Chapter 11TheCentralBankBalanceSheetandtheMoneySupplyProcessChapterOverviewIn this chapter we develop an understanding of how the central bank interacts with thefinancial system and how its balance sheet is connected to the money and credit thatflows through the economy.ImportantPointsoftheChapterOne of the great successes of modern central banking is the story of the U.S. FederalReserve on September 11.Because of its quick action, the Fed kept the financialmarketsafloat,andthefinancial systemreturnedtonearnormal withinweeks.Thisis a marked contrast to what happened in the 1930's, and the difference is that in the30's Fed officials failed to provide the liquidity that sound banks needed to stay inbusiness..In200l,thestatementthat camefromtheFed was:TheFederalReserve is open and operating.The discount window is available to meet liquidityneeds."Application of Core PrinciplesPrinciple #3:Information (page 431)The balance sheet published by the centralbankisprobablythemostimportantinformationthatitmakespublicPrinciple #5:Stability (page 439)In the aftermath of September 11, Fed officialssaw a looming crisis and reacted with a massive injection ofreserves to maintain theliquidity of the financial system.The actions enabled the system to withstand theenormous shock.Principle#2:Risk (page 448)The amount of excess reserves a bank holdsdepends on the costs and benefits of holding them.The cost is the interest foregone;the benefit is the safety in the event that deposits are withdrawn
Chapter 11 The Central Bank Balance Sheet and the Money Supply Process Chapter Overview In this chapter we develop an understanding of how the central bank interacts with the financial system and how its balance sheet is connected to the money and credit that flows through the economy. Important Points of the Chapter One of the great successes of modern central banking is the story of the U.S. Federal Reserve on September 11. Because of its quick action, the Fed kept the financial markets afloat, and the financial system returned to near normal within weeks. This is a marked contrast to what happened in the 1930’s, and the difference is that in the 30’s Fed officials failed to provide the liquidity that sound banks needed to stay in business. In 2001, the statement that came from the Fed was: “The Federal Reserve is open and operating. The discount window is available to meet liquidity needs.” Application of Core Principles Principle #3: Information (page 431) The balance sheet published by the central bank is probably the most important information that it makes public. Principle #5: Stability (page 439) In the aftermath of September 11, Fed officials saw a looming crisis and reacted with a massive injection of reserves to maintain the liquidity of the financial system. The actions enabled the system to withstand the enormous shock. Principle #2: Risk (page 448) The amount of excess reserves a bank holds depends on the costs and benefits of holding them. The cost is the interest foregone; the benefit is the safety in the event that deposits are withdrawn
Principle #5:Stability (page 452) Central bankers need to look at both themonetarybase and themoneymultiplierto figure out whether their policies areworking.As the example from the 1930s illustrates, looking only at the base canlead to the wrong policy at the wrong time, creating more instability.TeachingTips/Student StumblingBlocksStudents will likely have difficulty understanding the impact of differenttransactions on the central bank's balance sheet.Emphasize the rulefrom page433:When the value of an asset on the balance sheet increases, either the valueof another asset decreases (so the net change is zero) or the value of a liabilityrisesbythesameamount (andsimilarlyforanincreaseinliabilities)Featuresinthis ChapterYour Financial World:Why We Still Have Cash (page431)Despite the technological changes that have brought us credit cards and electronicmoney, there is still a tremendous amount of cash in use.The reasons for this areconvenience, tax avoidance, and the anonymity that cash provides.Applying the Concept:The Fed's Response on September 11, 2001 (page 439)In the aftermath of September 11, Fed officials saw a looming crisis and reactedimmediately,providing reserves to anyone who needed them.Reserves increased byan astonishing $145 billion over a two-day period.This massive injection ofreserves was quickly drained out over the next week,as thesystem got back tonormal.Your Financial World: Your Excess Reserves (page 447)Just as banks hold excess reserves, individuals need to have an emergency fund to payforunexpectedexpensesthatcan'tbepostponed.Mostfinancialplannersrecommend that thesefunds should equal a minimum ofthree months'income in cashaccounts.Tools of the Trade:The Irrelevance of Reserve Requirements (page 449)Deposit sweeping allows banks to temporarily move funds from checking accounts(which have reserve requirements) into savings accounts (which do not).Sweeping
Principle #5: Stability (page 452) Central bankers need to look at both the monetary base and the money multiplier to figure out whether their policies are working. As the example from the 1930s illustrates, looking only at the base can lead to the wrong policy at the wrong time, creating more instability. Teaching Tips/Student Stumbling Blocks Students will likely have difficulty understanding the impact of different transactions on the central bank’s balance sheet. Emphasize the rule from page 433: When the value of an asset on the balance sheet increases, either the value of another asset decreases (so the net change is zero) or the value of a liability rises by the same amount (and similarly for an increase in liabilities). Features in this Chapter Your Financial World: Why We Still Have Cash (page 431) Despite the technological changes that have brought us credit cards and electronic money, there is still a tremendous amount of cash in use. The reasons for this are convenience, tax avoidance, and the anonymity that cash provides. Applying the Concept: The Fed’s Response on September 11, 2001 (page 439) In the aftermath of September 11, Fed officials saw a looming crisis and reacted immediately, providing reserves to anyone who needed them. Reserves increased by an astonishing $145 billion over a two-day period. This massive injection of reserves was quickly drained out over the next week, as the system got back to normal. Your Financial World: Your Excess Reserves (page 447) Just as banks hold excess reserves, individuals need to have an emergency fund to pay for unexpected expenses that can’t be postponed. Most financial planners recommend that these funds should equal a minimum of three months’ income in cash accounts. Tools of the Trade: The Irrelevance of Reserve Requirements (page 449) Deposit sweeping allows banks to temporarily move funds from checking accounts (which have reserve requirements) into savings accounts (which do not). Sweeping
funds over a weekend dramatically reduces the reserves a bank must hold becauseFriday countsfromthreedays incomputingreserves.Atthe sametime,though,cash is being loaded into ATMs anticipating use over the weekend, and that counts asvault cash.The bottom line is that reserve requirements no longer have much of animpact on banks'behavior.Applying the Concept:MonetaryPolicy in the 1930s (page452)One of the important lessons of the Great Depression of the 1930s is that centralbankers need to look at both the monetary base and the money multiplier to figure outwhether their policies are workingIn the News:Record Federal Deficit Forecast; Drastic Increase over White House'sEarlier Estimates for This Year (page 454)A federal government budget deficit results in more borrowing which would suck upcapital and cause consumer and business interest rates to rise."This, in turn, wouldslow spending and lower economic growth.Lessons of the Article: By increasing the supply of bonds, increasedgovernment borrowing drives down the price of bonds, raising interest rates.Federal Reserve Board Chairman Greenspan is concerned about this trend fortworeasons.Thefirst isthat itmakesthejob of stabilizing interestratesmoredifficult, and the second is that it puts pressure on the Fed to purchase the bondsissuedbythegovernment.Whenthecentral bankpurchasesgovernment-issued bonds, its action increases the monetary base and expandsthe quantityof money in the economy,which can eventuallylead to inflationAdditional Teaching ToolsIs the money multiplier a myth?Read this article by Frank Shostak, which arguesthat,banks makeloansfirst and worry about reserves later."http://www.mises.org/fullarticle.asp?control=1118&id=69Some countries, including Canada, Australia, and Sweden have no reserverequirements.Download this PDF file of an article that looks at three countries thatconduct monetary policy without reserve requirements (Canada, the UK, and NewZealand)http://ideas.repec.org/a/fip/fedker/y1997iqip5-30n82(2).htmlVirtualTools
funds over a weekend dramatically reduces the reserves a bank must hold because Friday counts from three days in computing reserves. At the same time, though, cash is being loaded into ATMs anticipating use over the weekend, and that counts as vault cash. The bottom line is that reserve requirements no longer have much of an impact on banks’ behavior. Applying the Concept: Monetary Policy in the 1930s (page 452) One of the important lessons of the Great Depression of the 1930s is that central bankers need to look at both the monetary base and the money multiplier to figure out whether their policies are working. In the News: Record Federal Deficit Forecast; Drastic Increase over White House’s Earlier Estimates for This Year (page 454) A federal government budget deficit results in more borrowing which would “suck up capital and cause consumer and business interest rates to rise.” This, in turn, would slow spending and lower economic growth. Lessons of the Article: By increasing the supply of bonds, increased government borrowing drives down the price of bonds, raising interest rates. Federal Reserve Board Chairman Greenspan is concerned about this trend for two reasons. The first is that it makes the job of stabilizing interest rates more difficult, and the second is that it puts pressure on the Fed to purchase the bonds issued by the government. When the central bank purchases government-issued bonds, its action increases the monetary base and expands the quantity of money in the economy, which can eventually lead to inflation. Additional Teaching Tools Is the money multiplier a myth? Read this article by Frank Shostak, which argues that, “banks make loans first and worry about reserves later.” http://www.mises.org/fullarticle.asp?control=1118&id=69 Some countries, including Canada, Australia, and Sweden have no reserve requirements. Download this PDF file of an article that looks at three countries that conduct monetary policy without reserve requirements (Canada, the UK, and New Zealand). http://ideas.repec.org/a/fip/fedker/y1997iqiip5-30n82(2).html Virtual Tools
Learn more about reserve requirements on this site from the New York FederalReserve Bank:http:/www.newyorkfed.org/aboutthefed/fedpoint/fed45.htmlLearn more about open market operations on this site from the New York FederalReserve Bank:http:/www.newyorkfed.org/aboutthefed/fedpoint/fed32.htmlFor the latest data on the Ml money multiplier, visit this site from the St. LouisFederal Reserve Bank:http://research.stlouisfed.org/fred2/series/MULT/24What happens to all that borrowing by the federal government?Deficits accumulateinto the national debt.Find out how much the debt is “to the penny"at this Treasuryweb site:http:/www.publicdebt.treas.gov/opd/opdpenny.htmForMoreDiscussionHow much cash do we really use?Have students keep a journal for a week trackinghowmuch cashthey spend and wheretheyobtain it, i.e.,how often do theyuseATMs?Howhas the increaseduseofelectronic moneyaffected themultiplier?If theUnitedStatesmovesclosertoacashlesssociety,howwill thataffecttheFed initsconductofmonetary policy?ChapterOutlineTheCentralBank'sBalanceSheet1.The central bank engages in numerous financial transactions, all of whichcause changes in its balance sheet.2.Central banks publish their balance sheets regularly, the Fed and the ECBdo so weekly.Publication is a crucial part of transparency
Learn more about reserve requirements on this site from the New York Federal Reserve Bank: http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html Learn more about open market operations on this site from the New York Federal Reserve Bank: http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html For the latest data on the M1 money multiplier, visit this site from the St. Louis Federal Reserve Bank: http://research.stlouisfed.org/fred2/series/MULT/24 What happens to all that borrowing by the federal government? Deficits accumulate into the national debt. Find out how much the debt is “to the penny” at this Treasury web site: http://www.publicdebt.treas.gov/opd/opdpenny.htm For More Discussion How much cash do we really use? Have students keep a journal for a week tracking how much cash they spend and where they obtain it; i.e., how often do they use ATMs? How has the increased use of electronic money affected the multiplier? If the United States moves closer to a cashless society, how will that affect the Fed in its conduct of monetary policy? Chapter Outline The Central Bank’s Balance Sheet 1. The central bank engages in numerous financial transactions, all of which cause changes in its balance sheet. 2. Central banks publish their balance sheets regularly; the Fed and the ECB do so weekly. Publication is a crucial part of transparency
AssetsThe central bank's balance sheet shows three basic assets:securities, foreignexchange reserves, and loans.Securities: the primary assets of most central banks; independent central banksdetermine the quantity of securities that they purchase.For the U.S.Federal Reserve, these are primarily U.S. Treasury securities.Foreign ExchangeReserves:the central bank'sand government'sbalances offoreign currency and areheld asbonds issued byforeigngovernmentsThesereservesareused inforeignexchangemarket interventionsLoans are extended to commercial banks, and can fall into two categories:discountloansandfloatDiscount loans: the loans the Fed makes when commercial banks needshort-termcashFloat: a byproduct of the Fed's check-clearing business.The Fed creditsthe reserve account of the bank receiving the check before it debits theaccount of thebank on which the check was drawn and this createsfloat.Through its holdings of U.S. Treasury securities the Fed controls the federalfunds rateand theavailability of money and credit.Gold reserves, while still an asset of many central banks, are virtuallyirrelevant.B. LiabilitiesThere are threemajor liabilities:currency,the government's deposit account,andthedepositaccountsofthecommercialbanksThe first two items represent the central bank in its role as the government'sbank,and thethird shows itasthe bankers'bankCurrency:nearly all central banks have a monopoly on the issuance ofcurrency, and currency accounts for over 90 percent of the Fed's liabilities.Government's account:the central bank provides the government with anaccount into which it deposits funds (primarily tax revenues) and fromwhich it writes checks and makes electronic payments.Reserves:Commercial bank reserves consist of cash in the bank's own vaultand deposits at the Fed, which function like the commercial bank'schecking accountCentralbanksruntheirmonetarypolicyoperationsthroughchangesinbankingsystemreservesC.The Importance of Disclosure1.The balance sheet published by the central bank is probably the mostimportant information that it makes public; it is an essential aspect ofcentralbanktransparency
Assets The central bank’s balance sheet shows three basic assets: securities, foreign exchange reserves, and loans. Securities: the primary assets of most central banks; independent central banks determine the quantity of securities that they purchase. For the U.S. Federal Reserve, these are primarily U.S. Treasury securities. Foreign Exchange Reserves: the central bank’s and government’s balances of foreign currency and are held as bonds issued by foreign governments. These reserves are used in foreign exchange market interventions. Loans are extended to commercial banks, and can fall into two categories: discount loans and float. Discount loans: the loans the Fed makes when commercial banks need short-term cash. Float: a byproduct of the Fed’s check-clearing business. The Fed credits the reserve account of the bank receiving the check before it debits the account of the bank on which the check was drawn and this creates float. Through its holdings of U.S. Treasury securities the Fed controls the federal funds rate and the availability of money and credit. Gold reserves, while still an asset of many central banks, are virtually irrelevant. B. Liabilities There are three major liabilities: currency, the government’s deposit account, and the deposit accounts of the commercial banks. The first two items represent the central bank in its role as the government’s bank, and the third shows it as the bankers’ bank. Currency: nearly all central banks have a monopoly on the issuance of currency, and currency accounts for over 90 percent of the Fed’s liabilities. Government’s account: the central bank provides the government with an account into which it deposits funds (primarily tax revenues) and from which it writes checks and makes electronic payments. Reserves: Commercial bank reserves consist of cash in the bank’s own vault and deposits at the Fed, which function like the commercial bank’s checking account. Central banks run their monetary policy operations through changes in banking system reserves. C. The Importance of Disclosure 1. The balance sheet published by the central bank is probably the most important information that it makes public; it is an essential aspect of central bank transparency