The Federal Reserve and Money Supply

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Chapter 6

• The Federal Reserve and Money Supply

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NOTE

• Takes sections for chapters 10, 14, 15 from the
  Mishkin text (9th edition), Federal Reserve
  reader, and www.federalreserve.gov

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The Money Supply Process

• 3 key players
• 1. Depositors
• 2. Banks
• 3. Federal Reserve

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Depositors

• Depositors are the most important providers of
  funds and they are the biggest users of funds
• If depositors lose confidence ? bank runs can
  occur, causing banks to lose their sources of
  funds
• If depositors have confidence ? banks have an
  increase amount of funds

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Banks

• Banks are the keepers of depositors funds
• As before ? our deposits are their biggest
  liabilities, but their greatest assets

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The Balance Sheet for a Bank

• Balance Sheet is the most important document to
  understand the banking system
• It is made up of two broad categories
• Liabilities (Sources of Funds)
• Assets (Uses of Funds)
• Listed from most liquid to least liquid

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Liabilities

• Liabilities are simply the sources of funds
• Checkable deposits
• Payable on demand
• Considered to be an asset for depositor (us)
• Lowest cost of sources for banks ? we want easy
  access to liquidity
• Only 6 of total liabilities (per the Fed)
• Nontransaction deposits
• CDs
• Owners cannot write checks against such accounts
• Primary source of bank funds (53 of bank
  liabilities)

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Liabilities Cont.

• Liabilities Cont.
• Discount Loans / Fed Fund (31 of liabilities)
• Discount loans are loans from the Federal Reserve
  (also known as advances)
• Typically 1-pt above the fed funds rate
• Banks typically do not want to borrow from the
  Fed unless absolutely necessary!
• Fed Funds loan (overnight loans)
• Federal funds are overnight borrowings
  by banks to maintain their bank reserves at
  the Federal Reserve
• Transactions in the federal funds market allow
  banks with excess reserve balances  to lend
  reserves to banks with deficient reserves
• These loans are usually made for one day only
  (overnight).
• Bank Capital (10 of liabilities)

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Assets

• Typically referred to as the uses of funds
• The interest payments earned on them are what
  enable banks to make profits.

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Assets Cont.

• Reserve Requirements
• These are deposits plus currency that is
  physically held by banks.
• Reserves are made up by required reserves and
  excess reserves
• Required Reserves For every dollar of checkable
  deposits at a bank (a fraction must be kept as
  reserves)
• Excess Reserves The most liquid of all bank
  assets and the bank can use them to make other
  loans to banks (through the fed funds market) or
  other loans.
• Cash Items in Collection Process
• Checks in process of being cleared from another
  bank

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Assets Cont

• Correspondent banking
• Common in small banks
• Small banks hold deposits in larger banks in
  exchange for a variety of services, including
  check collection, foreign exchange transactions
  and securities purchases.
• Securities
• Most banks are not allowed to hold stock
• Tend to hold state and local bonds because then
  local government would do business with them
• Loans
• Loans are least liquid
• The lack of liquidity and relatively high default
  risk offers banks the highest source of profits.

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T-Account for a member bank
Assets Assets Liabilities Liabilities
Required Reserves 25,000 Deposits 100,000
Excess Reserves 75,000 Bank Capital 15,000
Securities 15,000

• Most important notion is that ASSETS must equal
  LIABILITIES
• When a bank receives additional deposits, it
  gains an equal amount of reserves
• When it loses deposits, it loses an equal amount
  of reserves
• If there is a 100,000.00 deposit, with a
  required reserve of 25, show what will happen

• Note that the 75,000 can be loaned out to other
  banks or consumers
• Note that bank cannot lend out more than its
  excess reserve amount

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Federal Reserve
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What is the Federal Reserve?

• Central bank of the US
• Considered to be the most important bank in the
  world
• Controls the so-called monetary base (broadest
  definition of money ? Currency in circulation
  reserves in banks
• All national banks are required to be
  members/participants of the Fed.
• Local banks are not.
• Independent of govt and private sector
• Board of Governors have 14 year terms
• Fed does not cater to pressure from banks (say to
  lower interest rates or push for deregulation)
• Extremely profitable (avg earnings of 40 bil a
  year!)

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The Federal Reserve Main Goal

• The Federal Reserve Bank of the United States
  (FED)
• Controls the money supply for the US through the
  use of monetary policy
• Federal Open Market Operations (FOMOs) ? the
  buying and selling for T-Bonds to banks,
  investors, public, etc
• The Fed has one main goal Price Stability
• Low/stable inflation ? Inflation creates
  fear/uncertainty in the economy, which affects
  economic growth

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Other Goals of the Fed (Monetary Policy)

• 1. Low Unemployment
• Resources are maximized, misery index is low,
  consumer spending (in the US at least) is
  relatively high and stable
• 3 Types of unemployment
• A. Frictional ? workers trying to find job that
  meets their skill set
• B. Structural ? workers are mismatched with
  skill set
• C. Cyclical ? students working during the
  holiday season
• 2. Economic Growth
• 3. Stability in the Financial Market
  (Liquidity!!!)
• 4. Interest Rate Stability

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Feds Balance Sheet
Federal Reserve System Federal Reserve System
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves

• Monetary Liabilities
• Important ? Assets must equal liabilities
• Currency in circulation in the hands of the
  public
• Reserves bank deposits at the Fed and vault cash

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The Feds Balance Sheet Cont.

• Assets
• Government securities holdings by the Fed that
  affect money supply and earn interest
• Positive relationship between govt securities and
  money supply
• Discount loans provide reserves to banks and
  earn the discount rate
• Positive relationship between discount loans and
  money supply.
• These are considered to be liabilities for a
  member bank!

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Federal Reserve Open Market Operations (OMOs)

• 2 ways that the Fed changes the monetary base in
  the economy
• 1. Open Market Purchases
• Fed buys bonds
• Increases money in the economy (interest rates
  fall)
• 2. Open Market Sales
• Fed sells bonds
• Decreases money in the economy (interest rates
  rise)

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How did that work? - OMP

• The effect of an open market purchase on the
  monetary base is always the same whether the
  seller of the bonds.
• An Open Market Purchase takes in securities and
  gives out cash
• The liquidity effect of an OMP is directly
  correlated with the reserve ratio
• Higher reserve ratio ? lower liquidity
• Lower reserve ratio ? higher liquidity

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Open Market Purchase from a Bank
Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Securities -100 Securities 100 Reserves 100
Reserves 100

• Net result is that reserves have increased by
  100
• No change in currency
• Monetary base has risen by 100

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Open Market Sale from a Bank
Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Securities 100 Securities 100 Reserves 100
Reserves -100

• Net result is that reserves have decreased by
  100
• No change in currency
• Monetary base has decreased by 100
• An Open Market Sale takes in cash and gives out
  securities

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The Advantages of OMOs

• 1. OMOs occur at the Feds whim (no political
  influence)
• 2. OMOs are flexible and precise
• 3. OMOs are easily reserved
• 4. OMOs can be implemented quickly

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The Feds biggest disadvantage

• While the Fed is key on providing liquidity, it
  must find a delicate balance in replenishing its
  reserve base.
• Currently, the Fed uses the reserve requirement
  to satisfy this goal.
• If the reserve requirement is constantly
  changing, banks and the population will become
  worried.