In this video, we are going to be examining the determinants of money supply. Money supply is in principle determined by central banks. They are the ultimate source of money either directly or indirectly, and we're going to see that they play a role in both channels. They have access to both channels directly affecting money supply and indirectly. Whatever decision they make has important implications for the economy as a whole, for the price level, for the income level, and they've been subject of discussion for a long time because central banks in some countries are independent, they make their own decisions, and some people don't like the outcome. In some other countries, there are under the control of politicians may still make political decisions rather than making decisions that are economically beneficial. Central banks control money supply through three main channels; open market operations, reserve requirements, and the discount rate. I'm going to explain all these three in detail in a moment. But before I do that, let me draw your attention to what a bond is because bonds play a key role in the way Central banks intervene in the money market and shape the money market. A bond is a piece of paper which has a face value. Lets say, this is a website that gives you the value of a bond in the market given the interest rate prevailing in the market, and interest rates written on the face of the bond. So let's say this bond has a face value of 1,000, and the interest rate paid on that 1,000 is four percent. That means that the bond gives you $40 per year as long as you hold it. Usually bonds have also a maturity period they do at some point. In this case, it's 30 years. Now, if the interest rate in the market is four percent, and you want to save, this would be one mechanism. You buy this at $1,000 and it gives you four percent interest exactly what you can do elsewhere. However, if the market interest rate goes down, let's say in this example, it goes down to two percent, you hold this piece of paper it gives you $40 a year. This is much more valuable than $1,000 because if you put your money elsewhere you're going to get a lot less. So this website actually calculates the bond price for you. The lower the market rate, the higher the bond price because essentially the bond is giving you a fixed amount of money when the interest rate is low. That piece of paper that brings you $40 a year is valued much more than $1,000 in this example with 30 years maturity is valued as 1,447.93. There's an inverse relationship between the market interest rate and bond prices. This is the key thing that I want to emphasize here. If we lower the interest rate the bond prices go up. Alternatively, what one can do, and this what central banks do, they try to push up the bond prices by creating demand for them, and that ends up lowering the market rate. So here's how open market operations work. The Fed conducts open-market operations when it buys and sells bonds. This is the primary mechanisms that it uses day-to-day to manage supply of money. When the Fed wants to increase money supply, it starts buying bonds. It takes the bond in, and holds onto the bond, gives the cash to the public, money that comes to the public start circulating. On the other hand, if the Fed wants to reduce the money supply, it starts selling the assets that it has the bonds that it has. So once it starts selling the bonds, it gets the cash from the public, and puts it away. The bond starts circulating, but the bond remember is not used as a means of exchange, people will have less cash. Therefore, that's going to affect the interest rate they're going to be willing to pay to have cash. I'm going to come to that in a moment. The other two mechanisms that the Fed uses to control money supply is through reserve requirements, and the discount rate. To understand these, we need to understand how the banking system works, and how the Fed enters the picture of that. Banks play a very important role in supply of money, essentially through their deposit and lending activities. They take people's deposits, and based on the deposits that they receive, they give loans. Those loans become new deposits in other banks or in the same bank. Therefore, checking account money goes up, and money supply goes up. In modern banking system, essentially when banks receive deposits, they keep a fraction of it, and lend the rest. The reason they keep a fraction is that some money needs to stay with the bank in case people who have deposited money need their cash back or they want to use their money in their checking account the bank should have some cash ready to give to them or transfer to other accounts. So if a dollar is deposited, some fraction of it is kept in the the bank, and the rest is lent out. So loans become an additional source of money. The fraction of the deposits that is kept as reserves ready to be paid to the depositors is known as reserve ratio. The amount of money that is created in the economy is inversely related to that reserve ratio, because the smaller the reserve ratio, the more of the deposits that are lent out that become new deposits. Therefore, that money in another bank becoming new deposit enables the other bank to also lend more, lend on a big chunk of the money. The lower the reserve ratio, the less banks keep cash, and the more they pass on to other banks to lend out, and as a result, money supply goes up very sharply. If reserve ratio is lower, money supply is larger. If the reserve ratio is higher, less money can be lent out, and as a result money supply shrinks. Fractional reserve banking systems, the systems that are in place commonly in all countries. In principle are very efficient, very effective means of providing credit, however, they could also run into serious problems if too many depositors want their money back at the same time. The reserve ratio guards against that to some extent because if more people come to take their money back, high enough reserve ratio means that there's enough cash to give to the depositors and there will be no problem in the way the system operates. The problem emerges if there are too many people relative to the amount of reserves being held. That could be triggered by rumors, that could be triggered by the bank actually not having enough money or the news about the bank not having enough assets to pay the depositors. Anything could cause trouble. If you want to look at an example of this in the old movie, "It's a Wonderful Life, " it should be available online. You can watch. There's a scene where a lot of people want their money back from me. Savings and loan association and from a small bank and the owner of the bank tries to explain to them that he has enough assets to pay them, he doesn't just have enough cash to provide it to them. The rumor that goes around that he's going under is not, he explains that it's not true but the depositors want their money back. That could itself cause the bank to go bankrupt because if you can't pay the depositors, no new money is going to be coming to the bank. If no new money is coming in, you can't make any money and as a result, you start moving towards bankruptcy or basically closure of the bank. In order to avoid these kinds of crisis, the Fed regulates the minimum reserve ratio. In fact, this goes back to early 20th century when the Fed was created and was given the task of regulating the reserve ratios which is known as reserve requirement, the minimum amount of reserves that the bank should hold in liquid forms to pay their depositors. The Fed also provides liquidity just in case banks need them through its discount window to make sure that depositors can get their money back quickly if they need it. So time deposits are honored all the time. Sometimes also we call them demand deposits exactly for that purpose. They should be available upon demand. So let's look at the Fed's tools of monetary control a bit more closely. First, reserve requirements. These are the requirements or regulations on the minimum amount of reserves that banks must hold against deposits. When you deposit a certain amount, remembers of certain amount of money should be kept at the bank and the Fed requires a minimum amount of cash holding. Raising the reserves reduces money supply because the banks can't lend a whole lot of the money deposited in them. Reserve requirement could be used to reduce money supply. However, practically speaking nowadays, the reserve requirement has become a less important means of regulation. The reason is that banks practically can borrow from the central bank whenever they want at a cost but they can borrow a lot if they want to and therefore replenish their reserves. So the reserve requirement doesn't play a whole lot of role in money supply anymore. The discount rate is the interest rate the Fed charges usually an overnight rate for short-term loans to banks to deal with their cash shortages or if they need liquidity very quickly. You can figure out, think about what exactly would happen to the money supply if the Fed lowers the discount rate. So let's look at this poll. I'm going to give you a moment to come up with the answer. It's pretty straightforward based on the discussions we've had so far. Suppose there's a meeting scheduled for next week and the Fed lowers the discount rate. After the meeting, the banks would want to borrow from the Fed more money than before, less money than before, about the same or we don't know, maybe more, maybe less. I hope you've chosen the option A. When the discount rate goes down, banks can borrow from the Fed more easily at less cost and therefore they borrow more and are able to lend more and as a result, there's going to be an increase in money supply. You can figure out what happens to the money supply and then you're going to see how that affects the interest rate. A few key points about the way the Fed controls the money supply. First thing to keep in mind is that the Fed's control over money supply is not perfect. The main reason is that the Fed may lower the discount rate or may provide more money through the open market operations, but when that money is deposited in the banks, the banks are the agents that decide how much of the deposit should be lent on. Sometimes they keep more reserves than required and that affects money supply. So that's why the control over money supply is not perfect, but the Fed tries to adjust it in order to influence the interest rate. In fact, actively they tried to fine tune that supply of money in order to make sure that interest rates remained within the boundaries that the Fed is interested in. Another factor that makes the control of the Fed over money supply difficult is the behavior of firms and households. They may decide to hold more money or less money depending on their needs, their perspectives about the future, their perceptions of what's happening in the money market.
