Understanding the Federal Reserve's Role in the Money Supply Process

1. Chapter 6 The Federal Reserve and Money Supply

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

3. The Money Supply Process • 3 key players • 1. Depositors • 2. Banks • 3. Federal Reserve

4. 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

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

6. 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

7. 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)

8. 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)

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

10. 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) • ExcessReserves: 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

11. 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.

12. T-Account for a member bank • 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 • 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:

13. Federal Reserve

14. 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!)

15. 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

16. 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

17. Fed’s Balance Sheet • 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

18. The Fed’s 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!

19. 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)

20. 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

21. Open Market Purchase from a Bank • Net result is that reserves have increased by $100 • No change in currency • Monetary base has risen by $100

22. Open Market Sale from a Bank • 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

23. The Advantages of OMOs • 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

24. The Fed’s 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.