Carbon trading has become a huge business in the past few years. But is it really going to save the planet, or is it just a lot of hot air?
Carbon trading has become a huge business in the past few years. But is it really going to save the planet, or is it just a lot of hot air?
Soaring oil prices, politicians’ growing focus on the dangers of climate change and mounting demand for energy among emerging economies could push the carbon trading market toward the trillion dollar point by 2020.
The market in the trading of carbon—measured as a reduction in 1 metric ton of carbon dioxide or its equivalent in other greenhouse gases—climbed to $64 billion in 2007, more than double the $31.2 billion recorded in 2006 and nearly six times the amount tallied in 2005, according to World Bank statistics. Bankers, traders and brokers are helping to develop this growing financial marketplace by keeping trading liquid and flexible as they help corporations manage the long-term costs linked to reducing carbon dioxide emissions and complying with government mandates.
The global attention on climate change and reducing greenhouse gases will only continue against a backdrop of events, from this summer’s Group of Eight summit in Japan, to the current US presidential campaign, to talks now under way to create a successor pact to the United Nations-linked Kyoto Protocol by the end of 2009.
“Political agendas and policy decisions, both large and small, affect the market,” says Karan Capoor, senior carbon markets specialist in the sustainable development operations group at the World Bank in Washington, DC. “It creates a long-term expectation that this market is not going to go away.”
Capoor points to the European Union’s recent proposal to extend the life of the European Union Emission Trading Scheme (EU ETS) until 2020 as an example of a “big picture shift” that affects the market. The EU’s decision to let European Union Allowances (EUAs) earned in the second phase of the program to be banked, or remain valid, through 2020 is an example of a policy decision that produces a smaller marketplace shift. “This creates confidence in the market for the future and encourages companies to make investments in reducing their emissions,” adds Capoor. The initial phase of the EU ETS ran from 2005 to 2007 while the second and current phase runs from 2008 to 2012.
Carbon Captures Headlines
Climate change is set to capture headlines when the G-8 leaders gather for their 34th summit in Hokkaido Toyako, Japan, in early July. Environmentalists, policymakers and carbon market players are waiting to see if the industrial country heads of state move to slash worldwide greenhouse gas emissions by 50% by 2050. In late May environment ministers from the G-8 nations backed the 50% target for mid-century. Last year the G-8 summit leaders agreed to consider halving global emissions by 2050, a proposal favored by Canada, France, Germany, Italy, Japan and the United Kingdom. It was opposed by the United States and Russia. Leading scientists are also advocating a 50% cut in global emissions by that time to minimize the risks stemming from devastating climate change.
A new US administration is expected to put a mandatory cap on carbon emissions.
In June the Japanese government advanced the case for carbon trading when prime minister Yasuo Fukuda announced a pledge to cut Japanese greenhouse gas emissions by 60% to 80% by 2050 and create an experimental carbon trading scheme for industry this fall. “This is a big deal,” says Capoor.
Annie Petsonk, chief international counsel for the Environmental Defense Fund in Washington, DC, says the Japanese government’s decision could signal another step for the carbon market’s growth. “However, much remains to be seen in terms of how the government will implement that commitment,” she adds. “Japan’s announcement does underscore the fact that, internationally, the US is a laggard rather than a leader when it comes to the battle against climate change.”
The US presidential campaign is another event that players, from environmentalists to investment bankers, will be eyeing later this year to determine each candidate’s stance on legislation to cap carbon emissions in the US and create a cap-and-trade system. Previous legislation, known as the Climate Security Act, would have mandated a 66% cut in US greenhouse gas emissions by 2050. When US senators debated the bill this spring before its demise in June, the price of carbon offsets traded on the voluntary Chicago Climate Exchange (CCX) jumped from $5 to $7 a metric ton, Capoor points out. “It focused attention on capping carbon emissions and created more demand for them,” she says, noting the carbon offsets on the CCX were trading at about $3 to $4 earlier in the year.
Sponsored by US senators Joe Lieberman and John Warner, the bill’s proponents said greenhouse gas emissions would have been reduced by about 2% a year between 2012 and 2050, based on 2005 emission levels. Opponents said the mandates would push fuel prices higher and slash jobs. Forty-eight senators voted for the bill while six additional senators, including the presumptive presidential nominees, Illinois Democrat Barack Obama and Arizona Republican John McCain, wrote letters saying they would have cast favorable votes if they had been in Washington. President George W. Bush, who opposes any cap on emissions, had vowed to cast a veto.
Environmentalists were not deterred by the bill’s demise, though some organizations criticized it for not setting more aggressive emissions targets or doing more to develop renewable forms of energy. “It was an important step forward in the process that demonstrates political progress and recognition of the urgency of the issue,” says Rick Duke, director of the Center for Market Innovation at the Natural Resources Defense Council in New York City. “It shows [the US is] marching in the right direction.”
Market players are confident that a new administration, whether Republican or Democratic, will create a mandatory cap on carbon emissions, and most are adamant that a cap-and-trade system should be a part of a larger program to reduce outputs of carbon dioxide.
Abyd Karmali, global head of carbon emissions at Merrill Lynch in London, says carbon trading is the most efficient way to reduce carbon emissions as long as the quantitative limits—the cap—produce enough scarcity to create a price that can mobilize capital and stimulate innovations in technology. “Carbon trading is not, however, the whole solution and needs to be implemented in a joined-up way as part of a broader suite of polices and measures that may be more applicable to some sectors not appropriate for emissions trading.” Karmali says.
Ryan Schuchard at Business for Social Responsibility in San Francisco agrees that carbon cap-and-trade programs should be a piece of a larger policy set by governments to reduce greenhouse gas emissions. The other primary pieces of a solid government policy would include technology incentives, product standards and tax incentives. A 21-member task force sponsored by the New York City-based Council on Foreign Relations stresses the need to support any cap-and-trade system with a variety of other steps: less dependence on foreign oil, greater energy efficiency gained with traditional targeted regulations, and improved energy infrastructure.
But cap-and-trade programs do work. “By turning emissions reductions into commodities, carbon markets lead companies to reduce emissions at the lowest cost, while driving entrepreneurs to continuously improve,” Schuchard says. “If legislation makes emissions more expensive while creating opportunities to buy reductions, the market will expand.” Adds Karmali: “The key determinant of success in carbon emissions trading is whether the [cap] set is tighter than the business-as-usual emissions trajectory.”
Currently, the EU ETS, the largest compulsory carbon reduction scheme, and the carbon credits linked to the Kyoto Protocol are responsible for nearly all of the $64 billion of carbon trading tallied by the World Bank for 2007. The voluntary markets are less than 1% of that total.
Trading System Under Fire
Carbon offsets, whether the European Union Allowances traded under the EU’s trading scheme or the Certified Emission Reduction certificates, known as CERs, traded to meet commitments mandated by the Kyoto Protocol, are generally traded in three ways. The first is through the half-dozen private exchanges around the world, such as the Chicago Climate Exchange or the European Climate Exchange; the over-the-counter market, where a broker can match a buyer and seller; or bilaterally, in a trade between two companies.
The Kyoto Protocol’s Clean Development Mechanism (CDM) has come under increasing criticism for creating a system where projects in developing countries that would have been built anyway are receiving grants for carbon reduction.
The CDM is a scheme that lets a corporation in a developed country, committed by Kyoto to reducing or limiting its carbon emissions, to buy emission credits from a project in a developing country that has ratified the pact. That means, for example, that a German power plant that is spewing out too many tons of carbon dioxide each year can buy CERs from a Chinese wind farm generating renewable energy or an Indian sugar plant that has replaced a generator running on diesel fuel with a machine that is friendlier to the environment.
But before the project in the developing world can sell its carbon credits, or offsets, the project must be vetted and approved by the UN body that oversees the program. Some environmental groups and academics claim companies in developing nations, from wind farms to chemical companies to sugar mills, are abusing the system and claiming carbon credits for projects that would have been built anyway. That means the CDM scheme may not be leading to any real reductions in greenhouse gases.
In a working paper issued in April, two Stanford University academics detailed their review of the CDM and concluded it was in urgent need of reform. “We suggest that the actual experience under the CDM has had perverse effects in developing countries. Rather than draw them into substantial limits on emissions, it has, by contrast, rewarded them for avoiding exactly those commitments,” say the authors, Michael Wara and David Victor.
CDM spokesperson David Abbass counters that projects registered under the CDM are vetted according to its rules, and to qualify for credits any emission reductions must be real, measurable, verifiable and “in addition” to what would have occurred without the project. “Unclear additionality is currently the principal reason that projects are sent back for review or rejected,” says Abbass. “The CDM welcomes public and academic scrutiny. In fact, it is designed to ensure such scrutiny. Virtually every document about every project registered under the CDM is available on the UNFCCC [United Nations Framework Convention on Climate Change] website.”
Abbass also notes that developed nations committed to limiting or reducing their emissions under the Kyoto Protocol can use offset credits to cover only a part of their commitment. The offsets have to be supplementary to emission reduction measures taken at home.
“Some stakeholders argue that the process is too rigorous; others argue the opposite. This is perhaps a good indication that the regulator is succeeding in its role,” says Abbass.
Since the first CDM project was registered in 2004, the scheme has issued more than 152 million CERs, the equivalent of 152 million tons of carbon dioxide. That represents more than 1,000 projects.
As the merits of the CDM are debated, initial talks are under way for a successor pact to the Kyoto Protocol, which some say is key to the future of carbon trading. In early June ministers from about 170 countries met in Bonn during the second session of a two-year push for a replacement vehicle that will widen and toughen the existing pact that expires at the end of 2012. United Nations officials would like to wrap up a new deal in Copenhagen in December 2009 to give companies and investors as much advance knowledge as possible of coming changes and provide national parliaments with time for ratification.
“There is a need for the carbon market to be seamless between the end of the first Kyoto budget period in 2012 and the start of the post-2012 market under the replacement agreement,” says Karmali. “Our view is that the science is growing ever more compelling and stakeholder pressure is building for a new longer-term agreement.” He worries, though, that a December 2009 wrap-up date may be too early for an incoming US administration, and 2010 may be more realistic. The next set of talks will be held in August in Accra, Ghana.
Experts agree that the key to a successful replacement protocol is getting the US and emerging economic giants, such as China and India, on board. “I think there will be a new protocol. It will be last minute and after a lot of gnashing of teeth,” says Henry Lee, a lecturer in public policy at Harvard University’s John F. Kennedy School of Government in Cambridge, Massachusetts. The US will demand that India and China sign a new pact, he says.
The need to entice China into the next global climate agreement was underlined by a recent report clearly showing that China has become the world’s leading emitter of carbon dioxide. The annual report, released in June by the Netherlands Environmental Assessment Agency, indicated that China’s emissions in 2007 were 14% higher than those of the US. “There’s a shot at getting China” as long as its leaders know signing on will not restrict their growth, adds Lee. “But in India the politics are tougher.”
In the meantime, most environmentalists are undeterred if banks are making money in the carbon trading process. “If there are ways for people to do good in the world by doing well for themselves, that is fine,” says Petsonk. “There is a role for banks and brokers to play in helping to reduce carbon emissions.”
WHAT IS CARBON TRADING?
A carbon offset is a financial measurement that represents a reduction in greenhouse gas emissions from a source anywhere around the planet. One carbon offset represents a reduction of 1 metric ton of carbon dioxide or its equivalent in other greenhouse gases.
Different greenhouse gases have different global warming potencies, and the goal of the United Nations-linked Kyoto Protocol is to lower overall emissions of six greenhouse gases—carbon dioxide, methane, nitrous oxide, sulfur hexafluoride, hydrofluorcarbons and perfluorcarbons—by 5.2% below 1990 levels by 2012. The reduction represents a 29% cut compared to the worldwide emissions that would be expected by 2010 without the protocol.
The International Treaty Behind the Market
Carbon trading’s roots lie in a 1989 deal where a US power company attempted to offset its carbon dioxide emissions through a tree-planting endeavor in the western highlands of Guatemala. Since then, the push to reduce emissions of carbon dioxide and other greenhouse gases has spread to 181 countries through the Kyoto Protocol. An international agreement linked to the United Nations Framework Convention on Climate Change, the Kyoto Protocol’s major feature is the adoption of binding targets for greenhouse gas reductions by 37 industrialized nations and the EU.
The pact was agreed in Kyoto, Japan, in December 1997 but did not enter into force until February 16, 2005. The first phase of mandatory emissions reductions runs from 2008 to 2012. Talks are already under way for a successor pact, which the UN hopes to have in place by the end of 2009. The United States and China, the world’s two largest emitters of carbon dioxide, have not ratified the pact.
# Paula L. Green
Tuesday, July 22, 2008
MONEY AND THE BANKING SYSTEM
MONEY AND THE BANKING SYSTEM
See opening quote, page 290, by Milton Friedman.
We will now switch from fiscal policy to monetary policy in the next two chapters. We first look at Money and the Banking System and then focus on monetary policy in the next chapter. Fiscal policy is conducted by Congress and the President (or Parliament and Prime Minister), Monetary policy is conducted by the Central Bank (Federal Reserve Bank), which is a "quasi-governmental" institution that supervises the banking system and regulates the supply of money in the economy.
WHAT IS MONEY?
Money is what we use to make payments for our debts, goods, services, products, and financial assets. But unlike gold or silver money, modern money has no real value - it is just green paper with no intrinsic value - but everyone wants more of it. Why? Because Money is an asset that performs three very important functions in the economy:
1. Medium of exchange - money is an asset used as a means to make final payment. We use dollars to pay for goods and services. Increases efficiency of trade and exchange. Without money in the economy, we would have a barter economy, where we would trade goods for goods, or services for goods, etc. instead of money for goods or services. Barter is inefficient because it relies on the "double coincidence of wants."
For example, to get food, you would have to find a farmer who has what you want and you would have to have something the farmer wants. To get medical service, the farmer would have to find a doctor who wants a cow or milk, etc. Barter is extremely inefficient.
Compared to barter, money is extremely efficient. The farmer can sell a cow for money, and then go out and buy whatever he/she wants with the cash - medical services, electricity, etc. Money eliminates the "double coincidence of wants" and makes the economy operate much more efficiently.
When is barter efficient? - baseball card convention, coin/stamp trading, etc. Market for dating/marriage. Russia - Pepsi/Stolys. To avoid high taxes. Or during hyperinflation.
2. Money is used as a unit of account. In the US, everything is priced in dollars, so we have a standard unit of measurement (dollars) to measure value in the economy, just like we use standard units to measure distance (yards, feet, miles, kilometers, etc). Money is a measuring rod of value. By having a common unit of account (measurement), we can compare prices/values easily since economic value is stated in dollars.
Another reason that a barter economy is inefficient - there is no standard unit of measurement. Makes comparison shopping very difficult.
3. Store of value/wealth - money is used as a financial asset to transfer purchasing power from the current period to a period in the future. You can put $100 bills under your mattress and transfer purchasing power to a later period (next year, ten years from now, etc.). You can also store wealth in stocks, bonds, mutual funds, real estate, etc., but money has some advantages:
Advantages of money as an asset (vs. stocks, bonds, real estate):
a. cash is more liquid than any other asset - (Liquidity: the degree to which an asset can be converted to cash quickly without loss of value.) Stocks and bonds are not as liquid as cash.
b. cash has a fixed nominal value ($100 bill will always be worth $100) - unlike stocks/bonds/real estate which could fluctuate in value.
c. cash is anonymous
Disadvantages of money as an asset:
a. pays no interest, and will lose value (purchasing power) when inflation is positive
b. cash is anonymous
In most cases, the same currency is used for the unit of account, the medium of exchange and a store of value. In U.S., we price everything in dollars, we use dollars for final pmt. and we use dollars to store wealth. Not always the case:
a. Israel - $ was used as the unit of account in many shops to avoid "menu costs" (costs of changing price tags, menus, catalogs, etc) during periods of high inflation when prices might be changing daily. Israeli shekl was still used as the medium of exchange, based on the daily $/shekl ex-rate.
b. Russia, S. America, etc - local currency is not used as a store of value, people hoard US dollars.
c. Euro, SDRs - unit of accounts without a medium of exchange. Basket of currencies, which are quoted daily in the WSJ as ex-rates.
WHY IS MONEY VALUABLE?
Commodity money has been used throughout history until this century - gold, silver, copper, tobacco, beads, salt, etc. We were on a limited form of commodity money until 1970, when all silver was removed from the half dollar. Silver was removed from quarters/dimes in 1964.
Advantage of commodity money - limited supply of precious metal can prevent inflation and stabilize the price level. Exception: tobacco.
Disadvantage: uses up scarce resources. High opportunity cost. Gold/silver have other uses besides coins.
Fiat money = money which has no intrinsic value and is not backed by a commodity. Paper money, metal coins and checks are now used in U.S. and this is fiat money. Fiat money means that the government has issued a decree of fiat, that US dollars are legal tender - for all debts, public and private. Illegal for a bank or private company to issue legal tender.
Money's source of value is related to: a) the fact that it is generally accepted as payment for real goods and services and b) how much it will buy (purchasing power).
Like other assets or goods, money's value is directly related to the supply of and demand for dollars. The greater the supply of dollars, the less valuable a $1 bill is. More money and higher prices reduce the purchasing power of money. Money's value (purchasing power) is inversely related to the supply of dollars and the price level. If money grows faster than the rate of real output, prices will rise, inflation will rise, and the value of money will fall. Inflation is caused by "too much money chasing too few goods." "Inflation is always and everywhere a monetary phenomenon."
Extreme case - hyperinflation. Money becomes worthless. Example: 1922-23, German govt. printed so much money that inflation was 250% per month. It cost 80B marks for an egg and 200B marks for a loaf of bread. Workers picked up wages in suitcases. Shops closed at lunchtime to change price tags. In recent times, Argentina, Brazil, Israel, Russia, etc. have had periods of hyperinflation.
SUPPLY OF MONEY -
How do we measure money? For the central bank to regulate the money supply (MS), they have to know how much money is in circulation. There is no clear definition of exactly what money is. For example, you have $1000 cash, that is definitely money, but what if you have a $1000 Certificate of Deposit (CD) or a $1000 T-bill? You can't use the CD or T-Bill to pay for goods and services, but they fit the definition of money as a store of value. Economists and the FRS use three arbitrary measures of money - M1, M2 and M3 - to account for the different functions of money.
M1 - most narrow definition of money. M1 measures those forms of money that can be used as a medium of exchange - money used for final payment. Only three ways to make final pmt.: pay with cash, write a check or use a traveler's check. There are two different types of checking accounts:
a) demand deposits, which are non-interest bearing checking accounts. Most businesses have demand deposit checking accounts.
b) other checkable deposits, that are interest-bearing personal checking accounts. Usually limits/restrictions to get interest, like maintaining a minimum account balance to get interest.
See page 294. M1 = $1203B, little over $1T (vs. GDP which is about $11T) . M1 is about 49% currency ($586B) and about 51% checking accounts ($609B), small fraction (less than 1%) in traveler's checks.
M2 - broader definition of money than M1. M2 includes everything in M1 plus other forms of money, all interest bearing financial assets. M2 includes money used as a store of value. M2 includes all savings accounts, small CDs, money market mutual funds, short-term overnight deposits.
Money market mutual funds (retail) - act like checking accounts, available at investment banks like Merrill-Lynch, investments in short-term money market instruments like 3 month T-bills for example. Operates like a mutual fund, pooled assets, but you have check-writing privileges like a checking account.
M2 = $5.48T, about 4.5x the amount of M1, or more than $4.2T larger. Reflects the fact that most people keep as much money as possible in interest-bearing accounts.
M1 (money as med. of exchange) and M2 (money as store of value) are the most important measures of the MS, although there are other measures like M3 (broader than M2) and L (broader than M3). We focus in this course on just M1 and M2.
CREDIT CARDS VS MONEY -
Money is a financial asset that provides us with current or future purchasing power. Credit cards are not part of the money supply because they are just convenient ways to make a loan. You are actually borrowing money from the bank that issued the card, and payment is deferred until you make pmt. to the credit card issuer. Money is an asset that represents current or future purchasing power. Credit purchases do not technically represent purchasing power, they represent consumer credit, a way to defer final payment. Credit cards are not counted as part of the MS, but do affect the money supply, since having the convenience of plastic reduces our average cash balances, decreases our demand for money.
BUSINESS OF BANKING -
We will now focus on the Banking Industry and look at the role of the banking industry in the process of money creation. Banking industry operates under the jurisdiction of the Federal Reserve System, the central bank of the U.S., although not all banks actually belong to the FRS. FRS supervises the banking system, sets banking requirements, processes checks and sets the nation's monetary policy.
Banks are in the process of Financial Intermediation, acting as financial intermediaries (middlemen) to bring together people who want to save for the future (savings = deferred consumption) and people who want to borrow money now for current consumption (buy a car) or current investment (business borrowing). We make deposits in checking accts/svgs. accts, which provides the bank with a source of funds, get paid 1-5% interest. The bank then uses those funds to make loans to borrowers for cars, home improvement, mortgages, credit cards, student loans, etc. at 8-20% interest. Bank profits are the spread between interest paid to depositors and interest received from borrowers.
Banks can be set up in several different ways -
State charter vs. National charter - Dual Banking System
Commercial Banks vs Investment banks (Merrill-Lynch)
S&L charter vs. Commercial bank vs Credit Union
Most commercial banks now are very similar - offer checking, savings, etc. When we talk about the "banking industry" we are referring to all the commercial banks, S & Ls, and credit unions in the U.S.
See page 298 for a consolidated balance sheet for the Commercial Banks. The majority (2/3) of a bank's source of funds ($4261B) comes from checking accounts (transaction deposits) and savings accounts and time deposits (CDs). Most of that money gets loaned out - $3964B, or invested - used to purchase securities ($1477). Only $41B is actually totally liquid - available immediately to meet cash withdrawals - $32B in vault cash (currency) and $9B on reserve at the Fed.
This illustrates that we operate under a Fractional Reserve Banking system. Banks are only required to maintain a small amount of reserves against their deposits (about 1% in this case). Vs. 100% reserve banking where a bank would be required to hold 100% of deposits in liquid reserves.
Required Reserves = minimum amount of reserves required by the FRS, to be held as vault cash and on deposit at the FRS. All banks are required to have an account with the FRS. In 2001, there was only 1.14% in reserves, against deposits ($41B/$4261B).
Required reserves are based on required reserve ratios - percentage requirement based on the type of deposit. See page 304 for current required reserve ratios.
Total Reserves = Required Reserves + Excess Reserves.
Excess reserves are reserves over and above the min requirement. Banks try to minimize reserves, ideally have 0 excess reserves, because Reserves pay 0% interest. Non-interest bearing asset for the banks.
Banks operate under what might seem like a very risky system - what is there is a run on the bank. Bank could not meet the demand for withdrawals if all depositors showed up at once. FDIC provides deposit insurance to stabilize the banking system. It was established in 1933 after 9000 banks failed. FDIC insures deposits up to $100,000. Banks pay a small premium based on their deposits and FDIC pays off depositors when a bank fails and can't pay its depositors.
HOW BANKS CREATE MONEY BY EXTENDING LOANS
Fractional reserve system allows money to be created through the banking system, there is an expansionary effect that takes place.
See page 300, Exhibit 3.
Example: Suppose that you found $1000 hidden in the basement. Or we could assume that the Fed had expanded the money supply by $1000. What effect would that have on M1? Assume that the required reserve ratio is 20%.
Step 1 - You take the $1000 and deposit it in your checking account at Bank A. Bank A's reserves increase by $1000 and demand deposits (D) increase by $1000. The bank is only required to keep 20% or $200 on reserve, so it has excess reserves of $800.
Step 2 - They then loan out the $800 to somebody that wants to buy a car. The bank has now created $800 in new money (demand deposit). The process starts all over again. When the $800 gets spent it becomes $800 in new reserves at a new bank - Bank B. The bank is only required to hold 20%, or $160, so it lends out a new loan for $640, and increases the demand deposits by $640.
Step 3 - The person with the loan spends the $640 on another car, or something else, and the process starts all over again when the $640 gets into a new bank - Bank C.
The deposit expansion process continues until there is $5000 of new demand deposits and M1. So, starting with $1000 of new money, the MS/M1 grew by 5x that amount.
The potential deposit multiplier (DM) is equal to: 1 / (required reserve ratio). In this case it was:
DM = 1 / .2 = 5x, meaning that for every $1 of new money created, the money supply will eventually increase by 5x that amount, or $5.
If the reserve requirement were .1, the DM would be 1 / .1 = 10x. As we will see later, one of the tools of monetary policy is the reserve requirement. If the FRS LOWERS the required reserve ratio (RRR), MS will go up, because the DM will go up. If FRS RAISES the RRR, the DM will fall, and the MS will fall.
ACTUAL DEPOSIT MULTIPLIER -
In reality, the actual DM will be less that the full potential amount, for example, of 5, for two reasons:
1. Cash leakages - if people hold cash, outside the banking system, the MS will increase by less than the full DM. For example, if the person who got the loan for $800 spent only $700 and kept $100 in cash for emergency, only $700 would go the next stage instead of $800, that would reduce the DM, DM < 5.
2. Excess reserves - if banks hold some excess reserves, the DM will also be less than 5. Banks only hold about 1% excess reserves.
Currency leakages and excess reserves will result in a DM that is less than its full potential. But since banks hold very few excess reserves, and since people hold very little cash, the actual DM would usually be very close to the full DM. Example: with credit cards, checks, ATMs, there is little need to hold very much cash.
FEDERAL RESERVE SYSTEM -
Most countries have a central banking authority that controls the MS and conducts monetary policy. In US it is the FRS, in UK it is the Bank of England, in Europe, the European Central Bank. Central banks are supposed to promote monetary stability. To achieve that goal, most effective central banks are supposed to be independent of the political authorities - pres/prime minister, Congress/Parliament, etc.
In most cases, the lower the inflation, the more independent the central bank. The higher the inflation the less independent the central bank. Example - Turkey, Brazil, most S. American countries.
Structure of the Fed -
FRS is a quasi-governmental agency, part private, part public, supposed to be independent from Congress/Pres.
12 FRS districts - 25 regional branches. We are in the Chicago district, and there is a regional FRS branch in Detroit. See page 332.
Board of Governors - Decision-making center of the FRS. 7 Members appointed to 14 year staggered terms by Pres and approved by Congress. Every other year a term expires, so the most number of appointees by any one president is 2 per term, or 4 total. President designates one of the members as Chair for a four year term. Greenspan is in fourth term as chairman of FRS. Appointed by Reagan in 1987, been through four presidents. Current term expires June 2004.
Board of Governors has two major functions:
1. Regulate the banking industry, e.g. set reserve requirements. Lend money to banks. Provide check-clearing services.
2. Conduct monetary policy. Regulate the money supply and thereby influence inflation, interest rates and ex-rates. Promote monetary stability.
How policy is determined:
FOMC - Federal Open Market Committee - 7 Governors + president of the NY District Bank + 4 of the remaining 11 district bank presidents, who rotate on the committee. FOMC determines the Fed's policy with respect to setting money supply and interest rates. All presidents can attend meetings, but only those on the FOMC can usually vote. FOMC is the true policymaking group for establishing monetary policy.
12 District Banks operate under the control of the Board of Governors and differ from commercial banks in several important respects:
1. FRS banks are not profit-making banks. All earnings go the Dept of Treasury.
2. FRS banks can issue money, private/commercial banks cannot.
3. FRS banks are the bankers' banks. Only commercial banks can have accounts with the FRS. The FRS does 85% of check-clearing, which is facilitated by having all banks having accounts with the FRS. As the check clears, the FRS credits one bank's reserve account and debits the other banks account.
FRS goal is to promote monetary stability, full employment and econ growth. Although it is technically independent, a quasi-governmental agency, it works closely with Congress, the Treasury, and the President's Council of Econ Advisors, to co-ordinate fiscal/monetary policy. Fed reports to Congress twice a year at public hearings.
INDEPENDENCE OF THE CENTRAL BANK - Important issue. The Central Bank should be independent from the influence of politicians, so that they can set monetary policy for the best long-term interest of the economy. Politicians are usually more short-sighted, and want to get re-elected. The central bank can control inflation more effectively when they are not accountable to the fiscal policymakers, elected officials, President, Congress, etc.
HOW THE FED CONTROLS THE MS
The Fed has three tools of monetary policy:
1. Set reserve requirements
2. Open market operations - buying/selling Treasury securities
3. Setting the discount rate - the rate it will lend money to member banks.
1. RESERVE REQUIREMENTS
Reserves are: a) vault cash and b) bank deposits at the Fed. Both can be used to meet depositors' withdrawals. Fed establishes minimum reserve requirements to make sure that all banks can meet a sudden increase in cash withdrawals. Stabilizes the banking system.
Currently banks are not required to have reserves against time deposits/savings accounts, only transaction accounts - checking accounts (int) and demand deposits (no int). Reserve ratios are listed on page 304. 3% up to $41.3m and then 10%.
Fed can affect the MS by changing the reserve requirements. If the Fed lowers reserve requirement, the MS will increase. If the reserve requirements were lowered from 10% to 5%, the banks would then have excess reserves. Banks don't like excess reserves, because they are non-interest bearing assets. The excess reserves would be loaned out, and the MS would increase.
Lower reserve requirements results in Expansionary monetary policy, or an easing of monetary policy.
Higher reserve requirements result in Contractionary policy, or restrictive policy or tightening. Changes in reserve requirements are rarely used as a tool of monetary policy. Reserve requirements are usually put in place and left alone.
2. OPEN MARKET OPERATIONS
Used MOST often.
Unlike us, or businesses or even other govt. agencies, state govt., the FRS can write a check without funds in its account. When the Fed buy things, it creates money. The Fed is restricted to buying/selling treasury securities, but the process would work no matter what it bought.
Fed buys T-bills - MS increases. Fed buys a T-bill from a bank, business or individual and writes a check with "new money." When the check is deposited, the reserves of the banking system are increased. The increased reserves support the creation of new loans, which increases the MS.
Example: Fed buys a $10,000 T-bond from me. I give the Fed a $10,000 T-bond, it writes me a check for $10,000. I deposit the check in my bank account and the bank's reserve account with the Fed is increased by $10,000. Assuming a 10% reserve requirement, the bank can create $9000 in new loans. That $9000 gets spent and when deposited, increases the reserves of another bank by $9000. Only $900 has to be kept as a deposit, so $8100 gets loaned out, etc.... The deposit expansion takes place over many banks and many transactions.
The Fed directly controls the Monetary Base, which is bank reserves (vault cash + deposits at Fed) plus the currency in circulation. The monetary base in 2001 was approx $635B and M1 was approx $1203B. There was about $594B in cash and $41B in bank reserves. Actual money multiplier ($1203/635) was about 1.89x.
Remember that the Deposit Multiplier (DM) is 1 / (required reserve ratio). If the required reserve ratio is .10, the DM would be 10. It is actually less than that because of leakages:
1. People hold cash, outside of the banking system, reduces the effect of the full DM. The more cash people hold, the lower the actual DM.
2. Some banks hold excess reserves.
Fed can directly control the monetary base, but it cannot really directly control M1 because it can't directly control people's demand for cash, and it can't control bank's desire to hold excess reserves. The actual money multiplier (m) is around 2x.
A Money Multiplier (m) of 2 means that for every $1 increase in the Monetary Base (M0), M1 will increase by $2. If the Fed wants to increase the MS by $20B, it would engage in a $10B open market operation, it would buy $10B of treasury securities.
If the Fed wants to contract the MS, it would sell treasury securities from its portfolio. They give you a T-bill, you give them a check. When the check clears, the reserves in the banking system are reduced/contracted, which then contracts the MS. The multiplier works the same way in reverse.
3. DISCOUNT RATE - BORROWING FROM THE FED
If banks have a shortage of reserves, and it needs to meet the reserve requirements, it has two sources for funds: a) the Federal Reserve Bank and b) the Federal Funds market. Banks can borrow from the Fed at the Discount Rate, currently at ____. Banks can also deal directly with each other in the Fed Funds Market. Banks with excess reserves can lend money to banks that need reserves, sometimes on just an overnight basis.
The current FFR is approx _____. Most banks would rather borrow at the FFR, even if it is higher.
If the Fed lowers the discount rate, it would be easier/cheaper to borrow reserves, would be considered expansionary. If the discount rate is very low, and it is cheap to borrow, banks will not need to hold excess reserves, they will make loans.
If the Fed raises the discount rate, it is expensive to borrow and banks will hold excess reserves to avoid having to borrow at the high discount rate.
SUMMARY:
See page 308. To increase MS, or have expansionary policy or "easing of money" the FRS can:
1. Lower reserve requirements
2. Lower the discount rate
3. Open market operation (OMO) - buy T-bills
To decrease MS, or have contractionary policy or "tightening of money" the FRS:
1. Raise reserve requirements
2. Raise discount rate
3. OMO - Sell Tbills.
On net, the MS is increasing. Reserve requirements don't change very often, and the discount rate doesn't change very often. The primary tool used most often by FRS is the Open Market Operation.
See Exhibit 7, page 306. Illustrates the MS process. FRS directly affects the Monetary Base by increasing the amount of bank reserves. If the increased reserves stay in the banking system and get loaned out there is an expansionary effect, 1/res. req. If some of the new reserves are held as cash, it is a "leakage" and the multiplier effect is only 1. Reserves are "high powered" money if they stay in the banking system and are expanded.
Point: FRS can directly control the MB, but it cannot directly control M1. M1 is influenced by peoples demand for currency/cash, and by bank's willingness to hold excess reserves.
Also, since OMOs are the primary tool used to influence M1, we would expect a direct relation between growth in the MB and M1, since the FRS is expanding the MB with OMOs to increase M1.
FED and TREASURY
There is a tendency to confuse the Fed and the Treasury. They are totally different and distinct. The Treasury is concerned with the federal budget and financing G exp, and is the agency that issues Treasury bills, bonds and notes to finance deficits. Treasury securities are sold at auctions to the public, not to the Fed, and this action does NOT change the MS. Just transfers money from the private sector to the public sector.
The Fed buys T-Bond in the secondary market, from individuals, banks, ins cos., etc. The Fed does NOT issue govt. securities, it just buys and sells them. Fed's action DOES change the MS.
See Thumbnail Sketch, page 310.
NEW Currency: EURO (�), introduced in 2002 in 12 European countries (Germany, Italy, France, Greece, Spain, Netherlands, etc.) to replace the marks, francs, guilders, etc. Advantages? Disadvantages?
FUTURE? 3 currencies in the world? Euro, Yen and Dollar?
See opening quote, page 290, by Milton Friedman.
We will now switch from fiscal policy to monetary policy in the next two chapters. We first look at Money and the Banking System and then focus on monetary policy in the next chapter. Fiscal policy is conducted by Congress and the President (or Parliament and Prime Minister), Monetary policy is conducted by the Central Bank (Federal Reserve Bank), which is a "quasi-governmental" institution that supervises the banking system and regulates the supply of money in the economy.
WHAT IS MONEY?
Money is what we use to make payments for our debts, goods, services, products, and financial assets. But unlike gold or silver money, modern money has no real value - it is just green paper with no intrinsic value - but everyone wants more of it. Why? Because Money is an asset that performs three very important functions in the economy:
1. Medium of exchange - money is an asset used as a means to make final payment. We use dollars to pay for goods and services. Increases efficiency of trade and exchange. Without money in the economy, we would have a barter economy, where we would trade goods for goods, or services for goods, etc. instead of money for goods or services. Barter is inefficient because it relies on the "double coincidence of wants."
For example, to get food, you would have to find a farmer who has what you want and you would have to have something the farmer wants. To get medical service, the farmer would have to find a doctor who wants a cow or milk, etc. Barter is extremely inefficient.
Compared to barter, money is extremely efficient. The farmer can sell a cow for money, and then go out and buy whatever he/she wants with the cash - medical services, electricity, etc. Money eliminates the "double coincidence of wants" and makes the economy operate much more efficiently.
When is barter efficient? - baseball card convention, coin/stamp trading, etc. Market for dating/marriage. Russia - Pepsi/Stolys. To avoid high taxes. Or during hyperinflation.
2. Money is used as a unit of account. In the US, everything is priced in dollars, so we have a standard unit of measurement (dollars) to measure value in the economy, just like we use standard units to measure distance (yards, feet, miles, kilometers, etc). Money is a measuring rod of value. By having a common unit of account (measurement), we can compare prices/values easily since economic value is stated in dollars.
Another reason that a barter economy is inefficient - there is no standard unit of measurement. Makes comparison shopping very difficult.
3. Store of value/wealth - money is used as a financial asset to transfer purchasing power from the current period to a period in the future. You can put $100 bills under your mattress and transfer purchasing power to a later period (next year, ten years from now, etc.). You can also store wealth in stocks, bonds, mutual funds, real estate, etc., but money has some advantages:
Advantages of money as an asset (vs. stocks, bonds, real estate):
a. cash is more liquid than any other asset - (Liquidity: the degree to which an asset can be converted to cash quickly without loss of value.) Stocks and bonds are not as liquid as cash.
b. cash has a fixed nominal value ($100 bill will always be worth $100) - unlike stocks/bonds/real estate which could fluctuate in value.
c. cash is anonymous
Disadvantages of money as an asset:
a. pays no interest, and will lose value (purchasing power) when inflation is positive
b. cash is anonymous
In most cases, the same currency is used for the unit of account, the medium of exchange and a store of value. In U.S., we price everything in dollars, we use dollars for final pmt. and we use dollars to store wealth. Not always the case:
a. Israel - $ was used as the unit of account in many shops to avoid "menu costs" (costs of changing price tags, menus, catalogs, etc) during periods of high inflation when prices might be changing daily. Israeli shekl was still used as the medium of exchange, based on the daily $/shekl ex-rate.
b. Russia, S. America, etc - local currency is not used as a store of value, people hoard US dollars.
c. Euro, SDRs - unit of accounts without a medium of exchange. Basket of currencies, which are quoted daily in the WSJ as ex-rates.
WHY IS MONEY VALUABLE?
Commodity money has been used throughout history until this century - gold, silver, copper, tobacco, beads, salt, etc. We were on a limited form of commodity money until 1970, when all silver was removed from the half dollar. Silver was removed from quarters/dimes in 1964.
Advantage of commodity money - limited supply of precious metal can prevent inflation and stabilize the price level. Exception: tobacco.
Disadvantage: uses up scarce resources. High opportunity cost. Gold/silver have other uses besides coins.
Fiat money = money which has no intrinsic value and is not backed by a commodity. Paper money, metal coins and checks are now used in U.S. and this is fiat money. Fiat money means that the government has issued a decree of fiat, that US dollars are legal tender - for all debts, public and private. Illegal for a bank or private company to issue legal tender.
Money's source of value is related to: a) the fact that it is generally accepted as payment for real goods and services and b) how much it will buy (purchasing power).
Like other assets or goods, money's value is directly related to the supply of and demand for dollars. The greater the supply of dollars, the less valuable a $1 bill is. More money and higher prices reduce the purchasing power of money. Money's value (purchasing power) is inversely related to the supply of dollars and the price level. If money grows faster than the rate of real output, prices will rise, inflation will rise, and the value of money will fall. Inflation is caused by "too much money chasing too few goods." "Inflation is always and everywhere a monetary phenomenon."
Extreme case - hyperinflation. Money becomes worthless. Example: 1922-23, German govt. printed so much money that inflation was 250% per month. It cost 80B marks for an egg and 200B marks for a loaf of bread. Workers picked up wages in suitcases. Shops closed at lunchtime to change price tags. In recent times, Argentina, Brazil, Israel, Russia, etc. have had periods of hyperinflation.
SUPPLY OF MONEY -
How do we measure money? For the central bank to regulate the money supply (MS), they have to know how much money is in circulation. There is no clear definition of exactly what money is. For example, you have $1000 cash, that is definitely money, but what if you have a $1000 Certificate of Deposit (CD) or a $1000 T-bill? You can't use the CD or T-Bill to pay for goods and services, but they fit the definition of money as a store of value. Economists and the FRS use three arbitrary measures of money - M1, M2 and M3 - to account for the different functions of money.
M1 - most narrow definition of money. M1 measures those forms of money that can be used as a medium of exchange - money used for final payment. Only three ways to make final pmt.: pay with cash, write a check or use a traveler's check. There are two different types of checking accounts:
a) demand deposits, which are non-interest bearing checking accounts. Most businesses have demand deposit checking accounts.
b) other checkable deposits, that are interest-bearing personal checking accounts. Usually limits/restrictions to get interest, like maintaining a minimum account balance to get interest.
See page 294. M1 = $1203B, little over $1T (vs. GDP which is about $11T) . M1 is about 49% currency ($586B) and about 51% checking accounts ($609B), small fraction (less than 1%) in traveler's checks.
M2 - broader definition of money than M1. M2 includes everything in M1 plus other forms of money, all interest bearing financial assets. M2 includes money used as a store of value. M2 includes all savings accounts, small CDs, money market mutual funds, short-term overnight deposits.
Money market mutual funds (retail) - act like checking accounts, available at investment banks like Merrill-Lynch, investments in short-term money market instruments like 3 month T-bills for example. Operates like a mutual fund, pooled assets, but you have check-writing privileges like a checking account.
M2 = $5.48T, about 4.5x the amount of M1, or more than $4.2T larger. Reflects the fact that most people keep as much money as possible in interest-bearing accounts.
M1 (money as med. of exchange) and M2 (money as store of value) are the most important measures of the MS, although there are other measures like M3 (broader than M2) and L (broader than M3). We focus in this course on just M1 and M2.
CREDIT CARDS VS MONEY -
Money is a financial asset that provides us with current or future purchasing power. Credit cards are not part of the money supply because they are just convenient ways to make a loan. You are actually borrowing money from the bank that issued the card, and payment is deferred until you make pmt. to the credit card issuer. Money is an asset that represents current or future purchasing power. Credit purchases do not technically represent purchasing power, they represent consumer credit, a way to defer final payment. Credit cards are not counted as part of the MS, but do affect the money supply, since having the convenience of plastic reduces our average cash balances, decreases our demand for money.
BUSINESS OF BANKING -
We will now focus on the Banking Industry and look at the role of the banking industry in the process of money creation. Banking industry operates under the jurisdiction of the Federal Reserve System, the central bank of the U.S., although not all banks actually belong to the FRS. FRS supervises the banking system, sets banking requirements, processes checks and sets the nation's monetary policy.
Banks are in the process of Financial Intermediation, acting as financial intermediaries (middlemen) to bring together people who want to save for the future (savings = deferred consumption) and people who want to borrow money now for current consumption (buy a car) or current investment (business borrowing). We make deposits in checking accts/svgs. accts, which provides the bank with a source of funds, get paid 1-5% interest. The bank then uses those funds to make loans to borrowers for cars, home improvement, mortgages, credit cards, student loans, etc. at 8-20% interest. Bank profits are the spread between interest paid to depositors and interest received from borrowers.
Banks can be set up in several different ways -
State charter vs. National charter - Dual Banking System
Commercial Banks vs Investment banks (Merrill-Lynch)
S&L charter vs. Commercial bank vs Credit Union
Most commercial banks now are very similar - offer checking, savings, etc. When we talk about the "banking industry" we are referring to all the commercial banks, S & Ls, and credit unions in the U.S.
See page 298 for a consolidated balance sheet for the Commercial Banks. The majority (2/3) of a bank's source of funds ($4261B) comes from checking accounts (transaction deposits) and savings accounts and time deposits (CDs). Most of that money gets loaned out - $3964B, or invested - used to purchase securities ($1477). Only $41B is actually totally liquid - available immediately to meet cash withdrawals - $32B in vault cash (currency) and $9B on reserve at the Fed.
This illustrates that we operate under a Fractional Reserve Banking system. Banks are only required to maintain a small amount of reserves against their deposits (about 1% in this case). Vs. 100% reserve banking where a bank would be required to hold 100% of deposits in liquid reserves.
Required Reserves = minimum amount of reserves required by the FRS, to be held as vault cash and on deposit at the FRS. All banks are required to have an account with the FRS. In 2001, there was only 1.14% in reserves, against deposits ($41B/$4261B).
Required reserves are based on required reserve ratios - percentage requirement based on the type of deposit. See page 304 for current required reserve ratios.
Total Reserves = Required Reserves + Excess Reserves.
Excess reserves are reserves over and above the min requirement. Banks try to minimize reserves, ideally have 0 excess reserves, because Reserves pay 0% interest. Non-interest bearing asset for the banks.
Banks operate under what might seem like a very risky system - what is there is a run on the bank. Bank could not meet the demand for withdrawals if all depositors showed up at once. FDIC provides deposit insurance to stabilize the banking system. It was established in 1933 after 9000 banks failed. FDIC insures deposits up to $100,000. Banks pay a small premium based on their deposits and FDIC pays off depositors when a bank fails and can't pay its depositors.
HOW BANKS CREATE MONEY BY EXTENDING LOANS
Fractional reserve system allows money to be created through the banking system, there is an expansionary effect that takes place.
See page 300, Exhibit 3.
Example: Suppose that you found $1000 hidden in the basement. Or we could assume that the Fed had expanded the money supply by $1000. What effect would that have on M1? Assume that the required reserve ratio is 20%.
Step 1 - You take the $1000 and deposit it in your checking account at Bank A. Bank A's reserves increase by $1000 and demand deposits (D) increase by $1000. The bank is only required to keep 20% or $200 on reserve, so it has excess reserves of $800.
Step 2 - They then loan out the $800 to somebody that wants to buy a car. The bank has now created $800 in new money (demand deposit). The process starts all over again. When the $800 gets spent it becomes $800 in new reserves at a new bank - Bank B. The bank is only required to hold 20%, or $160, so it lends out a new loan for $640, and increases the demand deposits by $640.
Step 3 - The person with the loan spends the $640 on another car, or something else, and the process starts all over again when the $640 gets into a new bank - Bank C.
The deposit expansion process continues until there is $5000 of new demand deposits and M1. So, starting with $1000 of new money, the MS/M1 grew by 5x that amount.
The potential deposit multiplier (DM) is equal to: 1 / (required reserve ratio). In this case it was:
DM = 1 / .2 = 5x, meaning that for every $1 of new money created, the money supply will eventually increase by 5x that amount, or $5.
If the reserve requirement were .1, the DM would be 1 / .1 = 10x. As we will see later, one of the tools of monetary policy is the reserve requirement. If the FRS LOWERS the required reserve ratio (RRR), MS will go up, because the DM will go up. If FRS RAISES the RRR, the DM will fall, and the MS will fall.
ACTUAL DEPOSIT MULTIPLIER -
In reality, the actual DM will be less that the full potential amount, for example, of 5, for two reasons:
1. Cash leakages - if people hold cash, outside the banking system, the MS will increase by less than the full DM. For example, if the person who got the loan for $800 spent only $700 and kept $100 in cash for emergency, only $700 would go the next stage instead of $800, that would reduce the DM, DM < 5.
2. Excess reserves - if banks hold some excess reserves, the DM will also be less than 5. Banks only hold about 1% excess reserves.
Currency leakages and excess reserves will result in a DM that is less than its full potential. But since banks hold very few excess reserves, and since people hold very little cash, the actual DM would usually be very close to the full DM. Example: with credit cards, checks, ATMs, there is little need to hold very much cash.
FEDERAL RESERVE SYSTEM -
Most countries have a central banking authority that controls the MS and conducts monetary policy. In US it is the FRS, in UK it is the Bank of England, in Europe, the European Central Bank. Central banks are supposed to promote monetary stability. To achieve that goal, most effective central banks are supposed to be independent of the political authorities - pres/prime minister, Congress/Parliament, etc.
In most cases, the lower the inflation, the more independent the central bank. The higher the inflation the less independent the central bank. Example - Turkey, Brazil, most S. American countries.
Structure of the Fed -
FRS is a quasi-governmental agency, part private, part public, supposed to be independent from Congress/Pres.
12 FRS districts - 25 regional branches. We are in the Chicago district, and there is a regional FRS branch in Detroit. See page 332.
Board of Governors - Decision-making center of the FRS. 7 Members appointed to 14 year staggered terms by Pres and approved by Congress. Every other year a term expires, so the most number of appointees by any one president is 2 per term, or 4 total. President designates one of the members as Chair for a four year term. Greenspan is in fourth term as chairman of FRS. Appointed by Reagan in 1987, been through four presidents. Current term expires June 2004.
Board of Governors has two major functions:
1. Regulate the banking industry, e.g. set reserve requirements. Lend money to banks. Provide check-clearing services.
2. Conduct monetary policy. Regulate the money supply and thereby influence inflation, interest rates and ex-rates. Promote monetary stability.
How policy is determined:
FOMC - Federal Open Market Committee - 7 Governors + president of the NY District Bank + 4 of the remaining 11 district bank presidents, who rotate on the committee. FOMC determines the Fed's policy with respect to setting money supply and interest rates. All presidents can attend meetings, but only those on the FOMC can usually vote. FOMC is the true policymaking group for establishing monetary policy.
12 District Banks operate under the control of the Board of Governors and differ from commercial banks in several important respects:
1. FRS banks are not profit-making banks. All earnings go the Dept of Treasury.
2. FRS banks can issue money, private/commercial banks cannot.
3. FRS banks are the bankers' banks. Only commercial banks can have accounts with the FRS. The FRS does 85% of check-clearing, which is facilitated by having all banks having accounts with the FRS. As the check clears, the FRS credits one bank's reserve account and debits the other banks account.
FRS goal is to promote monetary stability, full employment and econ growth. Although it is technically independent, a quasi-governmental agency, it works closely with Congress, the Treasury, and the President's Council of Econ Advisors, to co-ordinate fiscal/monetary policy. Fed reports to Congress twice a year at public hearings.
INDEPENDENCE OF THE CENTRAL BANK - Important issue. The Central Bank should be independent from the influence of politicians, so that they can set monetary policy for the best long-term interest of the economy. Politicians are usually more short-sighted, and want to get re-elected. The central bank can control inflation more effectively when they are not accountable to the fiscal policymakers, elected officials, President, Congress, etc.
HOW THE FED CONTROLS THE MS
The Fed has three tools of monetary policy:
1. Set reserve requirements
2. Open market operations - buying/selling Treasury securities
3. Setting the discount rate - the rate it will lend money to member banks.
1. RESERVE REQUIREMENTS
Reserves are: a) vault cash and b) bank deposits at the Fed. Both can be used to meet depositors' withdrawals. Fed establishes minimum reserve requirements to make sure that all banks can meet a sudden increase in cash withdrawals. Stabilizes the banking system.
Currently banks are not required to have reserves against time deposits/savings accounts, only transaction accounts - checking accounts (int) and demand deposits (no int). Reserve ratios are listed on page 304. 3% up to $41.3m and then 10%.
Fed can affect the MS by changing the reserve requirements. If the Fed lowers reserve requirement, the MS will increase. If the reserve requirements were lowered from 10% to 5%, the banks would then have excess reserves. Banks don't like excess reserves, because they are non-interest bearing assets. The excess reserves would be loaned out, and the MS would increase.
Lower reserve requirements results in Expansionary monetary policy, or an easing of monetary policy.
Higher reserve requirements result in Contractionary policy, or restrictive policy or tightening. Changes in reserve requirements are rarely used as a tool of monetary policy. Reserve requirements are usually put in place and left alone.
2. OPEN MARKET OPERATIONS
Used MOST often.
Unlike us, or businesses or even other govt. agencies, state govt., the FRS can write a check without funds in its account. When the Fed buy things, it creates money. The Fed is restricted to buying/selling treasury securities, but the process would work no matter what it bought.
Fed buys T-bills - MS increases. Fed buys a T-bill from a bank, business or individual and writes a check with "new money." When the check is deposited, the reserves of the banking system are increased. The increased reserves support the creation of new loans, which increases the MS.
Example: Fed buys a $10,000 T-bond from me. I give the Fed a $10,000 T-bond, it writes me a check for $10,000. I deposit the check in my bank account and the bank's reserve account with the Fed is increased by $10,000. Assuming a 10% reserve requirement, the bank can create $9000 in new loans. That $9000 gets spent and when deposited, increases the reserves of another bank by $9000. Only $900 has to be kept as a deposit, so $8100 gets loaned out, etc.... The deposit expansion takes place over many banks and many transactions.
The Fed directly controls the Monetary Base, which is bank reserves (vault cash + deposits at Fed) plus the currency in circulation. The monetary base in 2001 was approx $635B and M1 was approx $1203B. There was about $594B in cash and $41B in bank reserves. Actual money multiplier ($1203/635) was about 1.89x.
Remember that the Deposit Multiplier (DM) is 1 / (required reserve ratio). If the required reserve ratio is .10, the DM would be 10. It is actually less than that because of leakages:
1. People hold cash, outside of the banking system, reduces the effect of the full DM. The more cash people hold, the lower the actual DM.
2. Some banks hold excess reserves.
Fed can directly control the monetary base, but it cannot really directly control M1 because it can't directly control people's demand for cash, and it can't control bank's desire to hold excess reserves. The actual money multiplier (m) is around 2x.
A Money Multiplier (m) of 2 means that for every $1 increase in the Monetary Base (M0), M1 will increase by $2. If the Fed wants to increase the MS by $20B, it would engage in a $10B open market operation, it would buy $10B of treasury securities.
If the Fed wants to contract the MS, it would sell treasury securities from its portfolio. They give you a T-bill, you give them a check. When the check clears, the reserves in the banking system are reduced/contracted, which then contracts the MS. The multiplier works the same way in reverse.
3. DISCOUNT RATE - BORROWING FROM THE FED
If banks have a shortage of reserves, and it needs to meet the reserve requirements, it has two sources for funds: a) the Federal Reserve Bank and b) the Federal Funds market. Banks can borrow from the Fed at the Discount Rate, currently at ____. Banks can also deal directly with each other in the Fed Funds Market. Banks with excess reserves can lend money to banks that need reserves, sometimes on just an overnight basis.
The current FFR is approx _____. Most banks would rather borrow at the FFR, even if it is higher.
If the Fed lowers the discount rate, it would be easier/cheaper to borrow reserves, would be considered expansionary. If the discount rate is very low, and it is cheap to borrow, banks will not need to hold excess reserves, they will make loans.
If the Fed raises the discount rate, it is expensive to borrow and banks will hold excess reserves to avoid having to borrow at the high discount rate.
SUMMARY:
See page 308. To increase MS, or have expansionary policy or "easing of money" the FRS can:
1. Lower reserve requirements
2. Lower the discount rate
3. Open market operation (OMO) - buy T-bills
To decrease MS, or have contractionary policy or "tightening of money" the FRS:
1. Raise reserve requirements
2. Raise discount rate
3. OMO - Sell Tbills.
On net, the MS is increasing. Reserve requirements don't change very often, and the discount rate doesn't change very often. The primary tool used most often by FRS is the Open Market Operation.
See Exhibit 7, page 306. Illustrates the MS process. FRS directly affects the Monetary Base by increasing the amount of bank reserves. If the increased reserves stay in the banking system and get loaned out there is an expansionary effect, 1/res. req. If some of the new reserves are held as cash, it is a "leakage" and the multiplier effect is only 1. Reserves are "high powered" money if they stay in the banking system and are expanded.
Point: FRS can directly control the MB, but it cannot directly control M1. M1 is influenced by peoples demand for currency/cash, and by bank's willingness to hold excess reserves.
Also, since OMOs are the primary tool used to influence M1, we would expect a direct relation between growth in the MB and M1, since the FRS is expanding the MB with OMOs to increase M1.
FED and TREASURY
There is a tendency to confuse the Fed and the Treasury. They are totally different and distinct. The Treasury is concerned with the federal budget and financing G exp, and is the agency that issues Treasury bills, bonds and notes to finance deficits. Treasury securities are sold at auctions to the public, not to the Fed, and this action does NOT change the MS. Just transfers money from the private sector to the public sector.
The Fed buys T-Bond in the secondary market, from individuals, banks, ins cos., etc. The Fed does NOT issue govt. securities, it just buys and sells them. Fed's action DOES change the MS.
See Thumbnail Sketch, page 310.
NEW Currency: EURO (�), introduced in 2002 in 12 European countries (Germany, Italy, France, Greece, Spain, Netherlands, etc.) to replace the marks, francs, guilders, etc. Advantages? Disadvantages?
FUTURE? 3 currencies in the world? Euro, Yen and Dollar?
CANADA'S ECONOMIC SYSTEM, II
By Samatha Oliver
General Characteristics of Agricultural, Industrial, and Information Age Economic Systems Re: Barter and/or Money Economies
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Agricultural Age Economic Systems (Barter vs. Money):
Barter, pre-money economy; goods and services are traded without any money being exchanged -
Industrial Age Economic Systems (Barter vs. Money):
Money economy; rise of labour sold for wages, and goods and services sold for money/currecy. -
Information Age Economic Systems (Barter vs. Money):
Continued money economy as well as rise of a subtantial barter economy both within nations (a counter-economy) and between nations (counter trade)
Information/Data on Canada's Economic System (Whether Barter Economy or Money Economy)
Canada falls under counter trading(money economy)Conclusions on Canada (Whether Primarily Agricultural, Industrial, or Information Age Re: Being a Barter and/or Money Economy)
Canada is in the information age. (Barter vs. Money Economy) Canada has a free-trade North American free trade Agreement (NAFTA) with Mexico and the United States. This agreement provides for the freer movement of capital and goods, more cross-national investment, and a large market for many goods from each country. Therefore, it falls under the information age.RUSSIA'S ECONOMIC SYSTEM, II
By Daryl R. Evans
General Characteristics of Agricultural, Industrial, and Information Age Economic Systems Re: Barter and/or Money Economies
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Agricultural Age Economic Systems (Barter vs. Money): Barter, pre-money economy: goods and services are traded without any money being exchanged.
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Industrial Age Economic Systems (Barter vs. Money): Money economy: rise of labor sold for wages, and services sold for money/ currency.
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Information Age Economic Systems (Barter vs. Money): Continued money economy, as well as rise of a substantial barter economy both within nations( a counter-economy) and between nations (counter-trade).
Information/Data on Russia's Economic System (Whether Barter and/or Money Economy)
Russia is a money economy, that is in hte mist of economic problems. It has experienced inflation as high as 18% a month since Yelstin renoved price controls. The rate of inflation has dropped down to its current rate of 5%. There is a strong black market economy going on in the country, part of this is for hard currency, and part of this is a counter economy. The Russian government has also engaged in counter-trade with other independent states.Conclusions on Russia (Whether Primarily Agricultural, Industrial, or Information Age Re: Being a Barter and/or Money Economy)
Because of the increasing barter, counter-trade and counter-economy Russia could, by the guidelines of Alvin Toffler, be considered in the information age as far as economic systems.Monday, July 21, 2008
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Thursday, July 17, 2008
Mulakan dengan semester baru
Bismillahirahmanarahim
Subjek Yang di ambil sem ni
INGAT TU....!!!
Subjek Yang di ambil sem ni
- Management Accounting
- Design E commerce
- Risk Management
- Global Finance
- Multimedia
- Investment
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