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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.
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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.
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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.
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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.
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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.
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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
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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
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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.
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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.
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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?