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