The Federal Reserve, Commercial Banking, and the Supply of Money
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!
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 recession Like any commodity, excess supply lowers the value of money….too much money creates inflation. We need to find a balance between the two…
The Constitution grants the federal government the power "to coin Money, regulate the Value thereof...”
The US began minting US coins shortly after the constitution was ratified Half Cent (Copper) One Cent (Copper) Two Cents (Copper) Three Cents (Nickel/Copper) Nickel/Half Dime (Silver/Copper) Twenty Cents (Silver) Quarter Dollar (Silver) Dime (Silver/Copper
One Dollar (Silver) One Dollar (Gold) 2 ½ Dollar (Quarter Eagle) Three Dollar Five Dollar (Half Eagle) Ten Dollar (Eagle) Twenty Dollar (Double Eagle) Half Dollar (Silver) Production of gold coins ceased in 1934. Silver coins were minted until 1964.
Paper money was initially issued by commercial banks as claims to their deposits of gold and silver (coins or bars) Assets Liabilities $500 (Gold) $1,000 (Loans) $300 (Deposits) $1,000 (Notes) $200 (Equity) The supply of money was determined by the individual bank’s profit motive - they created loans by issuing bank notes Bank notes were only redeemable (for gold/silver) at the issuing bank Northampton Bank
Assets Liabilities $1,000 (Gold) $10,000 (T-Bills) $20,000 (US Notes) United States notes were printed until 1963, but were a small fraction of total money 1910: one tenth 1960: one hundredth 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 private US Treasury
Assets Liabilities $1,000 (Gold) $1,000 (Gold Notes) $10,000 (Silver Notes) Gold notes were printed until 1934. All $1 bills in the US were silver certificates until 1963 and were still convertible to silver until 1968 Gold/Silver Certificates were 100% backed by gold/silver reserves at the US Treasury, but were not legal tender US Treasury $10,000 (Silver)
National notes were convertible to T-Bills at any national bank National Bank notes were issued until 1934 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) Assets Liabilities $50,000 (T-Bills) $50,000 (Loans) $25,000 (Deposits) $45,000 (Notes) $30,000 (Equity) 1 st National Bank of Forest City
The Federal Reserve could issue new currency by purchasing US Debt either in private markets or directly from the Treasury Federal Reserve notes were convertible to gold until 1934 (individuals) 1971 (Central Banks) The Federal Reserve was created in 1913 to essentially take over the money supply role of national banks. Assets Liabilities $50,000 (T-Bills) $60,000 (Notes) Federal Reserve Bank $10,000 (Gold)
Denominations of $500, $1,000, $5,000, and $10,000 were no longer printed after 1946 for fear of German counterfeiting
The Largest denomination ever printed was a $100,000 gold certificate. It was never circulated, but was used for inter-bank transfers
Credit Channels under the National/State Banking System Small State banks who were short of funds would borrow from larger state banks Larger State banks who were short of funds would borrow from National banks National banks who were short of funds would borrow from money center banks Money center banks were the “root source” of credit
Credit Channels under the National/State Banking System
The Federal Reserve
The Federal Reserve System was created in 1913 by Woodrow Wilson.
Regulate the banking industry
“Lender of Last Resort”
Regulate the money supply
Provide banking services for the federal government
Credit Channels under the Federal Reserve System Federal Reserve = Federal Funds Market = Discount Window
The Federal Reserve System Divides the country into 12 Districts numbered 1 - 12 from east to west
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 Alan Greenspan (1992) Roger Ferguson (2001) Edward Gramlich (1997) Ben Bernanke (2003) Susan Bies (2001) Mark Olsen (2001) Donald Kohn (2002) The Chairman is elected from the Board for a renewable 4 year term
Each district has a Federal Reserve Bank with a bank president elected by the bank’s board of directors for 4 year renewable terms Board of Directors Bank President Class A (4) Class B (4) Class C (4) Member Banks Local Business Federal Reserve Board
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 vote Board 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.
Money can be anything that satisfies:
Store of Value
Unit of account
Medium of exchange
Lots of things satisfy these properties
Controlling the Supply of Money
Standard Definitions of Money
Monetary Base (M0): Direct liabilities of the central bank
Currency in circulation + Bank Reserves
Currency in circulation + Traveler's Checks + Checking accounts
M1 + Savings accounts + Money Market Accounts + Small Time Deposits
M2 + Large Time Deposits + Eurodollars
Once 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 MB M3 M2 M1 The Federal Reserve can perfectly control the monetary base (cash + bank reserves)
Money Supply in the US (in Billions) MB M1 M3 M2 Cash
Money Supply in the US
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) Assets Liabilities Assets Liabilities $45,000 (T-Bills) $50,000 (Deposits) $100,000 (Equity) Federal Reserve Acme National Bank $100,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) $ 2,500 (Reserves) Acme currently has 10% of its deposit liabilities on Reserve (Cash + Reserves)/Deposits Reserve Accounts are liabilities of the Fed
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) Assets Liabilities $45,000 (T-Bills) $50,000 (Deposits) $100,000 (Equity) Acme National Bank $100,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) Acme’s reserve ratio drops to 6.25% (5/80) $30,000 (Loan) $30,000 (Deposit) The loan shows up on both sides of the balance sheet
Reserves and cash are components of M0 while the newly created loans are components of M1 or M2 Assets Liabilities $45,000 (T-Bills) $50,000 (Deposits) $100,000 (Equity) Acme National Bank $100,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) $30,000 (Loan) $30,000 (Deposit)
Cash in Circulation
Cash in Circulation
The Reserve Requirement has no impact on the monetary base, but it restricts the ability of banks to create loans – this influences the broader aggregates. 0% Eurocurrencies 0% Time Deposits 10% More than $47.6M 3% $7M - $47.6M 0% $0 - $7M Transaction Account Reserve Requirement Type of Liability
The discount window was the primary policy tool of the federal reserve when it was first established in 1913. Discount window loans are collateralized by the assets of the bank (equal to around 90% of the loan) Assets Liabilities Assets Liabilities $45,000 (T-Bills) $80,000 (Deposits) $50,000 (Equity) Federal Reserve Acme National Bank $130,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) $ 2,500 (Reserves) This bank would like to create $70,000 loan, but doesn’t have the reserves to back it up Res. Req. = 5% A $2,500 loan from the discount window would raise reserves to the required 5% $ 2,500 (Reserves) $ 2,500 (Reserves) $ 2,500 (Loan) $ 2,500 (Disc. Loan)
Fed Funds + .2% (2.7%) Seasonal (Must demonstrate reoccurring seasonal liquidity needs, <$500M in Deposits) Fed Funds + 1.5% (4.0%) Secondary (Additional Financial Information Required) Fed Funds + 1% (3.5%) Primary (No Questions Asked) Interest Rate Type of Credit
By purchasing and/or selling securities, the Fed can directly control the quantity of non-borrowed reserves in the banking sector. Bond Dealer Federal Reserve Dealers Buy/Sell bonds from the Fed The Fed debits/credits the reserve account of the dealer’s bank Most transactions are done with repurchase agreements (Repos). These are purchases/sales along with an agreement to reverse the transaction at a later date
Currently, open market operations are the primary policy tool of the Fed. Trading takes place in NYC Assets Liabilities Assets Liabilities $45,000 (T-Bills) $80,000 (Deposits) $50,000 (Equity) Federal Reserve Acme National Bank $130,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) $ 2,500 (Reserves) Res. Req. = 5% An open market purchase increases the reserves of the banking sector – this raises M0 $ 2,500 (Reserves) - $ 2,500 (T- Bills) $ 2,500 (Reserves) $ 2,500 (T- Bills)
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 MB mm = 1 + Cash Deposits Cash Deposits Reserves Deposits + $ Change in M2 = mm2 * $ Change in MB mm2 = 1 + Cash Deposits Cash Deposits Reserves Deposits + M2-M1 Deposits + The Fed can influence total bank reserves, which affects the multipliers!
Fed Policy from start to finish…. Staff economists at each federal reserve bank brief the president of local/national economic conditions Bank Presidents/Governors present policy recommendations to the FOMC – A vote is taken. The monetary base is to be increased by $100M This order is passed to the trading desk in NYC Trading desk calls bond dealers and asks for bids
Fed Policy from start to finish…. Assets Liabilities Acme National Bank +$100M (Reserves) + $100M (Deposits) The dealers with the winning bids deliver the bonds. Their bank’s reserve accounts are credited 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 market Reserves FF Rate 5% Excess supply of reserves pushes down the Fed Funds Rate Supply
Fed Policy from start to finish…. Fed Funds Market Through the Fed Funds Market, the reserves are distributed throughout the banking sector Each bank uses its new reserves to create additional loans
M1 M1 Rate 6% Supply As banks increase the supplies of the various aggregates, their rates drop as well M2 M2 Rate 7% Supply $ Change in M1 = mm1 * $100M $ Change in M2 = mm2 * $100M 2 8 These newly created loans are used to purchase labor, materials, consumer goods, etc.
Hours Wages Demand Eventually, this newly created demand will influence prices… GDP Prices Demand Higher demand for goods and services drive up their prices (wages and prices) Increases in inflation raise the nominal interest rate Nominal Interest Rate = Real Interest Rate + Expected Inflation
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!