The Federal Reserve, Commercial Banking, and the Supply of Money
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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 recessionLike 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/CopperQuarter Dollar (Silver)Twenty Cents (Silver)
6 Production of gold coins ceased in 1934 Production of gold coins ceased in 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
8 Paper money was initially issued by commercial banks as claims to their deposits of gold and silver (coins or bars)Northampton BankAssetsLiabilitiesThe 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 privateUS TreasuryAssetsLiabilitiesUnited States notes were printed until 1963, but were a small fraction of total money1910: one tenth : 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 tenderUS TreasuryGold notes were printed until 1934.All $1 bills in the US were silver certificates until 1963 and were still convertible to silver until 1968AssetsLiabilities$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 CityNational notes were convertible to T-Bills at any national bankNational Bank notes were issued until 1934AssetsLiabilities$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 TreasuryFederal Reserve notes were convertible to gold until 1934 (individuals) 1971 (Central Banks)Federal Reserve BankAssetsLiabilities$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 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 creditNational banks who were short of funds would borrow from money center banksLarger State banks who were short of funds would borrow from National banksSmall 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 ReserveThe Federal Reserve System was created in 1913 by Woodrow Wilson.Regulate the banking industry“Lender of Last Resort”Regulate the money supplyProvide banking services for the federal governmentCheck Clearing
18 Credit Channels under the Federal Reserve System = 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 termsBank PresidentBoard of DirectorsClass A (4)Class B (4)Class C (4)Member BanksLocal BusinessFederal 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 voteBoard 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 ValueUnit of accountMedium of exchangeLots of things satisfy these properties
24 Standard Definitions of Money Monetary Base (M0): Direct liabilities of the central bankCurrency in circulation + Bank ReservesM1:Currency in circulation + Traveler's Checks + Checking accountsM2:M1 + Savings accounts + Money Market Accounts + Small Time DepositsM3:M2 + Large Time Deposits + Eurodollars
25 The Federal Reserve can perfectly control the monetary base (cash + bank reserves) MBM1M3M2Once 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) CashMBM1M2M3
28 Reserve Accounts are liabilities of the Fed 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 ReserveAcme National BankAssetsLiabilitiesAssetsLiabilities$ 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 FedAcme currently has 10% of its deposit liabilities on Reserve (Cash + Reserves)/Deposits
29 Acme’s reserve ratio drops to 6.25% (5/80) Suppose Acme Bank wanted to create a $30,000 loan. This is done by establishing a line of credit (i.e. creating a new checkable deposit)Acme National BankAssetsLiabilitiesThe loan shows up on both sides of the balance sheet$ 2,500 (Cash)$50,000 (Deposits)$ 2,500 (Reserves)$30,000 (Deposit)$45,000 (T-Bills)$100,000(Loans)$30,000 (Loan)$100,000 (Equity)Acme’s reserve ratio drops to 6.25% (5/80)
30 Reserves and cash are components of M0 while the newly created loans are components of M1 or M2 Acme National BankMonetary BaseCash in CirculationBank ReservesAssetsLiabilities$ 2,500 (Cash)$50,000 (Deposits)$ 2,500 (Reserves)$30,000 (Deposit)$45,000 (T-Bills)M1Cash in CirculationChecking Accounts$100,000(Loans)$30,000 (Loan)$100,000 (Equity)M2M1Savings Accounts
31 Type of LiabilityReserve RequirementTransaction Account$0 - $7M0%$7M - $47.6M3%More than $47.6M10%Time DepositsEurocurrenciesThe Reserve Requirement has no impact on the monetary base, but it restricts the ability of banks to create loans – this influences the broader aggregates.
32 The discount window was the primary policy tool of the federal reserve when it was first established in Discount window loans are collateralized by the assets of the bank (equal to around 90% of the loan)Federal ReserveAcme National BankAssetsLiabilitiesAssetsLiabilities$ 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
33 Type of CreditInterest RatePrimary (No Questions Asked)Fed Funds + 1% (3.5%)Secondary (Additional Financial InformationRequired)Fed Funds + 1.5% (4.0%)Seasonal (Must demonstrate reoccurring seasonal liquidity needs, <$500M in Deposits)Fed Funds + .2% (2.7%)
35 By purchasing and/or selling securities, the Fed can directly control the quantity of non-borrowed reserves in the banking sector.The Fed debits/credits the reserve account of the dealer’s bankFederal ReserveDealers Buy/Sell bonds from the FedBond DealerMost transactions are done with repurchase agreements (Repos). These are purchases/sales along with an agreement to reverse the transaction at a later date
36 Currently, open market operations are the primary policy tool of the Fed. Trading takes place in NYC Federal ReserveAcme National BankAssetsLiabilitiesAssetsLiabilities$ 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%$50,000 (Equity)An open market purchase increases the reserves of the banking sector – this raises M0
38 The Money multipliers describe the relationship between a change in the monetary base (controlled by the Fed) and the broader aggregates$ Change in M1= mm1 * $ Change in MBCash1 +Depositsmm =CashReserves+DepositsDeposits$ Change in M2= mm2 * $ Change in MBCashM2-M1+1 +DepositsDepositsmm2 =CashReserves+DepositsDepositsThe 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 $100MStaff economists at each federal reserve bank brief the president of local/national economic conditionsTrading desk calls bond dealers and asks for bidsThis order is passed to the trading desk in NYC
40 Fed Policy from start to finish…. Acme National BankThe dealers with the winning bids deliver the bonds. Their bank’s reserve accounts are creditedAssetsLiabilities+$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 $95M. Some of this will be loaned to business customers, some finds its way into the Federal Funds marketFF RateExcess supply of reserves pushes down the Fed Funds RateSupply5%Reserves
41 Fed Policy from start to finish…. Through the Fed Funds Market, the reserves are distributed throughout the banking sectorFed Funds MarketEach bank uses its new reserves to create additional loans
42 As banks increase the supplies of the various aggregates, their rates drop as well M1 RateM2 RateSupplySupply6%7%M1M2$ Change in M1$ Change in M2= mm2 * $100M= mm1 * $100M82These newly created loans are used to purchase labor, materials, consumer goods, etc.
43 Eventually, this newly created demand will influence prices… WagesPricesDemandDemandHoursGDPHigher demand for goods and services drive up their prices (wages and prices)Increases in inflation raise the nominal interest rateNominal Interest RateReal Interest RateExpected 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!