The Federal Reserve and Money Supply

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

 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.

AssetsLiabilities Required Reserves 25,000Deposits100,000 Excess Reserves75,000Bank Capital15,000 Securities15,000  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, 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 AssetsLiabilities Government securitiesCurrency in circulation Discount loansReserves

 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 SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Reserves+$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 SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities+$100Securities+$100Reserves+$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.