Chapter Seventeen. Understand 10/24/2017. The Central Bank Balance Sheet and the Money Supply Process Chapter 17

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1 Chapter Seventeen The Central Bank Balance Sheet and the Money Supply Process Chapter 17 Understand 1. The central bank s balance sheet. 2. Changing the size and the mix of the balance sheet. 3. The deposit expansion multiplier. 4. The monetary base and money supply and the money multiplier. Players in the Money Supply Process Central bank (Federal Reserve) Banks (depository institutions) Depositors (individuals and institutions) Borrowers 1

2 Fed s Balance Sheet (important items) Federal Reserve System Assets Liabilities Government Securities and Mortgage Backed Securities Discount loans Currency in circulation Reserves Monetary Liabilities Currency in circulation(in the hands of the public) Reserves: bank deposits at the Fed Assets Government securities: holdings by the Fed that affect money supply and earn interest. Fed now holding MBS. Discount loans: provide reserves to banks and earn the discount rate The Federal Reserve Balance Sheet: June 2003 Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETS LIABILITIES Gold $ 11,045 $593,031 Federal Reserve notes (outstanding) Loans to banks 36,538 U.S. Treasury securities 550,314 20,359 Bank reserves (from depository institutions) 6,219 U.S. Treasury Deposits All other assets 46,268 24,556 All other liabilities and net worth Total $ 644,165 $644,165 Total Source: Federal Reserve Bulletin, August 2003, Table Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis (Millions of Dollars) ASSETS LIABILITIES Gold $ 11,037 $777,769 Federal Reserve notes (outstanding) Loans to banks 1,342 U.S. Treasury securities Deposits: 779,642 12,771 Bank reserves (from depository institutions) 4,572 U.S. Treasury deposit All other assets 82,451 79,360 All other liabilities and net worth Total $ 874,472 $874,472 Total Source: Board of Governors of the Federal Reserve System. 2

3 THE FEDERAL RESERVE BALANCE SHEET: August 2009 ASSETS LIABILITIES Gold $ 11,037 $872,150 Federal Reserve notes (outstanding) Loans to banks 339,335 Deposits: U.S. Treasury securities 705, ,650 Bank reserves (from depository institutions) 261,487 U.S. Treasury All other assets 936, ,447 All other liabilities and net worth Total $ 1,991,734 $1,991,734 Total Credit facilities set up during the financial crisis. Source: Board of Governors of the Federal Reserve System. THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETS LIABILITIES Gold $ 11,037 $1122,000 Federal Reserve notes (outstanding) Loans to banks 449 Deposits: U.S. Treasury securities 1730,000 1,795,000 Bank reserves (from depository institutions) Mortgages 1,083,000 42,000 U.S. Treasury All other assets 234, ,000 All other liabilities and net worth Total $ 3,075,000 $3,075,000 Total Source: Board of Governors of the Federal Reserve System. THE FEDERAL RESERVE BALANCE SHEET: February 2015 Very much the same today ASSETS LIABILITIES Gold $ 11,037 $1,315,000 Federal Reserve notes (outstanding) Loans to banks 59 Deposits: U.S. Treasury securities 2,450,000 2,748,000 Bank reserves (from depository institutions) Mortgages 1,731,000 65,000 U.S. Treasury All other assets 290, ,000 All other liabilities (reverse Repo) and net worth Total $ 4,481,000 $4,481,000 Total Source: Board of Governors of the Federal Reserve System. 3

4 Liabilities Commercial Bank accounts (reserves). Commercial bank reserves are the sum of two parts: Deposits at the central bank, plus The cash in the bank s own vault. Vault cash is part of reserves. Reserves are assets of the commercial banking system and liabilities of the central bank. Liabilities Central banks run their monetary policy operations through changes in these reserves. There are two types of reserves. Required reserves that banks must hold, and Excess reserves = Actual required. Monetary Base (High Powered Money) High-powered money MB = C + R C = currency in circulation R = total reserves in the banking system Recall: M1 = C + DD 4

5 The Monetary Base Together, currency in the hands of the public and reserves in the banking system make up the monetary base. This is the privately held liabilities of the central bank. It is also called high-powered money. Currently around $4 trillion. The central bank can control the size of the monetary base. Changing the Size and Composition of the Balance Sheet The central bank can simply buy things and then create liabilities to pay for them. It can increase the size of its balance sheet as much as it wants. The book presents four types of transactions that impact both the central bank s balance sheet and the banking system s balance sheet. Changing the Size and Composition of the Balance Sheet 1. Open Market Operation. Buying or selling a security initiated by the central bank. 2. Foreign Exchange Intervention. Buy or sell foreign exchange reserves initiated by the central bank. (Skip) 3. Extend a discount loan. Initiated by commercial banks. 4. Decision by an individual to withdraw cash from their bank. Initiated by the nonbank public. 5

6 Open Market Operations When the Fed buys or sells securities in financial markets, it engages in open market operations. Example, Fed buys a U.S. Treasury bond from a commercial bank. The Money Supply Process: Open Market Purchase From a Commercial Bank (Assume a 10% reserve requirement) The Money Supply Process: Open Market Purchase From a Commercial Bank (Assume a 10% reserve requirement) Reserves have increased by $100. What about excess reserves? No change in currency Monetary base (C + R) has increased by $100 Has the money supply changed? 6

7 Fed Open Market Purchase from Nonbank Public Reserves have increased by $100. What about excess reserves? No change in currency Monetary base (C + R) has increased by $100 Has the money supply changed? The person selling the bonds cashes the Fed s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base (C+R) increases by the amount of the open market purchase Open Market Purchase: Summary Always increases the monetary base by the amount of the purchase: MB = C + R The effect on the level of reserves in the banking system depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits 7

8 Fed Open Market Sale to Nonbank Public Nonbank Public Federal Reserve System Assets Liabilities Assets Liabilities Securities +$100 Securities -$100 Currency in circulation Currency -$100 -$100 In this example, the public pays with cash. The monetary base is reduced by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves Cash Withdrawal When you take cash from an ATM, you are changing the Fed s balance sheet. By moving your own assets out of your bank and into currency, you force a shift from reserves to currency on the Fed s balance sheet. The transaction involves three balance sheets: The nonbank public, The banking system, and The central bank. Public withdraws $100 from Commercial Bank +$100 -$100 The amount of currency outstanding recorded on the Fed s balance sheet increases as shift from reserves to currency. There is no change in the monetary base. 8

9 Discount Loans The commercial banks ask for loans, the Fed does not force them. A borrowing bank must provide collateral. This usually takes the form of U.S. Treasury bonds, but the Fed has been willing to accept a broad range of securities and loans as collateral. This changes the balance sheet of both institutions. Fed Discount Loan to a Bank Fed Discount Loan to a Bank $100 9

10 Paying Off a Discount Loan from the Fed Reserves Banking System Federal Reserve System Assets Liabilities Assets Liabilities -$100 Discount loans -$100 Discount loans -$100 Reserves -$100 Net effect is to reduce the monetary base Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System Changing the Size and Composition of the Balance Sheet Open market operations are done at the discretion of the central bank. The level of discount borrowing is decided by the commercial banks. The nonbank public decides how much currency to hold. Deposit Creation at a Single Bank An open market purchase in which the Fed buys $100,000 worth of securities from a bank called First Bank. The bank s total assets are unchanged. $100,000 shifts out of securities into reserves. These are all excess reserves which First Bank can lend. 10

11 Deposit Creation at a Single Bank First Bank loans out the reserves to a customer, Office Builders Inc. (OBI). OBI s checking account is credited with $100,000. OBI writes checks totaling $100,000. As the checks are paid, OBI s checking account balance falls, and First Bank s reserve account balance falls. The loan replaces the securities as an asset on First Bank s balance sheet. Deposit Creation in a Single Bank Deposit Creation in a System of Banks All the checks that OBI wrote end up in someone else s bank account. Only the Fed can increase and decrease the monetary base. But the nonbank public determines how much of it ends up as reserves in the banking system and how much in currency. 11

12 Deposit Creation in a System of Banks We start with the following assumptions: Banks hold no excess reserves. The reserve requirement ratio is 10%. Currency holding does not change when deposits and loans change. When a borrower writes a check, none of the recipients of the funds deposit them back in the bank that initially made the loan. Deposit Creation in a System of Banks OBI pays $100,000 to American Steel. American Steel deposits $100,000 into Second Bank. Second Bank s reserve account at the Fed is credited with $100,000. Second Bank will make a loan of its now excess reserves minus the 10% they are required to hold. The new loan is deposited into Third Bank and the process continues. Deposit Creation in a System of Banks There is an intermediate step here which I will draw on the board. 12

13 Deposit Creation in a System of Banks Deposit Creation in a System of Banks No Excess Reserves and no Change in Currency Holding We can derive a formula for the deposit expansion multiplier. That is the increase in commercial bank deposits following a one-dollar open market purchase. This continues to assume there are no excess reserves and no changes in the amount of currency help by the nonbank public. Deposit Creation in a System of Banks No Excess Reserves and no Change in Currency Holding Let s being by assuming there is only one bank and everyone must use it. The level of reserves, then, is just the required reserve ratio r D times its deposits. Call required reserves are RR and deposits D, then the level of reserves can be expressed as: RR = r D D. 13

14 Deposit Creation in a System of Banks No Excess Reserves and no Change in Currency Holding Any change in deposits creates a corresponding change in reserves: ΔRR = r D ΔD The change in deposits is: D 1 RR r D For each dollar increase in reserves, deposits increase by (1/r D ). Deposit Creation in a System of Banks No Excess Reserves and no Change in Currency Holding This is the simple deposit expansion multiplier. For example: r D 0.10 An open market sale will decrease deposits in the same way. D $100,000 RR ($100,000) RR $1,000,000 The Monetary Base and the Money Supply The simple deposit expansion multiplier is too simple. In deriving it, we ignored a few details: 1. We assumed banks lend out all their excess reserves, but banks do hold some of their excess reserves. 2. We ignored the fact that the nonbank public holds cash. As people s account balances rise, they tend to hold more cash. Both of these affect the relationship among reserves, the monetary base, and the money supply. 14

15 Deposit Expansion With Excess Reserves and Cash Withdrawals Now let s assume: Checking account holders withdraw 5% of cash. Banks hold excess reserves of 5% of deposits. From our previous example, if American Steel takes some of the $100,000 in cash and Second Bank wishes to hold excess reserves, then the next loan cannot be $90,000. Deposit Expansion With Excess Reserves and Cash Withdrawals American Steel holds the 5% in cash leaving $95,000 in checking account. Second Bank holds 5% excess reserves, so they are left with $80,750 to loan out. Remember they hold 10% as required by the Fed and 5% excess reserves for a total of 15%. We can follow this as we did before to show the smaller the deposit expansion becomes if we take excess reserves and cash withdrawals into account. The Arithmetic of the Money Multiplier We can derive the money multiplier. This shows how the quantity of money is related to the monetary base. If we label the quantity of money M and the monetary base MB, the money multiplier m is defined as: M =? x MB 15

16 The Arithmetic of the Money Multiplier We can derive the money multiplier. This shows how the quantity of money is related to the monetary base. If we label the quantity of money M and the monetary base MB, the money multiplier m is defined as: M = m x MB The Arithmetic of the Money Multiplier We will start with the following relationships: Money equals currency, C, plus checkable deposits, D, The monetary base MB equals currency plus reserves in the banking system R, and Reserves equal required reserves RR plus excess reserves ER. M = C + D MB = C + R R = RR + ER The Arithmetic of the Money Multiplier Starting with banks, we know that their holdings of required reserves depends on the required reserve ratio r D. The amount of excess reserve a bank holds depends on the costs and benefits of holding them. The higher the interest rate on loans, the lower banks excess reserves, and The greater banks concern over the possibility of deposit withdrawals, the higher their excess reserves. 16

17 The Arithmetic of the Money Multiplier Labeling the excess reserve-to-deposit ratio {ER/D}, we can rewrite the reserve equation as: R = RR + ER = r D D + {ER/D}D = (r D + {ERD})D Banks hold reserves as a proportion of their deposits. The Arithmetic of the Money Multiplier The currency-to-deposit ratio, {C/D}, is the fraction of deposits that people hold as currency. C = {C/D}D The decision of how much currency to hold depends on the costs and benefits as well. The cost of currency is the interest it would earn on deposit. The benefit is its lower risk and greater liquidity. The Arithmetic of the Money Multiplier Putting this all together, we can see to following. MB = C + R = {C/D}D + (r D + {ER/D})D = ({C/D} + r D + {ER/D})D The monetary base has three uses: Required reserves, Excess Reserves, and Cash in the hands of the nonbank public. 17

18 The Arithmetic of the Money Multiplier We can do the same with the equation for money. M = C + D = {C/D}D + D = ({C/D} + 1)D The Arithmetic of the Money Multiplier We can use the equation for MB to solve for deposits: 1 D x MB {C/D} r {ER/D} D And substituting D into the money equation: { C / D} 1 m {C/D} r {ER/D} D The Arithmetic of the Money Multiplier We can use the equation for MB to solve for deposits: 1 D x MB {C/D} r {ER/D} D And substituting D into the money equation: { C / D} 1 M x MB {C/D} r {ER/D} D 18

19 The Arithmetic of the Money Multiplier This tells us that the quantity of money in the economy depends on: 1. The monetary base, which is controlled by Fed, 2. The reserve requirement, 3. The bank s desire to hold excess reserves, and 4. The public s demand for currency. Factors Affecting the Quantity of Money The central bank supplies the monetary base, but it is banks and the banking system that supply money. When the crisis peaked in September 2008, the deposit expansion multiplier plummeted to a fraction of its normal value. The standard process of deposit expansion assumes that banks will lend out most of additional dollar reserves supplied by the Fed. However, banks panicked and sought to hold more excess reserves collapsing the deposit expansion multiplier. 19

20 M1 and the Monetary Base, Source: Federal Reserve Bank of St. Louis, FRED database: Excess Reserves Ratio and Currency Ratio, Source: Federal Reserve Bank of St. Louis, FRED database: The Limits on the Central Bank s Ability to Control the Quantity of Money 20

21 The Limits on the Central Bank s Ability to Control the Quantity of Money The various factors affecting the quantity of money change over time. affect the cost of holding both excess reserves and currency. As increase, we expect to see {ER/D} and {C/D} fall. This increases the money multiplier and the quantity of money. The Limits on the Central Bank s Ability to Control the Quantity of Money The various factors affecting the quantity of money change over time. Market interest rates affect the cost of holding both excess reserves and currency. As interest rates increase, we expect to see {ER/D} and {C/D} fall. This increases the money multiplier and the quantity of money. The Limits on the Central Bank s Ability to Control the Quantity of Money If these changes in the money multiplier were, the central bank might choose to exploit this link in its policymaking. But, the money multiplier is. The relationship between the monetary base and the quantity of money is something that a central bank can exploit for short-run policy purposes. For short-run policy, have become the monetary policy tool of choice. 21

22 The Limits on the Central Bank s Ability to Control the Quantity of Money If these changes in the money multiplier were predictable, the central bank might choose to exploit this link in its policymaking. But, the money multiplier is too variable. The relationship between the monetary base and the quantity of money is not something that a central bank can exploit for short-run policy purposes. For short-run policy, interest rates have become the monetary policy tool of choice. The US monetary base is exploding, which usually leads to inflation. However, in this case, it is not happening because the broader monetary aggregates are not surging. The base is being held as excess reserves. As long as the interest being paid on the reserves is high enough, banks won t release reserves too quickly. Example r required reserve ratio = 0.10 C currency in circulation = $400B D checkable deposits = $800B ER excess reserves = $0.8B M money supply (M1) = C D = $1,200B c $400B $800B 0.5 e $0.8B $800B m This is less than the simple deposit multiplier Although there is multiple expansion of deposits, there is no such expansion for currency 22

23 Case Study: The Great Depression Bank Panics, Bank failures (and no deposit insurance) caused: Increase in deposit outflows and holding of currency (depositors) An increase in the amount of excess reserves (banks) Case Study: The Great Depression Bank Panic, Deposits of Failed Commercial Banks Bank failures (and no deposit insurance) caused: Increase in deposit outflows and holding of currency (depositors) An increase in the amount of excess reserves (banks) Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c? 23

24 Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base,