Monetary Policy and Bank Regulation

This is Unit Twelve of Principles of Macroeconomics, part one of two: monetary policy and bank regulation. Unit eleven built the money and the banks. This part builds the institution that acts on them. Carry one idea through. The central bank works on the price of holding money, and everything else follows from that price. But the three tools every textbook teaches assume reserves are scarce, and reserves stopped being scarce, so the last three entries here replace the apparatus the first twenty build. By the end you will tell a shift of money demand from a movement along it, work a change through the money market to aggregate demand, walk a balance sheet through a purchase and a sale, choose a tool for a goal, and say what replaced the traditional three.

Four entries on the institution: what it does, how it is built, where policy is decided, and why its independence is argued about.

What a central bank does.

MAC 1101 What a Central Bank Does

A central bank conducts monetary policy, supervises banks, and provides banking services to banks and to the government. It is a bank for banks rather than for households. Most countries have one, and they differ in structure more than in function. Two of those jobs are separate: setting policy, and regulating banks.

How this one is built.

MAC 1102 The Structure of the Federal Reserve

The Federal Reserve is deliberately semi-decentralised. A Board of Governors of seven members sits at the centre, appointed to fourteen-year staggered terms, with twelve regional banks beneath it and a Chair speaking for the whole. The long staggered terms exist to insulate decisions from short political cycles. This course teaches the office and its powers, never the office-holder.

Where policy is decided.

MAC 1103 The FOMC

Monetary policy is set by the Federal Open Market Committee: the seven governors plus five regional presidents, with New York holding a permanent seat and the other eleven rotating. It meets eight times a year, and between meetings its members can confer, so a decision can move quickly. The committee decides; the trading desk in New York executes.

The argument about independence.

MAC 1104 Independence, and Why It Is Contested

The Fed is insulated from the government by long terms and by funding itself from its own bond holdings, returning surplus earnings to the Treasury, so it is not strictly part of the government. The case for independence is that inflation control needs a longer horizon than an election cycle. The case against is that unelected officials make decisions with enormous distributional effects.

Two entries on the other half of the job: regulating banks, and the defences that keep the system standing.

The three arms of regulation.

MAC 1105 Bank Regulation: Three Arms

Regulation works through three instruments. Reserve requirements set what must be held. Capital requirements set a minimum net worth as a share of assets. Investment restrictions limit what banks may own: they may lend and hold government securities, and may not hold corporate stock. Valuing a bank's assets is genuinely hard, which makes supervision hard.

What stops a run.

MAC 1106 Deposit Insurance and Lender of Last Resort

Two defences protect a fractional reserve system. Deposit insurance guarantees balances up to a limit, funded by premiums on banks. The central bank also lends as a last resort to solvent institutions, which is why it was founded after a banking panic. Insurance stops runs; the lender of last resort addresses illiquidity, not insolvency.

Five entries on why anyone holds money at all, and what moves the demand for it.

Why hold money at all.

MAC 1107 Why Hold Money at All

Money pays little or no interest and bonds pay more, so holding money has a cost, and the question is why anyone holds it. The answer is that money can be spent while bonds must first be sold: the choice is between liquidity now and interest later. The cost of holding money is the interest given up, not a fee.

The three reasons.

MAC 1108 The Three Motives

People hold money for three reasons. Transactions demand covers purchases they expect to make. Precautionary demand covers contingencies they cannot date. Speculative demand is held against a fall in asset prices, which explains why expecting bond prices to fall raises money demand. No one sorts a balance into three piles; the motives are analytical.

The price that governs all three.

MAC 1109 The Interest Rate Is the Price of Holding Money

All three motives respond the same way to interest rates. When rates rise, holding money costs more, so people hold less; when rates fall, they hold more. A household can keep a month's spending in cash, or part in a bond fund and transfer as needed — and the second earns interest and costs attention, which is the real trade.

Drawing that relationship.

MAC 1110 The Money Demand Curve

The three motives together give a demand curve for money: the quantity people want to hold at each interest rate, everything else unchanged, and it slopes downward. This is the law of demand with the interest rate serving as the price. A change in the interest rate moves you along this curve; it does not shift it.

What shifts it.

MAC 1111 What Shifts Money Demand

Decide whether an event moves along the money demand curve or shifts it, using the test unit two established: if the interest rate changed, the movement is along the curve; if anything else changed, the curve shifts. Five things shift it. Real GDP rises, so more transactions need financing and demand shifts right. The price level rises, so a given basket takes more money and demand shifts right. People come to expect bond prices to fall, so speculative demand rises. Transfers between accounts become cheaper, so people economise on money and the curve shifts left. Households become more cautious, and the curve shifts right. Contrast all five with a central bank action that lowers the interest rate: that is a movement along the curve. Expectations here can be self-confirming, because if enough people expect bond prices to fall and sell bonds to hold money, the selling itself pushes bond prices down.

Two entries putting the two sides of the money market together, and working a change through it.

The other side of the market.

MAC 1112 The Money Supply Curve and Equilibrium

The money supply is set by the central bank rather than by the interest rate, so it draws as a vertical line, and equilibrium is where the two curves cross. With a supply of nine hundred billion, the rate settles where demand equals nine hundred. The interest rate is an outcome, not an input: the bank chooses the quantity.

Working a change through it.

MAC 1113 Working a Change in the Money Market

Given a change in money demand or supply, find the new interest rate and trace what follows, in four steps: what moved and which way, what happens to the rate, what that does to investment and net exports, and where aggregate demand ends up. Start with a supply of nine hundred billion and a rate of four percent. The central bank buys bonds and supply rises to one thousand. At four percent people do not want to hold the extra money, so they buy bonds; bond prices rise, and a higher bond price is a lower interest rate. The rate falls until quantity demanded reaches one thousand, say to three percent. Lower rates raise investment and durable consumption, and lower the exchange rate, which raises net exports, so aggregate demand shifts right by the multiplier times those changes. The money market and the bond market are two views of one adjustment, not two events: when people hold less money they are holding more bonds, so the rate that clears one clears the other.

Four entries on the main traditional tool, walked through a balance sheet both ways.

The tool that did that.

MAC 1114 Open Market Operations

The central bank buys and sells government bonds, and this is its main traditional tool. Buying injects reserves into the banking system; selling withdraws them. Treat the central bank as outside the system, so money flows from it when it buys and to it when it sells. It buys and sells existing bonds in the market, not new debt from the Treasury.

A purchase, on the books.

MAC 1115 Walking a Balance Sheet Through a Purchase

Take a purchase to the balance sheet and name what moves at each step. The engine is that the bank has a desired level of reserves and returns to it after any disturbance, so state that level first. Use unit eleven's bank: reserves six hundred, loans three thousand nine hundred, bonds five hundred, deposits four thousand five hundred, and a desired reserve level of six hundred. The central bank buys two hundred of its bonds, so bonds fall to three hundred and reserves rise to eight hundred, with total assets and net worth unchanged. The bank now holds two hundred more reserves than it wants, so it lends the two hundred: loans rise to four thousand one hundred and reserves return to six hundred. Only the composition of assets changed. Notice where the money supply changed: the purchase created the capacity to lend and changed no deposits, and the lending created the deposits. That new loan is round one of unit eleven's chain, so the two models join exactly here.

The same walk in reverse.

MAC 1116 Walking a Balance Sheet Through a Sale

Now run a sale through the same bank, keeping one side as the subject so the direction never blurs: the central bank sells and the commercial bank buys. Starting again at reserves six hundred, loans three thousand nine hundred, bonds five hundred and deposits four thousand five hundred, the bank buys two hundred of bonds, so reserves fall to four hundred and bonds rise to seven hundred, with assets and net worth unchanged. Reserves are now two hundred below the desired six hundred, so the bank reduces its loans by two hundred and reserves return. Contraction works by shrinking lending, the mirror of the purchase. Total assets and net worth were unchanged in both directions, which is worth saying plainly because it looks wrong: the bank is no richer or poorer either way, and the money supply is what moved.

Where the money supply moves.

MAC 1117 Where the Money Supply Actually Changes

The money supply does not change when the central bank buys the bond. It changes when the bank lends the resulting excess reserves, because lending creates deposits and deposits are money. The purchase creates the capacity; the lending creates the money. This is why expansion can stall: a bank that declines to lend leaves the capacity unused.

Four entries on the other two traditional tools, and choosing among all three.

The second traditional tool.

MAC 1118 The Discount Rate and the Discount Window

Banks short of reserves can borrow from the central bank at the discount window, and the rate charged is the discount rate. Raising it discourages borrowing and lowering it encourages it. A typical bank uses the window once or twice a year. The rate sits above what banks charge each other, so it is a backstop.

The rate they charge each other.

MAC 1119 The Federal Funds Rate

Banks lend reserves to one another overnight, and the rate on those loans is the federal funds rate. It is set by supply and demand for reserves, and other rates follow it. The central bank announces a target, then acts until the market rate reaches it. A one-point move in an overnight rate moves a mortgage rate by less.

The third traditional tool.

MAC 1120 Reserve Requirements as a Tool

Raising the required reserve ratio leaves banks less to lend and lowering it leaves more, so in principle it is a policy tool. In practice it was rarely moved, because sudden changes disrupt planning. Unit eleven recorded the ratio at zero since March twenty twenty, so the tool exists on paper but is not in use, which matters on the exam.

Choosing among the three.

MAC 1121 Which Tool, Which Direction

Given a goal, name an action that serves it and say which way each variable moves. Expansionary actions add reserves or make them cheaper; contractionary actions do the reverse; and each is worked through to the interest rate before it is judged. To expand: buy bonds, which raises reserves, lowers the federal funds rate and raises aggregate demand. To contract: sell bonds, which drains reserves and raises the rate. Lowering the discount rate is expansionary and weakly so, since the window is little used. Now the case the exam asks: to fight inflation the central bank contracts, so it sells bonds. The trap sits in the alternatives, because lowering the required reserve ratio is expansionary and would worsen inflation, and that ratio has been zero since March twenty twenty in any case. An open market sale is contractionary, and unit nine's Phillips curve shows the same event from the other side: a movement along the short-run curve toward lower inflation and higher unemployment.

Three entries on why those tools stopped describing policy, and what took their place.

Why the three stopped fitting.

MAC 1122 From Limited to Ample Reserves

The three traditional tools assume reserves are scarce, so adding or draining them moves lending. Reserves stopped being scarce: they grew from about fifteen billion dollars in two thousand and seven to two point seven trillion by late two thousand and fourteen, and in two thousand and nineteen the committee stated it would operate with ample reserves. The model did not become wrong. The conditions it assumed stopped holding.

What replaced them.

MAC 1123 Interest on Reserve Balances

The main tool now is the interest rate the central bank pays on reserves banks hold with it. It was authorised in two thousand and six, begun in two thousand and eight, and consolidated into one rate in twenty twenty-one. Paying interest on reserves changes what holding them costs a bank, which breaks unit eleven's step three: reserves that pay need not be lent.

How that moves a market rate.

MAC 1124 How IORB Moves the Federal Funds Rate

A bank will not lend reserves overnight for less than holding them earns. Lower the rate on reserves and banks lend into the funds market instead, so the funds rate falls; raise it and the reverse happens. The rate on reserves acts as a floor the funds rate tracks. The bank now steers a price rather than a quantity.

Look at what you can now do. You can tell a shift of money demand from a movement along it, by asking whether the interest rate was what changed. You can work a change through the money market to aggregate demand, remembering that the money market and the bond market are one adjustment seen twice. You can walk a balance sheet through a purchase and a sale, and say that net worth never moved in either. You can choose a tool for a goal and follow it through to the interest rate before judging it. And you can say why the traditional three stopped describing policy, and what a rate paid on reserves does instead. Part two takes policy to the zero bound and to what happens when the tools run out.