Transcript for:
Interest Rate Policy and Central Banks

all right let's uh let's start um so today I want to talk about uh interest rates uh you know if you have followed the news there's a lot of debate on these days on on on where will the interest rate in the US end at the end of this Titan tiing tightening cycle uh and um so I'll show you there has been a very aggressive monetary policy trying to fight the inflationary episode we're going through uh and that's done through interest rates and and the question that I want to address today is H well how is it that the interest rate is determined so when a central bank decides to hike interest rates how do they do that okay and obviously this is about financial markets interest rate are set in financial markets and financial markets are very very complicated so we're going to keep it very very simple we're want to make introduce more complexity later on in the course but still we're going to keep it pretty simple because our main objective in studying Financial Market is really a a to to re to achieve some sort of understanding of how the interest rate policy that the Central Bank H controls is is determined so before [Music] I I get into specifics so let's let's see some trivia here who knows who that person is okay you Geron Powell exactly and who's Jeron Powell the chair of the Federal Reserve uh system in the US which is the Central Bank of the US okay so that's that was an easy one and and every you know if you are into financial markets everyone is worried about what this guy is thinking and his friends are thinking at this moment because they determine the interest rate how do they do that well that's what we're going to talk about later on a little speaker who is this no no that's that's cheating katsu WEA he is the next ER president of the bank of Japan the Central Bank of Japan and an interesting there are many interesting things of him but about him but he's a he's a graduate from our program the PHD program which actually is an incredibly successful program at producing major Central Bankers Ben Bernan is our Alum Alum that he was the the chairman of the Central Bank the chair of the Central Bank of the FED during the financial crisis Mario dragi is a one of our graduates Mario dragi was the the most successful ER Central Banker in Europe he was the president of the ECB European Central Bank for many years and in particular during the Global Financial crisis and the European crisis which followed the global financial crisis uh I mean but you name it Stan Fisher in the past of the Bank of Israel and nowadays feel low of the the chair of the Reserve Bank of Australia in Chile we have had two or three er presents and so on so if you if this is your career this is a good program you should join our program you may end up in a in a good place but that's the the next one for Japan and and Japan is a very interesting place from the point of view of monetary policy precisely because they they haven't had much space to do conventional monetary policy so they have had to do lots of unconventional things from the point of view of what a central bank typically does but today we're going to study conventional things and we'll talk a little bit more about unconventional things later in the course now some institutional knowledge this is the the again in the US the Central Bank of the US is called called the Federal Reserve System and it's a system really H it's a he has a um in um the Board of Governors which sits in Washington DC um and and there are seven Governors and the governors are are are nominated by the president and and then confirmed by by the Senate and the president of that board is is H is so the president of the FED of the FED will be one of those members okay now on in addition to that the the US has a Federal Reserve Bank system there are seven there are 12 Regional Banks uh there's one in Boston in fact if you look at the skyline near the Waterfront there's a building built out of recycled aluminum well that's the Reserve Bank of Boston and uh and uh and of those 12 Regional Banks they rotate so so policy the interested is set into in a committee which is called the fomc Federal Open Market Committee um and and the member of that the voting members of that committee are the the seven Governors plus h four out of the 12 and they rotate most of them rotate the the only one I think does not rotate is the is the is the president of the of the New York fed because they're so important because that's a financial heart of the US that you certainly want that H ER president to be involved in in interest rate decisions and it's really the FED that is in charge of communication with financial Market which is a huge thing for the FED okay they are in New York and they're crucial for that okay so that's that's that's those are the people that and in most places around the world you're going to have at least something equivalent to the the seven governors out there okay most places obviously the ECB is different because it's multiple countries so each country sends one member no but but but otherwise um it tends to be like like the US without the the the regional Banks so why do we care about monetary policy well because I think it's one of the main policy tools you have in the short run remember in this part of the course we're trying to understand output in the short ter and one of the main policy levels I mean how can you affect output is monetary policy which one is the other one there are two major ones fiscal policy exactly and fiscal policy we did look at in the previous lecture remember we said an expansionary fiscal policies an increase in G or a decline in t would lead to an expansion in a great demand equilibrium output would go out up okay so fiscal policy is something you always use in in in deep recessions uh but monetary policy is much more Nimble is I mean it's a it's a bunch of people that need to meet and just change the interest rate anything that is fiscal there are some automatic stabilizers by the way so automatically fiscal policy becomes more expansionary during recessions and stuff like that but any deviation from the typical automatic stabilizers require Congress to approve things it's a long process and so it's not something that can react as quickly as monetary policy can okay um so that's what we're going to look that's that's that's that's the reason why monetary policy is important for us at this point then there are medium and long run issues fiscal policies still affects equilibrium output in the medium and long run monetary policies much less effective at that it's very difficult to to change sort of equilibrium growth or things like that with monetary policy it's going to be pretty minor most of the impact of monetary policy in the minum and long run is really on the price level and inflation more than on real activity okay but in the short run it's very powerful for reasons that we're going to discuss in this and the next lecture okay so as I said well monetary policy acts through financial markets I I think it's a very interesting part of my research agenda is about that is I think is the central bank is a very strange institution because most of its mandate are in terms of what happens in the Goods Market says you know you don't try not to get into recession try to get us out of a recession and so on but unlike fiscal policy which has tools that are directly aim at the Goods Market remember it's a it's a purchases by the government of goods so if there isn't sufficient demand for goods the fiscal policy the fiscal Authority can go out there and buy Goods that creates more demand the the central bank is given the same mandate aside from Price stability and things like that we're want to worry about later but it doesn't have any tools the the the central bank if there's insufficient demand the Central Bank cannot go out there and buy hamburgers right that's fiscal policy can do that and expand the demand for hamburgers but not monetary policy what monetary policy can do is by bonds by instruments in the financial markets and through that affects real activity so the is it's the fastest policy tool but it's the most indirect in a sense because it it it has to go through financial market and and and and that CH those channels can be very complex but obviously we're not in the business of complicating things in this course so we're going to make it very very simple we're going to assume that financial markets only have two instruments obviously the huge simplification there are millions of financial instruments out there but we're going to isolate two instruments because this happens to be the instrument where that that that where the central banks typically participate they affect all asset prices around but the direct interventions typically recently has been a little different but typically it's only in this kind of instruments and so we're going to focus all of our analysis on on those two instruments for now later on we're going to talk about equity and stuff like that but but just to isolate the the the how monetary policy works is sufficient to just focus on two financial instruments so we're going to assume that people have their wealth in only two forms in two Financial assets one we're going to call it money and the other one we want to call it bonds okay money the characteristic of money what we call money there are many definitions of money M1 M2 M3 M4 but let's keep it very simple money essentially means something that you can use very easily for transactions okay so for example the the most important example of money not the largest but the most important one is Cash currency okay you can buy anything with cash there no problem whatsoever now the the the a characteristic that money typically does not have is that it doesn't give you any return you don't invest in cash you know you have cash because you need to do transactions but it's not the way you get a return and so money that's what it's going to mean for us is something that is used in transactions but it pays no interest rate no interest there no interest on that a bond is going to be the polar opposite it's going to be something that pays a positive interest rate so if you buy a bone for 100 for 95 you're going to get a 100 a year from now say so you get something out of that bone but it's not very useful for transactions I mean you cannot go and buy your lunch with a bond you get the piece of B for that and and and many things cannot be even even within financial markets you cannot buy asset with asset you have to go through some process in which you come sell something get cash and and with cash you pay for the other stuff not necessarily cash it could be other forms of money but but but typically Financial instrument need to be sold before you can buy something else you don't swap them it's not a part them okay but this is what it means for us so this whenever you see something like this is always interesting for an economist why and any economies micro economies or whatever what what have I done there that makes economics is about decisions and then it's about equilibrium okay it's decisions and equilibrium there's a decision to be made here there's a tradeoff okay I I you know if I need to do lots of transactions I better sort of bias my portfolio towards cash towards money if if I don't need to do lots of transaction then I and the interest rate is very high particularly then I this is an issue today today interest rates are very high nobody care about bonds or anything you know two years ago when interest rate was Zero but today interest rate is 5% so it's an issue you're not going to if you want to keep it in cash you're going to give up a lot of return okay so it's a decision to be made there a portfolio decision and that's always interesting for economies so let's talk about uh that decision and we're going to talk you can describe this decision either from the side of bonds or from the side of money we're going to describe from the side of money because there's a total amount of wealth and you have to decide what to allocate it to so you know it suffices if I tell you there a total amount of wealth and if I tell you how to how much you allocate to money then I'm telling you implicitly how much you are allocating to bonds it's a compliment to that okay so I can do analysis either way but I'm going to do it through money which is the way is normally done so money demand if I plot it in the space of M money and the interest rate is a downward sloping curve why is it a downward sloping curve the interest rate is higher it pays off more to have B your utility should exactly your decision if the interest rate is very high is to go more towards bone the interest is very low I don't care too much about bones I'd rather keep the thing that helps me transact which is money okay and it's interesting because for most of your adult life you have Liv in a world in which that not was not a very interesting decision actually no because interest were very close to zero now you're living in a different environment interest Are For the First Time sort of high for you there may a bigger decision between invest in equity say and cash but bonds and and and and these are safe bonds by the way your treasures and things like that and money is not something you have to worry about okay good what I'm saying is interest is where around here so you we're all in cash one way or the other and now interest are a lot High the other thing that so that's a movement along the curve no I'm plotting something in the space of interest rate money and interest rate then when I tell you what happens when the inter Rises I'm asking you for a a a movement along the curve okay I see so if I raise interest rate I move along the curve up so the second thing that we have there is argument we have is something that shift the curve because it's not part of my Axis so so it will shift the curve it's a parameter for each of these curves and that's nominal income so in particular if nominal income goes up I'm showing you there that money demand goes out meaning for any given level of interest rate you're going to demand more money why do you think that's the case and again I'm looking here at the aggregate but but it applies to an individual as well so for the same level of wealth now nominal GDP is higher remember that nominal GDP is the same as nominal expenditure here okay so if GDP is higher then that means there's going to be more transactions because there's going to be more expenditure okay and therefore you need more of the thing that is use useful for transactions okay M demand goes up the second point to highlight is that you know while in most places I we use why here I'm using dollar y nominal y why do you think that's that why why don't I just put there real GDP rather than nominal GDP is the typo let's go in steps suppose that prices are totally fixed and real GDP goes up that means that this economy needs more transactions because it's going to be more expenditure there okay so that that explains that yeah when real output goes up then money demand goes up when I say money demand goes up I said for any given interest rate we have more money demand okay now fix real output and I tell you suppose that the price of goods doubles do you think you need more money to transact of course because it's the same it's equivalent now money is dollars I have $10 and now prices are twice what they used to be well I'm going to need more dollars to transact okay so that's a reason we have nominal GDP here rather than real GDP okay good so let's now determine the interest rate and I'm going to do it in the simplest possible model first and and by simplest I mean here in particular no banks no intermediaries okay so there's only Central Bank and and and and and people okay so so suppose that the central banks decides that wants to this is the way monetary policy used to be conducted suppose is the size that it wants to offer M dollars to the economy and the central bank is the one that produces the at this moment which I have no intermediaries a ER money is really currency okay the only one that can produce currency forget Bitcoin only one that can produce currency is the Central Bank okay I mean dollars you can no one else can produce dollars watch out when we talk about Banks later on in this economy I'm describing there are no banks the only one that can produce Dollars currency is the Central Bank any other one that produces dollars that's illegal okay so it's a central bank so the central bank can decide how much money to supply and suppose it decides to supply M that's it it's a decision well what is a now for the first time I can I can answer the question is well what the interest rate in this environment why do I know that because I have a money supply I have a money demand the intersection at this level of money supply the equilibrium interest rate that is interest is consistent with money demand equal to money supply is that one okay is it clear so I have my money demand and I'm saying the Central Bank suppos the Central Bank De size to supply m well in equilibrium that will be the interest rate okay that's the way the interest rate is determined now suppose that the Central Bank increases remember the the goal of this lecture is that we get to understand how is that interest rate is deter is determined how is that the fed the Central Bank determines the interest rate here we said look the Central Bank decide on certain am amount of money and then the market determines what the interest rate is and this is the way monetary policy used to be conducted the central banks would typically decide the amount of money in the system it was called monetary Aggregates the amount of money in the system and then the market would determine the interest rate it turned out that that was a nightmare and so now that's that's not what central banks do but and it was a night mayor because this money demand that looks so peaceful here in practice is moving around all the time for a variety of reason you know even holidays affect the money demand and all that so so if you fix the monetary Aggregates and many the man is moving all over the place what what happens suppose the Central Bank says I'm going to offer this amount of M that's it and now I tell you money the money is moving all over the place they're weeks that they have you know three days of of weekend that have you know vacations in between or there's a Super Bowl lots of people decide to buy tickets or whatever or beer so whatever well no because when you say shortage I mean depends what you mean by shortage but so so you could be right with that part of the answer but but when you say exess theand then I have a problem because that's true only if the interest rate doesn't move but in a in a in a situation you could just the Central Bank fix M and let the market do its thing then the interest rate will not be fixed and that's exactly the problem that the interest rate becomes very very volatile if you if you do it only only through through monetary arates because this guy is moving all over the place and so imagine what happens if this demand shift up then in equilibrium it say goes up precisely to avoid your excess demand no because if this thing goes up I have an excess demand at that interest rate but what happen in equili is the interest rate will go up and so until the the excess demand disappears now in in central banks like the US Central Bank the FED they can control this stuff fairly well many other central banks don't have that if you look at the at the central at at the Bank of China for example they have lots of high frequency movements in interest rate because they not very good at doing this stuff it's it's not that easy to okay to to to control an interest rate for example to keep it we but the Central Bank used to do that that's what I'm saying used to do that I'm saying in practice this system wasn't very good because this in practice this the man is moving around for a lot of EOS syncratic reasons okay some of them are EOS syncratic some of them are very predictable there was a lot of panic around the shift of the year 2000 that the ATMs would stop working and stuff like that so it was a massive increase in money demand because people wanted to have cash just in case ATMs sto working okay and and so there are some are predictable and so but but you can get very large fluctuations so in practice what central banks do nowadays is really is they tell you what the interest rate is and then they offer whatever M the market needs for that interest rate that's the way modern monetary policy works okay I I'll tell you a little bit more about that so let's see what happens here if if if if uh if the suppose the the Fed for reasons that you'll understand better in the SEC in the next lecture suppose the FED decides that they want to have an expansionary monetary policy expansion in monetary policy means it's going to spand M it was offering certain amount of M and now it decides to offer more of the D so what happens in equilibrium well we start from an equilibrium here if the interest rate remains at that level now we have an excess supply of money okay and the only way to restore that equilibrium is by people demanding more money and how when will people demand more money well when the interest rate is lower okay so excess demand the interest start declining then demand for money starts catching up with a new higher supply of money okay and you end up with a lower interest rate okay so that's an expansion in monetary policy an increasing M that leads to a decline in the interest rate again mod than central banks don't tell you we're going to increase M by 20% what they tell you is we're going to cut interest rate by say 50 basis points when they tell you that they're going to C cut interest in by 50 point they're reading you this accxes but behind that operation there must have been an increase in money supply and then it comes all the fine tuning that that they have to do know so so the interestate remains there when the man is vibrating around that thing there but the when we say an expansionary monetary policy we really mean cutting interest rates how is the interest rates cut effectively by increasing the money supply but they don't tell you that they are doing that but that's what they're doing okay good so nowadays we're in the opposite process we're moving that way no up but you seen in every single meeting now for the last seven minutes or so we have seen a hike in interest ratees okay H well that's they don't tell you that but they're saying we're going to cut money supply and moving in that direction that direction because if they move in that direction then interest rate go up clear good what else shifts uh this is different kind of shift suppose that nominal income goes up and this is happening all the time nominal income is growing in most economies most of the time unless you're in a recession nominal income is growing it's growing for two reasons one because we have inflation and the other one is because real output is growing that means that that typically in an average year manyy demand is Shifting to the right okay so if money demand shift to the right and money supply does not change then what happens to the interest rate money demand goes up money supplies doesn't change what happens to the interest rate increases because at this interest rate here we have an excess demand for money so we have to reduce the money demand how do we reduce money Demand by increasing the interest rate that's way we so that's yet another reason why why it's not a good idea to be targeting monetary Aggregates the FED tells you we we want the interest rate at 5% say okay and then the economy will be growing and so on and what the FED will be doing is if they want to maintain the interest rate at 5% well they'll keep expanding M so the interest rate doesn't go up okay that's the way normally conduct but if the if the FED stays sleepy and and and you have an increasing many demand then then the interest will tend to go up so I told you that that ER that the central bank is moving M increasing them reducing them or whatever so how do they do that I mean it's not that they although that police has been advocated it's not that they go in a helicopter and sort of fly bills on top of all of us they don't do that although again it has been advocated in extreme cases of recessions and so on and it's called helicopter money just give money away okay ER but that's not the way it's normally done for normal operations is not done that way so how is it done remember that we have a financial system that is very simple for now we have money and bonds so what the Central Bank does the Central Bank wants to change the portfolio of people that they want people to have less bonds say and more money that's when that's to ruce the interest rate so what the Central Bank does is goes up there and expansionary open market operation open market is because they go into the open market to buy bonds okay they as as opposed to an operation that happens behind doors if the if the FED went directly to the treasury and bought bonds that would not be an open market operation okay but what they do is they go to financial their financial system and they go with a big bag of money and say okay we want bones and so the public sells bones to them in exchange for money okay that's an expansion in market so what we saw that before when M shift to the right what the central bank really did is went out there and bought bonds from the public the public sold the bonds and got the cash okay at some price people when when I show you equilibrium in the money market that means also an equilibrium in the bond market necessarily so it has to be that the price is right for the for the portfolio of individuals a contractionary open market operation is the opposite is a central bank goes out there and sells bonds to the market and takes the cash back okay that's a contractionary monetary policy so when the FED wants to yeah when the FED let me justew when the FED wants to cut interest rate what the FED does is an expansion in monetary policy which means it goes out there and buys bonds from the market and gives cash to the market yeah can how can the Central Banking assistance guarantee that some's apply their bonds like if they didn't have if their government didn't have the financial stability I guess the like United States has how would they guarantee that these bonds will be worth anything in the long well I mean there's you're talking about risk premium and that's a that's that's that's an an additional issue typically a a central banks inter in in in in very short duration bonds so there it's not the typical bond that is risky in many sense it's very very very short duration bonds treasuries very short duration in fact it's even less nowadays central banks really intervene in the in the overnight Market is is but but you're right that that countries that don't have a bond market a well-developed market have problems with the management of monetary policy and so on because they have a cretive spread that is moving around around as well but they tend to focus on the type of instruments that thing becomes very important I mean for Japan even big guys very big guys now they have an issue because they have been buying bonds very long duration bonds 10 year bonds and stuff like that and there it's a little trickier Market need to trust you a lot more if you're dealing with 10e things and you're dealing with a three-month Horizons and so on in other instances a um erh for example Chile has a situation like that the Central Bank itself can issue bonds and so those are bonds issued by the central banks and they tend to be very reliable bonds because these are bonds that are issuing your same currency so you have the currency to always pay the you can always print money and pay for those bonds you see so it rarely happens that there is default on bonds of that kind ER the typical bonds government bond that defaults is a bond that is issuing a currency different from the one you have because then you may not have the currency to pay for stu okay and that's the reason em markets run into trouble and things of that kind okay so in terms of the balance sheet of the Central Bank how does an open market operation look so if you look at the at the balance sheet this is an incredibly simplified version of the balance sheet of the of the FED no they have lots of things some more assets gold and all sort of stuff but in our simple economy the government the the fed the assets of the feds is they have some bonds it has already some bonds out there and the liabilities is the money they issue they owe that to people I mean they issue currency but you know but but that's it's a liability people can do things with can buy things with that money and so it's a liability so that's the way the balance sheet looks so when when the the FED decides to do an expansionary open market operation then what it does is it goes out there it IT issues an say a $1 million expansionary open market operation they do it in much we get tickets on this but let's make it simple $1 million of an expansionary operation but they go they go out there they they print a million dollars and they buy a million dollars from the market okay and so at the end the balance sheet ends like it used to be the there's an extra $1 million of liabilities because now there's a million more of dollars circulating out there and but but the against that the Central Bank also has a million more of bonds Holdings okay so that's that's what happens with when so so when in an expansionary monetary policy the balance sheet of the Central Bank expands both sides expand by the same amount okay but expands and one of the big themes of recent years starting from the global financial crisis is that these balance sheets used to be small peanuts type things for I mean a trillion dollar or something like that for something like the the US the size nowadays they're much much larger than that because they have done so many operations to first get us out of the global financial crisis and then to get us out of covid and so on that these balance sheets are now an order or two orders of magnitude larger than they used to be okay but be in words they have had to do lots of expansionary monetary policy over the last couple of decades or so so let me talk about a little bit about interest rate and bond prices because that's the other side of this thing so so what is the connection because sometimes it's easier to understand things in terms of price in terms of bonds so suppose a bond pays $100 a year from now and and no coupon in between so if you buy a bond now for some price PB you get $100 a year from now so what is the interest rate of that bond that is what is the excess return that you get out of that or the return you get out of buying that Bond well it's going to be $100 minus whatever you pay today say you pay 95 then $5 divided by your investment initial investment which was 95 okay so that's a bond that gives you know a little bit more than 5% in a year okay that's a return that's interesting so that's a connection between interest rate and prices and notice that this is an inverse relation you know when the price of a bond goes up the interest rate pay goes down because you're paying more for the same principle you're going to get 100 but now you're paying more for it well that means the interest rate the return on that Bond went down okay conversion you can say the other way around the higher is the interest rate the lower is the price of bond of a bond so for example today the interest rate is 5% a ER if I want to issue a bond that doesn't pay any coupon and I'm completely safe so I'm the US Treasury I'm going to be able to sell that bone for 95 two years ago when the interest rate was Zero the fair would have been able to sell that bond for 100 okay so there's an inverse relationship between the interest rate and the price of bonds and now I can take you back to my open market operation so remember what what I said there's another way of remembering sort of which way these signs go remember when you have an expansionary monetary operation I said the FED goes out there with a back of money and buys bonds from the market when bonds when you buy something when there's an enormous increase in demand for something what do you think happens to the price of that something goes up no for anything cars whatever it is if there's a lot more demand then prices will go up and the FED has a lot of cash so he can really buy large amount of bonds and so when the FED goes out there and does an expansionary open market operation means it goes out there and buys a lot of bonds the price of those bonds goes up and made that formula that means the interest rate is going down okay so that's another way of understanding how is it expansion open market operation lowers the interest rate it's because it raises the price of the bonds that is demanding and when you raise the price of the bonds then the interest rate goes down will I do this to you well very quickly so really the only thing I really care I want you to understand what I what I just said well because we're going to use it I want to you to understand what comes next ideally well but but it's okay if you don't understand it too well okay and I'm going to tell you when do you have to start understanding very well again okay for now this this is a pie in qu is what I'm doing here is making things a little bit more realistic the the message will be similar but it's a little bit more complicated okay and that's the reason sort of substantively H um I already told you what I wanted to tell you what I'm going to tell you now will give you a little bit more realism and therefore will allow you to understand a little bit better a technical description of monetary policy or something like that so in practice you know in the economy I just describe you had sort of households and firms and the central bank but in practice there are lot of financial intermediaries okay and in financial intermed the most prominent of them for especially for monetary policy are the banks and there are certain Banks actually they're even more important than others but banks are financially intim intimidates they take money from someone or deposit from someone and lend it to someone else or buy some instruments okay so so they intermediate the funds of somebody that wants to save on in the bank a deposit in a deposit account or something and they they lend that money effectively in the name of the other person to H someone else okay so Banks do two things to the model I just described the first is that they produce money as well okay because ER money is made of currency which is is issued by the central bank but it's also made of a checkable deposits if you have a a checking account something you can have a debit card against or something like that then then that's money for you okay if you deposit in a bank in a checking account that's money okay and so when Banks the liabilities of banks the deposits is part of money it's something you can use for transactions you can write checks you can use your debit card and stuff like that okay so that's the first thing that Banks do okay the other thing the banks do is they themselves have a deposit account at the Central Bank okay so they themselves take part of the deposits they take the deposits part of the deposit they lend to other people another part they buy financial instruments Bond and stuff like that in this economy would be only bonds and the other part smaller part 10% or something like that they deposit at the central bank that deposit at the central bank is called Reserves okay so when you he the word reserves of the banking sector this is the deposits of the banks at the Central Bank okay and that's that's also liability for the Central Bank the central bank is holding that deposit of the banks it's not the central bank's money it's the it's the bank's money okay and they're holding it there it's a liability as well so now if you look at how the balance sheets look our central bank now has more things he has assets going to be Bonds in this economy this only thing you can have but now it will have the currency that had before and in liabilities but also will have the Reserves the deposits of the banks themselves okay okay and this is called this stuff here is called central bank money in contrast it is called Central Bank it has so many names it's called central bank money high power money some other name have some but but but he has several names and what is I I like the name central bank money because that's in contrast with this kind of money it's the money that the banking sector produces the checkable deposits okay so this is the money produced by the central bank and then the and then through deposits the financial system the banks themselves produce more money so The Total Money in the system is much more than the central bank money because deposits is a big thing you know this is much larger than that in practice okay good how does this change our mold not really much and so so again that's the reason I don't care too much if you understand these last two slides so let me rederive what we have with this approach with with this this uh extension so money demand is the same as it used to be what happens is you're going to demand it in the form of currency or checking accounts or something like that but but the total money demand is exactly as it used to be Banks typically hold a share of a and assume for now that there's no currency so everything is check is deposit otherwise you get a more complicated formula okay so no one holds cash which probably quite realistic nowadays you so everyone has a checking account and that's it okay so the banks typically hold for regulatory reasons a share of their Deposit they have a minimum for regulatory reasons a minimum share of the deposit they have that they need to hold in the form of reserves okay and I'm going to call that a fixed fraction Theta so if all the money is held in the form of the deposits then Theta which is a number like 0.1 say times the deposits which is money demand is equal to the reserves at the is equal to the central the demand for central bank money this is the demand for central bank money because is this are the N these are the reserves that the banks want to have at the central bank so the demand they they want to have this amount of deposits at the central bank this what we call HD it's Theta time m and so now rather than M what the Central Bank controls really because it's the only thing can really control is the money that it issues issues which is the central bank money so R supplying M which used to be currency now m is a bigger thing because has deposits and all sort of stuff but the central bank is the one that controls how much high power money how much central bank money it issues and we're going to call that H okay so if we go back to my balance sheet here the Central Bank cannot control total money because it cannot control the amount of checkable deposits in the economy but it can control this money here and since we have no currency my example it really can control how much supply of reserves it can do okay and so now we have a demand for Reserve which is just proportional to money demand equal to some fixed amount H which is the supply of high power money by the central bank and then the equilibrium looks exactly like before it's going to be some remember before we have m equal to Dollar y i now we're saying it's not M it's Theta times M really no because it's a fraction only of Total Money okay has to be equal to a money demand it's not Total Money demand it's the money demand that ends up being demand for central bank money because Total Money demand is the checkable checking account that leads to a demand for central bank money by the Banks which is Theta times those deposits it's not the full Deposit they don't Deposit they don't take all the deposit and deposit at Central Bank they say only 10% of those deposit will keep them at the central bank so $100 in deposit if 30 is point1 $100 in deposit leads to a demand for reserves that mean for deposits by the bank and the Central Bank of $10 okay and that is the thing that the central bank can control very well it's a m the is the demand that comes to me the central bank is $10 and I decide whether we do $10 or not you we can do five and then we're going to have the interest rate sort out five to be in equilibrium so it's if if if the banking sector wanted 10 and I'm only going to supply five then something the interest rate is going to have to rise so that deposits you know decline less demand for money and and the and the final demand that gets to me is five not 10 but the mechanism is exactly the same I know this this can be a little confusing but the mechanism exactly the same it's just this just illustrates it makes I mean this this is important because it's institutionally important more than conceptually important because this is the market where really the interest rate is set okay so this I'm doing next time that market the market for reserves really because what the banks do is they want Reserves okay deposit at the central bank that market for reserves the interest rate in that market for reserves is called the federal funds rate and it's called the federal funds rate because the Federal Reserves controls that rate so when the FED when when there is a meeting by the fed or a policy announcement that tell you that the the FED has increased the rate by 50 basis points it means it has increased the interest rate in that market by 50 basis points okay so the interest rate that the Central Bank controls corly is called the federal funds rate and the federal funds rate is that market is market for reserve for high power money so all the operations happen there they don't participate in the deposit Market or anything they participate in that market which every night is a is a Hu huge number of transactions every night because I put all the banks together but what happens every night is some banks have more reserves than they need some other banks have less reserves than they need so they supply and demand within the banking sector for for reserves and there's an interest rate that tends to equilibrate if too many banks are short reserves then there's going to be lots of demand for reserve and interest rate is going to tend to go up If the Fed doesn't want that interest rate to go up then what it will do overnight it will go there and inject reserves into the system high power money so the interest rate in that market comes down okay and that's the way the FED operates that's the way it controls it participates in that market controls the amount of high power money which regulates the rate in the resarch market and here it's only you know and then so here you have sort of the major Banks participating here and and and then this leaks into the other interest rates in the economy to into deposit rates to to bond rates and so on but but the real rate they control the rate that they control most directly is that rate here okay and that's the reason I wanted to give you a little bit of institutional I mean to add complexity so we could get to so you could get to this word federal funds rate because that's what you're going to read in the newspapers the FED increase the federal funds Target is going to say because they target they cannot guarantee it's going to be that they target an interest rate and typically they give you a range it's a very narrow range okay you let me just conclude by showing you how that rate has looked in the US recently okay and I finish here so here here is before covid okay H the interest rate the Fed was already hik in interest rate it had overdone it there so it was beginning to lower interest rate and then covid came boom and they cut interest rate very aggressively the this is the maximum they can cut it too and we're going to talk about that briefly in the next to zero you cannot go below zero you cannot pay negative interest rate because then I don't demand money I don't demand bonds why should I hold a bond that pays me a negative interest rate when cash pays zero always zero I can always keep it under the mattress and and and I don't pay in negative so the interest rate the lowest can be zero and you see that they they did the maximum they could in terms of cutting interest rate they went to zero effectively zero and now they have been trying to catch up because inflation is very high and so they're trying to to hike interest rate and you see how what they're doing okay well all those interventions happen in the reserve Market that's what where this is that's the rate is in that market over okay okay so I think we're meeting on Tuesday next week uh I think that's the plan