The Federal Reserve and Money Supply

 Takes sections for chapters 10, 14, & 15 from the Mishkin text (9 th 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 can occur, causing banks to lose their sources of funds  bank runs If depositors have confidence an increase amount of funds  banks have

 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  access to liquidity we want easy  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 ◦ Securities ◦ Most banks are not allowed to hold stock ◦ Small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions and securities purchases. 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 Required Reserves Excess Reserves Securities 25,000 75,000 15,000 Liabilities Deposits Bank Capital 100,000 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 economic growth  Inflation creates fear/uncertainty in the economy, which affects

 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  set workers trying to find job that meets their skill B. Structural  C. Cyclical  workers are mismatched with skill set students working during the holiday season  2. Economic Growth  3. Stability in the Financial Market (Liquidity!!!)  4. Interest Rate Stability

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

 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

Assets

Banking System

Liabilities Securities Reserves -$100 +$100

Federal Reserve System

Assets Liabilities Securities +$100 Reserves +$100    Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100

Assets

Banking System

Liabilities Securities Reserves +$100 -$100

Federal Reserve System

Assets Liabilities Securities +$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

 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.