R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

R. GLENNHUBBARDANTHONY PATRICKO’BRIEN Money,Banking, andthe Financial System

The Federal Reserve’s BalanceSheet and the Money SupplyProcess 14 C H A P T E R LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain the relationship between the Fed’s balance sheet and the monetary base 14.1 Derive the equation for the simple deposit multiplier and understand what it means 14.2 Explain how the behavior of banks and the nonbank public affect the money multiplier 14.3 Appendix: Describe the money supply process for M2 14A

The Federal Reserve’s BalanceSheet and the Money SupplyProcess 14 C H A P T E R • GEORGE SOROS, “GOLD BUG” • While some individual investors, known as “gold bugs,” have always wanted to hold gold, the surge in demand for gold during 2009 and 2010 surprised many economists. John Paulson, Thomas Kaplan, and George Soros are some of the famous hedge fund managers with a preference for gold. • For many, holding gold is a way to hedge the risk of inflation created by a rapid increase in the money supply. • An Inside Look at Policy on page 434 discusses the Federal Reserve’s “exit strategy” from the increases in reserves and the money supply that resulted from its policies during the financial crisis of 2007–2009.

Key Issue and Question Issue:During and immediately following the financial crisis, bank reserves increased rapidly in the United States. Question: Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should the increase be a concern to policymakers?

14.1 Learning Objective Explain the relationship between the Fed’s balance sheet and the monetary base.

The Federal Reserve’s Balance Sheet and the Monetary Base The Money Supply Process Figure 14.1 Three actors determine the money supply: the central bank (the Fed), the nonbank public, and the banking system.• Our model of how the money supply is determined includes three actors: 1. The Federal Reserve, which is responsible for controlling the money supply and regulating the banking system. 2. The banking system, which creates the checking accounts that are the most important component of the M1 measure of the money supply. 3. The nonbank public, which refers to all households and firms. The nonbank public decides the form in which they wish to hold money—for instance, as currency or as checking account balances.

The Federal Reserve’s Balance Sheet and the Monetary Base The process starts with the monetary base, which is also called high-powered money. Monetary base (or high-powered money) The sum of bank reserves and currency in circulation. Monetary base = Currency in circulation + Reserves. The money multiplier links the monetary base to the money supply. As long as the value of the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. There is a close connection between the monetary base and the Fed’s balance sheet, which lists the Fed’s assets and liabilities.

The Federal Reserve’s Balance Sheet Table 14.1 The Federal Reserve’s Balance Sheet and the Monetary Base

The Monetary Base Currency in circulation Paper money and coins held by the nonbank public. Vault cash Currency held by banks. Currency in circulation = Currency outstanding – Vault cash. Bank reserves Bank deposits with the Fed plus vault cash. Reserves = Bank deposits with the Fed + Vault cash. • Reserve deposits are assets for banks, but they are liabilities for the Fed because banks can request that the Fed repay the deposits on demand with Federal Reserve Notes. The Federal Reserve’s Balance Sheet and the Monetary Base

Reserves = Required reserves + Excess reserves. Required reserves Reservesthat the Fed compels banks to hold. Excess reserves Reserves that banks hold over and above those the Fed requires them to hold. Reserves = Required reserves + Excess reserves. Required reserve ratio The percentage of checkable deposits that the Fed specifies that banks must hold as reserves. The Federal Reserve’s Balance Sheet and the Monetary Base

How the Fed Changes the Monetary Base The Fed increases or decreases the monetary base by changing the levels of its assets—that is, the Fed changes the monetary base by buying and selling Treasury securities or by making discount loans to banks. Open market operations The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. Open market purchase The Federal Reserve’s purchase of securities, usually U.S. Treasury securities. Open market operations are carried out by the Fed’s trading desk, which buys and sells securities electronically with primary dealers. In 2010, there were 18 primary dealers, who are commercial banks, investment banks, and securities dealers. In an open market purchase, which raises the monetary base, the Fed buys Treasury securities. The Federal Reserve’s Balance Sheet and the Monetary Base

We use a T-account for the whole banking system to show the results of the Fed’s open market purchase: The Fed’s open market purchase from Bank of America increases reserves by $1 million and, therefore, the monetary base increases by $1 million. A key point is that the monetary base increases by the dollar amount of an open market purchase. The Federal Reserve’s Balance Sheet and the Monetary Base

Open market sale The Fed’s sale of securities, usually Treasury securities. Because reserves have fallen by $1 million, so has the monetary base. We can conclude that the monetary base decreases by the dollar amount of an open market sale. The Federal Reserve’s Balance Sheet and the Monetary Base

The public’s preference for currency relative to checkable deposits does not affect the monetary base. To see this, consider what happens if households and firms decide to withdraw $1 million from their checking accounts. One component of the monetary base (reserves) has fallen while the other (currency in circulation) has risen. The Federal Reserve’s Balance Sheet and the Monetary Base

Discount Loans Discount loan A loan made by the Federal Reserve, typically to a commercial bank. Discount loans alter bank reserves and cause a change in the monetary base. An increase in discount loans affects both sides of the Fed’s balance sheet: As a result of the Fed’s making $1 million of discount loans, bank reserves and the monetary base increase by $1 million. The Federal Reserve’s Balance Sheet and the Monetary Base

If banks repay $1 million in discount loans to the Fed, reducing the total amount of discount loans, then the preceding transactions are reversed. Discount loans fall by $1 million, as do reserves and the monetary base: The Federal Reserve’s Balance Sheet and the Monetary Base

Comparing Open Market Operations and Discount Loans Both open market operations and discount loans change the monetary base, but the Fed has greater control over open market operations. The discount rate differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets. The monetary base has two components: the nonborrowed monetary base, Bnon, and borrowed reserves, BR, which is another name for discount loans. We can express the monetary base, B, as The Fed has control over the nonborrowed monetary base. Discount rate The interest rate the Federal Reserve charges on discount loans. B = Bnon + BR. The Federal Reserve’s Balance Sheet and the Monetary Base

Making the Connection Explaining the Explosion in the Monetary Base The monetary base increased sharply in the fall of 2008. Most of the increase occurred because of an increase in the bank reserves component, not the currency in circulation component. In this case, the Fed’s holdings of Treasury securities actually fell while the base was exploding. As the Fed began to purchase assets connected with Bear Stearns and AIG, the asset side of its balance sheet expanded, and so did the monetary base. There is an important point connected with this episode for understanding the mechanics of increases in the monetary base: Whenever the Fed purchases assets of any kind, the monetary base increases. It doesn’t matter if the assets are Treasury bills, mortgage-backed securities, or computer systems. The Federal Reserve’s Balance Sheet and the Monetary Base

Making the Connection Explaining the Explosion in the Monetary Base In the fall of 2008 when the Fed began to purchase hundreds of billions of dollars worth of mortgage-backed securities and other financial assets, it was inevitable that the monetary base would increase. The Federal Reserve’s Balance Sheet and the Monetary Base

14.2 Learning Objective Derive the equation for the simple deposit multiplier and understand what it means.

We now turn to the money multiplier to further understand the factors that determine the money supply. The money multiplier is determined by the actions of three actors in the economy: the Fed, the nonbank public, and banks. Multiple Deposit Expansion How a Single Bank Responds to an Increase in Reserves Suppose that the Fed purchases $100,000 in Treasury bills (or T-bills) from Bank of America, increasing its reserves that much. Here is how a T-account can reflect these transactions: The Simple Deposit Multiplier

Next, Bank of America extends a loan to Rosie’s Bakery by creating a checking account and depositing the $100,000 principal of the loan in it. Both the asset and liability sides of Bank of America’s balance sheet increase by $100,000: If Rosie’s spends the loan proceeds by writing a check for $100,000 to buy ovens from Bob’s Bakery Equipment and Bob’s deposits the check in its account with PNC Bank, Bank of America will have lost $100,000 of reserves and checkable deposits: The Simple Deposit Multiplier

How the Banking System Responds to an Increase in Reserves After PNC has cleared the check and collected the funds from Bank of America, PNC’s balance sheet changes as follows: Suppose that PNC makes a $90,000 loan to Jerome’s Printing who writes a check in that amount for equipment from Computer Universe who has an account at SunTrust Bank. The balance sheets change as follows: The Simple Deposit Multiplier

Suppose that SunTrust lends its new excess reserves of $81,000 to Howard’s Barber Shop to use for remodeling. When Howard’s spends the loan proceeds and a check for $81,000 clears against it, the changes in SunTrust’s balance sheet will be as follows: If the proceeds of the loan to Howard’s Barber Shop are deposited in another bank, checkable deposits in the banking system will rise by another $81,000. To this point, the $100,000 increase in reserves supplied by the Fed has increased the level of checkable deposits by $100,000 + $90,000 + $81,000 = $271,000. This process is called multiple deposit creation. Multiple deposit creation Part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits and an increase in the money supply that is a multiple of the initial increase in reserves. The Simple Deposit Multiplier

Calculating the Simple Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Or, simplifying: The Simple Deposit Multiplier

So, . Simple deposit multiplier . or, in our example, The Simple Deposit Multiplier

14.3 Learning Objective Explain how the behavior of banks and the nonbank public affect themoney multiplier.

The Effect of Increases in Currency Holdings and Increases inExcess Reserves In deriving the money multiplier, we made two key assumptions: 1. Banks hold no excess reserves. 2. The nonbank public does not increase its holdings of currency. In order to build a complete account of the money supply process, we change the simple deposit multiplier in three ways: 1. Rather than a link between reserves and deposits, we need a link between the monetary base and the money supply. 2. We need to include the effects on the money supply process of changes in the nonbank public’s desire to hold currency relative to checkable deposits. 3. We need to include the effects of changes in banks’ desire to hold excess reserves relative to deposits. Banks, the Nonbank Public, and the Money Multiplier

Deriving a Realistic Money Multiplier We need to derive a money multiplier, m, that links the monetary base, B, to the money supply, M: This equation tells us that the money multiplier is equal to the ratio of the money supply to the monetary base: The money supply is the sum of currency in circulation, C, and checkable deposits, D. The monetary base is the sum of currency in circulation and bank reserves, R. To expand the expression for the money multiplier, we separate reserves into its components: required reserves, RR, and excess reserves: Banks, the Nonbank Public, and the Money Multiplier

Currency-to-deposit ratio (C/D) The ratio of currency held by the nonbank public, C, to checkable deposits, D. The excess reserves-to-deposit ratio (ER/D) measure banks’ holdings of excess reserves relative to their checkable deposits. We can introduce the deposit ratios into our expression for the money multiplier this way: Since the ratio of required reserves to checkable deposits is the required reserve ratio, rrD, then: Banks, the Nonbank Public, and the Money Multiplier

So, we can say that because: then, With the following values: C = $500 billion, D = $1,000 billion, rrD = 0.10, and ER = $150 billion, the money multiplier is: A money multiplier of 2 means that every $1 billion increase in the monetary base will result in a $2 billion increase in the money supply. Banks, the Nonbank Public, and the Money Multiplier

There are several points to note about the expression above linking the money supply to the monetary base: 1. The money supply will change in the same direction of a change in either the monetary base or the money multiplier. 2. An increase in the currency-to-deposit ratio (C/D) causes the value of the money multiplier and the money supply to decline. 3. An increase in the required reserve ratio, rrD, causes the value of the money multiplier and the money supply to decline. 4. An increase in the excess reserves-to-deposit ratio (ER/D) causes the value of the money multiplier and the money supply to decline. Banks, the Nonbank Public, and the Money Multiplier

14.3 Solved Problem Using the Expression for the Money Multiplier Consider the following information: Bank reserves = $500 billion Currency = $400 billion a. If banks are holding $80 billion in required reserves, and the required reserve ratio = 0.10, what is the value of checkable deposits? b. Given this information, what is the value of the money supply (M1)? What is the value of the monetary base? What is the value of the money multiplier? Banks, the Nonbank Public, and the Money Multiplier

14.3 Solved Problem Solved Problem Using the Expression for the Money Multiplier Solving the Problem Step 1Review the chapter material. • Step 2 Answer part (a) by calculating the value of checkable deposits. The value of required reserves is equal to the value of checkable deposits multiplied by the required reserve ratio: • ) = $800 billion. • Step 3Answer part (b) by calculating the values of the money supply, the monetary base, and the money multiplier. The M1 measure of the money supply equals the value of currency in circulation plus the value of checkable deposits: • The monetary base is equal to the value of currency in circulation plus the value of bank reserves: Banks, the Nonbank Public, and the Money Multiplier

14.3 Solved Problem Solved Problem Using the Expression for the Money Multiplier Solving the Problem We can calculate the money multiplier two ways. First, note that the money multiplier is equal to the ratio of the money supply to the monetary base: Or, using the expression for money multiplier: Banks, the Nonbank Public, and the Money Multiplier

Recall that the monetary base is the sum of borrowed plus nonborrowed reserves: B = Bnon + BR. Rewriting the relationship between the money supply and the monetary base: We now have a complete description of the money supply process. Banks, the Nonbank Public, and the Money Multiplier

The Money Supply, the Money Multiplier, and the Monetary Base During the 2007–2009 Financial Crisis Movements in the Monetary Base, M1, and the Money Multiplier, 1990–2010 Figure 14.2 Panel (a) shows that beginning in the fall of 2008, the size of the monetary base soared. M1 also increased, but not nearly as much. As panel (b) shows, the value of the money multiplier declined sharply during the same period.• Banks, the Nonbank Public, and the Money Multiplier

Why did the monetary base increase so much more than M1? Figure 14.3 helps to solve the mystery. Figure 14.3 Movements in (C/D) and (ER/D) The currency-to-deposit ratio (C/D) had been gradually trending upward since 1990, but it fell during the financial crisis of 2007–2009. At the same time, the excess reserves-to–deposits ratio (ER/D) soared, increasing from almost zero in September 2008—because banks were holding very few excess reserves—to about 1.3 in the fall of 2009. Banks began to hold more excess reserves than they had checkable deposits.• Banks, the Nonbank Public, and the Money Multiplier

Making the Connection Did the Fed’s Worry over Excess Reserves Cause theRecession of 1937–1938? Following the end of the bank panics in early 1933, excess reserves in the banking system soared. Many banks had suffered heavy losses and had a strong desire to remain liquid. Nominal interest rates had also fallen to very low levels, which reduced the opportunity cost of holding reserves at the Fed. By late 1935, unemployment remained high and inflation low. Nevertheless, the Fed’s Board of Governors worried about a rapid increase in stock prices and some feared an increase in the inflation rate. The Board of Governors decided to reduce excess reserves by raising the required reserve ratio. But the Fed’s policy ignored the reasons banks during this period were holding excess reserves. As bank loans contracted, so did the money supply. The economy fell into recession again in 1937. Banks, the Nonbank Public, and the Money Multiplier

Making the Connection Did the Fed’s Worry over Excess Reserves Cause theRecession of 1937–1938? The Fed reversed course in April 1938 by cutting the required reserve ratio. But the damage had been done. Most economists believe that the Fed’s actions in raising the required reserve ratio contributed significantly to the recession. Banks, the Nonbank Public, and the Money Multiplier

In 2010, banks’ enormous holdings of excess reserves left investors, policymakers, and economists concerned about the implications for future inflation. If banks were to suddenly begin lending the nearly $1 trillion in excess reserves they held in November 2010, the result would be an explosion in the money supply and, potentially, a rapid increase in inflation. Fear of this potential for a much higher rate of inflation in the future drove some investors in 2010 to buy gold. Banks, the Nonbank Public, and the Money Multiplier

Making the Connection Worried About Inflation? How Good Is Gold? In 2010, many investors bought gold because they were worried about the possibility that increases in reserves and the money supply might lead to much higher rates of inflation in the future. But how good an investment is gold? Gold clearly has some drawbacks as an investment: Gold pays no interest or dividend; it has to be stored and safeguarded. Because gold pays no interest, it is difficult to determine its fundamental value as an investment. Gold’s value as an investment depends on how likely its price is to increase in the future because its rate of return is entirely in the form of capital gains. Many individual investors believe that gold is a good hedge against inflation because the price of gold can be relied on to rise if the general price level rises. But is this view correct? The record of the past 30 years was not encouraging. Banks, the Nonbank Public, and the Money Multiplier

Making the Connection Worried About Inflation? How Good Is Gold? The real price of gold, calculated by dividing the nominal price of gold by the consumer price index, shows that even after the strong nominal price increases of 2009 and 2010, the real price of gold was still 30% below its September 1980 level. In other words, in the long run, gold has proven a poor hedge against inflation. Banks, the Nonbank Public, and the Money Multiplier

Answering the Key Question At the beginning of this chapter, we asked the question: “Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should the increase be a concern to policymakers?” As we have seen in this chapter, the rapid increase in bank reserves that began in the fall of 2008 was a result of the Fed purchasing assets. Whenever the Fed purchases an asset, the monetary base increases. Both components of the base increased in 2008, but the increase in reserves was particularly large. Banks were content to hold large balances of excess reserves because the Fed was paying interest on them and because of the increased risk in alternative uses of the funds. Inflation remained very low through mid-2010, but some policymakers were concerned that, ultimately, if banks began to lend out their holdings of excess reserves, a future increase in the inflation rate was possible.

AN INSIDE LOOK AT POLICY Fed’s Balance Sheet Needs Balancing Act WASHINGTON POST, Federal Reserve Hopes Clear Exit Strategy Will Boost Market Confidence Key Points in the Article • After two years of taking aggressive steps to stimulate a weak economy, the Federal Reserve had to decide how to phase out its initiatives in order to reduce the risk of inflation. • Reducing the growth of the money supply and raising interest rates threatened to slow an economy that suffered from high unemployment. • Analysts believe that changing the interest rate on reserves will become a more important tool to control the growth of the money supply. • The Fed had to decide what to do with its holdings of $1 trillion of mortgage-backed securities. Selling the securities would pull money out of the economy at the risk of driving up interest rates. • The key to chairman Ben Bernanke’s strategy is to win the confidence of market participants in the Fed’s ability to drain cash from the financial system.

AN INSIDE LOOK AT POLICY The table below documents the rapid increase in the Fed’s holdings of federal agency debt and mortgage-backed securities between July 2008 and July 2010. The increase in its debt holdings was over $1.5 trillion over this two-year period.

APPENDIX The Money Supply Process for M2 Describe the money supply process for M2 14A M2 is a broader monetary aggregate than M1, including not only currency, C, and checkable deposits, D, but also nontransaction accounts. These nontransaction accounts consist of savings and small-time deposits, which we will call N, and money market deposit accounts and similar accounts, MM. So we can represent M2 as: M2 = C + D + N + MM. We can express M2 as the product of an M2 multiplier and the monetary base: M2 = (M2 multiplier) x Monetary base.

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN