Tuesday 922

 

Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 10 Money and Prices in the Long Run
Chapter 29 of 36 The Monetary System
Section 19 of 20
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As discussed in previous sections, the Fed has these three tools to control the money supply, open-market operations, reserve requirements, and the discount rate.
However, the Fed's money supply control is not complete.
The Fed faces two problems beyond its control.
Each arises because the money supply is created by the fractional-reserve banking system.
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#1 problem is the Fed does not control the amount of money households decide to keep as deposits in banks.
The more money households deposit at banks
· the more reserves (money held at banks to pay depositors’ demands for their money rather than loaned out) banks have
· the more money the banking system can create by making loans
Conversely, the less money households deposit at banks
· the less reserves banks have
· the less money the banking system can create by making loans
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Suppose tomorrow people begin to lose confidence in the banking system and decide to withdraw deposits from banks and hold more currency at home.
The banking system loses reserves, makes fewer loans, and creates less money and the money supply falls without any Fed action.
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#2 problem is the Fed does not control the amount bankers choose to lend when money is deposited in a bank.
Money is created only when the bank loans it out.
Because banks can choose to hold excess reserves instead of loaning money
the Fed cannot be certain how much money the banking system will create.
Suppose tomorrow bankers become more cautious because of economic conditions.
Bankers decide to make fewer loans and hold more reserves
· the banking system creates less money
· the money supply falls
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In a fractional-reserve banking system the amount of money in the economy depends partially on the behavior of depositors and bankers.
So, the Fed cannot perfectly control the money supply because it cannot control
· how much money people deposit at banks
· how much money banks loan out
The Fed is able to minimize these two problems by
· constant review of data of bank deposits and reserves
· responding to these changes to keep the money supply close to its target
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constant review of data
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How does the Fed respond to these changes? ChatGPT:
If deposits and bank lending cause the money supply to grow too slowly,
the Fed can add reserves to the banking system,
for example by buying Treasury bonds.
If they cause money supply to grow too rapidly,
the Fed can remove reserves from the banking system,
for example by selling Treasury bonds.