R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 14 The Federal Reserve’s Balance Sheet and the Money Supply Process LEARNING OBJECTIVES After studying this chapter, you should be able to: 14.1 Explain the relationship between the Fed’s balance sheet and the monetary base 14.2 Derive the equation for the simple deposit multiplier and understand what it means 14.3 Explain how the behavior of banks and the nonbank public affect the money multiplier 14A Appendix: Describe the money supply process for M2 © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 14 The Federal Reserve’s Balance Sheet and the Money Supply Process GEORGE SOROS, “GOLD BUG” •While some individual investors, known as “gold bugs,” have always wanted to hold gold, the surge in demand for gold during 2009 and 2010 surprised many economists John Paulson, Thomas Kaplan, and George Soros are some of the famous hedge fund managers with a preference for gold •For many, holding gold is a way to hedge the risk of inflation created by a rapid increase in the money supply •An Inside Look at Policy on page 434 discusses the Federal Reserve’s “exit strategy” from the increases in reserves and the money supply that resulted from its policies during the financial crisis of 2007–2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During and immediately following the financial crisis, bank reserves increased rapidly in the United States Question: Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should the increase be a concern to policymakers? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 14.1Learning Objective Explain the relationship between the Fed’s balance sheet and the monetary base © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 Figure 14.1 The Money Supply Process Three actors determine the money supply: the central bank (the Fed), the nonbank public, and the banking system.• Our model of how the money supply is determined includes three actors: The Federal Reserve, which is responsible for controlling the money supply and regulating the banking system The banking system, which creates the checking accounts that are the most important component of the M1 measure of the money supply The nonbank public, which refers to all households and firms The nonbank public decides the form in which they wish to hold money—for instance, as currency or as checking account balances The Federal Reserve’s Balance Sheet and the Monetary Base © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 The process starts with the monetary base, which is also called high-powered money Monetary base (or high-powered money) The sum of bank reserves and currency in circulation Monetary base = Currency in circulation + Reserves The money multiplier links the monetary base to the money supply As long as the value of the money multiplier is stable, the Fed can control the money supply by controlling the monetary base There is a close connection between the monetary base and the Fed’s balance sheet, which lists the Fed’s assets and liabilities The Federal Reserve’s Balance Sheet and the Monetary Base © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 Table 14.1 The Federal Reserve’s Balance Sheet The Federal Reserve’s Balance Sheet and the Monetary Base © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 The Monetary Base Currency in circulation Paper money and coins held by the nonbank public Vault cash Currency held by banks Currency in circulation = Currency outstanding – Vault cash Bank reserves Bank deposits with the Fed plus vault cash Reserves = Bank deposits with the Fed + Vault cash • Reserve deposits are assets for banks, but they are liabilities for the Fed because banks can request that the Fed repay the deposits on demand with Federal Reserve Notes The Federal Reserve’s Balance Sheet and the Monetary Base © 2012 Pearson Education, Inc Publishing as Prentice Hall of 46 Reserves = Required reserves + Excess reserves Required reserves Reserves that the Fed compels banks to hold Excess reserves Reserves that banks hold over and above those the Fed requires them to hold Reserves = Required reserves + Excess reserves Required reserve ratio The percentage of checkable deposits that the Fed specifies that banks must hold as reserves The Federal Reserve’s Balance Sheet and the Monetary Base © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 46 Solved Problem 14.3 Using the Expression for the Money Multiplier Consider the following information: Bank reserves = $500 billion Currency = $400 billion a If banks are holding $80 billion in required reserves, and the required reserve ratio = 0.10, what is the value of checkable deposits? b Given this information, what is the value of the money supply (M1)? What is the value of the monetary base? What is the value of the money multiplier? Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 33 of 46 Solved Problem 14.3 Using the Expression for the Money Multiplier Solving the Problem Step Review the chapter material Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 34 of 46 Solved Problem 14.3 Using the Expression for the Money Multiplier Solving the Problem Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 35 of 46 Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 46 The Money Supply, the Money Multiplier, and the Monetary Base During the 2007–2009 Financial Crisis Figure 14.2 Movements in the Monetary Base, M1, and the Money Multiplier, 1990–2010 Panel (a) shows that beginning in the fall of 2008, the size of the monetary base soared M1 also increased, but not nearly as much As panel (b) shows, the value of the money multiplier declined sharply during the same period.• Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 46 Why did the monetary base increase so much more than M1? Figure 14.3 helps to solve the mystery Figure 14.3 Movements in (C/D) and (ER/D) The currency-to-deposit ratio (C/D) had been gradually trending upward since 1990, but it fell during the financial crisis of 2007–2009 At the same time, the excess reserves-to–deposits ratio (ER/D) soared, increasing from almost zero in September 2008—because banks were holding very few excess reserves—to about 1.3 in the fall of 2009 Banks began to hold more excess reserves than they had checkable deposits.• Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 46 Making the Connection Did the Fed’s Worry over Excess Reserves Cause the Recession of 1937–1938? Following the end of the bank panics in early 1933, excess reserves in the banking system soared Many banks had suffered heavy losses and had a strong desire to remain liquid Nominal interest rates had also fallen to very low levels, which reduced the opportunity cost of holding reserves at the Fed By late 1935, unemployment remained high and inflation low Nevertheless, the Fed’s Board of Governors worried about a rapid increase in stock prices and some feared an increase in the inflation rate The Board of Governors decided to reduce excess reserves by raising the required reserve ratio But the Fed’s policy ignored the reasons banks during this period were holding excess reserves As bank loans contracted, so did the money supply The economy fell into recession again in 1937 Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 46 Making the Connection Did the Fed’s Worry over Excess Reserves Cause the Recession of 1937–1938? The Fed reversed course in April 1938 by cutting the required reserve ratio But the damage had been done Most economists believe that the Fed’s actions in raising the required reserve ratio contributed significantly to the recession Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 46 In 2010, banks’ enormous holdings of excess reserves left investors, policymakers, and economists concerned about the implications for future inflation If banks were to suddenly begin lending the nearly $1 trillion in excess reserves they held in November 2010, the result would be an explosion in the money supply and, potentially, a rapid increase in inflation Fear of this potential for a much higher rate of inflation in the future drove some investors in 2010 to buy gold Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 46 Making the Connection Worried About Inflation? How Good Is Gold? In 2010, many investors bought gold because they were worried about the possibility that increases in reserves and the money supply might lead to much higher rates of inflation in the future But how good an investment is gold? Gold clearly has some drawbacks as an investment: Gold pays no interest or dividend; it has to be stored and safeguarded Because gold pays no interest, it is difficult to determine its fundamental value as an investment Gold’s value as an investment depends on how likely its price is to increase in the future because its rate of return is entirely in the form of capital gains Many individual investors believe that gold is a good hedge against inflation because the price of gold can be relied on to rise if the general price level rises But is this view correct? The record of the past 30 years was not encouraging Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 46 Making the Connection Worried About Inflation? How Good Is Gold? The real price of gold, calculated by dividing the nominal price of gold by the consumer price index, shows that even after the strong nominal price increases of 2009 and 2010, the real price of gold was still 30% below its September 1980 level In other words, in the long run, gold has proven a poor hedge against inflation Banks, the Nonbank Public, and the Money Multiplier © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 46 Answering the Key Question At the beginning of this chapter, we asked the question: “Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should the increase be a concern to policymakers?” As we have seen in this chapter, the rapid increase in bank reserves that began in the fall of 2008 was a result of the Fed purchasing assets Whenever the Fed purchases an asset, the monetary base increases Both components of the base increased in 2008, but the increase in reserves was particularly large Banks were content to hold large balances of excess reserves because the Fed was paying interest on them and because of the increased risk in alternative uses of the funds Inflation remained very low through mid-2010, but some policymakers were concerned that, ultimately, if banks began to lend out their holdings of excess reserves, a future increase in the inflation rate was possible © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 46 AN INSIDE LOOK AT POLICY Fed’s Balance Sheet Needs Balancing Act WASHINGTON POST, Federal Reserve Hopes Clear Exit Strategy Will Boost Market Confidence Key Points in the Article • After two years of taking aggressive steps to stimulate a weak economy, the Federal Reserve had to decide how to phase out its initiatives in order to reduce the risk of inflation • Reducing the growth of the money supply and raising interest rates threatened to slow an economy that suffered from high unemployment • Analysts believe that changing the interest rate on reserves will become a more important tool to control the growth of the money supply • The Fed had to decide what to with its holdings of $1 trillion of mortgagebacked securities Selling the securities would pull money out of the economy at the risk of driving up interest rates • The key to chairman Ben Bernanke’s strategy is to win the confidence of market participants in the Fed’s ability to drain cash from the financial system © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 46 AN INSIDE LOOK AT POLICY The table below documents the rapid increase in the Fed’s holdings of federal agency debt and mortgage-backed securities between July 2008 and July 2010 The increase in its debt holdings was over $1.5 trillion over this two-year period © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 46 APPENDIX The Money Supply Process for M2 14A Describe the money supply process for M2 M2 is a broader monetary aggregate than M1, including not only currency, C, and checkable deposits, D, but also nontransaction accounts These nontransaction accounts consist of savings and small-time deposits, which we will call N, and money market deposit accounts and similar accounts, MM So we can represent M2 as: M2 = C + D + N + MM We can express M2 as the product of an M2 multiplier and the monetary base: M2 = (M2 multiplier) x Monetary base © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 46 ... controlling the money supply and regulating the banking system The banking system, which creates the checking accounts that are the most important component of the M1 measure of the money supply The. .. sheet and the monetary base 14. 2 Derive the equation for the simple deposit multiplier and understand what it means 14. 3 Explain how the behavior of banks and the nonbank public affect the money. .. Reserves The money multiplier links the monetary base to the money supply As long as the value of the money multiplier is stable, the Fed can control the money supply by controlling the monetary