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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 20 Understanding Movements in Bank Reserves.

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Presentation on theme: "Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 20 Understanding Movements in Bank Reserves."— Presentation transcript:

1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 20 Understanding Movements in Bank Reserves

2 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Learning Objectives Analyze the Federal Reserve balance sheet and how changes in its assets and liabilities impact the money supply Explain how the U.S. Treasury Department’s spending decisions impact the money supply Understand the bank reserve equation Define the monetary base

3 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Introduction The balance sheet of the Fed shows the movements of reserves in the system Very complicated since many things can impact the level of reserves –Open Market operations and Discounting –Other entries may offset movements in reserves –The Fed does not control many of these items –US Treasury can add or absorb bank reserves through fiscal spending or tax revenue

4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Introduction (Cont.) Bank Reserve Equation –The expanded view of reserve movements –A summary sheet for sources and uses of reserves –Useful for monitoring trends in reserves— fundamental framework of monetary control.

5 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet Table 20.1 is a simplified balance sheet of the Federal Reserve System in mid-2003 Every item on the balance sheet (asset or liability) has an effect on reserves –Total assets = total liabilities –Fed’s total liabilities include reserves—“bank deposits” in the Fed plus cash in bank vaults –Therefore, bank reserves must equal total Federal Reserve assets minus all other Fed liabilities –Anything affecting a Fed’s asset or liability must alter reserves, unless it is offset somewhere else in the balance sheet

6 Copyright © 2009 Pearson Addison-Wesley. All rights reserved TABLE 20.1 The Federal Reserve’s Balance Sheet (March, 2008, in billions of dollars)

7 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet (Cont.) ASSETS –Gold certificates Gold purchased from abroad or from domestic mines US Treasury purchases gold with a check drawn on its deposit in the Fed To replenish its checking account with Federal Reserve, Treasury issues a “gold certificate” and the Fed credits the Treasury’s deposit account by the same amount Federal Reserve assets have risen, but reserves are not affected (by this transaction) since a liability other than reserves (Treasury deposits) has risen simultaneously However, the net result of both the above transactions is an increase in bank reserves

8 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet (Cont.) ASSETS (Cont.) –Coins—Coins and bills issued by the Treasury that the Fed has in its vaults –Loans—Bank borrowings from the Fed through the discount window –Term Auction Facility (TAF)—Federal Reserve auctions short-term funds to banks who can then deliver a wide variety of assets as collateral –US government and agency securities Securities acquired by the Fed through open market operations Purchase of securities expands reserves Sales of securities by the Fed lowers reserves

9 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet (Cont.) ASSETS (Cont.) –Items in process of collection Arises in process of clearing checks “Deferred credit items” on the liability side. The difference between the two is the “float” Occurs because many checks are not collected within the specified time period Float can fluctuate considerably, either adding to or subtracting from reserves Can cause serious short-term disruptions in bank reserves As the use of electronic payment systems increases, float will diminish in size and importance

10 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet (Cont.) ASSETS (Cont.) –Other Federal Reserve Assets Consists primarily of securities denominated in foreign currencies Purchases and sales of foreign securities usually occur in connection with foreign exchange operations of the Fed

11 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Balance Sheet (Cont.) Liabilities –Federal Reserve Notes Outstanding Liability to the Fed, but an asset to holder of the currency The change in this account does not alter bank reserves—notes outstanding rises, bank deposits at Fed falls Impacted by the decision of the public to hold more currency, which lowers bank reserves. –US Treasury Deposits—Represents the “working balance” of the Treasury reflected in spending and tax revenues

12 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The U.S. Treasury’s Monetary Accounts Purchase of gold –Treasury, not the Fed, that officially buys and sells gold for the government –After purchasing gold by depleting reserves on deposit, the Treasury issues an equal amount of gold certificates –The Fed purchases these gold certificates to replenish the Treasury’s deposit account –When the Treasury buys gold, bank reserves rise and when the Treasury sells gold, bank reserves fall

13 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The U.S. Treasury’s Monetary Accounts (Cont.) Changes in the Treasury’s deposits at the Federal Reserve banks will affect bank reserves Currency issued by the Treasury –The Treasury also issues a small amount of currency, including all coins –There is no difference between currency issued by the Treasury or Fed, all coins and bills in bank vaults count as reserves.

14 Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Bank Reserve Equation Table 20.2 shown in the textbook Record of sources and uses of bank reserves Primary difference between Table 20.1 and 20.2 is the inclusion of Treasury currency in banks vaults which are counted as reserves Consolidation of the Fed’s balance sheet with Treasury’s monetary accounts Bank Reserves = bank deposits with Fed plus currency in bank vaults

15 Copyright © 2009 Pearson Addison-Wesley. All rights reserved TABLE 20.2 The Bank Reserve Equation (March, 2008; in billions of dollars)

16 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Putting it all to Use In Chapter 18 it was assumed that the Fed could control the volume of reserves by judicious use of open market operations However, the reserve equation demonstrates that other influences outside control of the Fed can affect reserves These outside influences need to be forecasted and monitored to assist the Fed in controlling the level of reserves

17 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Putting it all to Use (Cont.) Defensive Measure –Fed engages in open market operations aimed at defending a target level of reserves from “outside” influences. –Offset transitory changes in reserves which are trying to push level of reserves outside the range desired by the Fed –Extensive use of Repurchase Agreements as temporary injections or deletions of reserves

18 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Putting it all to Use (Cont.) Dynamic Measures—Open market operations aimed at either increasing or deceasing the overall level of bank lending capacity by changing the level of bank reserves

19 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Focusing on the Monetary Base What specific variable should the Fed attempt to control to regulate money supply? Control variable (operating target) is the immediate objective of open market operations It is suggested that the Fed should attempt to control the monetary base—total reserves plus currency held by the nonbank public. Reserve equation depicted in Table 20.2 can be altered to focus on the monetary base.

20 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Appendix MONETARY EFFECTS OF TREASURY FINANCING

21 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing Budget Deficit—when government spends more than it receives in taxes Financing the deficit is the responsibility of the Treasury Department Could print money to pay the bills, but this responsibility falls under the Fed Treasury prints and sells bonds and uses proceeds to meet its obligations Debt financing/Treasury spending complicates Fed’s job of controlling money

22 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Taxation –When taxes are paid, demand deposits at commercial banks are transferred from private sector to Treasury’s account –Initially these funds are held in the Treasury’s accounts at commercial banks –Money supply falls since government deposits are not counted in the money supply

23 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Taxation (Cont.) –Total bank reserves fall when Treasury moves funds from commercial banks to the Fed –Money supply and bank reserves increase to original level when the Treasury spends the money

24 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Borrowing from Nonbank Public –Rather than raise taxes, Treasury engages in deficit spending— raising the money by selling bonds to the nonbank public. –Selling bonds reduces the money supply as funds are transferred from the private sector to Treasury accounts –Reserves also fall when the Treasury shifts funds from commercial banks to Fed

25 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Borrowing from Nonbank Public (Cont.) –When the Treasury spends the money, both money supply and reserves revert to their original level –Public winds up with government bonds rather than a receipt saying they have paid their taxes.

26 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Borrowing from Commercial Banking System –Banks, rather than the public, purchases bonds –Two possibilities Banks are fully loaned up –Must dispose of other assets –Reserves and money supply initially decrease, but are restored when Treasury spends the money Banks have excess reserves –No need to dispose of other assets –Increases the money supply when the Treasury spends the money

27 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Borrowing from the Fed –This method of borrowing does not reduce either the money supply or bank reserves when the bonds are sold –The Treasury sells bonds to the Fed which deposits the proceeds from the sale in the Treasury’s account –When the Treasury spends the funds, both demand deposits and the money supply increase

28 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Printing Money –If the Treasury could print money, it could deposit the newly created currency with the Fed –When it spends the money, both bank reserves and the money supply could increase –This method is virtually identical to the case of borrowing from the Fed

29 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Financing the deficit –Deficit must be financed by one of the above options –Fed decides how much will come from new money and how much must come through the sale of bonds to the public

30 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Appendix—Monetary Effects of Treasury Financing (Cont.) Financing the deficit (Cont.) –Monetizing the Debt—Federal Reserve prints new money to purchase the new Treasury bonds Could make the Treasury’s job easier by printing money—very inflationary Congress created the Fed to keep the printing press from the Treasury and force the Treasury to pay interest on its debt. When the Fed monetizes the debt by buying Treasury bonds, it lets the Treasury print money through the back door


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