Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

Money multiplier becomes the term within the brackets. We divide both the numerator and denominator in the fraction by D, shown in Equation 12.

Currency-deposit ratio equals C / D while the reserves-deposit ratio is R / D. Both ratios are fixed.

For example, the currency in circulation equals $240 billion; checkable deposits equal $600 billion, and total bank reserves equal $60 billion. We substitute these numbers into the currencydeposit ratio and total reserves-deposit ratio in Equations 13 and 14.

We substitute the currency-deposit and reserve-deposit ratios into the money supply equation, yielding Equation 15.

0.4+1.0

M1= 0.4+0.1 B (15)

M1= 2.8 B

Money multiplier equals 2.8. Although the money multiplier relates the total monetary base to the money supply, the money multiplier also works for changes in the monetary base. For example, if the Fed buys $100,000 in T-bills, then the monetary base increases by $100,000, expanding the M1 money supply by $280,000. The multiplier assumes the banks lend their entire excess reserves.

Banks can weaken the ratio between the monetary base and money supply. For example, if the Fed increased the monetary base by buying $100,000 in T-bills and the banks hold the entire excess reserves, subsequently, the money supply expands only by $100,000. Banks do not lend any reserves, causing the money supply multiplier to equal one. We can prove this because R = D.

We derive the money supply multiplier for M2 similarly. The M2 definition includes time deposits, denoted by T. We define the M2 definition as M2 = C + D + T.

Similarly to the M1, we start with Equation 16. Monetary base (B) would cancel, leaving M2 = M2.

141

Money, Banking, and International Finance

The M2 money multiplier exceeds the M1 always. Furthermore, we can derive the money multipliers for M3 and L similarly. Of course, these multipliers would be larger than M2 and M1. Consequently, economists can measure the sophistication of a country’s financial system by comparing the money definitions and their money multipliers. If a country’s money multipliers are close together, then this country small, undeveloped financial markets. If these multipliers diverge greatly, subsequently, this country possesses sophisticated financial markets.

Fed has problems implementing monetary policy if the money multipliers are unstable. Although the Fed can control the monetary base precisely (B), it only influences the money supply. The Fed sets the required reserve ratio, but the public determines the currency-deposit ratio, and the banks decide the level of excess reserves to hold. Hence, we conclude the Fed cannot control the money supply precisely.

1.Identify the assets and liabilities on the Fed’s balance sheet.

2.Defines the money multiplier and identify the parties who influence the money multiplier.

3.Required reserve ratio equals 5%; the banks hold zero excess reserves, and the public does not withdraw money out of their currency accounts. Calculate the change in the M1 definition of the money supply if the Fed purchases $50,000 in U.S. government securities.

4.Required reserve ratio equals 20%; the banks hold zero excess reserves, and the public does not withdraw money out of their currency accounts. Compute the change in the M1 definition of the money supply if the Fed sells $10,000 in U.S. government securities.

5.Required reserve ratio equals 10%, and the banks hold zero excess reserves. Calculate the change in the M1 definition of the money supply if a person deposits $1,000 in cash into his checking account.

143

12.The Fed’s Balance Sheet

This chapter explains the items on the Federal Reserve’s balance sheet and uses more T- account transactions. For instance, the students learn how the Fed clears a check between two banks. Then we derive an equation that relates changes in the Fed’s assets and liabilities to the monetary base and money supply. Then students learn whether a government issues securities to cover a budget deficit impacts its central bank’s balance sheet, monetary base, and money supply. Finally, a central bank can intervene in its currency exchange markets to strengthen or weaken its currency.

The Fed’s Balance Sheet

Similar to any corporation or business, the Federal Reserve has a balance sheet. The Fed’s assets are anything of value the Fed owns. Moreover, the Fed has liabilities, which are obligations and debt the Fed owes to another party. After we subtract the Fed’s total assets from total liabilities, the remainder becomes the Fed’s net worth. The Fed publishes its balance sheet in the Federal Reserve Bulletin, and the public has free access to it. The Federal Reserve Bulletin is a monthly publication of the Board of Governors that includes money supply numbers, interest rates, and other economic data. Each Federal Reserve’s asset, liability, and net worth are itemized in Table 1 for September 26, 2012: The word consolidated means all assets, liabilities, and capital for all 12 Federal Reserve district banks are added together.

The Fed’s Assets:

Securities are the largest holdings of the Fed’s assets, and they consist of U.S. government securities: T-bills, T-notes, and T-bonds. When the Fed uses open-market operations, it buys and sells securities. The Federal Reserve held $1.7 trillion in securities in 2012.

Mortgage-Backed Securities: The Federal Reserve purchased mortgage securities from the commercial banks and public corporations during the 2008 Financial Crisis. These mortgages are bad loans, where the borrowers defaulted. The Fed purchased $835 billion in mortgage-back securities, removing the bad loans from the banking industry.

Discount Loans are Federal Reserve loans funds to banks, helping the banks overcome short-term liquidity problems. The Fed controls the interest rate on these loans, which influence the amount of loans that banks need. We call the interest rate the discount rate. The Fed loaned $1.7 billion to the commercial banks in 2012.

Items in the Process of Collection (CIPC) are assets that arise from the Fed's check clearing process, and it equaled $138 million in 2012. We show the check clearing process in this chapter.

145

Kenneth R. Szulczyk

Table 1. Federal Reserve's Consolidated Balance Sheet on September 26, 2012

Source: Federal Reserve. September 27, 2012. Federal Reserve Statistical Release-Factors Affecting Reserve Balances. Available from http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab9 (accessed 9/29/2012)

Gold Certificates are claims to gold held by the U.S. Treasury. When the U.S. Treasury buys gold, it sells the certificates to the Federal Reserve. In turn, the Fed credits the U.S. Treasury account at the Fed. The Fed held $11 billion in gold certificates in 2012.

Special Drawing Rights (SDRs): The International Monetary Fund (IMF) issues Special Drawing Rights that are credit securities. The IMF allocates SDRs to various countries around the world, and the Fed holds approximately $5.2 billion. We discuss SDRs in Chapter 15.

Coins: The U.S. Mint designs and produces all coins for the United States. The U.S. Mint is a department under the U.S. Treasury. Normally, the Federal Reserve prints the U.S. paper money, a Fed’s liability. Nevertheless, the Fed buys the coins from the U.S. Mint, making it an asset. The Fed had $2.2 billion in coins in 2012.

Central Bank Liquidity Swaps are Federal Reserve loans made to other country’s central banks of developed countries. For example, the European Central Bank needs a loan from the Fed. The Fed can lend the European Central Bank dollars and can accept euros as collateral. The Federal Reserve created the central bank liquidity swaps during the 2008 Financial Crisis. The Fed granted $14.7 billion in central bank liquidity swaps in 2012.

Bank premises are the buildings and equipment owned by the Federal Reserve, which was $2.4 billion in 2012.

Other assets: The Fed owns other assets, including foreign-exchange reserves, deposits and bonds denominated in foreign currencies. Moreover, the Federal Reserve created companies, such as Maiden Lane Transactions, to facilitate transactions with investment

146

Money, Banking, and International Finance

banks and insurance companies during the 2008 Financial Crisis. The Fed held $202 billion in 2012 for other assets

The Fed’s Liabilities and Capital Accounts:

Federal Reserve notes are U.S. paper money that the Federal Reserve issues. Currency outstanding only includes cash held in bank vaults or cash circulating within the economy. In 2012, $1.1 trillion of U.S. currency circulated outside the Federal Reserve.

Deposits by depository institutions: Banks hold reserves in vault cash and deposits at the Fed. Deposits are assets to the financial institutions, but liabilities to the Fed. The Federal Reserve held $1.5 trillion in bank deposits in 2012.

U.S. Treasury deposits: The U.S. Treasury deposits its money into commercial banks that it collects from tax payments, fees, and U.S. government securities. When the U.S. Treasury pays expenditures, it transfers funds from its commercial bank accounts to its accounts at the Fed. Then the Treasury Department writes checks on its Fed account. Consequently, the U.S. Treasury Deposits are an asset to the U.S. government, but a liability to the Federal Reserve. The U.S. Treasury deposited $65.7 billion at the Fed.

Foreign and other deposits: The Fed holds deposits from foreign governments, IMF, World Bank, United Nations, and U.S. government agencies such as FDIC. The Fed held $24.2 billion in 2012.

Deferred Availability Cash Items (DACI) are liabilities that arise from the Fed’s role in the check-clearing process, which was $779 million in 2012. We explain the check clearing process in this chapter.

Other liabilities include reverse repurchase agreements and dividends the Fed owes to the national commercial banks. Other liabilities were $101.4 billion in 2012.

Capital account equals the Federal Reserves' total assets minus total liabilities. This category was substantial and equaled $54.7 billion in 2012. The Federal Reserve is a public corporation and every U.S. commercial bank with a charter from the U.S. government must buy stock into its Federal Reserve district bank. Subsequently, the Fed pays the commercial banks 6% annual dividend on their Fed stock.

The Check Clearing Process

The Fed has the authority to clear checks, and the check clearing process can cause bank reserves and the money supply to fluctuate through the Federal Reserve float. The Federal Reserve float is the difference between cash items in the process of collection (CIPC) and

147

Kenneth R. Szulczyk

deferred availability cash items (DACI), and it is always positive. As a float increases, it expands both the bank reserves and money supply.

For example, you live in California, and you sent a $1,000 check to a firm in New York City to buy a computer. Computer firm deposits the check in its bank account. Subsequently, its bank sends the check to the Fed because the Fed can clear the check between your bank and the computer firm's bank. Accordingly, the Fed credits the computer firm’s bank a $1,000 asset, the DACI. Next, the Fed must collect $1,000 from your bank, the CIPC. We record the computer firm’s bank and Fed’s T-accounts below:

Computer firm’s bank cannot touch the asset, DACI. The Fed acknowledges the asset and is in the process of collecting money for the computer firm’s bank. After two days, the Fed converts the DACI into bank reserves. Consequently, the bank can lend these reserves.

If the Fed did not collect $1,000 from your bank with two days, subsequently, the Fed extends credit to the computer firm’s bank. Thus, the total reserves of the banking system increase because banks did not lose reserves. That $1,000 check you wrote now exists as a $1,000 in your bank account and the computer firm’s bank account. We calculated the float from your check in Equation 1, and it equals $1,000.

The Fed collects the $1,000 from your bank. Accordingly, the float returns to zero, and your checking account decreases by $1,000. Your check for $1,000 no longer exists in two places. Check clearing process is a long-drawn-out process because if you write a check for $100 and

148

Money, Banking, and International Finance

have only $10 in your checking account, then this check does not clear. That is why the Fed needs permission to lower the bank’s reserves to clear the check; instead of automatically doing it. We display the final transaction below:

Usually the float changes predictably during the mid-month because people pay their bills. Furthermore, the float changes in December because people write checks to buy Christmas presents or in April when people pay their taxes. Moreover, bad weather and transportation strikes can cause the float to soar expectantly as the Fed experiences delays in check collections. Consequently, an increase in the float expands both the bank reserves and money supply. Then the Fed must nullify the float by selling U.S. government securities that reduce the money supply.

Many banks join a clearinghouse that can clear checks and wire transfers without using a central bank. For example, a large bank in New York is the clearinghouse between two small banks. One bank is May Bank in Malaysia while the other is First National Bank in Indiana. Both banks have accounts at the clearinghouse. If a person transfers money from Malaysia to Indiana electronically, then the clearinghouse reduces the account for the Malaysian bank and adds the amount of the wire transfer to the Indiana's bank. Consequently, banks and central banks clear checks and wire transfers similarly.

Changes in the Monetary Base

If the Fed’s balance sheet changes, subsequently, both the monetary base and money supply change. At first, this process seems complex, but economists use a trick. First, we list the Fed’s total assets in Equation 2 and total liabilities in Equation 3.

Next, we substitute the monetary base formula into Equation 3 because the monetary base equals deposits held by depository institutions plus currency in circulation, or B = D + C. After substituting the monetary base into Equation 3, we yield Equation 4.

149