Consolidated Balance Sheet of the Federal Reserve Banks: First we look at what a balance sheet for the FED should look like. Unlike traditional commercial banks – the FED does not take deposits or make loans to individuals or companies. They make loans and take deposits (called reserves) from banks and thrifts.
Assets: The FED has two basic assets.
- Securities: These are government issued bonds (government debt) and the FED uses their stockpile to manipulate the Money Supply. They “need” government to have a debt in order to use Open Market Operations as a monetary policy tool. (technically, they could use anyone’s bonds – but for ease of sale and purchase, using one universal and completely secure bond is the easiest way for them to control the money supply through OMO).
- Loans to Commercial Banks: Banks borrow money from the FED at the discount rate (interest rate charged by the FED to banks who need to borrow money. This is the interest rate that the FED Chairman announces changes too every few weeks or so when speaking before Congress). The loans are either to make up for a shortage of reserves at the FED – or to use as funds to make commercial loans to bank customers. The FED can sell these loans – so they are an asset – even if they don’t care about the interest income generated from these loans.
Liabilities: The FED has 3 basic liabilities:
- Reserves of Commercial Banks: The deposits (reserves) that bank hold at the FED are a liability to the FED because they owe that money back to the banks.
- Treasury Deposits: These are the tax revenues that government collects. The FED acts as the federal government’s bank – so checks written by the Treasury are drawn against their account at the FED.
- Federal Reserve Notes Outstanding: Since the FED distributed the dollars we use – they are the responsibility of the FED. We value them because of the promise the FED has made to make sure they retain their value. Therefore, these promissory notes are the responsibility of the FED – a liability. They are liable only for the value of the ones in circulation – called “outstanding” here.
In total (including misc assets and misc liabilities) the FED assets must always equal the FED’s liabilities.
Tools of Monetary Policy:
Open Market Operations: the buying and selling of government debt. This is what the FOMC does at the Open Market Desk in the NYC Regional FED. This is also why the NYC Regional FED President is always a member of the FOMC.
Buying Securities: The FED buys mostly already circulated Government Debt(they don’t generally buy it directly from the federal government). This way, their purchases directly inject money into the hands of consumers or banks.
From Commercial Banks: When they purchase from banks, they add tot heir assets by way of adding securities. Too be sure that the T account above is still balanced, they must either add an equal sized liability or subtract an equal sized asset. In this case, they add a liability. When they purchase the securities, they pay for them by check. The bank accepts the check and sends it to the FED to be cleared (remember, the FED clears all checks). When they receive a check that they wrote, they credit the bank’s reserveaccount.
The Bank’s T account must also balance: When they sell their securities; they lose that asset and accept a check in its place. The check becomes a “reserve” at the FED (as described above) – increasing an asset for the bank.
Buying a Security from the Public: The overall effect is the same when they buy from the public instead of from a bank – but the details are a little different.
The FED buys the security and gives up the check to the consumer. The consumer deposits the check at his/her own bank – which sends it to the FED to be cleared. The FED credits their account. This balances the FED’s Taccount.
The banks accepts the check as a deposit (a liability to them) and then sends it off to the FED to be cleared. They receive an increase in their reservebalance (an asset to them). The bank’s T account balances.
The individual gives up their bond and receives the money for it.
Selling Securities: The process is reversed for selling securities.
"The Reserve Ratio”: The reserve ratio is the percentage of each deposit not available to be used by the bank to make money.
"The Reserve Ratio”: The reserve ratio is the percentage of each deposit not available to be used by the bank to make money.
- Raising the Reserve Ratio decreases the amount available for the bank can use.
- Lowering the Reserve Ratio increases the amount available for the bank to use.
(Increased) RRR --> a shortage of funds in reserve (at the old rate). Banks must liquidate assets to get cash to deposit at the FED to cover their reserve shortage. This decreases what is left for others to use and drives interest rates up (as firms and consumers compete for what few available dollars are left).
The Discount Rate: The discount rate is then rate banks are charged by the FED to borrow money.
Moral Suasion: Basically, it means that the FED persuades banks to behave as they would like. Perhaps the FED would like to see interest rates rise – but doesn’t want to raise the discount rate to banks. They could appeal to the banking system to raise them on their own for the good of the economy (a moral duty).
Easy Money and Tight Money -
Easy Money Policy (Expansionary Monetary Policy): Your book uses the term “easy money policy”, but it is usually called “expansionary fiscal policy”. Just like expansionary fiscal policy – it’s aim is to expand the economy (make GDP grow). But this time, it is accomplished my means of the money market.
Buy Securities: puts money in people’s hands in return for this asset
--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decrease)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
--> which causes i rates to fall (from i to i’) (decrease)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
Lower the Reserve ratio: leaves banks with excess reserves, which they can pull out (to use to make loans that make profits for them. Reserves at the FED do not earn the banks any interest, so they won’t leave large excess reserves with the FED)
--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
Lower the Discount Rate: allows banks to take low interest loans from the FED – freeing up reserves that they used to borrow from other banks. They may also borrow more funds to then turn around and lend these out (at slightly higher rates) knowing that this lower rate will increase the number of loans that private industry is willing to take out.
--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)
Tight Money Policy (Contractionary Monetary Policy): Just the opposite reactions occur when the FED uses one of these three tools in the opposite direction to decrease the MS. This causes the economy to contract (GDP to fall). Usually the purpose is to stop inflation.
Sell Securities: When the FED sells securities, they take in a illiquid asset and introduce more money into the economy. People have cash in their hands instead of a bond.
--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
Increase the Reserve Ratio: Increasing the reserve ratio causes banks to send more money to the FED to satisfy that requirement. This leaves less for them to loan out. With less loanable funds, competition for what there is increases:
--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
Raise the Discount Rate: raising the discount rate means that fewer banks would be willing to borrow money from the FED – instead borrowing from each other or calling in loans to meet the reserve requirement without the assistance of a loan.
--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)
Relative Importance: These three tools (changing the RRR, changing the discountrate and buying and selling government debt) are available to the FED – but the FED doesn’t use all of them equally. The FED generally favors OMO (buying and selling government debt) over the other methods. It’s quick and flexible. Next, they use the discount rate occasionally. They generally do not use changing the RRR because it’s too disruptive to the banking system.
The Focus on the Federal Funds Rate: Through much of the recent past, the FED has concentrated of setting the Fed Funds Rate in order to effect the economy. This means that the FED may or may not be overly concerned about inflation or unemployment. The FED could just as easily concentrate on the growth rate of the Money Supply as a target (and sometimes they have – as this is the suggestion of the Monetarists).
Lags: Like with Fiscal Policy, there are lags in the use of monetary policy:
- Recognition Lag: technically, the lag here between the recession starting and knowing a recession has started is the same length. But Monetary policy does allow more second- guessing than fiscal policy. The FED can react to signals that the economy may be changing (leading indicators) and then reverse course very easily if they decide they were wrong later.
- Administrative Lag: This lag (from the time the government knows the situation until it can react) is reduced to almost no time at all. The FED does not need to draft a new budget, overhaul the tax code or seek Congressional approval to change policy. They can just change it. There is no meaningful administrative lag with monetary policy.
- Operational Lag: The time from policy action until there are results. Your book seems very optimistic here – assuming that the effect happens rather quickly. But since we are dealing with the effect of interest rates on Investment – the effect is probably longer term than they are suggesting.
Changes in Velocity: Basically, the formula relates money supply, inflation, production and this new term called velocity.
V = velocity of money. This is the number of times that a dollar bill cycles through the economy each time period. The assumption here is that the velocity of money is fairly constant.
P = Price Level
Q = Output
M = Money Supply
P = Price Level
Q = Output
M = Money Supply
If V is a constant and real output rises at a fairly constant rate (approx 3-4 % per year), then if M does not increase by more than that 3-5% per year, the PL must be fairly stable. By setting the growth rate of money supply equal to the growth rate of realoutput, the FED can eliminate the threat of inflation.
Cyclical Asymmetry: This term just means that the policy works well in only one direction. In this case, monetary policy works well in combating inflation – but doesn’t fair well in combating recessions. Therefore, monetary policy is a good inflation fighter – but a lousy recession fighter. To be fair, fiscal policy is also cyclically asymmetrical. It works well in combating recessions – but less so in combating inflation.
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