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Central Banks and Money Supply

Professor Lamont Black FIN320 Week 8

The Structure of the Federal Reserve System

•  First Bank of the United States – Disbanded in 1811

•  Second Bank of the United States – Charter renewal vetoed by A. Jackson in 1832

•  NaMonwide bank panics (especially 1907)

•  Federal Reserve Act of 1913 (Centennial!)

•  A balance of federal and regional power

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Structure of the Federal Reserve System

•  Board of Governors (in DC) –  Public –  Fourteen year term (4 year chair) –  Sets regulatory policy

•  12 Federal Reserve Banks –  Part-private (owned by private member banks in the district) –  Boards of directors (including bankers)

•  Federal Open Market CommiXee (FOMC) –  Sets monetary policy

Chicago Fed

•  About the Chicago Fed: A Short Film

•  The Federal Reserve does three things: – Monetary policy – Financial regulaMon and supervision – Payments system (financial services for banks)

•  3 basements below – $10 Billion in the vault below the Chicago Fed

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FOMC

•  FOMC consists of 7 governors, NY Fed president, four rotaMng bank presidents (from other 11)

•  NY Fed always votes (trading desk) •  Meets 8 Mmes a year (every 6 weeks)

•  Open market opera,ons (OMOs) –  the purchase and sale of government securiMes (Treasuries) that affect both interest rates and the amount of reserves in the banking system

How the Fed Operates

•  Handling external pressure •  Conflict between Fed and Treasury •  Seeking the public interest? •  Fed independence – Pros and cons – “Audit the Fed” and “End the Fed”

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Other Central Banks

•  Bank of England •  Bank of Japan •  Bank of Canada •  European Central Bank

•  What are these banks doing with monetary policy?

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The Fed’s Balance Sheet and Money Supply Process

•  Gold – a hedge against economic chaos?

•  Who “controls” the money supply?

•  Bank deposits are the largest component of the money supply.

•  3 players in the money supply process –  Central bank – oversees banking system and monetary policy –  Banks – accept deposits (individual and insMtuMonal) and make loans

–  Depositors – hold deposits in banks

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The Money Supply Process

•  Monetary base = Currency in M1 + Bank reserves

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The Fed’s Balance Sheet

Federal Reserve System

Assets Liabilities

Securities Currency in circulation

Loans to Financial Institutions

Reserves

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(a) Federal Reserve balance sheet, August 2016 Blank Blank Blank Assets Blank Liabili,es Blank

SecuriMes Blank Currency in circulaMon $1,418,599

U.S. Treasury securiMes $2,463,447 Reverse repurchase agreements 323,693 Federal agency debt securiMes 22,492 Reserve balances of banks (including

term deposits) 2,394,467

Mortgage-backed and other securiMes 1,916,806 Treasury deposits, General Account 241,426 Discount loans to banks 212 Deposits of foreign governments and

internaMonal organizaMons, and other deposits

40,748

Gold 11,037 Deferred availability cash items 552 Bear Stearns–related holdings 1,707 Other liabiliMes 6,852 Items in the process of collecMon 221 Total liabiliMes $4,426,337

Buildings 2,211 Blank Blank Coins 1,930 Capital $40,139 Central bank liquidity swaps 105 Blank Blank Foreign currency denominated assets 21,627 Blank Blank Other assets 24,681 Blank Blank Total assets $4,466,476 Total liabiliMes and capital $4,466,476

(b) Simplified Federal Reserve balance sheet Blank Blank Blank Assets Blank Liabili,es Blank

U.S. Government securiMes Blank Currency in circulaMon Blank Discount loans to banks Blank Reserves of banks Blank

Open Market OperaMons

•  Open market purchase of bonds – Increases monetary base

•  Open market sale of bonds – Reduces monetary base

•  Primary dealers are the banks that transact with the Fed’s trading desk – hXps://www.newyorkfed.org/markets/ primarydealers

Open Market Purchase •  Fed buys $1 million of Treasury bills from primary dealer

•  Reserves increase by $1m •  Monetary base has risen by $1m

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities

Securities -$1m Securities +$1m Reserves +$1m

Reserves +$1m

Open Market Sale •  Fed sells $1 million of Treasury bills to primary dealer

•  Reserves decrease by $1m •  Monetary base has fallen by $1m

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities

Securities +$1m Securities -$1m Reserves -$1m

Reserves -$1m

Discount Loan •  Monetary base changes one-for-one with loans to banks

•  Less controlled by the Fed (borrower demand) •  Discount rate

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities

Reserves +$1m Loans +$1m Loans +$1m Reserves +$1m

(borrowing from Fed) (borrowing from Fed)

Fed Balance Sheet

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Post-Crisis •  Does expanding the monetary base dramaMcally increase the money supply?

•  QuanMtaMve easing –  Large Scale Asset Purchases (LSAP) –  QE is the Fed buying long-term government debt and mortgage-backed securiMes (MBS)

–  ECB and Bank of Japan

•  Pushing down the yield curve

•  Pushing on a string?

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QE dates in the U.S. Start End

QE1 Nov-2008 Mar-2010

QE2 Nov-2010 Jun-2011

OperaMon Twist Sep-2011 Jun-2012

QE3 Sep-2012 Oct-2014

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Normalizing Interest Rates •  The “Zero Lower Bound”

0 to 0.25% Reached on December 17, 2008 10th rate cut in a liXle over a year

•  “Tapering” is reducing asset purchases

•  Returning to convenMonal monetary policy –  “Lir Off” was on December 16, 2015 (25 bps) –  Second hike was on December 14, 2016 (25 bps)

•  Rates in 2018

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