Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

send the U.S. government a check for $2,000. We record the T-account transactions below for you, your bank, the Fed, and the U.S. Treasury Department.

The U.S. Treasury, subsequently, spends your $2,000 to buy more paper for a government agency. A company receives $2,000 and deposits the funds into the company’s bank account. Although you paid higher taxes, the U.S. government returns your money to the economy. Thus, when a government raises taxes and immediately spends it, the taxes have no impact on the monetary base and money supply. Nevertheless, the government does transfer funds from one party to another.

For the next example, the U.S. Treasury finances a budget deficit by selling T-bills. You buy a $20,000 T-bill. We record the T-account transactions below for you, your bank, the Fed,

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The U.S. Treasury collects your $20,000 and buys something with it. When the Treasury pays for a product or service from the public, then the U.S. government pays $20,000 to a company, and the company deposits the $20,000 into its bank account. Consequently, the U.S. government returns $20,000 to the economy, causing zero changes in bank reserves. Thus, when the U.S. Treasury issues new securities, the new securities do not affect the monetary base and money supply.

If the U.S. Treasury sold government securities directly to the Fed, subsequently, the Fed is financing budget deficits, called monetizing the debt. Media refers this to printing money. For example, the Fed directly buys $100,000 in T-bills from the U.S. government. Consequently, we show the impact on the Fed’s and U.S. Treasury T-accounts below:

The Fed purchasing securities directly from the U.S. Treasury do not increase the monetary base as long as the money sits into the account. However, once the U.S. Treasury spends the money in its account, then the Fed’s assets increase, expanding both the monetary base and money supply.

The Federal Reserve is not required to buy U.S. government securities or help the U.S. Treasury finance budget deficits. The Fed and U.S. Treasury are independent. However, the Fed can finance budget deficits indirectly. For instance, if the Fed stabilizes interest rates, then the Fed could monetize the debt indirectly. For example, the U.S. Treasury issues new securities, decreasing the securities’ market price and raising the interest rate. If the Fed maintains the original interest rate, subsequently, the Fed must buy the U.S. government securities to return the interest rates to the same level.

Central banks are not independent from their finance ministries in developing countries. Unfortunately, the finance ministry forces the central bank to finance budget deficits. When a

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central bank monetizes the debt, it increases in the money supply, creating inflation. Consequently, many developing countries suffer from high inflation rates.

A Central Bank Intervenes with its Currency Exchange Rate

The United States financial system is linked to the international financial markets. Investors, savers, households, businesses, and governments in foreign countries can influence the financial markets in the United States, while the U.S. financial markets similarly affect foreign financial markets. Consequently, governments intervene into the international markets to affect their financial markets.

The Federal Reserve tries to manage the value of the U.S. dollar in the international markets. However, governments and central banks have difficulties in influencing the exchange rate of their currency because over $1 trillion in transactions occur daily in the foreign-exchange market. Foreign-exchange market is the largest international market in the world. As countries engage in international trade, goods move in one direction while money moves in the opposite direction. When a central bank tries to control the foreign-exchange rate of its currency, economists call this foreign-exchange market intervention.

The Federal Reserve and U.S. Treasury Department intervene in the foreign-exchange markets, manipulating the U.S. dollar exchange rate. Usually the Federal Reserve and Treasury coordinate their policies together. For example, the Federal Reserve holds foreign currencies, such as British pounds, European euros, and Japanese yen. Foreign currencies are an asset to the Federal Reserves, which are called international reserves. The Federal Reserve can sell or purchase U.S. dollars on the international markets that impact the U.S. exchange rates and U.S. money supply. Table 2 summarizes the impact of a strong or weak U.S. dollar on the U.S. economy.

Table 2. Impact of a Strong or Weak Dollar on the U.S. Economy

The Fed believes the dollar is too weak and strengthens the dollar. The Fed will sell foreign currencies and buy U.S. dollars. The Fed sells $10,000 in foreign currency, and we record the transaction in the T-account below.

Kenneth R. Szulczyk

This transaction removed $10,000 of U.S. currency out of the international market because the Fed holds the U.S. dollars. Consequently, the monetary base decreases by $10,000 while the money supply contracts. Unfortunately, the Fed’s international reserves decline by $10,000. The Fed does not buy U.S. currency. Instead, the Fed could accept a check for the foreign-currency sales. When the Fed cashes a check, the Fed decreases the bank reserves as it removes money from the banking system. We record the transaction below:

In this case, the monetary base still decreases by $10,000 while the money supply contracts. It makes no difference whether the Federal Reserve accepts a check or cash denominated in U.S. dollars. Both transactions impact the monetary base the same. If the Federal Reserve believes the U.S. dollar is too strong, then the Fed can weaken or depreciate the dollar by selling U.S. currency and buying foreign currencies. For example, the Fed buys $30,000 of foreign currency. We record this transaction in the T-account below.

The Federal Reserve’s assets increase by $30,000, increasing the monetary base by $30,000 and expanding the money supply. World’s economy has $30,000 more U.S. dollars in circulation. If the Fed let these foreign exchange transactions change the monetary base, then we call this unsterilized foreign-exchange intervention.

The Federal Reserve can prevent changes to the monetary base, when it influences the U.S. dollar exchange rates, called sterilized foreign-exchange intervention. For example, the Fed believes the dollar is too strong and wants to weaken it. The Fed buys $30,000 in foreign currencies and sells $30,000 in U.S. currency, boosting the monetary base. However, the Fed performs an open-market operation by selling $30,000 in T-bills for cash. These two transactions cancel changes to the monetary base. Consequently, the change in the Fed’s assets and liabilities are zero, and we record the transaction in the T-account below.

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1.Identify the Fed’s assets, liabilities, and capital.

2.Explain how the Federal Reserve clears a check between two banks.

3.Which factors influence the reserve float?

4.Identify the changes to the monetary base and money supply if bad weather causes the float to increase.

5.Identify the changes to the monetary base and money supply if the U.S. Treasury increases its deposits at the Federal Reserve.

6.Identify the changes to the monetary base and money supply if the commercial banks reduce the amount of discount loans from the Fed.

7.Which assets and liabilities the Fed cannot control?

8.Identify the changes to the monetary base and money supply if the U.S. Treasury changes the taxes or changes its borrowing behavior.

9.Explain how the Federal Reserve can monetize the U.S. debt if the Fed and the U.S. Treasury Department are independent.

10.Why do central banks and governments intervene in the foreign-exchange markets?

11.Distinguish between a “weak” dollar and “strong” dollar. How would a strong U.S. dollar affect the U.S. economy?

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12. Distinguish between unsterilized and sterilized foreign-exchange intervention.

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13.The Central Banks of Europe and the United States

We explain the structure of the world’s two largest and most powerful central banks in this chapter: The Federal Reserve System (Fed) and the European Central Bank (ECB). The Fed has an unusual structure because Congress and the President decentralized the power of its central bank, where each central bank branch can tailor services for its unique region of the United States. Moreover, the Board of Governors manages the Fed, while the Federal Open Market Committee handles the purchase and sale of the U.S. government securities and other assets. Keeping it straight, the Board of Governors devises monetary policy, while the Open Market Committee puts monetary policy into action. Then we shift focus to the structure of the European Central Bank, whose structure mirrors the United States. The Executive Board devises monetary policy while the Governing Council implements it. Finally, a central bank should remain independent of its government because a self-governing central bank can focus on price stability and low inflation.

Why the U.S. Government Created Federal Reserve System

The United States was a late comer to the world when it created its central bank. The U.S. government permanently established a central bank in 1913 and named it the Federal Reserve System. Congress, government officials, and the public did not want to create a powerful financial institution, so the U.S. government created the Federal Reserve System to have many checks and balances. Most European countries formed their central banks in the 17, 18, and 19th centuries. They converted a large private bank into a central bank. For example, Great Britain established the Bank of England in 1694, and France founded the Bank of France in 1800.

The Federal Reserve System comprises of 12 Federal Reserve banks. The United States is decomposed into 12 regions, and each region has a Federal Reserve Bank as shown in Figure 1. The Board of Governors is located in Washington D.C. while the dots show the headquarters for each Federal Reserve bank within its region. The Fed is spread across 12 banks because each section of the country is economically different. For example, Michigan originally manufactured U.S. cars while Texas and Oklahoma supplied oil and natural gas. Therefore, a Federal Reserve Bank can provide services to its unique region. Originally, each Federal Reserve Bank provided the following functions:

A Fed bank clears checks for banks.

A Fed bank regulates member commercial banks.

A Fed bank manages the currency by issuing new currency and removing old, worn-out currency.

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commercial bank is required to purchase stock of the Federal Reserve Bank in its district, equaling to 6% of the commercial bank’s net equity (capital). National commercial banks are banks whose charter comes from the U.S. government. These national banks are also called member banks, and they earn a fixed 6% dividend on their shares of Federal Reserve stock.

Each Federal Reserve Bank has nine directors. Member commercial banks elect six directors: Three directors are bankers while the other three are from business. Board of Governors, which holds the power at the Fed, appoints the last three directors. In turn, the nine directors elect the president of the Fed district bank. Of course, this is not a free election because the Board of Governors must approve the bank president.

Commercial banks have no control over their Fed district banks, although they privately own them. A Fed bank does not operate like a corporation where the stockholders can freely elect the board of directors, who vote on the major corporate policies. Congress created this odd structure because it did not want the Fed to be part of government or controlled by the banks, but somewhere between them. Nevertheless, the Fed is a part of government or quasigovernment. When Congress created the Fed in 1913, it dispersed the Fed’s power over the 12 Fed Banks. Over time, the Board of Governors consolidated the central bank’s power.

Board of Governors is the entity that controls the Federal Reserve System. It determines monetary policy, reserve requirements, and discount policy. Board consists of seven members, who serve a 14-year term. Most board members will not finish their term because they resign and work for the financial firms on Wall Street for five times their Fed salary. A board member earns roughly $150,000 per year. A U.S. president with Senate approval appoints the members and appoints the chairperson and vice-chairperson of the board. Chairperson and vicechairperson serve a four-year term. The Comptroller of the Currency and Secretary of the Treasury cannot be members of the board because the Federal Reserve must remain independent of the U.S. federal government. If the U.S. government is accumulating a massive debt, and the Treasury cannot increase taxes or borrow, then the Treasury could resort to printing money to cover deficits by forcing the Fed to buy its securities. Unfortunately, printing money always leads to inflation.

Board of Governors is independent of the U.S. federal government in three ways. First, Board of Governors earns its revenue from the 12 district banks. The Fed does not ask Congress for money. Whoever controls the money is directly or indirectly in command. Second, the terms of the board members are staggered. Every two years, the U.S. President appoints one member to the Board of Governors, or 14 years divided by seven members. This prevents a newly elected President from appointing all members at once, who become loyal to the President. Third, the government cannot completely audit the Fed. Less government knows; the less it can tamper with things. Please do not think the Fed is entirely independent! If the Federal Reserve angers Congress too much, Congress could rewrite the laws that created the Fed.

The Federal Open Market Committee (FOMC) is a special committee within the Fed that makes decisions about open-market operations. Although the Board of Governors determines monetary policy, the Federal Open Market Committee puts the policy into action. After the FOMC makes a decision, the committee sends a directive to the manager at the New York City Federal Reserve Bank to buy and sell U.S. government securities.

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