All Terrain Thinking

A Compendium of things I think are Important
"If you teach a man to think he is thinking, he will love you. If you teach a man to think, he will hate you. - Ed McArthur"
 
 

Economics: It's not just whats' in your wallet

1970s: Money Supply Process

The setting

"Money connected human in a more extensive and efficient way than any other known medium.  It created more social ties, but in making them faster and more transitory, it weakened the traditional ties based on kinship and political power." Weatherford

The use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." Weatherford

"The decimal system, and its twin, metric measurement, not only changed the way people handled money and numbers but also transformed the way people thought.  A new empiricism in thought, coupled with money's strict discipline in the use of numbers and categories [emerged]. ... the new class of intellectuals no longer sought to discover knowledge only through studying the works of ancient scholars and religious writers.  They themselves could create knowledge through observation and the recording of events around them."  Weatherford p 149    

"It is no accident that the intellectual formulations of science, the technical changes of industry, and the economic and political domination of capitalism would grow and flourish together at the same times and the same places. "J. D. Bernal

"neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion." David Ricardo

"the war arrested and ultimately broke up this unprecedented monetary cosmopolitanism... At the close of the war the practical monetary solidarity of the world had disappeared, and the overprinting of money continued." Weatherford

Questions of the day

1. Let's talk about money. More specifically, let's talk about the history of money.

  • When and where did we first see coins used as money? Why was this such an important development?
  • When and where did we see first see paper money used?
  • What is debasement of currency and what problem did it cause Nero, a Roman emperor in the first Century AD?

2. The island economy of Tundrania produces five goods using its only resource: labor. Below, these five goods are listed along with the amount of labor time embodied in the goods. Assume that any individual could produce each item if they so desired.

    Auto

    Food

    Clothing

    Shelter

    Recreation

    1,000

    10

    15

    4,000

    5

    a. What is the price of an auto in this economy? Tell me all the information I need to know for transactions purposes (how many different trades are there)?

    b. Develop a commodity money and describe the prices of all the goods produced in the economy.

    c. Develop a fiat money and describe all the prices in the economy.

3. During financial crises people tend to prefer cash to checks so they often attempt to take cash out of banks. This is what happened during the Great Depression as banks collapsed and people withdrew their money and put it into their mattresses.  If they convert their checking accounts into cash, what will happen to the money supply?

4. Assume that your forecaster, a fairly reliable source, has informed you that the economy is expected to emerge from a long recession. Please use S&D to develop a forecast for interest rates.

5. What if we found ourselves in a situation where the FED did not want to see interest rates rise. Please describe to me how the FED could reverse the expected rise in rates and describe the three major tools that the FED could use to alter the money supply to achieve this goal.

6. Explain, in words, what happens when the Federal Reserve conducts an open-market sale of $100 million in bonds. What is the ultimate effect on high-powered money, the money supply and interest rates?

7. Determine with the aid of the MS-MD diagram the impact of the following on interest rates and the money supply.

  • a. an expansion in the economy
  • b. the public's desire to hold a greater share of money as currency
  • c. the Fed's open-market purchases of government securities
  • d. a decision on the part of banks to lower their excess reserves

Outline

  • What is money
    • Evolution of money
    • Properties of money
    • Measurement of money
  • Interest rates: the price of money
    • Alternative rates
    • Components of interest rates
      • inflation effect: real vs nominal rates
      • maturity effect: yield curve
    • Supply - Demand model of interest rates
      • Money demand
      • Money supply
  • Money supply process
    • Fed structure
    • Banks' balance sheets
      • money multiplier
    • Fed's policy tools
      • discount rate
      • required reserve rate
      • open market operations

What is money?

  • medium of exchange
  • unit of account
  • store of value

What are the desirable properties of money?

  • durable
  • divisible
  • transportable
  • readily accepted
  • not easily duplicated

What are the important events in the evolution of the dollar?

  • commodity money
  • metalic money
  • coins
  • bills of exchange
  • bank notes
  • paper money

How do we measure the supply of money? Ms

  • M1 / M2

M1.gif (8130 bytes)

What is the price of money?

  • Interest rates are the price of money

Diagram 1
Money Market

MM0.gif (3553 bytes)

Diagram 3
Money Market: Comparative Statistics
The Graphs

MD_out.gif (4270 bytes)MS_out.gif (4162 bytes)

Money Market: Comparative Statistics
A Summary

 

Interest Rate

Money Supply

Increase Demand

UP

UP

Decrease Demand

DOWN

DOWN

Increase Supply

DOWN

UP

Decrease Supply

UP

DOWN

  • There are many interest rates
  • Discount rate: rate that the FED charges banks for overnight borrowing
  • Federal funds rate: rate banks charge other banks for overnight borrowing
  • Prime rate: the rate banks charge their 'best' customers
  • T-bill rate: the rate on short-term (<1 year) on government (Treasury) securities
  • Mortgage rate: the rate on home loans
  • There are many components to each interest rate

r =  ri + rd + rl + rm+ rr

  • ri= inflation effect

When 5% is not 5%:
Real and nominal interest rates

  scenario 1 scenario 2 scenario 3
Nominal rate 5.0% 5.0% 10.0%
Inflation rate 0.0% 5.0% 5.0%
Real rate 5.0% 0.0% 5.0%
Loan $100 $100 $100
Interest paid $5 $5 $10
Total payment $105 $105 $110
Cost of living $100 $105 $105
Gain to lender 5% 0% 5%

The mathematics of real and nominal rates

rn = rr + ie
or
rr = rn - ie

  • rr = real rate   rn = nominal rate   ie = expected inflation rate

The track record of rates

Short-term US government rates

  Nominal Inflation Real
1950-59 2.03 2.25 -0.22
1960-69 4.00 2.53 1.47
1970-79 6.32 7.41 -1.09
1980-89 8.85 5.12 3.73
1990-95 4.87 3.33 1.53
  • rd= default effect

rates2.gif (5395 bytes)

  • rm= maturity effect

Int.ma8.gif (3830 bytes)

The mathematics of the maturity effect

Long-term interest rates:    rnLT = rrLT + iLT

Short-term interest rates:    rnST = rrST + iST

The track record

wpe4.jpg (16998 bytes)

  • rl = liquidity effect
  • rr= real, risk free rate

Money demand

Transactions Demand

Higher Income Þ More Transactions Þ More Money Demand

Speculative Demand

Higher Interest Rate Þ Higher Opportunity Cost of Money Þ Lower Money Demand

                            Diagram 1
Keynesian Money Demand                              Increase in Demand

 MD3.gif (2342 bytes)MD4.gif (2569 bytes)

Money supply process: overview

MSschematic.gif (4840 bytes)

The Fed

Organizational structure

FED1.gif (7108 bytes)

 

Money supply process: The banks

Stage 1: ACM's Initial Balance Sheet

 

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposit $5,000,000
Actual $1,000,000 Saving deposit $0
Required $1,000,000 Net Worth $500,000
Excess $0 *    
Loans $4,000,000    
Total $5,500,000 Total $5,500,000

The money supply process: stage2

Stage 2: ACM's books after a $100,000 infusion of cash

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposits $5,100,000
Actual $1,100,000 Saving deposits $0
Required $1,020,000 Net Worth $500,000
Excess $80,000    
Loans $4,000,000    
Total $5,600,000 Total $5,600,000
  • bank accepts $100,000 in cash (reserves rise by $100,000) and adds $100,000 to the account of the depositor (checking deposits rise by $100,000)
  • with 20% required reserve rate, bank needs to hold $1,020,000 as required reserves (.2*$5,100,000). Bank has excess reserves (cash earning no return) of $80,000

The money supply process: stage3

Stage 3: ACM's books after a $100,000 infusion of cash

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposits $5,100,000
Actual $1,020,000 Saving deposits $0
Required $1,020,000 Net Worth $500,000
Excess $0    
Loans $4,080,000    
Total $5,600,000 Total $5,600,000
  • bank lends out $80,000 of excess reserves in form of cash (reserves fall by $80,000 and loans rise by $80,000)
  • $80,000 will work its way back into the banking system as another infusion of cash - this time an infusion of $80,000 into Bank KAB.

The money supply process: stage4

Stage 4: KAB's books after deposit $80,000

Assets   Liabilities  
Securities $0    
Reserves   Checking deposits $80,000
Actual $80,000 Saving deposits $0
Required $16,000 Net Worth $0
Excess $64,000    
Loans $0    
Total $80,000 Total $80,000
  • bank takes in $80,000 as cash and credits checking accounts for the $80,000
  • the bank must hold $16,000 as additional required reserves (.2*$80,000) which gives it $64,000 of excess reserves

The money supply process: stage5

Stage 5: KAB's books after elimination of excess reserves

Assets   Liabilities  
Securities $0    
Reserves   Checking deposits $80,000
Actual $16,000 Saving deposits $0
Required $16,000 Net Worth $0
Excess $0    
Loans $64,000    
Total $80,000 Total $80,000
  • bank takes excess reserves of $64,000 and loans out this cash (excess reserves and actual reserves decline by $64,000 and loans increase by $64,000)
  • the $64,000 in cash eventually works its way back into banking system as additional cash infusion

Conclusion: Money creation in banking system

Cumulative effect

Bank ACM      
Reserves $20,000 Checking account $100,000
Loans $80,000    
Bank KAB      
Reserves $16,000 Checking account $80,000
Loans $64,000    
Bank MRM      
Reserves $12,800 Checking account $64,000
Loans $51,200    
Bank AJM      
Reserves $10,240 Checking account $51,200
Loans $40,960    
Bank LRG      
Reserves $8,192 Checking account $40,960
Loans $32,768    
  • the infusion of a $100,000 deposit into the bank A produces a ripple effect throughout the system. The $100,000 additional cash generates $100,000 in demand deposits, $80,000 in additional cash loans, and $20,000 left as cash reserves (reserve rate is 20 percent). The $80,000 cash loan then works its way into Bank B which increases its demand deposits by $80,000, its reserves by $16,000 and its loans by $64,000...

Cumulative effect

  Reserves Deposits Loans
Bank ACM $20,000 $100,000 $80,000
Bank KAB $36,000 $80,000 $64,000
Bank MRM $48,800 $64,000 $51,200
Bank AJM $59,040 $51,200 $40,960
Bank LRG $67,232 $40,960 $32,768
Bank FTS $73,786 $32,768 $26,214
...      
Total $100,000 $500,000 $400,000
  • the infusion of a $100,000 deposit into the banking system eventually produces an increase in Deposits of $500,000. Since this is part of M1, we have seen a $100,000 increase in cash has produced a $500,000 increase in the money supply

Money multiplier

Money.3.gif (3602 bytes)

Fed control of the money supply: A verbal perspective

The money supply (M1) can be increased if the coins and currency in circulation increase or the checking account balances (demand deposit) increase. There are four ways that this can happen. 

  1. required reserve rate is lowered (rr):
  2. discount interest rate decreases (re):
  3. publics holding of cash changes (cd):
  4. open market purchases (Reserves):

Fed Policy Tools

Tools Increase Money Supply Decrease Money Supply
Discount rate lower raise
Required reserve rate lower raise
Open market operations but securities sell securities

Fed control of the money supply: A graphical perspective

Increase in Money Supply

MSout.gif (2252 bytes)

 
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