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The Federal Reserve and Money Supply
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Takes sections for chapters 10, 14, & 15 from
the Mishkin text (9th edition), Federal Reserve
reader, and www.federalreserve.gov
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3 key players
◦ 1. Depositors
◦ 2. Banks
◦ 3. Federal Reserve
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Depositors are the most important providers
of funds and they are the biggest users of
funds
If depositors lose confidence  bank runs
can occur, causing banks to lose their
sources of funds
If depositors have confidence  banks have
an increase amount of funds
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Banks are the keepers of depositors funds
As before  our deposits are their biggest
liabilities, but their greatest assets
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Balance Sheet is the most important
document to understand the banking system
It is made up of two broad categories
◦ Liabilities (Sources of Funds)
◦ Assets (Uses of Funds)
 Listed from most liquid to least liquid
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Liabilities are simply the sources of funds
◦ Checkable deposits
 Payable on demand
 Considered to be an asset for depositor (us)
 Lowest cost of sources for banks  we want easy
access to liquidity
 Only 6% of total liabilities (per the Fed)
◦ Nontransaction deposits
 CDs
 Owners cannot write checks against such accounts
 Primary source of bank funds (53% of bank liabilities)
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Liabilities Cont.
◦ Discount Loans / Fed Fund (31% of liabilities)
 Discount loans are loans from the Federal Reserve (also known as
advances)
 Typically 1%-pt above the fed funds rate
 Banks typically do not want to borrow from the Fed unless absolutely
necessary!
 Fed Funds loan (overnight loans)
 Federal funds are overnight borrowings by banks to maintain
their bank reserves at the Federal Reserve
 Transactions in the federal funds market allow banks with excess
reserve balances to lend reserves to banks with deficient reserves
 These loans are usually made for one day only (‘overnight’).
◦ Bank Capital (10% of liabilities)
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Typically referred to as the uses of funds
The interest payments earned on them are
what enable banks to make profits.
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Reserve Requirements
◦ These are deposits plus currency that is physically
held by banks.
◦ Reserves are made up by required reserves and
excess reserves
 Required Reserves: For every dollar of checkable deposits
at a bank (a fraction must be kept as reserves)
 Excess Reserves: The most liquid of all bank assets and
the bank can use them to make other loans to banks
(through the fed funds market) or other loans.
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Cash Items in Collection Process
◦ Checks in process of being cleared from another bank
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Correspondent banking
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Securities
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Loans
◦ Common in small banks
◦ Small banks hold deposits in larger banks in exchange
for a variety of services, including check collection,
foreign exchange transactions and securities
purchases.
◦ Most banks are not allowed to hold stock
◦ Tend to hold state and local bonds because then local
government would do business with them
◦ Loans are least liquid
◦ The lack of liquidity and relatively high default risk
offers banks the highest source of profits.
Assets
Liabilities
Required
Reserves
25,000
Deposits
100,000
Excess Reserves
75,000
Bank Capital
15,000
Securities
15,000
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Most important notion is that ASSETS must equal LIABILITIES
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When a bank receives additional deposits, it gains an equal amount of reserves
◦ When it loses deposits, it loses an equal amount of reserves
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If there is a $100,000.00 deposit, with a required reserve of 25%, show what will happen:
•Note that the 75,000 can be loaned out to other banks or consumers
•Note that bank cannot lend out more than it’s excess reserve amount
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Central bank of the US
◦ Considered to be the most important bank in the world
◦ Controls the so-called monetary base (broadest definition
of money  Currency in circulation + reserves in banks
All national banks are required to be
members/participants of the Fed.
◦ Local banks are not.
Independent of govt and private sector
◦ Board of Governors have 14 year terms
◦ Fed does not cater to pressure from banks (say to lower
interest rates or push for deregulation)
◦ Extremely profitable (avg earnings of $40 bil a year!)
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The Federal Reserve Bank of the United States
(FED)
◦ Controls the money supply for the US through the use
of monetary policy
 Federal Open Market Operations (FOMOs)  the buying
and selling for T-Bonds to banks, investors, public, etc…
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The Fed has one main goal: Price Stability
◦ Low/stable inflation  Inflation creates
fear/uncertainty in the economy, which affects
economic growth
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1. Low Unemployment
◦ Resources are maximized, misery index is low, consumer
spending (in the US at least) is relatively high and stable
◦ 3 Types of unemployment
 A. Frictional  workers trying to find job that meets their skill
set
 B. Structural  workers are mismatched with skill set
 C. Cyclical  students working during the holiday season
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2. Economic Growth
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3. Stability in the Financial Market (Liquidity!!!)
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4. Interest Rate Stability
Federal Reserve System
Assets
Liabilities
Government securities Currency in
circulation
Discount loans
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Reserves
Monetary Liabilities
◦ Important  Assets must equal liabilities
◦ Currency in circulation: in the hands of the
public
◦ Reserves: bank deposits at the Fed and vault
cash
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Assets
◦ Government securities: holdings by the Fed that
affect money supply and earn interest
 Positive relationship between govt securities and money
supply
◦ Discount loans: provide reserves to banks and
earn the discount rate
 Positive relationship between discount loans and money
supply.
 These are considered to be liabilities for a member bank!
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2 ways that the Fed changes the monetary
base in the economy
◦ 1. Open Market Purchases
 Fed buys bonds
 Increases money in the economy (interest rates fall)
◦ 2. Open Market Sales
 Fed sells bonds
 Decreases money in the economy (interest rates rise)
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The effect of an open market purchase on the
monetary base is always the same whether the
seller of the bonds.
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An Open Market Purchase takes in securities
and gives out cash
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The liquidity effect of an OMP is directly
correlated with the reserve ratio
◦ Higher reserve ratio  lower liquidity
◦ Lower reserve ratio  higher liquidity
Banking System
Assets
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Liabilities
Securities
-$100
Reserves
+$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Reserves
Net result is that reserves have increased by
$100
No change in currency
Monetary base has risen by $100
+$100
Banking System
Assets
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Liabilities
Securities
+$100
Reserves
-$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Reserves
Net result is that reserves have decreased by
$100
No change in currency
Monetary base has decreased by $100
An Open Market Sale takes in cash and gives
out securities
+$100
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1. OMOs occur at the Fed’s whim (no
political influence)
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2. OMOs are flexible and precise
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3. OMOs are easily reserved
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4. OMOs can be implemented quickly
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While the Fed is key on providing liquidity, it
must find a delicate balance in replenishing
its reserve base.
◦ Currently, the Fed uses the reserve requirement to
satisfy this goal.
◦ If the reserve requirement is constantly changing,
banks and the population will become worried.