The Federal Reserve, Commercial Banking, and the Supply of Money

1. The Federal Reserve, Commercial Banking, and the Supply of Money

2. Remember the story of Goldilocks and the three bears? “ Papa bear’s bed was too hard…..Mama bear’s bed was too soft…..but baby bear’s bed was just right!

3. Baby bear’s bed and the supply of money… Without enough money, it becomes difficult to conduct commerce…transactions slow down and the economy falls into recession Like any commodity, excess supply lowers the value of money….too much money creates inflation. We need to find a balance between the two…

4. The Constitution grants the federal government the power "to coin Money, regulate the Value thereof...”

5. The US began minting US coins shortly after the constitution was ratified One Cent (Copper) Two Cents (Copper) Three Cents (Nickel/Copper) Half Cent (Copper) Nickel/Half Dime (Silver/Copper) Dime (Silver/Copper Quarter Dollar (Silver) Twenty Cents (Silver)

6. Production of gold coins ceased in 1934. Silver coins were minted until 1964. 2 ½ Dollar (Quarter Eagle) Half Dollar (Silver) One Dollar (Silver) One Dollar (Gold) Five Dollar (Half Eagle) Ten Dollar (Eagle) Twenty Dollar (Double Eagle) Three Dollar

7. Current US Coins 99% Zinc, 1%Copper Annual Production: 6.8M 75% Copper, 25% Nickel Annual Production: 1.4B 75% Copper, 25% Nickel Annual Production: 2.5B 75% Copper, 25% Nickel Annual Production: 2.4B 75% Copper, 25% Nickel Annual Production: 5.8M 88% Copper, 6% Zinc, 3% Magnesium, 3% Nickel Annual Production: 5.3M

8. Paper money was initially issued by commercial banks as claims to their deposits of gold and silver (coins or bars) Northampton Bank Assets Liabilities The supply of money was determined by the individual bank’s profit motive - they created loans by issuing bank notes $500 (Gold) $300 (Deposits) $1,000 (Loans) $1,000 (Notes) $200 (Equity) Bank notes were only redeemable (for gold/silver) at the issuing bank

9. The US began issuing Greenbacks in 1862 after passing the legal tender act. US Notes were fractionally backed by gold, but were “legal tender for all debts public and private US Treasury Assets Liabilities United States notes were printed until 1963, but were a small fraction of total money 1910: one tenth 1960: one hundredth $1,000 (Gold) $10,000 (T-Bills) $20,000 (US Notes)

10. Gold/Silver Certificates were 100% backed by gold/silver reserves at the US Treasury, but were not legal tender US Treasury Gold notes were printed until 1934. All $1 bills in the US were silver certificates until 1963 and were still convertible to silver until 1968 Assets Liabilities $1,000 (Gold) $1,000 (Gold Notes) $10,000 (Silver) $10,000 (Silver Notes)

11. The National Banking Act of 1863 allowed Nationally chartered banks to distribute bank notes (deemed legal tender) secured by US Debt (banks could issue notes equal to 90% of their US debt holdings) 1st National Bank of Forest City National notes were convertible to T-Bills at any national bank National Bank notes were issued until 1934 Assets Liabilities $50,000 (T-Bills) $25,000 (Deposits) $50,000 (Loans) $45,000 (Notes) $30,000 (Equity)

12. The Federal Reserve was created in 1913 to essentially take over the money supply role of national banks. The Federal Reserve could issue new currency by purchasing US Debt either in private markets or directly from the Treasury Federal Reserve notes were convertible to gold until 1934 (individuals) 1971 (Central Banks) Federal Reserve Bank Assets Liabilities $50,000 (T-Bills) $60,000 (Notes) $10,000 (Gold)

13. Denominations of $500, $1,000, $5,000, and $10,000 were no longer printed after 1946 for fear of German counterfeiting

14. The Largest denomination ever printed was a $100,000 gold certificate. It was never circulated, but was used for inter-bank transfers

15. Credit Channels under the National/State Banking System Money center banks were the “root source” of credit National banks who were short of funds would borrow from money center banks Larger State banks who were short of funds would borrow from National banks Small State banks who were short of funds would borrow from larger state banks

16. Credit Channels under the National/State Banking System

17. The Federal Reserve • The Federal Reserve System was created in 1913 by Woodrow Wilson. • Regulate the banking industry • “Lender of Last Resort” • Regulate the money supply • Provide banking services for the federal government • Check Clearing

18. Credit Channels under the Federal Reserve System Federal Reserve = Federal Funds Market = Discount Window

19. The Federal Reserve System Divides the country into 12 Districts numbered 1 - 12 from east to west

20. The Chairman is elected from the Board for a renewable 4 year term Alan Greenspan (1992) Roger Ferguson (2001) Edward Gramlich (1997) Susan Bies (2001) Mark Olsen (2001) Ben Bernanke (2003) Donald Kohn (2002) The Federal Reserve board is headquartered in Washington DC. The Board Consists of 7 “Governors” appointed by the President and confirmed by the Senate for 14 Year Non-Renewable terms

21. Each district has a Federal Reserve Bank with a bank president elected by the bank’s board of directors for 4 year renewable terms Bank President Board of Directors Class A (4) Class B (4) Class C (4) Member Banks Local Business Federal Reserve Board

22. The Federal Open Market Committee (FOMC) is the policymaking group of the Federal Reserve System. They meet approximately 8 times per year. Policies are determined by majority vote Board of Governors (7) NY Fed President (1) Regional Fed Presidents (4) Generally, all 12 bank presidents are present at the meeting, but only 5 can vote. The NY Fed president has a permanent vote while the remaining presidents vote on a revolving basis.

23. Controlling the Supply of Money • Money can be anything that satisfies: • Store of Value • Unit of account • Medium of exchange • Lots of things satisfy these properties

24. Standard Definitions of Money • Monetary Base (M0): Direct liabilities of the central bank • Currency in circulation + Bank Reserves • M1: • Currency in circulation + Traveler's Checks + Checking accounts • M2: • M1 + Savings accounts + Money Market Accounts + Small Time Deposits • M3: • M2 + Large Time Deposits + Eurodollars

25. The Federal Reserve can perfectly control the monetary base (cash + bank reserves) MB M1 M3 M2 Once those reserves enter the banking sector, they are used as the basis for creating loans. These loans make up the rest of the money supply. The fed can’t control this, but can influence it

26. Money Supply in the US (in Billions) Cash MB M1 M2 M3

27. Money Supply in the US

28. The Reserve Requirement is the least used of the Fed’s policy tools. A Bank is required to keep a minimum percentage of its deposits either as cash or on deposit at the federal reserve (reserve deposits pay no interest) Federal Reserve Acme National Bank Assets Liabilities Assets Liabilities $ 2,500 (Reserves) $ 2,500 (Cash) $50,000 (Deposits) $ 2,500 (Reserves) $45,000 (T-Bills) $100,000(Loans) $100,000 (Equity) Reserve Accounts are liabilities of the Fed Acme currently has 10% of its deposit liabilities on Reserve (Cash + Reserves)/Deposits

29. Suppose Acme Bank wanted to create a $30,000 loan. This is done by establishing a line of credit (i.e. creating a new checkable deposit) Acme National Bank Assets Liabilities The loan shows up on both sides of the balance sheet $ 2,500 (Cash) $50,000 (Deposits) $ 2,500 (Reserves) $30,000 (Deposit) $45,000 (T-Bills) $100,000(Loans) $30,000 (Loan) $100,000 (Equity) Acme’s reserve ratio drops to 6.25% (5/80)

30. Reserves and cash are components of M0 while the newly created loans are components of M1 or M2 Acme National Bank • Monetary Base • Cash in Circulation • Bank Reserves Assets Liabilities $ 2,500 (Cash) $50,000 (Deposits) $ 2,500 (Reserves) $30,000 (Deposit) $45,000 (T-Bills) • M1 • Cash in Circulation • Checking Accounts $100,000(Loans) $30,000 (Loan) $100,000 (Equity) • M2 • M1 • Savings Accounts

31. The Reserve Requirement has no impact on the monetary base, but it restricts the ability of banks to create loans – this influences the broader aggregates.

32. The discount window was the primary policy tool of the federal reserve when it was first established in 1913. Discount window loans are collateralized by the assets of the bank (equal to around 90% of the loan) Federal Reserve Acme National Bank Assets Liabilities Assets Liabilities $ 2,500 (Loan) $ 2,500 (Reserves) $ 2,500 (Cash) $80,000 (Deposits) $ 2,500 (Reserves) $ 2,500 (Reserves) $ 2,500 (Reserves) $ 2,500 (Disc. Loan) $45,000 (T-Bills) $130,000(Loans) Res. Req. = 5% $50,000 (Equity) A $2,500 loan from the discount window would raise reserves to the required 5% This bank would like to create $70,000 loan, but doesn’t have the reserves to back it up

34. Discount Lending

35. By purchasing and/or selling securities, the Fed can directly control the quantity of non-borrowed reserves in the banking sector. The Fed debits/credits the reserve account of the dealer’s bank Federal Reserve Dealers Buy/Sell bonds from the Fed Bond Dealer Most transactions are done with repurchase agreements (Repos). These are purchases/sales along with an agreement to reverse the transaction at a later date

36. Currently, open market operations are the primary policy tool of the Fed. Trading takes place in NYC Federal Reserve Acme National Bank Assets Liabilities Assets Liabilities $ 2,500 (T- Bills) $ 2,500 (Reserves) $ 2,500 (Cash) $80,000 (Deposits) $ 2,500 (Reserves) $ 2,500 (Reserves) $ 2,500 (Reserves) - $ 2,500 (T- Bills) $45,000 (T-Bills) $130,000(Loans) Res. Req. = 5% $50,000 (Equity) An open market purchase increases the reserves of the banking sector – this raises M0

37. Federal Reserve Banking Sector Assets Liabilities Assets Liabilities $700B (T- Bills) $ 700B (Currency) $ 54B (Cash) $ 800B (Checking) Reserves $ 46B (Reserves) $ 4,500B (Saving) $ 1B (Loans) $ 2,000 (T-Bills) Loans $ 44B (Required) $25B (Gold) Loans $ 1B (Excess) $ 1B (Discount) $20B (Other) $ 2,701 (Mortgage) $ 1B (Borrowed) $ 1,500B(Fed Funds) $ 3,000 (Other) Res. Req. = 5% $1,000B (Equity) MB = $746B M1 = 2.01 M2 MB = 8.04 M1 = $700B + $800B = 1,500B MB M2 = $700B + $800B + $4,500B = $6,000B

38. The Money multipliers describe the relationship between a change in the monetary base (controlled by the Fed) and the broader aggregates $ Change in M1 = mm1 * $ Change in MB Cash 1 + Deposits mm = Cash Reserves + Deposits Deposits $ Change in M2 = mm2 * $ Change in MB Cash M2-M1 + 1 + Deposits Deposits mm2 = Cash Reserves + Deposits Deposits The Fed can influence total bank reserves, which affects the multipliers!

39. Fed Policy from start to finish…. Bank Presidents/Governors present policy recommendations to the FOMC – A vote is taken. The monetary base is to be increased by $100M Staff economists at each federal reserve bank brief the president of local/national economic conditions Trading desk calls bond dealers and asks for bids This order is passed to the trading desk in NYC

40. Fed Policy from start to finish…. Acme National Bank The dealers with the winning bids deliver the bonds. Their bank’s reserve accounts are credited Assets Liabilities +$100M (Reserves) + $100M (Deposits) The bank must keep approximately 5% (reserve requirement) of the new deposit on reserve, but is free to loan out the remaining $95M. Some of this will be loaned to business customers, some finds its way into the Federal Funds market FF Rate Excess supply of reserves pushes down the Fed Funds Rate Supply 5% Reserves

41. Fed Policy from start to finish…. Through the Fed Funds Market, the reserves are distributed throughout the banking sector Fed Funds Market Each bank uses its new reserves to create additional loans

42. As banks increase the supplies of the various aggregates, their rates drop as well M1 Rate M2 Rate Supply Supply 6% 7% M1 M2 $ Change in M1 $ Change in M2 = mm2 * $100M = mm1 * $100M 8 2 These newly created loans are used to purchase labor, materials, consumer goods, etc.

43. Eventually, this newly created demand will influence prices… Wages Prices Demand Demand Hours GDP Higher demand for goods and services drive up their prices (wages and prices) Increases in inflation raise the nominal interest rate Nominal Interest Rate Real Interest Rate Expected Inflation = +

44. If all goes well, the open market purchase of securities (an increase in the monetary base) will raise employment and GDP in the short run, but raise prices in the long run. However, the economy can always through a wrench in the Fed’s plans!