Fin 453 Chapter 17: The Central Bank Balance Sheet and Money Supply

Balance sheet Transaction Table

- 17.2

Foreign Exchange Reserves

- Balances of foreign currency - Foreign exchange interventions

Treasury Security Market Relief

- Went down 300 B - Flight to safety (gold and other treasuries) - Massive shock to demand for treasuries (causes prices to sky rock and yields go down) - Fed served the role of market maker and sold treasuries to those demanding them

Discount Loans

- borrowing bank must provide collateral - for the borrowing bank, the loan is a liability - for the Fed, the loans is an asset

Fed's Response to 2008 Crisis (assets)

- increase term auction credit - increased net holdings of commercial paper - Other assets increased - Treasury securities decreased

Currency

- issuance of currency

Since the Federal Reserve can only control two of the four variables that determine the money supply, it no longer targets the money supply as policy tool. Instead, for short-run policy, ________________ have become the monetary policy tool of choice for the Federal Reserve. Interest rates The required reserve ratio The stock markets Commodity prices

Interest rates

Lecture Notes

Lecture Notes

When the Federal Reserve buys $1 million worth of Treasury bills from a US commercial bank through its open market operations ____________________________. The "government deposits" portion of its liabilities decreases by $1 million The securities portion of its assets decreases by $1 million The foreign exchange portion of its assets increases by $1 million The reserves portion of its liabilities increases by $1 million

The reserves portion of its liabilities increases by $1 million

Why did the Fed drive its balance sheet up?

They drove it up to raise prices and decrease yields, to jumpstart GDP and raise employment levels

Fed balance sheet before, during, and after Crisis

Total Assets in 2007 = 850 Billion Total Assets in 2008 = 2.2 Trillion Total Assets Today = 4.4 Trillion

Increasing Excess Reserves

- 1990 excess reserves = 1 Billion - very consistently 1-2 Billion -Big pop in 9/11 => reserves go to 19 Billion - adjust back to near 1 Billion for a few years before financial crisis - It is now 2.1 Trillion

What does the Balance sheet look like now?

- 4.4 Trillion Assets - No more commercial paper funding facility - No more term auction credit - buying 2.4 Trillion in Treasuries - 1.7 Trillion in Mortgage Backed Securities (buying MBS pushed demand out, raising the price and decreasing yields) This was trying to get us to full employment

The Monetary Base

- Also called high- powered money - Currency in the hands of the public and reserves in banking system - Fed controls the size of monetary bank

Results of increased excess reserves

- Banks are holding more excess reserves, which is decreasing the the money multiplier - While the Monetary Base is increasing, because the money multiplier has decreased, the money supply hasn't gone up and inflation hasn't happened

Why are the Banks sitting on Money?

- Banks remember the crisis - Dodd-Frank and regulation requires banks to hold more reserves (CAMELS) - Interest Rates are low so the opportunity cost to sit on these reserves is low.

US Currency

- Created by the treasury - Controlled by the Federal Reserve - Represents a liability to the Fed - Location matters (money is only a liability when someone else has it, if its in the basement of the fed its not a liability) - Fed can create liabilities at will

Fed Reserve Notes and Physical Cash

- Currency in the Hands of the Public - Reserves of Banks on deposit at Fed

Loans

- Extended to commercial banks - Discount loans=> when commercial banks need short term cash

Cash Withdrawal

- Fed can't shift liabilities - By taking cash out of an ATM, you are changing the Fed's balance sheet - Monetary base doesn't change - You increase currency in the Fed and decrease reserves

Government Account

- Gov. deposits funds and makes payments out of

There was a 1.5 Trillion Budget Deficit during Crisis

- Government needed to issue bonds during the deficit, issuing bonds drops prices and raises yields - Central banks want yields to be low so bought bonds to shift the supply curve to match the demand curve, pushing prices up and yields low

Excess Reserves of 2 Trillion

- If interest rates increase, banks will loan money out and decrease excess reserves - This will cause the money multiplier to go up, causing money supply to increase. - If monetary base remains unchanged, the increase in money multiplier will cause inflation to occur.

Commercial Paper Funding Facility

- Increase 300 B - Lehman Brothers defaulted on commercial paper - Some of America's top corporations require commercial paper - Fed decides it will step in and buy commercial paper

Central Bank Liquidity Swaps (other assets)

- Increased 500 B - No dollars flowing - International trade comes to a halt - Offered central bank liquidity swaps to central banks around the world - Currency swap with a foreign central bank and then a few weeks later swap back.

Demand for Reserves (Why banks want reserves)

- Liquidity - Lend it out (opportunity cost of sitting on liquidity is low because interest rates are low) - Required by law

Roles of the Federal Reserve

- Monitor Banks - Serve as lender of last resort - Balance Dual mandate (full employment and stable prices) - These are all positive externalities

Bank reserves

- Required reserves and excess reserves - Bank reserves are the most important in determining the quantity of money and credit in the economy - Increase in reserves leads to a rise in deposits and growth and the availability of money and credit.

Deposit Expansion Multiplier

- The increase in commercial bank deposits following a one dollar open market purchase

The quantity of money depends on four variables

- The monetary base, which is controlled by central banks - The reserve requirement imposed by regulators on banks that accept deposits - The desire on the part of banks to hold excess reserves - The demand for currency by the nonbank public

Fed's big unwind

- They are trying to reduce the monetary base - While the fed is trying to shrink the money base, it might raise interest rates and cause lower excess reserves and increase money multiplier, potentially increasing money supply and inflation

Term Auction Credit Facility

- increased 400 B - intermediate term loans to banks - Give banks longer and more stable liquidity

Securities

- primary asset of most central banks (prior to crisis) - quality of securities known as open market operations

Commercial Bank Accounts (Reserves)

- sum of two parts: deposits at the central bank and cash in the bank's own vault - deposits equal a commercial bank's checking account - Vault cash is an insurance function for which reserves are designed - Reserves are the largest liability for the Fed

The has increased the Monetary Base by 3 Trillion

- the money supply however isn't increasing which is why we don't have inflation - The solution is the money multiplier has have to gone down - The money multiplier went down because total excess reserves are going up

Movements in the Money Supply ( 17.4)

-Monetary Base increase => money supply increase -increase in reserve requirement => decrease in money supply - increase in excess reserves => decrease in money supply - increase in currency ratio => decrease in money supply - increase in interest rates => increase in money supply

The following information relates to question 8 Total required reserves at US banks are $65,965 million Total excess reserves at US banks are $1,120,371 million Total deposit accounts at banks are $1,029,500 million Cash in the hands of the public is $943,800 million What is the excess-reserves-to-deposit ratio? 0.7273 0.9167 1.0883 1.5532

1.0883

Assuming that banks hold no excess reserves and there is no cash in the hands of the non-banking public, what is the money multiplier if the required reserve ratio is 8.5%? 1.093 4.53 10.00 11.765

11.765

How man Fed district banks are there

12

What does money supply equal?

=C+D =monetary base x money multiplier - We know the monetary base has increased because of the Fed's balance sheet but the money supply hasn't increased - something has happened in the money multiplier which is explaining why the money supply ins't growing

Based on the formula that estimates the money supply as a function of the deposit expansion multiplier and the monetary base, which of the following would increase the money supply? An increase in the amount of cash that consumers hold relative to their deposits A decrease in the required reserve ratio An increase in the amount of excess reserves banks hold relative to deposits A decrease in the monetary base

A decrease in the required reserve ratio

Money Multiplier Formula

C/D +1/ (C/D) + Rd + (ER/D)

What does the monetary base equal?

Currency + Reserves - This is the Fed's liabilities side of the balance sheet

The monetary base = ___________________________. Currency in the hands of the public Currency in the hands of the public + reserves in the banking system Currency in the hands of the public + deposits in the banking system Currency in the hands of the public + deposits in the banking system + reserves in the banking system

Currency in the hans of the public + reserves in the banking system

The central Bank's Balance sheet

Government's Banks - Assets: securities, foreign exchange reserves -liabilities: currency, governments account Banker's Bank - Assets: Loans - Liabilities: accounts of the commercial banks

What chases goods and services in an economy?

Deposit accounts

_________________ loans are loans the Fed makes when banks need short-term cash. Debenture Discount Amortized Divestiture

Discount

There are two types of reserves: those that banks are required to hold, called required reserves, and those they hold voluntarily, called ___________ reserves. Courtesy Excess Optional Non-Mandatory

Excess

Fed buys 1 million in MBS from Bank of America

Fed Balance Sheet => Securities increases 1 M and DOA deposits at Fed increase 1M BOA Balance Sheet => Securities decrease in 1 M and Deposits at Fed increase 1 M

Fed makes a discount loan for 1 M

Fed's balance sheet - discount loan raises 1 M and reserves rise 1 M Bank's balance sheet - reserves rise 1 M and discount loans rise 1 M

Foreign Exchange Intervention => Fed buys foreign bonds from commercial bank for 1 M

Fed's balance sheet => Foreign exchange reserves goes up by 1 M and reserves go up by 1 M Bank's Balance sheet => reserves go up by 1 M and securities go down by 1 B

Fed Purchases a U.S. Treasury for 1 Million

Fed's balance sheet => securities go up by 1 M and Reserves go up by 1 M Bank's Balance sheet => Reserves go up by 1 M and securities go down by 1 M

U.S GDP

GDP = C + I + G + NX - 20 Trillion C = 12-13 Trillion I = 3 Trillion - C and I based economy (16 of 20 Trillion) - When C and I contract, drop interest rates to get them back up

Assume that a financial crisis leads to the following: banks decide to hold higher excess reserves and the non-banking public decides to carry more cash in their wallets and homes. Which of the following would result? I. The cash to deposit ratio would increase II. The excess reserves to deposit ratio would increase III. The money multiplier would increase I I and II I and III II and III I, II, and III

I and II

Which of the following is considered an asset on the balance sheet of the Federal Reserve? Currency in circulation Deposits of the US Government at the Federal Reserve Loans issued to banks by the Federal Reserve Deposits of commercial banks at the Federal Reserve

Loans issued to banks by the Federal Reserve

M1 and M2

M1 = Currency + demand deposits M2 = M1 + time deposits

Money Supply

Money Multiplier x Monetary Base

Big daddy Money Supply Formula

Money Supply = Monetary Base x (C/D) +1 / (C/D) + Rd + (ER/D)

4 ways to change the size and composition of Fed's balance sheet

Open Market Operations - Central bank buys or sells a security Foreign Exchange Intervention - Central bank buys or sells foreign currency Discount Loan - Loan to commercial banks (borrowing bank must provide collateral) Withdraw Cash - individual withdraws cash from the bank - The first 3 change the size of the balance sheet and monetary base and the last one keeps it the same size but changes the composition and structure

When the Federal Reserve buys or sells securities in financial markets, it engages in _______. Open market operations Liquidity swapping Discount lending Primary dealing activities

Open market operations

Withdraw 100 from ATM

Public's balance sheet => Cash rises 100 and checkable deposits decrease 100 Fed's balance sheet => Currency rises 100 and reserves fall 100 Bank's balance sheet => reserves fall 100 and checkable deposits fall 100