The Federal Reserve and Money Supply

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

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

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

Banks are the keepers of depositors funds

As before our deposits are their biggest liabilities, but their greatest assets

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

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)

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)

Typically referred to as the uses of funds The interest payments earned on them are

what enable banks to make profits.

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

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.

Assets 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 it’s excess reserve amount

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!)

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

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

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

Federal Reserve System

Assets Liabilities

Government securities

Currency in circulation

Discount loans Reserves

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!

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)

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

Net result is that reserves have increased by $100

No change in currency Monetary base has risen by $100

Banking System Federal Reserve System

Assets Liabilities Assets 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

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities

Securities +$100 Securities +$100 Reserves +$100

Reserves -$100

1. OMOs occur at the Fed’s whim (no political influence)

2. OMOs are flexible and precise

3. OMOs are easily reserved

4. OMOs can be implemented quickly

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.