Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
18 CHAPTER Changes in the Monetary Base “The devil lies in the details,” commented a frenzied trader at the government securities trading desk of the Federal Reserve Bank of New York. She was trying to implement the Fed’s instructions for changing the monetary base. The trader and her colleagues had just finished a week of hectic buying and selling of securities on the Fed’s behalf. None of the transactions was carried out to implement a planned change in the monetary base by the Fed. Instead, each of the trades was designed to offset some disturbance to the monetary base beyond the Fed’s direct control. Each disturbance created the need for offsetting transactions by the Fed’s traders—a vast amount of detailed work for them. What caused the problems for this trader? In Chapter 17, we described the Fed’s ability to manage the size of the monetary base primarily by buying and selling Treasury securities in open market transactions. In the real world, however, the situation facing the Fed is not quite so simple. The monetary base fluctuates, particularly over short horizons, for many reasons. For the Fed to control the size of the monetary base and the money supply, it must offset these changes. This task can be daunting, as is illustrated by the problems facing the traders at the Fed’s securities trading desk. In this chapter, we describe reasons why the monetary base fluctuates. We also examine the connection between the government budget deficit and changes in the monetary base, an important policy topic in the United States and other countries. Balance Sheet of the Federal Reserve System We opened our discussion of the monetary base in Chapter 17 by looking at the Fed’s balance sheet. To build our model of the money supply process, we focused on two assets—government securities and discount loans—and two liabilities—currency in circulation and reserves—to simplify our analysis. Although changes in the Fed’s securities holdings and discount loans are the major sources of variation in the monetary base, there are other sources of variation as well. To identify these sources, we start once again with the Fed’s balance sheet, but this time we include all of the assets and liabilities of the Fed. Table 18.1 shows the Fed’s balance sheet for April 30, 2003. As you read the description of each item, note its relative size to the other assets and liabilities listed. The Fed’s Assets The Fed’s largest asset is its holdings of securities, which it acquires in open market operations. In addition, in its role as a banker’s bank, the Fed holds discount loans (claims on banks that have borrowed funds from it) and other assets, including cash items in the process of collection, other Federal Reserve assets, gold and special drawing right certificate accounts, and Treasury currency outstanding. 417 418 TA B L E 1 8 . 1 PART 5 The Money Supply Process and Monetary Policy The Federal Reserve’s Balance Sheet ($ billions) Assets Liabilities Securities (U.S. Treasury, government agency, and bankers’ acceptances) 684.8 Currency outstanding Discount loans Foreign and other deposits 0.6 Deferred availability credit items 8.1 Other Federal Reserve liabilities and capital accounts 40.8 Deposits by depository institutions 31.9 0.04 Items in the process of collection Other Federal Reserve assets Gold and SDR certificate accounts 8.2 40.0 U.S. Treasury deposits 655.2 10.6 13.2 Coin 1.0 $747.2 $747.2 Source: Data are for April 30, 2003, and are taken from Federal Reserve Bulletin, July 2003, p. A10. Securities. Most of the Fed’s portfolio of securities consists of U.S. Treasury securities, with smaller amounts of U.S. government agency securities and bankers’ acceptances. The Fed controls the amount of securities it holds through open market operations. An open market purchase increases the Fed’s holdings of securities; an open market sale decreases the Fed’s holdings of securities. The Fed makes discount loans to banks, generally to assist them in overcoming short-term liquidity problems. Although the Fed doesn’t completely control the amount of discount loans, it influences the amount by setting the discount rate, the interest rate that it charges on discount loans to banks. Discount loans. These assets are holdings from the Fed’s check-clearing role in the payments system. They include funds that the Fed has not yet collected from banks against which checks have been drawn. If a bank presents a check to the Fed for clearing, several days may elapse before the bank receives its funds. The funds that are on deposit with the Fed prior to the check’s being cleared are an asset and are recorded as an item in the process of collection. Items in the process of collection. These assets include the Fed’s foreign-exchange reserves—deposits and bonds denominated in foreign currencies—as well as buildings, equipment, and other physical goods owned by the Fed. Other Federal Reserve assets. Gold used to be the official medium of exchange in international financial transactions. Currently, special drawing rights (SDRs), issued by the International Monetary Fund (IMF), are exchanged by parties that are engaged in international financial transactions. When the U.S. Treasury acquires SDRs or gold in its international transactions, it issues SDR or gold certificates (claims on the SDRs or gold) to the Fed. The Fed then credits the Treasury with deposit balances. Hence the gold and SDR accounts consist of gold and SDR certificates issued to the Fed by the Treasury. Gold and SDR certificate accounts. This small item in the Fed’s balance sheet includes U.S. Treasury currency held by the Fed. It is mostly in the form of coins. Coin. CHAPTER 18 Changes in the Monetary Base 419 The Fed’s Liabilities The Fed’s principal liability is currency outstanding. Other Fed liabilities include U.S. Treasury deposits, foreign and other deposits, deferred availability cash items, other Federal Reserve liabilities and capital accounts, and deposits by depository institutions. Currency issued by the Fed in the form of Federal Reserve Notes is a liability for the Fed. Currency outstanding. The Treasury typically deposits receipts from taxes, fees, and sales of securities in accounts in commercial banks. When the Treasury needs the funds to pay for expenditures, it transfers the funds to its accounts at the Fed.✝ U.S. Treasury deposits. Foreign and other deposits. These deposits include those made at the Fed by international agencies (such as the United Nations), foreign central banks and governments, and U.S. government agencies (such as the FDIC). Deferred availability cash items. These liabilities arise from the Fed’s role in the check-clearing process. When a bank presents a check to the Fed to be cleared, the Fed promises to credit the bank within a certain period of time (never more than two days). Analogous to cash items in the process of collection on the assets side of the Fed’s balance sheet, these promises to pay are liabilities of the Fed. This catch-all account includes liabilities that are not contained in other categories of the balance sheet. It also includes shares of stock in the Federal Reserve System purchased by the Fed’s member banks. Other Federal Reserve liabilities and capital accounts. These deposits at the Fed are assets to banks and liabilities for the Fed. They are part of bank reserves, which also include vault cash held in banks. Deposits by depository institutions. Determining the Monetary Base In this section, we extend our simple expression for the monetary base, B C R, to include the effect of all assets and liabilities contained on the Fed’s balance sheet. Our objective is to develop a complete equation for the monetary base that allows us to see how all components of the monetary base determine its size. We start by using the components of the Fed’s balance sheet to refine our interpretation of C and R. Currency in circulation, C, is the total of Federal Reserve Notes and Treasury currency not held at the Fed (Treasury currency outstanding minus Coin) less banks’ vault cash.✝✝ Reserves, R, consist of deposits at the Fed by depositing institutions and Federal Reserve Notes held as vault cash. Hence ✝ We don’t consider Treasury deposits with the Fed to be part of the monetary base because they aren’t assets of either the nonbank public or banks, which, along with the Fed, are the principal participants in the money supply process. ✝ ✝ Federal Reserve Notes constitute about 90% of the nation’s currency. The balance consists principally of coins issued by the U.S. Treasury, but some $300 million in U.S. Treasury Notes, called “greenbacks,” dating back to Civil War issues, are still outstanding. 420 PART 5 The Money Supply Process and Monetary Policy BCR Federal Reserve Notes Reserve deposits by depository institutions Treasury currency outstanding Coin. (18.1) The terms on the right-hand side of Eq. (18.1) represent uses of the monetary base— that is, how the base is allocated among Federal Reserve currency held by the nonbank public and banks, bank reserves held at the Fed, and Treasury currency outstanding. Equation (18.1) doesn’t reveal all the potential sources of change in monetary base. To identify them, we return to the Fed’s balance sheet. Both Federal Reserve Notes and deposits by depository institutions are Fed liabilities. Because assets must equal liabilities, we use information from the balance sheet to equate the sum of Federal Reserve Notes and deposits by depository institutions with the other entries. Specifically, the sum of Federal Reserve Notes and deposits by depository institutions equals the total of all Fed assets minus the total of the other liabilities:✝ Federal Reserve Notes Reserve deposits by depository institutions Securities Discount loans Cash items in the process of collection Other Federal Reserve assets Gold and SDR certificates Coin − U.S. Treasury deposits − Foreign and other deposits − Deferred availability cash items − Other Federal Reserve liabilities and capital accounts. (18.2) We can simplify Eq. (18.2) by taking the difference between the two items that relate to check clearing (cash items in the process of collection and deferred availability cash items) and calling it Federal Reserve float.✝✝ Simplifying in this way and substituting the elements on the right-hand side of Eq. (18.2) for the sum of currency in circulation and deposits by depository institutions in Eq. (18.1) yield the complete expression for the monetary base, B: B Securities Discount loans Federal Reserve float Other Federal Reserve assets Gold and SDR certificates Treasury currency outstanding − U.S. Treasury deposits − Foreign and other deposits − Other Federal Reserve liabilities and capital accounts. (18.3) Changes in the Monetary Base Equation (18.3) contains the nine sources of change in the monetary base. Increases in the six items added on the right-hand side of Eq. (18.3) increase the monetary base, and decreases in those items decrease the monetary base. Increases in the three items subtracted on the right-hand side of Eq. (18.3) decrease the monetary base, and decreases ✝ Not all bank deposits at the Fed are included in reserves because some are service-related deposits. Technically, these deposits must be subtracted from the right-hand side of Eq. (18.2) to define the monetary base precisely. ✝✝ When the Fed reports its balance sheet in the Federal Reserve Bulletin, the total of Federal Reserve float, securities, and bank borrowing is called “Federal Reserve credit.” CHAPTER 18 Changes in the Monetary Base 421 in those items increase the monetary base. Increases and decreases in each of the factors in the equation cause the monetary base to fluctuate. It was the variation in these sources that caused the problems faced by the trader described at the opening of the chapter. It is relatively easy to juggle two balls and keep them in the air; but as you add more and more objects, juggling becomes more difficult. Because there are nine items that can fluctuate, the problem of maintaining the monetary base can be daunting for the traders at the Fed’s securities desk. In this section, we describe the effect on the monetary base caused by each component of Eq. (18.3). We summarize the effects of an increase in each component in Table 18.2. Determinants That Increase the Monetary Base In Chapter 17, we traced the effects of the Fed’s open market operations and discount loans on the monetary base. An increase in the Fed’s holdings of securities acquired through open market purchases or an increase in the volume of discount loans increases the monetary base dollar for dollar. Securities and discount loans. Web Site Suggestions: http://www.federal reserve.gov/releases/ h41/ Provides weekly data on factors affecting reserves. TA B L E 1 8 . 2 Federal Reserve float. Federal Reserve float occurs during the check-clearing process when the Fed doesn’t credit a bank with payment at the same time that it debits the bank on which the check is drawn. Suppose that Bigco receives a check for $1 million from Engulf, drawn on Engulf’s bank, Megabank in New York. Bigco deposits the $1 million check in Onebank in Chicago. The clearing process works as follows: Onebank sends the check to the Federal Reserve Bank of Chicago, which sends it to the Federal Reserve Bank of New York, which presents it to Megabank. The Fed promises to credit the payee bank (Onebank) within two business days, even if the Fed takes longer to present the check to the payor bank (Megabank). The difference in timing between the crediting of Onebank and debiting of Megabank causes float. Let’s see how the float resulting from this transaction affects the Fed’s balance sheet. When the Federal Reserve Bank of Chicago gets the check, its assets rise by $1 million Sources of Change in the Monetary Base An increase in . . . Causes the monetary base to . . . Because . . . securities rise reserves rise. discount loans rise reserves rise. Federal Reserve float rise cash items in the process of collection rise relative to deferred availability cash items, increasing reserves. other Federal Reserve assets rise an increase is like an open market purchase, increasing reserves. Treasury currency outstanding rise bank vault cash or currency in circulation rises, increasing reserves. gold and SDR certificate accounts rise an increase is like an open market purchase, increasing reserves. U.S. Treasury deposits at the Fed fall reserves and/or currency in circulation falls. foreign and other deposits at the Fed fall reserves fall. other Federal Reserve liabilities and capital accounts fall contributions to capital accounts reduce reserves. 422 USING PART 5 THE The Money Supply Process and Monetary Policy NEWS ... Federal Reserve Data and Change in the Monetary Base Federal Reserve Data MEMBER BANK RESERVE CHANGES Changes in weekly averages of reserves and related items during the week and year ended August 13, 2003 were as follows (in millions of dollars) Chg fm wk end Aug. 31 Aug. 6 Aug.14 Reserve bank credit: 2003 2003 2002 U.S. Gov t securities: Bought outright ......................... 653,072 +76 + 52,845 Held under repurch agreemt .... .... .... .... Federal agency issues: Bought outright ......................... 10 .... .... Each week (on Friday or Monday), The Wall Street Journal publishes Federal Reserve data on bank reserve changes. The Member Bank Reserve Changes data provide information on sources of change in the monetary base. For example, for the week ending August 13, 2003, the predominant source of change in the monetary base came from the Fed’s purchases of U.S. government securities ($653.0 billion). Other sources are also listed, including discount loans (primary credit, secondary credit, and seasonal credit), which totaled $140 million. Note that the Fed’s holdings of securities increased from the previous year (increasing the monetary base) but that discount loans fell (decreasing the monetary base). The predominant use of the monetary base was currency in circulation, at about $695 billion on this date. Borrowings from Fed: Primary credit ..................... Secondary credit ................ Seasonal credit .................. Float ......................................... Other Federal Reserve Assets... Total Reserve Bank Credit ........ Gold Stock ................................ SDR certificates ........................ Treasury currency outstanding ............................ Total ......................................... Currency in circulation .............. Treasury cash holdings ............ Treasury dpts with F.R. Bnks ... Foreign dpts with F.R. Bnks ..... Other dpts with F.R. Bnks ........ Service related balances, adj ... Other F.R. liabilities & capital ................................ Total........................................... 7 — 14 +7 .... .... .... 138 +5 — 43 596 + 124 — 1,310 40,334 +478 —95 711,825 — 4,153 + 58,365 11,043 .... +1 2,200 .... .... 35,116 +14 +1,020 760,184 — 4,139 +59,386 694,937 +675 +34,044 369 +4 —12 5,611 — 28 +715 149 —28 + 73 287 —7 +86 11,158 —129 —1,003 20,190 752,264 +340 +1,443 +718 +56,191 RESERVE AGGREGATES (daily average in millions) 2 WEEKS ENDED: Aug. 6 Jul. 23 Total Reserves (sa)........................... 44,431 43,524 Nonborrowed Reserves (sa) ............. 44,291 43,407 Required Reserves (sa) .................... 42,310 41,932 Excess Reserves (nsa) ..................... 2,121 1,591 Borrowings from Fed (nsa)-a ............ 140 117 Free Reserves (nsa) ......................... 1,981 1,474 Monetary Base (sa) ........................... 705,460 702,548 a-Excluding extended credit. nsa-Not seasonally adjusted. sa-Seasonally adjusted. The Reserve Aggregates data present information on various measures of reserves and the monetary base. For instance, the average value of the monetary base was about $705.5 billion for the week ending on August 13, 2003. Source: The Wall Street Journal, August 15, 2003. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc., © 2003 Dow Jones & Co., Inc. All Rights Reserved Worldwide. with an entry under cash items in the process of collection. The Fed’s liabilities also rise by $1 million because there is an offsetting deferred availability cash items entry: FEDERAL RESERVE Assets Cash items in the process of collection Liabilities $1 million Deferred availability cash items $1 million After two days, the Fed credits Onebank with $1 million, even if the check has not yet cleared. At this stage of the transaction, Onebank has gained $1 million of reserves, even though Megabank hasn’t yet lost reserves. Total reserves in the banking system, then, have increased by $1 million: CHAPTER 18 Changes in the Monetary Base 423 FEDERAL RESERVE Assets Cash items in the process of collection Liabilities $1 million Deferred availability cash items (Onebank) $1 million Deposits by Onebank $1 million Deferred availability cash items (Onebank) $1 million When the check finally is presented to and accepted by Megabank, its account balance with the Fed is reduced by $1 million: FEDERAL RESERVE Assets Cash items in the process of collection Liabilities Reserves 0 Deposits by Onebank $1 million Deposits by Megabank $1 million After this transaction, the banking system’s reserves return to the level that existed before the Bigco and Engulf transaction. In reality, checks continually flow through the Fed’s clearing system, so the amount of cash items in the process of collection exceeds the amount of deferred availability cash items. This Federal Reserve float is a source of increases in the monetary base. It fluctuates daily and is beyond the Fed’s direct control. Over long periods of time, however, float is not a significant source of change in the monetary base. An increase in Federal Reserve float causes a dollar-for-dollar increase in the monetary base. Gold and SDR certificate accounts. The acquisition of gold or SDRs by the Fed expands the monetary base just as an open market purchase of securities does. An increase in the Fed’s gold or SDR certificate accounts leads to a dollar-for-dollar increase in the monetary base. An increase in the Fed’s holdings of other assets—say, a deposit or bond denominated in a foreign currency—works like an open market purchase of securities, increasing reserves and the monetary base. Hence intervention by the Fed in the foreign-exchange market affects the other Federal Reserve assets balance. An increase in other Federal Reserve assets raises the monetary base dollar for dollar. Other Federal Reserve assets. Treasury currency outstanding is not an item on the Fed’s balance sheet, but it does affect the monetary base. When the amount of Treasury currency held in bank vaults (where it becomes part of vault cash and reserves) or by the nonbank public (where it becomes currency in circulation) increases, the monetary base rises. An increase in Treasury currency outstanding leads to a dollar-for-dollar increase in the monetary base.✝ Treasury currency outstanding. ✝ In practice, increases in Treasury currency are generally met with offsetting changes in other entries on the Fed’s balance sheet. For example, if the Treasury mints more coins and sends them to the Fed, the Fed credits the Treasury’s deposits. The monetary base is unaffected because coin (a Fed asset) and Treasury deposits (a Fed liability) rise by the same amount. 424 PART 5 The Money Supply Process and Monetary Policy Determinants That Decrease the Monetary Base Increases in any of the remaining three sources of change in the monetary base in Table 18.2 reduce the monetary base. U.S. Treasury deposits at the Fed. Whenever the federal government makes a payment—for highway construction, the salary of a staff economist, or a retiree’s Social Security benefits—the Treasury writes a check drawn on its account at the Fed. This Treasury account at the Fed is known as the General Account. Suppose that the government buys $1000 worth of small tools from Toolco, which deposits the $1000 check in its bank, Megabank. Megabank then sends the check to the Fed, which increases Megabank’s balance and reduces the Treasury’s General Account balance. As a result of the purchase from Toolco, Megabank’s reserves—and the banking system’s reserves—rise by $1000, the amount of the payment: FEDERAL RESERVE Assets Liabilities Deposits Megabank $1000 U.S. Treasury $1000 Bank reserves and the monetary base rise whenever the federal government makes a payment. Likewise, bank reserves and the monetary base fall whenever the federal government receives a payment. The flow of payments out of and into the General Account is extremely large. The U.S. government spends more than $1.8 trillion each year, or about $7 billion each business day. Because government receipts and expenditures differ significantly over short periods of time, the Treasury’s balance would fluctuate significantly if it deposited all its receipts with the Fed. To reduce the impact of its transactions on the monetary base, the Treasury first deposits most of its receipts (income tax withheld from a worker’s paycheck, for example) into Treasury tax and loan accounts in banks. The Treasury keeps these accounts at most local banks. When the Treasury moves funds from its tax and loan accounts to the General Account, it times these transfers to match its payments from the General Account. In this way, the Treasury reduces the effects of its receipts and payments on bank reserves. An increase in U.S. Treasury deposits with the Fed reduces reserves and the monetary base dollar for dollar. Before 1978, Treasury tax and loan accounts were an interest-free source of funds for banks. Since then, banks have had to pay interest on these deposits after one day at an interest rate equal to 0.25% below the average federal funds rate for the week. The Fed acts as the U.S. banker for foreign central banks and international agencies. Increases or decreases in the amount of these deposits affect bank reserves and the monetary base in a manner similar to the effect of fluctuations in the Treasury’s General Account. However, these fluctuations are much smaller than those of Treasury deposits. An increase in foreign and other deposits at the Fed reduces reserves and the monetary base dollar for dollar. Foreign and other deposits at the Fed. Other liabilities and capital accounts. If a bank joins the Federal Reserve System and purchases the required amount of stock in the Fed, the Fed’s capital accounts CHAPTER 18 Changes in the Monetary Base 425 increase. The bank’s deposits with the Fed fall by the same amount. As a result, bank reserves and the monetary base fall. An increase in other liabilities and capital leads to a dollar-for-dollar reduction in the monetary base. Concluding Remarks The most important source of change in the monetary base is the Federal Reserve System’s holdings of securities, which it controls through open market operations. Some determinants that are not under the Fed’s control (such as U.S. Treasury deposits with the Fed and Federal Reserve float) can lead to significant fluctuations in the monetary base over a day or a week. However, these fluctuations are usually predictable, so Fed traders can reverse them with open market operations. Although some components of the monetary base fluctuate over short periods of time, those fluctuations do not significantly reduce the Fed’s ability to control the monetary base. C H E C K P O I N T What is the effect of each of the following events on the monetary base? (a) The Treasury withdraws $9 billion from its tax and loan account and deposits the funds in the General Account. (b) The Fed buys $1 billion of gold. (c) The Fed sells $100 million worth of bonds denominated in deutsche marks. Answers: (a) The increase in Treasury deposits with the Fed decreases the monetary base by $9 billion. (b) The Fed’s gold purchase, like an open market purchase, raises the monetary base by $1 billion. (c) The sale reduces other Federal Reserve assets and the monetary base by $100 million. ♦ The Federal Budget Deficit and the Monetary Base The federal budget deficit was a major topic of political debate and controversy in the 1980s and 1990s. Some businesspeople and policymakers complained about the large deficits of the 1980s and early 1990s—the excesses of government spending over tax revenue—because they were afraid that it would increase the monetary base and, ultimately, the money supply. (The United States reported budget surpluses at the end of the 1990s, which turned out to be short-lived.) Behind this concern was the fear that persistent increases in the money supply would lead to inflation. (We explore the relationship between the money supply and inflation in Part 6.) Is there a connection between the federal budget deficit and change in the monetary base? To answer this question, we begin with some simple government budget accounting. The government can finance a deficit by raising taxes, borrowing money (selling bonds), or creating money to finance part of its spending for goods and services and payments to individuals. In the United States, the President and Congress determine federal government expenditures and tax rates, and they define the types of income and expenditures that 426 PART 5 The Money Supply Process and Monetary Policy are subject to taxation. A budget deficit results when government expenditures exceed tax revenue. To finance this deficit, the Treasury sells securities and uses the proceeds to pay the costs of government. This type of transaction (except possibly for short-term lags between receipts and expenditures) doesn’t alter the monetary base. In terms of budget arithmetic, Government expenditures Tax revenue Federal budget deficit Sales of securites by the Treasury. (18.4) The President and Congress set spending and tax policies, but the Fed’s actions most directly affect the monetary base. When the Treasury issues securities, the monetary base changes only to the extent that the Fed buys those securities. Because the Fed, banks, and the nonbank public purchase Treasury securities in the market, Sales of securities by the Treasury Change in Treasury securities held by banks and the nonbank public Fed purchases of Treasury securities. (18.5) Recall that a purchase of securities by the Fed leads to an equivalent increase in reserves and expansion of the monetary base. Hence combining Eqs. (18.4) and (18.5) yields Federal budget deficit Change in Treasury securities held by banks and the nonbank public Fed purchases of Treasury securities Change in Treasury securities held by banks and the nonbank public increase in monetary base. (18.6) Equation (18.6) shows the relationship among federal spending and tax decisions, sales of securities by the Treasury, and changes in the monetary base. Economists call it the government budget constraint because it shows the trade-offs facing the government when it runs a deficit. Thus a federal budget deficit must be financed by a combination of an increase in Treasury securities held by banks and the nonbank public and an increase in the monetary base. The media sometimes refer to the latter strategy as “printing money.” Although some countries allow their Treasury departments to determine the volume of currency, the United States does not. Here, currency must be issued by the Federal Reserve System. In fact, the Fed is not literally printing money but is purchasing Treasury securities in the market for its own account. When the Fed purchases Treasury securities to finance budget deficits, we say that it is monetizing the debt. Alternative Strategies We can use T-accounts to illustrate the effects on the monetary base of alternative strategies to finance government spending. Suppose that the President and Congress agree to embark on a new $2 billion program to repair interstate highways. This program could be paid for by raising taxes, selling bonds to the public, and selling bonds to the Fed. Suppose that the President and Congress agree to raise the tax on gasoline to obtain the $2 billion. The nonbank public then collectively writes checks to the Treasury totaling $2 billion, which are first deposited in the Treasury’s tax and loan Raising taxes. CHAPTER 18 OTHER TIMES, Changes in the Monetary Base OTHER PLACES 427 ... the war, the Fed agreed to buy quantities of securities sufficient to maintain that interest rate. Immediately after the war, no problem emerged Government budget deficits increase because the federal government had the monetary base only when the Fed budget surpluses in 1947–1949. The purchases Treasury bonds issued to Fed didn’t have to continue purchasfinance the deficit. The Fed is inde- ing Treasury securities on the open pendent of the Treasury Department, market to maintain the agreed-upon and at times there have been conflicts yield. In fact, the Fed sold Treasury between the Fed and the Treasury securities to maintain the interest rate over the extent to which the Fed at the pegged level. should finance the federal budget The advent of the Korean War in 1950 deficit. significantly increased government One noteworthy conflict raged after spending and borrowing. To keep its World War II. In 1942, the Fed had promise, the Fed bought large quantiagreed to peg the interest rate on ties of Treasury securities, expanding short-term Treasury securities at the monetary base and fueling infla3/8% per year. In other words, to tion. Fed officials publicly questioned assist the Treasury’s efforts to finance the wisdom of effectively placing con- Dealing with the Debt: The Treasury–Federal Reserve Accord trol of changes in the monetary base in the hands of the Treasury. On March 3, 1951, the Treasury and the Fed reached a compromise: the Treasury–Federal Reserve Accord. The Fed stopped buying bonds and increasing the monetary base to keep yields on Treasury securities low. (The Treasury’s delegate was William McChesney Martin, who later became Chairman of the Board of Governors of the Federal Reserve System.) President Truman nonetheless encouraged the Fed to buy bonds if interest rates rose sufficiently. It wasn’t until President Eisenhower took office that the Fed finally ceased intervening to maintain the interest rate at or below a specified level. accounts and then redeposited in the Treasury’s General Account at the Fed. In the process, deposits in the banking system fall by $2 billion, reducing reserves by the same amount. The Treasury’s deposits at the Fed rise by $2 billion. In the end, the T-accounts for the nonbank public, the Treasury, the banking system, and the Federal Reserve System show the following entries: NONBANK PUBLIC Assets Liabilities $2 billion Deposits $2 billion Taxes due TREASURY Assets Liabilities $2 billion $2 billion Deposits at the Fed Taxes due BANKING SYSTEM Assets Liabilities $2 billion Reserves $2 billion Deposits FEDERAL RESERVE Assets Liabilities Reserves U.S. Treasury deposits $2 billion $2 billion 428 PART 5 The Money Supply Process and Monetary Policy When the Treasury pays contractors the $2 billion by check for the highway projects, the funds flow back into the banking system and have no net effect on reserves and monetary base:✝ BANKING SYSTEM Assets Liabilities 0 Reserves 0 Deposits FEDERAL RESERVE Assets Liabilities Reserves U.S. Treasury deposits 0 0 Thus, in general, financing government spending by raising taxes doesn’t affect the monetary base. Selling bonds to the public. Suppose that to finance highway repair, the Treasury sells $2 billion of bonds to the nonbank public, which pays by check. In this case, the Treasury’s deposits increase by $2 billion, while the nonbank public loses $2 billion of deposits: NONBANK PUBLIC Assets Liabilities $2 billion $2 billion Deposits Securities TREASURY Assets Liabilities $2 billion Deposits $2 billion Securities BANKING SYSTEM Assets Liabilities $2 billion Reserves $2 billion Deposits FEDERAL RESERVE Assets Liabilities Reserves U.S. Treasury deposits $2 billion $2 billion When the Treasury pays the highway contractors by check, the funds flow back into the banking system and have no effect on reserves and the monetary base: BANKING SYSTEM Assets Reserves ✝ If Liabilities 0 Deposits 0 the transactions took place in currency (which is not very likely), the monetary base would also be unaffected. CHAPTER 18 Changes in the Monetary Base 429 FEDERAL RESERVE Assets Liabilities Reserves U.S. Treasury deposits 0 0 As we noted earlier, financing government spending by selling bonds to the nonbank public doesn’t affect the monetary base. Selling bonds to the Fed. Although the U.S. Treasury cannot directly finance government spending by creating money, selling bonds to the Fed has the same effect. Two steps are involved. First, as in the preceding case of bond financing, the Treasury sells $2 billion of bonds to the nonbank public to finance the highway repairs; as was noted, this transaction doesn’t change the monetary base. In the second step, however, the Fed buys the $2 billion of bonds from the nonbank public. This open market purchase increases the monetary base by the same amount. Financing government spending by selling bonds that the Fed ultimately acquires leads to an increase in the monetary base. The Government Budget Constraint and the Monetary Base Although useful for connecting the elements of government finance, the government budget constraint can be misinterpreted. In the United States, no one participant makes all of the government’s budget and financing decisions: Authority is divided among the President, Congress, and the Federal Reserve. The Fed’s decisions regarding changes in the monetary base reflect its own monetary policy objectives; the influence of federal budget deficits on those decisions is indirect (though the Fed monitors the effect of interest rates on the economy). The Fed has not monetized the large federal deficits of the 1980s and early 1990s to any great extent. Even during the 1980s, the monetary base increased by less than $15 billion per year, while the federal budget deficit averaged about $155 billion per year. Hence, even in the presence of these large budget deficits, the Fed monetized less than 10% of the annual deficit. There is no direct relationship between government deficits and the monetary base. The monetary base rises when the government runs a deficit only when the Fed acquires government bonds that are used to finance the deficit. Over long periods of time, changes in the money supply primarily reflect changes in the monetary base rather than changes in the money multiplier. The Treasury doesn’t control the Fed and therefore can’t force the central bank to monetize government deficits. In other countries, the degree of central bank independence varies. Our analysis of the government budget constraint might lead you to suspect that the less independent the central bank is, the more likely it is to monetize government budget deficits and increase the money supply. In a study of monetary policy in 17 countries during the 1970s and 1980s, Alberto Alesina of Harvard University analyzed the independence of central banks.✝ The measure that he used incorporated information on the formal relationships between the central bank and the government, including the presence of government officials on the bank’s board and the existence of rules forcing ✝ Alberto Alesina, “Politics and Business Cycles in Industrial Democracies,” Economic Policy, No. 8, April 1989. 430 PART 5 The Money Supply Process and Monetary Policy the central bank to monetize portions of budget deficits. Countries in which the central bank had the least independence (such as Italy) experienced the most rapid growth of the money supply. Countries with relatively independent central banks (such as the United States and Japan) had slower rates of growth of the money supply. The Maastricht Treaty gave the European Central Bank independence to pursue its goal of price stability. KEY TERMS AND CONCEPTS Federal Reserve float Monetizing the debt General Account Treasury tax and loan accounts Government budget constraint SUMMARY 1. Changes in the monetary base can be explained by fluctuations in nine determinants. Increases in the Fed’s holdings of securities, discount loans, Federal Reserve float, other Federal Reserve assets, Treasury currency outstanding, and gold and SDR accounts lead to an equal increase in the monetary base. Increases in U.S. Treasury deposits with the Fed, foreign and other deposits with the Fed, and other Federal Reserve liabilities and capital accounts lead to an equal decrease in the monetary base. 2. The most important determinant of change in the monetary base is the Federal Reserve’s holdings of securities. The Fed controls the amount of its holdings through open market operations. Some determi- QUIZ nants that are not under the Fed’s control (such as U.S. Treasury deposits with the Fed and Federal Reserve float) can lead to significant fluctuations in the monetary base over a day or a week. However, these fluctuations are predictable and can be reversed by open market operations. 3. A given government budget deficit can be financed by selling government securities to banks and the nonbank public or to the Fed. Financing a deficit by selling bonds to banks and the nonbank public doesn’t affect the monetary base. Financing a deficit by selling bonds to the Fed leads to an equivalent expansion of the monetary base. REVIEW QUESTIONS 1. What are the sources and uses of the monetary base? 2. What is the government budget constraint? Does it imply that budget deficits increase the monetary base? Explain. 3. State whether each of the following is an asset or a liability of the Fed: j. Gold and SDR certificate accounts 4. Explain whether an increase in each of the following items from the Fed’s balance sheet will cause the monetary base to increase or decrease: a. U.S. Treasury deposits b. Federal Reserve float a. Holdings of securities c. Discount loans b. U.S. Treasury deposits d. Foreign and other deposits c. Cash items in the process of collection d. Deposits by depository institutions e. Coins f. Deferred availability cash items g. Foreign deposits h. Federal Reserve Notes outstanding i. Discount loans 5. What is the Fed’s biggest asset? What is its biggest liability? 6. Define “Federal Reserve float.” Do increases in float cause the monetary base to rise or fall? 7. Why does the relationship between a government’s budget deficits and the inflation rate depend on how independent the central bank is from the government? CHAPTER 18 Changes in the Monetary Base 8. What is the Treasury’s General Account? Does the Treasury keep all its money there? 9. Why did the beginning of the Korean War increase the desire of Fed officials to be relieved of the commitment to peg the interest rate on Treasury securities? 431 10. Evaluate: The Fed controls all determinants of change in the monetary base, and therefore the Fed controls the monetary base. ANALYTICAL PROBLEMS QUIZ 11. Suppose that the following changes take place in the Fed’s balance sheet: Securities – $1 billion Discount loans + $250 million SDR certificates + $500 million Cash items in the process of collection b. A financial crisis erupts, and the Fed makes $2.5 billion of discount loans to the distressed Bigbank. c. The World Bank deposits $10 million in its account at the Fed. d. An electricity blackout knocks out banks’ computers in New York for two days. + $2 billion Deferred availability cash items + $1 billion General Account – $2 billion e. The Treasury decides to buy $1 billion of earthmoving equipment for use in a new public highway construction program and puts the funds in the General Account. Deposits by depository institutions + $1 billion f. The Fed buys $1 billion of U.S. Treasury securities. What are the changes in Federal Reserve float? In the monetary base? 12. Suppose that the federal government’s annual budget deficit is $250 billion and that the Fed’s holdings of government securities increase by $10 billion over the year. How much of the deficit was monetized? 13. Suppose that an erroneous report that Congress has abolished the FDIC is widely believed and banks start to experience withdrawals of deposits. What will be the impact on the monetary base? What actions might the Fed take to help banks deal with the withdrawals? What would the impact of those actions be on the monetary base? Would the Fed be likely to take action to offset this impact? 14. Suppose that the Treasury decides to move its principal checking account from the Fed to the Chase Bank. Discuss the implications for the stability of the monetary base over time. 15. Suppose that the President and Congress sign a budget agreement that eliminates the federal budget deficit. Does this agreement mean that the monetary base will grow by less than it would otherwise? Explain. 16. Explain the effect on the monetary base of each of the following: a. $25 billion is withheld from payrolls as withholding taxes and paid to the U.S. Treasury through tax and loan accounts. g. The regional Federal Reserve banks decide to put expensive new marble shells around their buildings. 17. For cash items in the process of collection, the Fed’s balance sheet shows $10 billion, while deferred availability cash items are $8 billion. What is the size of the Federal Reserve float? Why do you think the Fed tries to keep the float as small as possible? 18. Suppose the Fed buys $150 million of Japanese yen with Federal Reserve Notes. What is the net effect on the monetary base? How has the Fed’s balance sheet been affected? 19. Suppose the Fed buys $100 million of British pounds with Federal Reserve Notes and, at the same time, sells $100 million of U.S. government securities for cash in a domestic open market operation. What is the net effect on the monetary base? How has the Fed’s balance sheet been affected? 20. Suppose the Sacagawea dollar coin suddenly becomes popular, and people stop using as many dollar bills as they once did. What happens to the monetary base? 21. Economic theory tells us that (under reasonable assumptions) a rise in the government budget deficit raises interest rates. Show how the debt is monetized if the Fed tries to maintain stable interest rates when the government budget deficit rises. 432 PART 5 MOVING The Money Supply Process and Monetary Policy FROM THEORY TO PRACTICE THE FINANCIAL TIMES ... FEBRUARY 25, 2003 Fukui and the Monetary Base Inflation targeting as a likely remedy for Japan’s economic problems disappeared off the radar screen yesterday with the nomination of Toshihiko Fukui as next head of the Bank of Japan. However, less drastic measures to adjust monetary policy appear imminent. The government’s inability to manage the market’s expectations meant the nomination was greeted with widespread disappointment and suspicion, but experts reacted by concluding the policy implications were not necessarily as negative. Paul Sheard, chief economist at Lehman Brothers, said it was unlikely there would be a “regime shift” towards inflation targeting, but added: “Monetary policy a will evolve over time in a more reflationary direction.” He added: “There will [also] be improvement in the ‘three Cs’—the content of policy, its communication with the market and co-ordination with government.” Clues regarding Mr. Fukui’s own policy preferences can be derived from an interview granted to a Japanese newspaper in the run-up to the nomination. “Current deflation is a very deep-rooted economic illness that is much more than simply a monetary phenomenon,” he said. Chris Walker, economist at Credit Suisse First Boston, remarked: “[In this] he parts company with most central bankers and virtually all economists.” Mr. Fukui also said he believed “demand only develops when the economy is regenerated through deregulation and opening of markets” and that “it is wrong to think that the current deflation can be stemmed through monetary easing alone” and that “structural reforms are more important than ever before.”. . . More immediately, there was agreement among commentators that the BoJ would increase its selfb imposed monthly cap on bond purchases of ¥1,200bn ($10.2bn, €9.5bn, £6.4bn) and instead purchase up to ¥2,000bn a month. The ministry has made this request in previous meetings of the BoJ’s policy board and Mr. Gittler said it was likely Mr. Muto [new Deputy Governor]— an ex-ministry man— would be arguing it be adopted at the first board meeting. . . . “[This is] conceptualised as monetary policy support to offset deflationary fallout from accelerated structural reform and as a correction of market failure,” Mr. Sheard said. Although the outlook as envisaged by international commentators was mildly reflationary, one well-placed official said the close links between the BoJ and the ministry as a result of Mr. Fukui’s appointment were troubling. “I believe this means more emphasis will be placed on fiscal policy and debt management rather c than monetary policy. The BoJ will be used to contain increases in long-term interest rates,” he said. Mr. Gittler concluded: “The likely outcome will be that the BoJ will gradually increase its purchases of JGBs, allowing the forces of resistance to increase public works and allowing the MoF to issue more JGBs without blowing up the market.” CHAPTER 18 ANALYZING THE Changes in the Monetary Base NEWS The government budget constraint tells us that a budget deficit can be financed by a combination of selling bonds to banks and the nonbank public and money creation (increases in the monetary base). Persistent rapid growth in the money supply leads to inflation. (We examine this process in Part 6.) If the money multiplier is stable over the long run, persistent growth in the money supply can be traced to persistent growth in the monetary base from central bank decisions. 433 ... a A recommendation that the Bank debt sales would have a smaller effect of Japan substantially increase its purchases of Japanese government debt is tantamount to a recommendation that the central bank promote faster growth of the monetary base, leading eventually to faster growth of the money supply and the price level. Japan had experienced “deflation”—a falling general price level—for many years, and many economists attributed part of Japan’s sluggish economic growth to deflation. The proposed policy change for the Bank of Japan, if implemented, Japan has exhibited a very low money could arrest deflation. multiplier in recent years, as rapid Using Eqn. (18.5), we can see growth in the monetary base has not b that the increase in the Bank of translated into rapid growth in monetary aggregates. In the early 2000s, Japan’s purchases of Japanese govmany economists in the United States ernment bonds from ¥1.2 trillion per and Japan urged the Bank of Japan to month to ¥2.0 trillion per month monetize some Japanese government decreases the quantity of debt the debt. When a new Bank of Japan Gov- Japanese government must sell to the ernor was appointed in February public. The Bank believed that in so 2003, the issue came to the forefront. doing, the higher volume of public on bond interest rates in the near term than would be the case if the Bank’s policy had not changed. The likely modest effect in interest rates would be expansionary. Would you expect future budget deficits to increase inflation? This result seems likely because economic reform remained shaky in Japan in the early 2000s. Many analysts were concerned that, because of political pressure, governments might delay spending reductions. c For further thought . . . Why might reducing budget deficits help a country stabilize its exchange rate with the U.S. dollar? Explain. Source: From David Ibison, “Nomination of BoJ Chief ‘Offers Room for Flexibility,’” Financial Times, February 25, 2003. Reprinted by permission. 434 PART 5 The Money Supply Process and Monetary Policy 22. Suppose the government of a country substantially increases its spending. What are the main ways in which this additional funding might be financed? What factors will determine which way is chosen? DATA QUESTIONS 23. Obtain a copy of the latest Economic Report of the President from your library. Find the U.S. budget deficit for 2002, and the change in the monetary base in 2002. Do you think the Fed is actively monetizing federal budget deficits? Why or why not? 24. Look at the assets and liabilities of the Fed over the past six months as listed in the latest Federal Reserve Bulletin. Which items seem to fluctuate greatly from month to month? Which items are fairly stable? Which seem to grow at a constant rate? 25. Given the Federal Reserve’s concern about deflation in during the first half of 2003, how would you expect it to attempt to change the monetary base during this time? Locate the monetary base statistics found under the heading of “Aggregate Reserves of Depository Institutions and the Monetary Base” at its Releases and Historical Data web site (http://www.federalreserve.gov/releases/). How did the monetary base change during the time period that corresponds to the economic boom of the late 1990s? Explain both movements in the monetary base in light of Fed policies that applied to each. Do you think that the Fed was actively monetizing federal budget deficits? Would such a policy help or hinder its fight against deflation? Why or why not?