HO_MB1e_ch14 - Dickinson State University

Report
R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
14
The Federal Reserve’s Balance
Sheet and the Money Supply
Process
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
14.1
Explain the relationship between the Fed’s balance sheet and the monetary base
14.2
Derive the equation for the simple deposit multiplier and understand what it means
14.3
Explain how the behavior of banks and the nonbank public affect the money
multiplier
14A
Appendix: Describe the money supply process for M2
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
14
The Federal Reserve’s Balance
Sheet and the Money Supply
Process
GEORGE SOROS, “GOLD BUG”
• While some individual investors, known as “gold bugs,” have always
wanted to hold gold, the surge in demand for gold during 2009 and 2010
surprised many economists. John Paulson, Thomas Kaplan, and George
Soros are some of the famous hedge fund managers with a preference
for gold.
• For many, holding gold is a way to hedge the risk of inflation created by a
rapid increase in the money supply.
• An Inside Look at Policy on page 434 discusses the Federal Reserve’s
“exit strategy” from the increases in reserves and the money supply that
resulted from its policies during the financial crisis of 2007–2009.
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Key Issue and Question
Issue: During and immediately following the financial crisis, bank
reserves increased rapidly in the United States.
Question: Why did bank reserves increase rapidly during and after the
financial crisis of 2007–2009, and should the increase be a concern to
policymakers?
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14.1 Learning Objective
Explain the relationship between the Fed’s balance sheet and the monetary base.
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Figure 14.1 The Money Supply Process
Three actors determine the money supply: the central bank (the Fed), the nonbank public, and the
banking system.•
Our model of how the money supply is determined includes three actors:
1. The Federal Reserve, which is responsible for controlling the money supply
and regulating the banking system.
2. The banking system, which creates the checking accounts that are the most
important component of the M1 measure of the money supply.
3. The nonbank public, which refers to all households and firms. The nonbank
public decides the form in which they wish to hold money—for instance, as
currency or as checking account balances.
The Federal Reserve’s Balance Sheet and the Monetary Base
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The process starts with the monetary base, which is also called highpowered money.
Monetary base (or high-powered money) The sum of bank reserves and
currency in circulation.
Monetary base = Currency in circulation + Reserves.
The money multiplier links the monetary base to the money supply. As long as
the value of the money multiplier is stable, the Fed can control the money
supply by controlling the monetary base.
There is a close connection between the monetary base and the Fed’s balance
sheet, which lists the Fed’s assets and liabilities.
The Federal Reserve’s Balance Sheet and the Monetary Base
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Table 14.1 The Federal Reserve’s Balance Sheet
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The Monetary Base
Currency in circulation Paper money and coins held by the nonbank public.
Vault cash Currency held by banks.
Currency in circulation = Currency outstanding – Vault cash.
Bank reserves Bank deposits with the Fed plus vault cash.
Reserves = Bank deposits with the Fed + Vault cash.
• Reserve deposits are assets for banks, but they are liabilities for the Fed
because banks can request that the Fed repay the deposits on demand with
Federal Reserve Notes.
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Reserves = Required reserves + Excess reserves.
Required reserves Reserves that the Fed compels banks to hold.
Excess reserves Reserves that banks hold over and above those the Fed
requires them to hold.
Reserves = Required reserves + Excess reserves.
Required reserve ratio The percentage of checkable deposits that the Fed
specifies that banks must hold as reserves.
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How the Fed Changes the Monetary Base
The Fed increases or decreases the monetary base by changing the levels
of its assets—that is, the Fed changes the monetary base by buying and
selling Treasury securities or by making discount loans to banks.
Open market operations The Federal Reserve’s purchases and sales of
securities, usually U.S. Treasury securities, in financial markets.
Open market purchase The Federal Reserve’s purchase of securities, usually
U.S. Treasury securities.
Open market operations are carried out by the Fed’s trading desk, which buys
and sells securities electronically with primary dealers.
In 2010, there were 18 primary dealers, who are commercial banks, investment
banks, and securities dealers.
In an open market purchase, which raises the monetary base, the Fed buys
Treasury securities.
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We use a T-account for the whole banking system to show the results of the
Fed’s open market purchase:
The Fed’s open market purchase from Bank of America increases reserves by
$1 million and, therefore, the monetary base increases by $1 million. A key
point is that the monetary base increases by the dollar amount of an open
market purchase.
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Open market sale The Fed’s sale of securities, usually Treasury securities.
Because reserves have fallen by $1 million, so has the monetary base. We can
conclude that the monetary base decreases by the dollar amount of an open
market sale.
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The public’s preference for currency relative to checkable deposits does not
affect the monetary base. To see this, consider what happens if households
and firms decide to withdraw $1 million from their checking accounts.
One component of the monetary base (reserves) has fallen while the other
(currency in circulation) has risen.
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Discount Loans
Discount loan A loan made by the Federal Reserve, typically to a
commercial bank.
Discount loans alter bank reserves and cause a change in the monetary
base. An increase in discount loans affects both sides of the Fed’s balance
sheet:
As a result of the Fed’s making $1 million of discount loans, bank reserves and
the monetary base increase by $1 million.
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If banks repay $1 million in discount loans to the Fed, reducing the total
amount of discount loans, then the preceding transactions are reversed.
Discount loans fall by $1 million, as do reserves and the monetary base:
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Comparing Open Market Operations and Discount Loans
Both open market operations and discount loans change the monetary
base, but the Fed has greater control over open market operations.
Discount rate The interest rate the Federal Reserve charges on discount
loans.
The discount rate differs from most interest rates because it is set by the
Fed, whereas most interest rates are determined by demand and supply in
financial markets.
The monetary base has two components: the nonborrowed monetary base,
Bnon, and borrowed reserves, BR, which is another name for discount loans.
We can express the monetary base, B, as
B = Bnon + BR.
The Fed has control over the nonborrowed monetary base.
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Making the Connection
Explaining the Explosion in the Monetary Base
The monetary base increased sharply in the fall of 2008. Most of the increase
occurred because of an increase in the bank reserves component, not the
currency in circulation component.
In this case, the Fed’s holdings of Treasury securities actually fell while the
base was exploding.
As the Fed began to purchase assets connected with Bear Stearns and AIG,
the asset side of its balance sheet expanded, and so did the monetary base.
There is an important point connected with this episode for understanding the
mechanics of increases in the monetary base: Whenever the Fed purchases
assets of any kind, the monetary base increases. It doesn’t matter if the assets
are Treasury bills, mortgage-backed securities, or computer systems.
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Making the Connection
Explaining the Explosion in the Monetary Base
In the fall of 2008 when the Fed began to purchase hundreds of billions of
dollars worth of mortgage-backed securities and other financial assets, it was
inevitable that the monetary base would increase.
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14.2 Learning Objective
Derive the equation for the simple deposit multiplier and understand what it means.
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We now turn to the money multiplier to further understand the factors that
determine the money supply.
The money multiplier is determined by the actions of three actors in the
economy: the Fed, the nonbank public, and banks.
Multiple Deposit Expansion
How a Single Bank Responds to an Increase in Reserves
Suppose that the Fed purchases $100,000 in Treasury bills (or T-bills) from
Bank of America, increasing its reserves that much. Here is how a T-account
can reflect these transactions:
The Simple Deposit Multiplier
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Next, Bank of America extends a loan to Rosie’s Bakery by creating a checking
account and depositing the $100,000 principal of the loan in it. Both the asset
and liability sides of Bank of America’s balance sheet increase by $100,000:
If Rosie’s spends the loan proceeds by writing a check for $100,000 to buy
ovens from Bob’s Bakery Equipment and Bob’s deposits the check in its
account with PNC Bank, Bank of America will have lost $100,000 of reserves
and checkable deposits:
The Simple Deposit Multiplier
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How the Banking System Responds to an Increase in Reserves After PNC
has cleared the check and collected the funds from Bank of America, PNC’s
balance sheet changes as follows:
Suppose that PNC makes a $90,000 loan to Jerome’s Printing who writes a
check in that amount for equipment from Computer Universe who has an
account at SunTrust Bank. The balance sheets change as follows:
The Simple Deposit Multiplier
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Suppose that SunTrust lends its new excess reserves of $81,000 to Howard’s
Barber Shop to use for remodeling. When Howard’s spends the loan proceeds
and a check for $81,000 clears against it, the changes in SunTrust’s balance
sheet will be as follows:
If the proceeds of the loan to Howard’s Barber Shop are deposited in another
bank, checkable deposits in the banking system will rise by another $81,000.
To this point, the $100,000 increase in reserves supplied by the Fed has
increased the level of checkable deposits by $100,000 + $90,000 + $81,000 =
$271,000. This process is called multiple deposit creation.
Multiple deposit creation Part of the money supply process in which an
increase in bank reserves results in rounds of bank loans and creation of
checkable deposits and an increase in the money supply that is a multiple of
the initial increase in reserves.
The Simple Deposit Multiplier
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Calculating the Simple Deposit Multiplier
Simple deposit multiplier The ratio of the amount of deposits created by
banks to the amount of new reserves.
∆ = $100,000 + 0.9 × $100,000 + 0.9 × 0.9 × $100,000
+ 0.9 × 0.9 × 0.9 × $100,000 + . . .
Or, simplifying: ∆ = $100,000 × 1 + 0.9 + 0.92 + 0.93 + . . . .
The Simple Deposit Multiplier
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An infinite series, such as 1 + 0.9 + 0.92 + 0.93 + . . . , reduces to:
1
1
=
= 10.
1 − 0.9 0.10
So, ∆ = $100,000 × 10 = $1,000,000.
1
Simple deposit multiplier =  .

We can derive an equation showing how a change in deposits, ∆, is related to
an initial change in reserves, ∆:
∆ =
∆
,

or, in our example,
∆ =
$100,000
= $1,000,000.
0.10
The Simple Deposit Multiplier
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14.3 Learning Objective
Explain how the behavior of banks and the nonbank public affect the
money multiplier.
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The Effect of Increases in Currency Holdings and Increases in
Excess Reserves
In deriving the money multiplier, we made two key assumptions:
1. Banks hold no excess reserves.
2. The nonbank public does not increase its holdings of currency.
In order to build a complete account of the money supply process, we change
the simple deposit multiplier in three ways:
1. Rather than a link between reserves and deposits, we need a link between
the monetary base and the money supply.
2. We need to include the effects on the money supply process of changes in
the nonbank public’s desire to hold currency relative to checkable deposits.
3. We need to include the effects of changes in banks’ desire to hold excess
reserves relative to deposits.
Banks, the Nonbank Public, and the Money Multiplier
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Deriving a Realistic Money Multiplier
We need to derive a money multiplier, m, that links the monetary base, B, to the
money supply, M:
 =  × .
This equation tells us that the money multiplier is equal to the ratio of the
money supply to the monetary base:

= .

The money supply is the sum of currency in circulation, C, and checkable
deposits, D. The monetary base is the sum of currency in circulation and bank
reserves, R. To expand the expression for the money multiplier, we separate
reserves into its components: required reserves, RR, and excess reserves:
=
+
 +  + 
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Currency-to-deposit ratio (C/D) The ratio of currency held by the nonbank
public, C, to checkable deposits, D.
The excess reserves-to-deposit ratio (ER/D) measure banks’ holdings of
excess reserves relative to their checkable deposits. We can introduce the
deposit ratios into our expression for the money multiplier this way:
+
1/
/ + 1
=
×
=
.
 +  + 
1/
/ + / + /
Since the ratio of required reserves to checkable deposits is the required
reserve ratio, rrD, then:
/ + 1
=
.
/ +  + /
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So, we can say that because:
Money supply = Money multiplier × Monetary base
then,
=
/ + 1
/ +  + /
× .
With the following values: C = $500 billion, D = $1,000 billion, rrD = 0.10, and
ER = $150 billion, the money multiplier is:
=
0.5 + 1
1.5
=
= 2.
0.5 + 0.10 + 0.15
0.75
A money multiplier of 2 means that every $1 billion increase in the monetary
base will result in a $2 billion increase in the money supply.
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=
/ + 1
/ +  + /
× .
There are several points to note about the expression above linking the money
supply to the monetary base:
1. The money supply will change in the same direction of a change in either the
monetary base or the money multiplier.
2. An increase in the currency-to-deposit ratio (C/D) causes the value of the
money multiplier and the money supply to decline.
3. An increase in the required reserve ratio, rrD, causes the value of the money
multiplier and the money supply to decline.
4. An increase in the excess reserves-to-deposit ratio (ER/D) causes the value
of the money multiplier and the money supply to decline.
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Solved Problem
14.3
Using the Expression for the Money Multiplier
Consider the following information:
Bank reserves = $500 billion
Currency = $400 billion
a. If banks are holding $80 billion in required reserves, and the required
reserve ratio = 0.10, what is the value of checkable deposits?
b. Given this information, what is the value of the money supply (M1)? What is
the value of the monetary base? What is the value of the money multiplier?
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Solved Problem
14.3
Using the Expression for the Money Multiplier
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by calculating the value of checkable deposits. The value of
required reserves is equal to the value of checkable deposits multiplied by the
required reserve ratio:
 =  ×  .
$80 billion =  × 0.10
 = ($80 billion/0.10) = $800 billion.
Step 3 Answer part (b) by calculating the values of the money supply, the monetary
base, and the money multiplier. The M1 measure of the money supply equals
the value of currency in circulation plus the value of checkable deposits:
 =  +  = $400 billion + $800 billion = $1,200 billion.
The monetary base is equal to the value of currency in circulation plus the value of
bank reserves:
 =  +  = $400 billion + $500 billion = $900 billion.
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Solved Problem
14.3
Using the Expression for the Money Multiplier
Solving the Problem
We can calculate the money multiplier two ways. First, note that the money multiplier is
equal to the ratio of the money supply to the monetary base:
=
 $1,200 billion
=
= 1.33.

$900 billion
Or, using the expression for money multiplier:
=
=
($400 billion/$800 billion
($400 billion/$800 billion)+0.10+($420 billion/$800 billion)
1.5
= 1.33.
1.125
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Recall that the monetary base is the sum of borrowed plus nonborrowed
reserves: B = Bnon + BR. Rewriting the relationship between the money supply
and the monetary base:
=
/ + 1
/ +  + /
× ( + ).
We now have a complete description of the money supply process.
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The Money Supply, the Money Multiplier, and the Monetary Base
During the 2007–2009 Financial Crisis
Figure 14.2 Movements in the Monetary Base, M1, and the Money Multiplier, 1990–2010
Panel (a) shows that beginning in the fall of 2008, the size of the monetary base soared. M1 also
increased, but not nearly as much.
As panel (b) shows, the value of the money multiplier declined sharply during the same period.•
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Why did the monetary base increase so much more than M1? Figure 14.3
helps to solve the mystery.
Figure 14.3
Movements in (C/D)
and (ER/D)
The currency-to-deposit ratio
(C/D) had been gradually
trending upward since 1990,
but it fell during the financial
crisis of 2007–2009.
At the same time, the excess
reserves-to–deposits ratio
(ER/D) soared, increasing
from almost zero in
September 2008—because
banks were holding very few
excess reserves—to about
1.3 in the fall of 2009. Banks
began to hold more excess
reserves than they had
checkable deposits.•
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Making the Connection
Did the Fed’s Worry over Excess Reserves Cause the
Recession of 1937–1938?
Following the end of the bank panics in early 1933, excess reserves in the
banking system soared.
Many banks had suffered heavy losses and had a strong desire to remain
liquid. Nominal interest rates had also fallen to very low levels, which reduced
the opportunity cost of holding reserves at the Fed.
By late 1935, unemployment remained high and inflation low. Nevertheless, the
Fed’s Board of Governors worried about a rapid increase in stock prices and
some feared an increase in the inflation rate.
The Board of Governors decided to reduce excess reserves by raising the
required reserve ratio.
But the Fed’s policy ignored the reasons banks during this period were holding
excess reserves. As bank loans contracted, so did the money supply. The
economy fell into recession again in 1937.
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Making the Connection
Did the Fed’s Worry over Excess Reserves Cause the
Recession of 1937–1938?
The Fed reversed course in April 1938 by cutting the required reserve ratio. But
the damage had been done. Most economists believe that the Fed’s actions in
raising the required reserve ratio contributed significantly to the recession.
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In 2010, banks’ enormous holdings of excess reserves left investors,
policymakers, and economists concerned about the implications for future
inflation.
If banks were to suddenly begin lending the nearly $1 trillion in excess reserves
they held in November 2010, the result would be an explosion in the money
supply and, potentially, a rapid increase in inflation.
Fear of this potential for a much higher rate of inflation in the future drove some
investors in 2010 to buy gold.
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Making the Connection
Worried About Inflation? How Good Is Gold?
In 2010, many investors bought gold because they were worried about the
possibility that increases in reserves and the money supply might lead to much
higher rates of inflation in the future.
But how good an investment is gold? Gold clearly has some drawbacks 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. Gold’s value as an investment depends on how likely its
price is to increase in the future because its rate of return is entirely in the form
of capital gains.
Many individual investors believe that gold is a good hedge against inflation
because the price of gold can be relied on to rise if the general price level rises.
But is this view correct? The record of the past 30 years was not encouraging.
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Making the Connection
Worried About Inflation? How Good Is Gold?
The real price of gold, calculated by dividing the nominal price of gold by the
consumer price index, shows that even after the strong nominal price increases
of 2009 and 2010, the real price of gold was still 30% below its September
1980 level. In other words, in the long run, gold has proven a poor hedge
against inflation.
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“Why did bank reserves increase rapidly during and after the financial crisis of
2007–2009, and should the increase be a concern to policymakers?”
As we have seen in this chapter, the rapid increase in bank reserves that
began in the fall of 2008 was a result of the Fed purchasing assets.
Whenever the Fed purchases an asset, the monetary base increases. Both
components of the base increased in 2008, but the increase in reserves was
particularly large. Banks were content to hold large balances of excess
reserves because the Fed was paying interest on them and because of the
increased risk in alternative uses of the funds. Inflation remained very low
through mid-2010, but some policymakers were concerned that, ultimately, if
banks began to lend out their holdings of excess reserves, a future increase
in the inflation rate was possible.
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AN INSIDE LOOK AT POLICY
Fed’s Balance Sheet Needs Balancing Act
WASHINGTON POST, Federal Reserve Hopes Clear Exit Strategy Will Boost Market Confidence
Key Points in the Article
• After two years of taking aggressive steps to stimulate a weak economy, the
Federal Reserve had to decide how to phase out its initiatives in order to
reduce the risk of inflation.
• Reducing the growth of the money supply and raising interest rates
threatened to slow an economy that suffered from high unemployment.
• Analysts believe that changing the interest rate on reserves will become a
more important tool to control the growth of the money supply.
• The Fed had to decide what to do with its holdings of $1 trillion of mortgagebacked securities. Selling the securities would pull money out of the economy
at the risk of driving up interest rates.
• The key to chairman Ben Bernanke’s strategy is to win the confidence of
market participants in the Fed’s ability to drain cash from the financial system.
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AN INSIDE LOOK AT POLICY
The table below documents the rapid increase in the Fed’s holdings of
federal agency debt and mortgage-backed securities between July 2008
and July 2010. The increase in its debt holdings was over $1.5 trillion over
this two-year period.
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APPENDIX
The Money Supply Process for M2
14A
Describe the money supply process for M2
M2 is a broader monetary aggregate than M1, including not only currency, C,
and checkable deposits, D, but also nontransaction accounts. These
nontransaction accounts consist of savings and small-time deposits, which we
will call N, and money market deposit accounts and similar accounts, MM. So
we can represent M2 as:
M2 = C + D + N + MM.
We can express M2 as the product of an M2 multiplier and the monetary base:
M2 = (M2 multiplier) x Monetary base.
1 + (/) + (/) + (/)
2 multiplier =
.
(/) +  + (/)
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