The Fed and the Money Supply

Instructions: Please show all work or points will be taken off. Good luck!

1. In this problem, we are going to calculate the money multiplier one year prior to the Great Recession (12/2006) and compare it to the money multiplier five years hence (12/2011). The implication, as you may have guessed, is that since the Fed has been paying interest on excess reserves (10/2008), the excess reserve to deposit ratio has risen which implies a lower money multiplier.

Data you need for problem 1:

Monetary Base Dec 2006: 837.701 ; Dec 2011: 2603.487

Excess Reserves Dec 2006: 1.863 ; Dec 2011: 1502.206

Currency Dec 2006: 749.6 ; Dec 2011: 1001.5

Required Reserves Dec 2006: 41.419 ; Dec 2011: 96.510

Demand Deposits Dec 2006: 609.9 ; Dec 2011: 1154.6

a) Calculate the money multiplier for Dec 2006, one year prior to the Great Recession. Please show all work.

b) Calculate the money multiplier for Dec 2011, five years hence and a little more than three years after the Fed got the authority to pay interest on excess reserves. See the Federal Reserve's press release.

c) What is the percent change in the money multiplier in this five year period?

d) Now consider the change in the monetary base during this same five year period and compare it to the change in excess reserves. Is it a true statement to say most of the open market purchases that caused the monetary base to "blow up" ended up on bank's balance sheets as excess reserves. Be very specific with your answer using actual numbers. Which change is bigger and why??

2. You are the director of monetary affairs at the Fed and you are in charge of keeping track of the money supply, making sure it does not fall, as it did in the Great Depression, but also making sure it does not ‘blow up' as we know it might, knowing that the banks are sitting on piles and piles of excess reserves (see pic below). You have the following initial conditions:

RR/D= .10

C = 400 b

D = 1000 b

ER = 500 b

a) i) Calculate the MB.
ii) Calculate the money multiplier.
iii) What is the money supply (use mm x MB to calculate this)?

Show work

Now you know that if these banks get rid of their excess reserves all at once, the amount of open market sales that you need to conduct (to keep a handle on the money supply) will be massive and raise more than one eyebrow in Washington (from the politicians) as the infamous ‘exit strategy' will be full speed ahead. The Fed's treasured independence would be tested once again and you want to avoid that. Suppose that you had major influence and convinced the banks that it would be much more stabilizing for all parties if they gradually lent out their excess reserves rather than lending them out all at once. As such, you convince the banks to cut (lower) their excess reserve to deposit ratio in half (note: the ER/D ratio is cut in half not ER itself). Assuming importantly that:
• The C/D and RR/D remain the same as in the initial conditions (they are stable)
• The monetary base does not change

b) Repeat part a) except for part i).

c) Given that 10% is the optimal growth rate of the money supply (from its initial value in part a), what type and how many open market operations do you need to conduct to achieve this target, given what happened to the money supply in part b)? Assume importantly that the money multiplier is stable at its new level (after the banks cut E/D in half, i.e., part b).

We now pretend that this crisis is well behind us and now it is time to go back to targeting the funds rate. You are facing the following conditions:

Reserve Market

Initial Conditions

rr/D= .10
C = 200 b
D = 1000 b
ER = 00

M = C + D

d) If Rd = 400 - 100 iff, given the information above, what is the market clearing federal funds rate? This happens to be the fed funds target.

Show work.

e) Suppose two things happen simultaneously:1) reserve demand is increasing and is now expected to be: Rd = 500 - 100 iff and 2) Chairman Bernanke calls you up and wants you to increase the funds rate by 150 basis points (one and one half percentage points) beyond its equilibrium value in part d). What type and how many open market operations must you conduct to satisfy Chairman Bernanke? Show all work.

Now Draw a Reserve market diagram depicting the initial conditions as point A and the new conditions (account for the changes from part d to part e) as point B. A completely labeled and correct graph is worth 10 points.

3. We know that the Fed is heavily criticized for not reacting aggressively enough during the Great Depression as we witnessed a fall in the money supply during the Great Depression.

a) It is your turn to take 'shots' at the Fed by writing an essay criticizing the Fed for not reacting appropriately during the Great Depression. Be sure to explain exactly what shocks hit the system (and why) and how the Fed, if they acted differently, could have lessoned the devastating effects the Great Depression had on the economy and its people.

During the Great Depression many shocks hit our nation, leaving terrible outcomes. One of the most serious shocks was the crash of the Stock Market. This crash instilled uncertainty in our economic system, which eventually led to many banks failings.

We then incurred numerous debts and deflation began as trades decreased.

It is normal for economies to fluctuate and the Great Depression may have just started fluctuating. But what happened that made it the worst economic situation in our nation's history? It can be the fact that the Fed's did not realize what was happening or how bad the situation would end up. If they took the steps to realize what could have happened, they could have implemented monetary policies to prevent such incidences. The money supply could have been increased so we would not have had to deal with such a shortage.

If the government cut the taxes instead of raising them, consumers would have spent more, keeping businesses open and money circulating.

b)  Ben Bernanke is known as a student of the Great Depression (as in expert since he has performed a significant amount of research on the topic) so if anyone knows what happened and what went wrong during the Great Depression, it would be Ben Bernanke. In this question, we are going to see if the Fed "learned their lesson." The data you need are highlighted below (note, this is weekly data and the actual money multiplier numbers do not match those that you calculated in question 1, but don't worry about that).

Money Multiplier (M1) 12/06/2006: 1.640 ; 12/14/2011: 0.821

Monetary Base 12/06/2006: 841.665 ; 12/14/2011: 2631.332

We know that M = MM X MB so that money supply is influenced by shocks to the money multiplier as well as through shocks to the monetary base (aka, open market operations). Using the observations 12/06/2006 and 12/14/2011 (basically the same five year period we worked with in problem 1), calculate the percent change in the MM as well as the percent change in the MB during this period. Then calculate the percent change in the money supply during this same five year period. Did the Fed learn their lesson?? Why or why not? Compare this response to your response in part 3 a).