曼昆第10版讲义mankiw10e-irm-ch04

CHAPTER4

TheMonetarySystem:WhatItIsandHowItWorks

NotestotheInstructor

ChapterSummary

Thischapterpresentsstandardmaterialdefiningwhatmoneyisandexplaininghowthemoneysupplyprocessworks.Thechapterbeginsbydescribingthefunctionsandtypesofmoney,alongwithhowmoneyiscontrolledandmeasured.Next,thechapterdiscussestheroleofbanksinthemonetarysystem.Finally,thechaptercloseswithananalysisofhowcentralbanksinfluencethemoneysupplyandproblemsinmonetarycontrol.

Comments

Thematerialinthischaptercanbecoveredinoneortwolectures.StudentssometimesconfusethemoneymultiplierwiththeconceptofaggregatedemandmultiplierspresentedinChapter11(andwhichtheymayhavestudiedinaprinciplesofeconomicscourse).Ifinditusefultohighlightthedifferencebetweenthesemultipliers.

UseoftheWebsite

Thedataplottercanprovidestudentstheopportunitytoexploretherelativeimportanceofcurrencycomparedwithdemanddepositsinmeasuringthemoneysupply.

UseoftheEWebsite

GototheEwebsiteanddownloadmonthlydatafromthepasttwoyearsforthemoneysupply(M1)andthemonetarybase(currencyheldbythepublicplusreservesheldbybanks).ComputethemoneymultiplierastheratioofM1tothemonetarybase.Whathappenedtothemoneymultiplierduringthelastseveralmonthsof2008?Discussimplicationsfortheratioofreservestodepositsatbanks.Howdidbanksrespondtothefinancialcrisis?

ChapterSupplements

Thischapterincludesthefollowingsupplements:

4-1 MoneyasaMediumofExchange:TheSearchModel

4-2 IfYouThinktheIslandofYapHasProblems…(CaseStudy)

4-3 MoreonCreditCards

4-4 FinancialInnovation,NearMoney,andtheDemiseofMonetaryAggregates

4-5 ChecksWithoutBanks:TheIrishBankingStrike

4-6 AdditionalReadings

LectureNotes

Introduction

Thischapterintroducestheconceptofmoneyanddiscusseshowthemoneysupplyisdetermined,highlightingtheroleofcommercialbanksinthemonetarysystem.Thechapteralsodescribeshowcentralbanksinfluencethemoneysupplyandconsidersproblemsofmonetarycontrol.Casestudiesonthe1930sandthefinancialcrisisof2008–2009provideopportunitiestousethemoneysupplyframeworktoassesstheeffectivenessofpolicyresponses.Thechaptersetsthestagefordetaileddiscussionoflong-runpricedeterminationandinflationinChapter5,aswellasthemorecomplex,short-runeffectsofmonetarypolicyinlaterchapters.

4-1 WhatIsMoney?

Supplement3-4,“Economists’Terminology”

Economistsmakeasharpdistinctionbetweenmoneyandincome.Money,toaneconomist,representsthestockofassetsthatareusedtocarryouttransactions.Mostimportant,moneyincludescurrency—dollarbillsandcoins—aswellasotherassets,suchasbankaccounts.Understandingmoneywouldseemtobecentraltounderstandingmacroeconomics,butthistaskisnotstraightforward.Themysteryofmoneyisthatwecarryaroundlittlepiecesofpaperthatareintrinsicallyworthless,yetwecangointoastore,giveupsomeofthesepiecesofpaper,andreceivegoodsthathavesomeintrinsicvalue.Whyarepeoplewillingtogiveupvaluablegoodsinexchangeforintrinsicallyworthlesspiecesofpaper?

Toanswerthisquestion,weneedtoknowwhatmoneyis.Essentially,money,oramonetarysystem,issomethingthatallowspeopletocarryouttransactionswitheachother.Itisasocialarrangement,likelanguage.Aneconomywithoutacommonlyagreed-uponmoneyresemblesasocietywithoutacommonlyagreed-uponlanguage:alotofefforthastogointotheeverydaybusinessofdealingwithotherpeople.

TheFunctionsofMoney

Thetraditionalstartingpointforananalysisofmoneyisintermsofthedifferentfunctionsthatmoneycanserve.Todevelopanunderstandingofmoney,economistsfocusonthreeaspects,orfunctions,ofmoney:mediumofexchange,storeofvalue,andunitofaccount.

Themedium-of-exchangefunctionofmoneyemphasizesthatmoneymakesexchangeeasier.Inaneconomywithoutmoney(abartereconomy),peoplespendalotoftimecarryingoutexchanges.Insuchaneconomy,aneconomicsprofessorwhowantsabeermighthavetohuntaroundalongtimeforabarthatiswillingtogiveherabeerinexchangeforalectureoneconomicsoraPDFofoneofherarticles.Butinamonetaryeconomy,shecanacceptlittlegreenpiecesofpaperfromheremployerandthenusethemtobuybeer.Thebarwillacceptthesepiecesofpaperbecauseit,inturn,believesthatotherswillacceptthepiecesofpaper,andsoon.Fromthisperspective,moneyhasvaluebecausepeopleexpectittohavevalue.

Thissoundstenuous,anditis.Monetarysystemshaveoftencollapsedthroughhyperinflation,wherepricesrisebymanythousandsoftimesayear.Oncepeoplebelievethatmoneynolongerwillbeaccepted,itceasestohavevalue.People,therefore,wanttogetridofanymoneytheymayhave,whichmeanstheywillgiveupmoreandmoremoneyinexchangeforgoods.Thispushesupprices,furtherdecreasingthevalueofmoney,untilthesystemfallsapart.(Weconsiderhyperinflationslateron.)Theideathatmoneycanserveasamediumofexchangeisthuslinkedtotheroleofmoneyasastoreofvalue.Peoplewillholdmoneyonlyiftheybelieveitwillcontinuetohavesomevalueinthefuture,somoneycanoperateasamediumofexchangeonlyifitservesasastoreofvalueaswell.Butthestore-of-valuefunctionofmoneyalsorecognizesthatpeoplecanchoosetoholdsomeoftheirwealthintheformofmoney.

Theunit-of-accountfunctionofmoneyidentifiestheconvenienceofhavingawidelyrecognizedmeasureforaccountingandtransactions.Peoplenegotiatecontractsindollarsandpostpricesindollarsbecauseitisconvenientandbecausetheyknowthatotherswillunderstand.AstoreintheUnitedStatescoulddecidetoquoteallitspricesintermsofEnglishpounds,orZambiankwacha,orkilogramsofColombiancoffeeifitwantedto,butthatwouldobviouslybefoolish.Itissimplertohaveacommonlyagreed-uponandwell-understoodunitforrecordingpricesandobligations.

TheTypesofMoney

Historically,manydifferentthingshaveperformedtherolesofmoney,includingseashells,cigarettes,andpreciousmetalssuchasgold,aswellaslittlepiecesofpaper.Theuseofpiecesofpaperwasagradualdevelopmentasthegovernmenttookagreaterandgreaterinterestinthemonetarysystem.Today,otherpiecesofpaper—checks—alsoservetofacilitatepayments,andmanytransactionstakeplacewithoutanypaperchanginghandsatall,intheformofelectronictransfers.

Moneythathasnointrinsicvalue—suchasdollarbills—isknownasfiatmoney;itismoneybecausethegovernmentsaysso.Itisdistinctfromcommoditymoney,whichexistswhensomeintrinsicallyvaluablegoodalsoservesasmoney.Manyofthemonieslistedpreviously—mostnotablygold—areexamplesofcommoditymonies.

CaseStudy:MoneyinaPOWCamp

InprisonerofwarcampsduringWorldWarII,cigarettesevolvedasaformofcommoditymoney.PrisonersusedcigarettestotradethegoodstheyreceivedinRedCrossparcelsbecausethiseliminatedtheneedforacoincidenceofwantsbeforetradecouldtakeplace.

TheDevelopmentofFiatMoney

Supplement4-1,“MoneyasaMediumofExchange:TheSearchModel”

Fiatmoniescanariseasanaturalevolutionfromcommoditymonies.Ifgoldisservingasacommoditymoney,thenthegovernmentcanstepinandmintgoldcoinsthatareofaspecifiedandguaranteedpurityandweight.Then,thegovernmentcanissuepromissorynotesbackedbygold—piecesofpaperthatcanbeexchangedforgold.Finally,itmaynolongerbenecessaryforthesepiecesofpapertobebackedbygoldifeveryoneiswillingtoacceptthem.

CaseStudy:MoneyandSocialConventionsontheIslandofYap

Supplement4-2,“IfYouThinktheIslandofYapHasProblems…”

TheislandofYapinthePacificusedlargestonewheelsformoney.Sincetheseweredifficulttotransport,transactionsoftentookplacewithoutthesestonewheelsactuallybeingmovedatall;instead,islanderssimplytradedclaimstothestonesforgoods.

FYI:Bitcoin:TheStrangeCaseofaDigitalMoney

Bitcoinisatypeofmoneythatexistsonlyinelectronicform.Createdin2009byanonymouscomputerexperts,bitcoinisnotcommoditymoney,sinceithasnointrinsicvalue,norfiatmoney,sinceitisnotissuedbygovernmentaction.Itisamediumofexchangethatreliesonpeople’sacceptingitinexchange.Inthisway,itissimilartotheprimitivemoneyusedontheislandofYap.ThevalueofbitcoinintermsofU.S.dollarshasfluctuatedsharply,rangingfromlessthan10centsduringitsfirstyearoftradingtomorethan$1,000in2013,beforefallingtolessthan$500in2014.Itspricethenshotupwardoverthenextfewyears,reachingaround$5,000in2017.Althoughbitcoinisamediumofexchange,thevolatilityinitsdollarpricemakesitapoorstoreofvalueandaninconvenientunitofaccount.Hence,whetheritbecomesthemoneyofthefutureorashort-livedspeculativefadremainstobeseen.

HowtheQuantityofMoneyIsControlled

Foracommoditymoneysystem,thesupplyofmoneyisdeterminedsimplybytheamountofthecommodityinexistence,whereasforafiatmoneysystem,thesupplyofmoneyiscontrolledbythegovernment.Thegovernment’scontroloverthemoneysupplyisreferredtoasmonetarypolicy.Inmanycountries,monetarypolicyismanagedbyaninstitutionknownasacentralbank.Sometimesthecentralbankismerelyabranchofthegovernment,whileinothercasesitispartiallyindependentofthepoliticalsystem,liketheFederalReserve(Fed)intheUnitedStates.

TheFed’sFederalOpenMarketCommittee(FOMC)meetsabouteverysixweekstomakedecisionsaboutmonetarypolicy.Thiscommitteeconsistsofthe7membersoftheFed’sBoardofGovernorsand5ofthe12presidentsoftheregionalFederalReserveBanks.ThepresidentoftheFederalReserveBankofNewYorkalwayshasavote,whiletheother4votesrotateannuallyamongtheremaining11bankpresidents.NonvotingregionalbankpresidentsattendFOMCmeetingsandcontributetothediscussionaboutpolicy.AlthoughmembersoftheBoardofGovernorsareappointedbythepresidentoftheUnitedStatesandconfirmedbyCongress,theyhavea14-yeartenure,sotheboardisnotcompletelyunderthecontrolofthecurrentadministration.ThepresidentsoftheregionalFedbanksarechosenbythebanks’boardsofdirectors.

TheprimarywayinwhichtheFedinfluencesthesupplyofmoneyisbybuyingandsellinggovernmentbonds,whichthegovernmenthasissuedtothepublictofinanceitsdeficits.Toincreasethemoneysupply,theFedpurchasesbondsfromthepublic—thusexchangingbondsfordollars—andincreasesthequantityofmoneyincirculation.Thisisknownasanopen-marketoperation.Conversely,theFeddecreasesthemoneysupplybysellingbondsandtakingmoneyoutofcirculation.Althoughopen-marketoperationsareapowerfultoolattheFed’sdisposal,theFed,asdiscussednext,hasonlyimperfectcontroloverthesupplyofmoney.

HowtheQuantityofMoneyIsMeasured

Table4-1

Supplement4-3,“MoreonCreditCards”

Therearemanydifferentassetsthathavesomemoney-likecharacteristics,suchascurrency,checkingaccounts,savingsaccounts,moneymarketfunds,andotherassets.Someoftheseserveprincipallyasameansofpayment;othersserveprincipallyasastoreofvalue;mostfulfillbothfunctionstodifferentdegrees.Thus,itisimpossibletogiveasingleprecisemeasureoftheamountofmoneyintheeconomy;thereareseveraldifferentmeasures.

First,andmostobviously,wehavecurrency—billsandcoins.Ifweadddemanddepositsandothercheckabledepositstocurrency,wegetM1.Whenwetalkofmoneyinmacroeconomics,thisiswhatweusuallymean.Asweaddinother,lessliquiddeposits,wegetM2(M1plussavingdeposits,moneymarketfunds,andsmalltimedeposits).

FYI:HowDoCreditCardsandDebitCardsFitintotheMonetarySystem?

Supplement4-4,“FinancialInnovation,NearMoney,andtheDemiseofMonetaryAggregates”

Althoughcreditcardsareusedtomakepurchases,theyarenotreallyamethodof“payment”butinsteadamethodof“deferringpayment.”Ineffect,thecreditcardcompanyismakingaloantoyou.Whenyoupayoffthecreditcardbillattheendofthemonthbywritingacheckagainstyourcheckingaccount,youfinallyaremakingapayment.Thebalanceinyourcheckingaccountispartofthemoneysupply,buttheoutstandingdebtonyourcreditcardisnot.Apaymentwithadebitcard,ontheotherhand,isdrawndirectlyfromthebalanceinyourbankaccount,similartowritingacheck.Accordingly,theaccountbalancebehindthedebitcardispartofthemoneysupply.Eventhoughcreditcardbalancesarenotpartofthemoneysupply,increaseduseofcreditcardstopurchasegoodsandservicesmayreducetheamountofmoneypeopleholdandthusaffectthedemandformoney.

4-2 TheRoleofBanksintheMonetarySystem

Thedefinitionofthemoneysupplythatwegenerallyuseinmacroeconomicsis

M=C+D,

whereMisthesupplyofmoney,Ciscurrencyinthehandsofthepublic,andDisdemanddeposits(thatis,depositsinbanksthatcanbeusedfortransactions,suchasthoseheldincheckingaccounts).

100-Percent-ReserveBanking

Iftherewerenobanksintheeconomy,therewouldbenodemanddeposits,andsothemoneysupplywouldsimplyequaltheamountofcurrency.Thesamewouldbetrueifallthecurrencyweredepositedinbanksandthebanksdidnotmakeanyloans.Suchbankswouldbeoperatingunderasystemof100-percent-reservebanking.Inotherwords,theywouldacceptdepositsandsimplystorethemintheirvaultsasreserves,orelsetheywoulddeposittheminturnattheFederalReserve,whichactsasabankforbanks.Ifthepublictookalltheircurrencyanddepositeditinthebankingsystem,therewouldnolongerbeanycurrencyinthehandsofthepublic—allnotesandcoinwouldbeheldasreserves—buttherewouldinsteadbedemanddepositsequaltotheamountofcurrency.Thiscanbeillustratedintermsofthebalancesheetofthebankingsector,whichweassumeconsistsofonebank.Thisbankhasassetsequaltothereservesitholdsandliabilitiesequaltothedepositsofitscustomers.Under100-percent-reservebanking,bankshavenoinfluenceonthemoneysupply.

Fractional-ReserveBanking

Supplement4-5,“ChecksWithoutBanks:TheIrishBankingStrike”

Intherealworld,banksalsomakeloans.Sincebanksassumethatnotalloftheirdepositorswillwithdrawalltheirmoneyatonce,theydonotneedtoholdreservesequaltotheamountofdeposits.Instead,theyholdonlyafractionoftheirdepositsasreservesandloanouttherest.Thisisknownasfractional-reservebanking.

Supposethat,asbefore,thepublicdepositsallitscurrencyinthebankingsystem.Thus,thereisnocurrencyinthehandsofthepublic.Butnowsupposethatbanksadoptareserve–depositratio(rr)of20percent,sothatforevery$1ofdeposits,thebankshold$0.20inreservesandlendouttheremaining$0.80.Themoneysupplyhasnowincreased,sincethereisstill$1worthofdeposits,andthereisnowanadditional$0.80ofcurrencybackinthehandsofthepublic.Themoneysupplynowequals$1.80foreverydollarofdeposits.Moreover,theprocessdoesnotstophere.Ifthe$0.80isinturndepositedbackinthebankingsystem,thenbankswillhold20percent($0.16)asreservesandloanouttheremaining80percent($0.64).Themoneysupplyincreasesfurther.Wecanagainillustratethisbylookingatthebalancesheetsofbanks.

Ifwefollowthisprocessthrough,wefindthateachdollarofreservescontributes1/rrdollarstothemoneysupply,since

1+(1–rr)+(1–rr)2+(1–rr)3+...=1/rr.

Inourexample,thereserve–depositratioequals0.2,sothemoneysupplyequals$5foreverydollarofreserves.

BankCapital,Leverage,andCapitalRequirements

Themodelofthebankingsystempresentedaboveignorestheneedforbankownerstohavesomefinancialresources,knownasbankcapital,representingtheirequitystakeinthebank.Amorerealisticbalancesheetforabankwouldaccountforbankcapitalontheliabilitysideandwouldalsoincludethedebtissuedbythebankinadditiontodepositsasliabilityitems.Theassetsideofthebalancesheetwouldincludebankinvestmentsinsecuritiesofthegovernmentandprivatesectorinadditiontoreservesandloans.Bankswillallocateresourcestotheseassetsbasedontheriskandreturneachprovidesandanyregulationsthatmayrestrictthetypeofinvestments.Ineffect,abankusesastrategyofleveragetoaugmentitscapitalforthepurposesofinvestment—thatis,itborrowsmoney(throughdepositsanddebt)toincreasetheresourcesavailableforinvestment.Theleverageratioistheratiooftotalassetstobankcapital.

Inbadtimes,thebankcanlosealargeamountofitscapitalveryquickly.Forabankwithahighleverageratio,arelativelysmallpercentagedropinthevalueofthebank’sassetscanresultinadollarlossthateasilyequalsorexceedsthevalueofitsbankcapital.Becausedepositorsanddebtholderslegallyhavetobepaidfirst,thecapitalofthebank’sownerscanbewipedout.Concernthatbankcapitalisrunningshortmayleaddepositorstodemandtheirmoneyand,intheabsenceofdepositinsurance,causeabankrun.Bankregulators,therefore,requirebankstoholdsufficientcapital,underwhatareknownascapitalrequirements,toensurethattheycanpayofftheirdepositors.Manybanksendedupwithtoolittlecapitalduring2008and2009asaresultoflossesoninvestmentstheyhadmadeinmortgageloansandmortgage-backedsecurities.Thiscapitalshortageinturnledbankstoreducelending,contributingtothedownturnintheeconomy.Tocounteractthis,theTreasuryandFederalReservebegantoputpublicfundsintobanksinanattempttorecapitalizethebankingsystem.

4-3 HowCentralBanksInfluencetheMoneySupply

Havingdescribedthefunctionsofmoney,howitismeasured,andthewayinwhichthebankingsystemaffectstheamountofmoneyintheeconomy,wenowanalyzehowacentralbankinfluencesthemoneysupply.Thisroleofthecentralbankisthekeyelementofmonetarypolicy.

AModeloftheMoneySupply

Wenowexaminefractional-reservebankingmorecarefully,takingintoaccounttheinteractionsamongthecentralbank(FederalReserve),households,andcommercialbanks.Someoftheeconomy’snotesandcoin—themonetarybase—isingeneralheldbythepublic(C)andsomeisheldbybanksasreserves(R).LettingBdenotethemonetarybase,wehave,bydefinition,

B=C+R.

Recallalsothat

M=C+D.

Nowdefinethecurrency–depositratio(cr)as

cr=C/D

andnotethatthereserve–depositratiois

rr=R/D.

Thecurrency–depositratioandthereserve–depositratiodescribethebehaviorofthepublicandofbanks,respectively.Wecannowusetheseequationstofindhowthemoneysupplydependsuponthesetwovariablesandonthemonetarybase.First,dividethesecondequationbythefirsttoget

NowdividethenumeratoranddenominatoroftheterminbracketsbyD:

Theterm(cr+1)/(cr+rr)isknownasthemoneymultiplier,sinceitshowshoweachdollarofthemonetarybaseismultiplieduptogivealargervalueforthemoneysupply.Forexample,ifthereserve–depositratiois10percentandthecurrency–depositratiois40percent,thenthemoneymultiplierequals2.8:themoneysupplyisalmostthreetimesthemonetarybase.Increasesinthereserve–depositratioandthecurrency–depositratiobothdecreasethemoneymultiplier.Notealsothatifthecurrency–reserveratioiszero,thenthemoneymultiplieris1/rr,aswefoundbefore.

TheInstrumentsofMonetaryPolicy

ThischaptermakesthesimplifyingassumptionthattheFederalReservecontrolsthemoneysupplydirectly.Butinreality,theFedhasonlyindirectcontroloverthemoneysupply,usingavarietyofinstruments.Theseinstrumentscanbecategorizedasthosethataffectthemonetarybaseandthosethataffectthereserve–depositratioandtherebythemoneymultiplier.

TheFed’sprimaryinstrumentforchangingthemonetarybaseisopen-marketoperations—thatis,thepurchaseandsaleofgovernmentbonds.IftheFedbuysagovernmentbond,thenitincreasesthemonetarybaseandviceversa.TheFedcanalsochangethemonetarybasebylendingreservesdirectlytobanks.ThishastraditionallybeendonethroughtheFed’sdiscountwindow,andtheinterestratethattheFedchargestobanksisknownasthediscountrate.Areductioninthediscountratelowersthecosttobanksofborrowingreservesandincreasestheincentiveforbankstoborrowfromthediscountwindow.Inresponsetothefinancialcrisisof2008–2009,theFeddevelopednewmechanismsforbankstoborrowreserves,includingtheTermAuctionFacility.Underthisfacility,theFedsetsthequantityofreservesitdesirestolendandbanksthenbidforthefunds.Thelastauctionunderthisfacilitywasheldin2010.

Changesintheminimumreserve–depositratiothattheFedimposesonbanksthroughregulations,knownasreserverequirements,leadtochangesinthemoneymultiplierandtherebythemoneysupply.ThistoolistheleastusedoftheFed’spolicyinstruments.Furthermore,becausebanksinrecentyearshaveoftenheldexcessreserves,thisinstrumenthasbecomelesseffective.Sincetheendof2008,theFedhaspaidinterestonreservesheldondepositattheFed.Bypayinginterestonreserves,theFedaimstoinfluencetheamountofreservesheldondeposit,therebyaffectingthereserve–depositratio.Anincreaseintheinterestrateonreserveswouldraisethereserve–depositratio,lowerthemoneymultiplier,andlowerthemoneysupply.

CaseStudy:QuantitativeEasingandtheExplodingMonetaryBase

Figure4-1

Themonetarybasehastypicallygrowngraduallyovertime,butfrom2007–2014itexpandedrapidly,increasingaboutfivefoldinsize.ThisexplosioninthemonetarybaseresultedfromtheFederalReserveactingboldlyduringthefinancialcrisisandeconomicrecessionasalenderoflastresort.Initially,theFedpurchasedmortgage-backedsecuritiestohelpstabilizethemortgagemarketsothatpotentialhomeownerscouldborrow.Later,theFedpurchasedlong-termgovernmentbondswiththegoalofkeepinglong-terminterestrateslow.Thispolicyofquantitativeeasingissimilartoanopen-marketoperation,exceptthatlong-term,somewhatriskiersecuritiesarepurchasedratherthanshort-termTreasurybills.

Supplement18-11,“TheMoneyMultiplierDuringtheFinancialCrisisof2008–2009”

Supplement18-12,“BanksHoardReservesDuringtheFinancialCrisis”

Supplement18-16,“ExitStrategiesfortheFed”

Despitetheenormousexpansioninthemonetarybase,broadermeasuresofthemoneysupplydidnotincreasenearlyasmuch.Althoughthemonetarybaseincreasedabout400percentfrom2007to2014,M1increasedbyonly100percent,andM2increasedbyonly55percent.Thereasonwasthatthemoneymultiplierfellsharplyasbanksincreasedtheirreserve–depositratio,holdinglargeamountsofexcessreserves.Thisincreaseinexcessreservesreflectedinpartaresponsebybankstotightencreditstandardsasaresultoflossesonbadloansmadepriortothefinancialcrisis.Theincreasealsoreflectedthereducedprofitabilityofbankloansasinterestratesonsuchloansfelltoverylowlevels,discouragingbanksfromlending.

Withthehugeexpansioninthemonetarybase,someobserversraisedconcernsaboutfutureinflationifinterestratesreachednormallevelsandbankssteppeduptheirlending,increasingthemoneysupply.TheFed,however,wasreadytohandlethisproblembyraisingtheinterestratepaidonreservestodiscouragebanklendingandkeepthemoneymultiplierlow.

ProblemsinMonetaryControl

Byusingitsvariousinstruments,theFedcanpowerfullyinfluencethemoneysupply.Butitdoesnothaveperfectcontrol.Bankdecisionstoincreaseholdingsofexcessreserveswillincreasethereserve–depositratioandlowerthemoneysupply.TheFedalsocannotfullycontroltheamountthatbanksborrowfromthediscountwindow.Ifbanksreducetheirborrowing,themonetarybaseandmoneysupplywilldecrease.

CaseStudy:BankFailuresandtheMoneySupplyinthe1930s

Table4-2

Chapter12discusseshowsomeeconomistsbelievethatalargedeclineinthemoneysupplyduringtheearly1930swasthemaincauseoftheGreatDepression.Butexactlywhydidthemoneysupplyfallsodramatically?Interestingly,betweenAugust1929andMarch1933themonetarybaseroseby18percent,eventhoughthemoneysupplyfellby28percent.Thus,thefallinthemoneysupplyisattributabletoadeclineinthemoneymultiplier,whichinturnwastheresultofariseinboththecurrency–depositratioandthereserve–depositratio.

AlargenumberofbankfailuresoccurredintheearlyyearsoftheGreatDepression.Thesefailuresaretheprobableresultofthechangedbehaviorofindividualsandbanks.Thelikelihoodofbankfailuremakescurrencyseemlikeasaferwaytoholdwealth,increasingthecurrency–depositratio.Meanwhile,bankmanagerswhofeararunontheirbankarelikelytoincreasetheirholdingsofreserves.TheFed,therefore,wasnotdirectlyresponsibleforthefallinthemoneysupply,inthesensethatitdidnotreducethemonetarybase.However,itcouldhaveincreasedthemonetarybasefurthertooffsetthefallinthemoneymultiplier.Italsocouldhaveactedmoreaggressivelytopreventrunsonbanksbybeingalenderoflastresorttobanksthatwereindifficulty.

Sincethe1930s,manypolicieshavebeenadoptedtoreducethelikelihoodofasudden,largedeclineinthemoneymultiplier.Themostimportantisthesystemoffederaldepositinsurancethatprotectsdepositorswhenabankfails,therebysupportingpublicconfidenceandpreventingasharpincreaseinthecurrency–depositratio.Duringthefinancialcrisisof2008–2009,theFederalDepositInsuranceCorporationraisedtheinsureddepositamountto$250,000from$100,000soastostabilizethebankingsystemandmoneysupply.

4-4 Conclusion

Thischapterhasexplainedthenatureofmoneyandhowcentralbanksinfluenceitssupply.Thenextchapterdevelopsanunderstandingofhowchangesinthemoneysupplyaffecttheeconomyinthe