long-term time deposits, Commercial paper
General definition: A tool used by governments to affect the
economy

Monetary policy is geared towards influencing interest rates. If

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

Central Bank (Federal Reserve Bank - Founded 1913) is the

central authority appointed by the government to implement
monetary policy.

Example: increasing interest rates slows the economy by

making funds
more expensive to firms, and promotes consumer savings
which decreases
revenues by firms.
 Tools used by the Central bank for implementing
monetary policy
Open market transactions:
Buying and selling of treasury securities changes the money
supply 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 or
so) because of the disequilibrium that it creates.
5. Discount window lending:
Sets the base lending rate among financial institutions. A
somewhat imaginary rate since few institutions actually
borrow from the central bank, so this requires nothing other
than a statement by the central bank chairman.
 Banks can be viewed as counterfeit operations (bank maintains
enough in reserve to meet depositor demands, they can lend these
receipts and earn interest) controlled by the government, and are
an essential tool in affecting monetary policy

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

 Reserve requirements set by the government determine the extent

to which banks can counterfeit. Fewer required reserves means
more 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 at
any time. But, customers don’t ask for their money back since
counterfeiting is profitable and they earn a part of the returns
(interest), but they tolerate the behavior only as long as they
 Since the bulk of deposits never leave the bank, warehouse
banks recognized that they could lend out excess deposits
and 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 by

lending loans, but the ability to do this is limited by the
reputation of the bank and requirements of central Bank.

 The fractional reserve “counterfeiting” operation is

threatened by:
1. Reputation of the note – the institution backing the promise
2. Increased likelihood of note redemption (a function of issuer
reputation)
3. An increase in the note float
Central Bank: A bank with supreme reputation and
credibility, 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 one
individual or family was needed.
5.While it is possible for a cartel of banks to organize and support
each other, a government is best suited for this task. Governments
generally have more longevity than institutions, individuals or
families in developed economies.
6.The Bank of England (1690) is the first modern Central Bank, and
until this century, was privately owned.
7.The Federal Reserve Bank in the U.S. was founded in 1913 in
response to the contagious bank runs of 1910 (bank runs are
failures of fractional reserve banking)
The central bank delegate the task of money creation to banks.

The money creation process: Making one loan, creates the

opportunity to make another loan, a process which continues in
perpetuity.
Step Description
1 Bank issues a promissory note for which there is no
“direct” reserve. (i.e. the bank) makes a loan and gives
the 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 the
new holder, creating anew deposit (bank liability).
5 The promissory note is available once again to be loaned
 A bank that receives $100 Million in deposits and keeps $20 million in
reserve while loaning the rest.
Assets Liabilities
Portion held in reserve: $20 M Deposits: $100 M
New loan issued without reserve: $80 M
 But the $80M in loans returns to the banking system somewhere else, if
not this bank, the second Generation Bank
Assets Liabilities
Reserve: $16 M Dep. of loan from 1st bank: $80 M
Loans from new deposit: $64 M

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

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

Loans from new deposit: $51.2 M

The money multiplier: The extent to which “money” can be
created 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
 Changes in money supply affect interest rates
1. An increase in money supply makes the economy feel
wealthier by putting more money in the hands of
consumers
2. An increase in money supply decreases interest rates
 The central bank induces interest rate changes by changing the
money supply.
Main responsibilities of central bank are to formulate policies
to 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 an

increase in loanable funds, and rates drop.
2. When the central bank tightens monetary policy, money
supply drops, interest rates increase and consumers feel
less wealthy.

 The central bank affects money supply through all three

monetary policy tools
6. Reserve requirements – affects the level of loans banks are
able to make
 If the central bank increases the reserve requirement from 10
to 12%, then banks would have to recall loans to the extent
that 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 (all
loans 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 the
central bank has the flexibility to move rates between 8% and
 Open Market Transactions: The Federal Reserve (monitored
through central bank) buys and sells government securities
issued by the government Treasury.

 Open market Buy Order: increases the money supply and

lowers rates
 Federal Reserve Bank buys securities from the open market
(banking sector). Federal Reserve creates new Fed money to make
payment, crediting the seller with dollars at the Federal Reserve
Bank
 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 liability
which can be used by the banking system to create new loans.
 Open market Sell order: The Federal Reserve
decreases the money supply and increases rates.
Federal Reserve destroys Fed money when it sells
treasuries on the open market. The revenue generated by
the sell simply disappears into the vast depths of the
Federal Reserve Bank, with ownership of the liability no
longer assigned to a consumer or commercial claimant
(The government owns it).

 This destroyed money unravels the effect of the money

multiplier.
If a bank buys the security, then the “cash” used is no
longer available for a “money creating” loan.
If a firm or consumer buys the security, they no longer holds
liability in the banking system (it is replaced with a
government security), and the banking system must increase