Feds Balance Sheet & Monetary Base Model of

Feds Balance Sheet & Monetary Base Model of

Feds Balance Sheet & Monetary Base Model of M1 money supply determination starts with Monetary base & includes 3 actors: 1. Fed: responsible for controlling money supply & regulating banking system. 2. Banking system: creates checking accounts that are a major component of M1. 3. Nonbank public (households & firms): decides form in which to hold money (e.g., currency vs. checking deposits). When money multiplier is stable Fed controls money supply by controlling Monetary Base (High-powered Money) = Currency in Circulation + Reserves. Currency in circulation = Currency outstanding = (Paper money & coins held by nonbank public) Vault cash.

(Currency held by banks) Reserves = Deposits with Fed (Required reserves) + Vault cash (Excess reserves). There is close connection between monetary base & Feds balance sheet. Usually Feds most important assets are Treasury holdings & discount loans to banks. 2012 balance sheet reflects unusual policy actions Fed took during 2007-09 fin crisis: Purchased many MBS guaranteed by Fannie Mae & Freddie Mac to aid housing market. Participated in saving investment bank Bear Stearns & insurer AIG. Participated in liquidity swaps with foreign central banks. Participated in program to help asset-backed securities market (securitized loans). Comparing Open Market Operations & Discount Loans Both change monetary base, but Fed has greater control over open market operations.

Discount rate (Fed sets & charges on discount loans) differs from most % determined by demand & supply in fin markets. Base = nonborrowed base (controlled by Fed) + borrowed reserves (discount loans) . Feds purchase of assets monetary base. (NY Fed buys computers w/ $10M check. Firm cashes check, currency in circulation by $10M => monetary base $10M or firm deposits check, its banks reserves by $10M => monetary base by $10M.) . Monetary base sharply in fall of 2008 & stayed through 2012, due to bank reserves (Fed bought Federal agency debt, MBS, Bear Stearns & AIG assets, liquidity swaps), not currency in circulation. Feds Treasury holdings actually while base exploded. How Fed Changes Monetary Base By changing level of its assets through open market operations (electronically trading securities, usually Treasuries, with primary dealers, in 2012 21 including commercial &

investment banks & securities dealers) or making discount loans to banks. Ex: Open market purchase of $1M T-bills from Bank of America (ownership transferred electronically, Fed deposits $1M in BOA account at FED) => monetary base $1M. Ex: Open market sales of $1M T-bills to Barclays Bank => monetary base $1M. Ex: BNY Mellon takes $1M discount loans from Fed => bank reserves & monetary $1M. Ex: Citi bank repays $1M discount loans from Fed => bank reserves & monetary $1M. Publics cash v checkable deposits holdings components but keep monetary base =. Single Bank Reaction to Reserves Fed buys $100K T-bills from BOA, its

excess but not required reserves. Banking System Reaction to Reserves Bob deposits check w/ PNC, its reserves & checkable deposits. Assume no excess reserves & no change in currency v deposit holdings, w/ 10% required reserve PNC loans $90K to Jerome: Rosies Bakery borrows $100K from BOA, its loans & checkable deposits. Rosies buys ovens from Bobs Equipment, BOAs loans & checkable deposits.

Jeromes buys equipment from Print World w/ SunTrusts account, which reserves & checkable deposits , allowing $81K loan: So far checkable deposits by $100K + $90K + $81K = $271K. Multiple deposit creation: bank reserves results in bank loans & checkable deposits, causing money supply to as a multiple of initial reserves . Simple deposit multiplier: ratio of deposits created by banks to amount of reserves . D = R + R(1-rrD) + R(1-rrD)2 ++ R(1-rrD) = R (1-rrD) = R/rrD. Open market sales cause multiple deposit contraction. The Effect of Increases in Currency Holdings & in Excess Reserves To build complete account of money supply process, change simple deposit multiplier: 1. Instead of reserve-to-deposit (rrD = R/D) need money supply-to-monetary base link (m = M/B, M = currency C + deposits D, B = C + R, w/ R = required RR + excess ER).

2. Include effects of changes in nonbank public currency v checkable deposits holdings (measured by currency-to-checkable deposit ratio C/D). The more currency nonbank public holds, the smaller the multiplier deposit creation process. 3. Include effects of changes in banks excess reserves holdings (measured by excess reserves-to-deposit ratio ER/D). The more excess reserves banks hold, the smaller the multiplier deposit creation process. Key points about the multiplier expression: 1. money supply & monetary base in the same direction. 2. C/D => money multiplier & money supply. 3. rrD

=> money multiplier & money supply. 4. ER/D => money multiplier & money supply. Using the Expression for the Money Multiplier Assume that bank reserves = $500B, currency = $400B, banks hold $80B required reserves & required reserve ratio = 0.10. What is value of checkable deposits? rrD = RR / D => D = RR / rrD = $80B / 0.1 = $800B What is the value of the money supply (M1)? M = C + D = $400B + $800B = $1,200B What is the value of the monetary base?

B = C + R = $400B + $500B = $900B What is the value of the money multiplier? m = M / B = $1,200 / $900 = 1.33 or m = (400/800 + 1) / (400/800 + 0.1 + 420/800) = 1.5 / 1.125 = 1.33 Variables in the Money Supply Process M2 = M1 + nontransaction accounts, consisting of savings & small-time deposits N & money market deposit accounts and similar accounts M2 = C + D + N + MM. Money Supply, Money Multiplier & Monetary Base in 200709 Fin Crisis In fall of 2008, responding to crisis, Fed bought huge amounts of fin assets (including MBS) causing monetary base to much > than M1. C/D during fin crisis because households & firms switched from money market

mutual funds & assets whose riskiness they believed to checkable deposits. Because in ER/D (=> m) was significantly > than in C/D (=> m) money multiplier & monetary base resulted in much smaller in M1. Did Feds Worry over Excess Reserves Cause Recession of 19371938? After bank panics in early 1933, excess reserves in banking system soared. Many banks suffered heavy losses & strongly desired to remain liquid. Nominal interest rates were very low, reducing the opportunity cost of holding reserves. By 1935 unemployment remained high & inflation low. Yet Fed worried about higher inflation. Board of Governors decided to excess reserves by required reserve ratio. But Feds ignored the reasons banks were holding excess reserves. As bank loans contracted, so did the money supply. The economy fell into recession again in 1937. The Fed reversed its in policy in April 1938 & cut back rrD.

If You Are Worried About Inflation, Should You Invest in Gold? In 2012 banks enormous ER (almost $1T) raised concerns about future inflation if banks suddenly begin lending => rapid in money supply & inflation. Fear of this potential for much higher inflation in future drove some investors in to buy gold. Beginning in 2008, many investors bought gold for fear of future higher inflation. But how good an investment is gold? Drawbacks of gold as an investment: Gold pays no interest or dividend; it has to be stored and safeguarded. Because gold pays no interest, it is difficult to determine its fundamental value as an investment. Golds value depends on how likely its price is to increase in the future. Many investors believe gold is good hedge against inflation because its price with inflation.

But is this view correct? Record of past 30 years does not support it. In 2012, real price of gold (nominal divided by CPI) was still below September 1980 level.

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