monetary policies

Introduction

• Speaker: Jacob Clifford

• Purpose: Discussing economic concepts related to monetary policy and the banking system.

• Thesis: Life in economics and monetary policy is not always what it seems due to widespread misinformation and misunderstanding.

Overview of Monetary Policy

• Definition: The actions taken by a central bank to control the money supply to influence interest rates and overall economic activity.

• Main Tools of the Central Bank:

  • Reserve Requirement: The fraction of deposits that banks must hold as reserves.

  • Discount Rate: The interest rate charged by central banks on loans to commercial banks.

  • Open Market Operations: The buying and selling of government securities in the open market.

• Simplification: These tools are often simplified in textbooks but may not reflect the complexities of contemporary U.S. banking.

Deceptive Simplicity of Textbook Economics

• Traditional Understanding of Money Multiplier:

  • Textbook Example: The money multiplier is calculated based on the reserve requirement.

  • Real Life Scenario: Current U.S. reserve requirement is zero.

  • Implication: Banks can lend out all deposits, leading to an infinite money multiplier.

• Example: A bank receives a $100 deposit, loans it to a customer, and can continue this process repeatedly.

Changes in the Banking System Post-2008

• Distinction: Banking systems before and after the 2008 financial crisis.

• Pre-2008 Characteristics:

  • Limited reserves were held by banks.

  • Small changes in money supply had significant impacts on interest rates.

  • Central bank actions such as bond purchasing would rapidly lead to increased money supply and decreased interest rates.

• Post-2008 Characteristics:

  • Banks started holding a significant amount of reserves with the central bank due to stricter regulations.

  • Federal Reserve began paying interest on reserves (known as the interest on reserves balance rate).

  • Example Rate: 2% might be the interest paid on reserves, providing banks an incentive to hold reserves instead of lending.

Monetary Policy Mechanics

• New Banking Graph:

  • X-axis: Quantity of reserves deposited with the central bank.

  • Y-axis: The federal funds rate (policy rate).

Demand for Reserves

• Inverse Relationship:

  • High federal funds rate → banks prefer to loan out money rather than deposit it.

  • Low federal funds rate → banks may choose to deposit excess reserves with the central bank.

• Graph Dynamics:

  • Downward sloping demand curve.

  • Banks consider both borrowing from each other and the central bank at the discount rate (if the discount rate is lower, it caps the federal funds rate).

Supply of Reserves

• Vertical Supply Curve:

  • Set by the central bank, indicating it does not change with interest rates.

Equilibrium Federal Funds Rate

• Combinations of demand and supply curves determine the equilibrium.

• Limited Reserves: Changes in money supply directly affect the federal funds rate and, subsequently, interest rates.

• Ample Reserves: Changes in money supply have a minimal effect on interest rates.

Current Monetary Policy in Ample Reserves Environment

• Central Bank's Tool Today:

  • Adjusting the interest rate on reserves.

Expansionary vs. Contractionary Monetary Policy

• Expansionary Monetary Policy:

  • Lowering the interest on reserves → lowers overall interest rates → stimulates investment and increases aggregate demand.

• Contractionary Monetary Policy:

  • Raising the interest on reserves → raises federal funds rate and overall interest rates → decreases investment and consumer spending, thus decreasing aggregate demand.

• Current Example: The Fed is raising interest on reserves to combat inflation.

Summary of Key Concepts

• Limited reserves require traditional monetary policy tools, primarily open market operations.

• Ample reserves necessitate a change in the strategy, emphasizing interest on reserves as a primary tool.