Chapters 17 and 18 How the Fed Implements Monetary Policy

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Chapters 17 and 18How the Fed
ImplementsMonetary Policy
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The Fed and the Economy

• The Fed influences the economy by changing the
  amount of its monetary liabilities that the banks
  and nonbank public hold.
• The monetary liabilities of the government
  consist of currency and the deposits of banks at
  the Fed.
• Their total is called the monetary base because
  the monetary system stands on this base.

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A Simplified Model

• We ignore Treasury currency (fairly small).
• We also greatly simplify the Feds balance sheet
  to

L
A
Government securities Discount loans to banks
Currency Outstanding Deposits of banks at the Fed
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Implication

• Given these simplifications, we then have
• Monetary base currency outstanding
• deposits of the banks at the Fed
• government securities discount loans to banks

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1. Reserves

• Banks holdings of monetary base satisfy legal
  reserve requirements and are termed reserves.
• Banks can hold reserves as either deposits at the
  Fed or vault cash
• Reserves deposits of banks at the Fed
• vault cash
• Reserves can be divided in two different ways
• Reserves required reserves excess reserves
• Reserves nonborrowed reserves
• borrowed reserves

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2. Reserves

• Required reserves are 10 of checkable deposits
  in the US.
• By law, excess reserves cannot be negative and
  are always positive in practice.
• The banks reduce the amount of excess reserves
  that they hold as the interest rate rises.
• Borrowed reserves is another term for discount
  loans by the Fed to the banks.
• Nonborrowed reserves (NBR) is the instrument that
  the Fed uses to keep the federal funds rate near
  the Feds target for it.

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1. The Feds Assets

• Before the financial crisis began in July 2007,
  the Fed held about 850 B in government
  securities and virtually no discount loans.
• On 11/28/2008, it held only 500 B in government
  securities.
• In lieu of government securities, it held 80 B
  in non-Treasury RPs, 339 B in commercial paper,
  and 740 B in several types of loans including
  discount loans.

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2. The Feds Assets

• Any changes in the amount of assets that the Fed
  holdswhatever form they may takechanges the
  monetary base by an equal amount.
• As a result, the monetary base swelled from about
  850 B to 1659 B, 195 in a mere 18 months.
• This big expansion in the monetary base and in
  the classes of assets that the Fed holds have
  reflected its heroic efforts to stem the
  financial crisis.

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How the Fed Changes NBR

• The Fed changes NBR by X simply by buying X in
  Treasury securities or any other asset.
• The simplest and most relevant case is a purchase
  or sale of Treasury securities from the banks.
• For example, consider an open-market purchase of
  X from Chase as indicated in the T-accounts on
  the next page

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Changing NBR
Fed
Chase
A
L
A
L
Dep at Fed XB Tbills -X
Borrowing from Fed B
Tbills X Discount Loans B
Dep at Fed XB

• If banks change their borrowing from the Fed by
  B, this open-market purchase increases both the
  monetary base and reserves by XB.
• But it increases NBR by exactly X
• Reserves NBR borrowed reserves
• Up XB up X up B
• Conclusion An open-market purchase or sale with
  banks changes NBR by an equal amount.

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How the Nonbank PublicObtains Currency

• The Fed provides the nonbank public with whatever
  currency they demand.
• Example The nonbank public exchanges 100M in
  checkable deposits for 100M in currency as in
  the T-accounts below

NB Public
Banks
A
L
A
L
Vault Cash 100M
Ch. Dep 100M
Currency 100M Ch. Dep -100M
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1. Obtaining Currency

• The banks then replenish their vault cash by
  exchanging 100 M in deposits at the Fed for 100
  M in cash as in the T-accounts below

Banks
Fed
A
L
A
L
Vault Cash 100 M Dep. at Fed 100 M
Currency 100 M Dep. of Banks 100M
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2. Obtaining Currency

• Finally, the Fed makes an open-market purchase of
  100 M from banks as shown in the T-accounts
  below

Banks
Fed
L
L
A
A
Dep of Banks 100 M
Dep at Fed 100 M Tbills -100 M
Tbills 100 M
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Altogether
NB Public
Banks
Fed
A
A
A
L
L
L
Cur- rency 100 M
Currency 100 M Checkable Dep -100 M
Check- able Dep -100 M
Tbills 100 M
Tbills -100 M

• Result The nonbank public has obtained more
  currency while the Fed has kept NBR constant.

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A More Complete Model

• We complicate our simplified model slightly by
  recognizing that the Fed has more assets and
  liabilities than we considered see below

A
L
Government and Other Securities Discount Loans to
Banks Other Assets
Currency Deposits of Banks at Fed Other
Liabilities
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Other Assets

• Cash Items in Process of Collection (CIPC) The
  value of checks being cleared through the Fed
• Miscellaneous
• Gold 42/oz. times number of oz. of gold owned
  by the US federal government
• SDRs The paper gold issued by the
  International Monetary Fund to the US federal
  government
• Currency swaps
• Buildings, computers, etc.

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Other Liabilities

• Deferred Availability Cash Item (DACI)
• The Fed credits the checks it clears according to
  a fixed schedule.
• They are DACI until credited and then deposits of
  the banks.
• Treasury deposits
• The Treasury makes payments to others from an
  account at the Fed.
• It deposits most receipts into commercial banks
  and then transfers funds to the Fed as needed.
• Miscellaneous e.g. Federal Reserve Bank stock
  held by the member banks.

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Miscellaneous Liabilities

• As part of the Feds effort to diffuse the
  liquidity crisis, it added large new entries
  here.
• The Treasury had a Supplementary Financing
  Account with 479 B on 11/28/2008, enabling the
  Fed to expand its assets without affecting NBR.
• Currency swaps of 72 B in dollars lent to
  foreign central banks ( currency swaps on the
  asset side).

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Float

• Float CIPC DACI.
• It was typically positive in the past because on
  average payee banks were credited before payer
  banks were debited.
• The Fed has sped up check-clearing in recent
  years, eliminating most of it and making its much
  less variable.
• Rather than treating CIPC and DACI separately, we
  treat Float as a net asset.

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Currency

• Currency consists of not just Federal Reserve
  Notes but also a small amount of Treasury
  currency, mostly coins.
• For simplicity, we consolidate the monetary part
  of the Treasury with the Fed.
• This is reasonable since all currency, both the
  Feds and the Treasurys, enters circulation in
  the same way i.e., via the Fed.

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The Monetary Base Again

• The monetary base consists of the monetary
  liabilities of the government i.e. currency
  deposits of the banks at the Fed. As a result,
• Monetary base government and other securities
• discount loans float Treasury deposits
• miscellaneous assets miscellaneous
  liabilities
• The monetary base is increased by any increase in
  Feds assets and decreased by any increase in the
  Feds nonmonetary liabilities.

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And NBR Again

• To get from the monetary base to NBR, subtract
  discount loans and the currency held by the
  nonbank public
• NBR (Securities Currency held by NB public)
• float Treasury deposits net miscellaneous
• The Feds operating procedure prevents changes in
  the NB publics currency from affecting NBR.
• NBR is increased by any increase in any of the
  Feds assets and decreased by any increase in any
  Feds nonmonetary liabilities.

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Factors Contributing Variabilityto NBR

• Float is unpredictable and somewhat variable.
• For example, it can jump 10 B or more if bad
  weather (or 911) prevents planes from flying and
  checks from being cleared.
• Treasury deposits are also somewhat unpredictable
  and vary appreciably.
• Net miscellaneous assets varies little and is
  highly predictable.

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Open-Market Operations

• The Fed engages in two types of open-market
  operations
• Defensive
• Dynamic
• Defensive operations prevent predictable changes
  in float, Treasury deposits, etc., from changing
  NBR.
• Almost all open-market operations are defensive.
• Dynamic operations are used to change the federal
  funds rate.

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Example of a Defensive Operation
A
L
L
Fed
A
Banks
Dep at Fed 10 B 10B 0 Sec. 10 B
Dep of NB public 10B
Float 10 B Securities -10 B
Dep of banks 10 B (a) Dep of banks -10 B (b)
Float -10 B Securities 10 B
Dep of banks -10 B (c) Dep of banks 10 B (d)
two days later
Dep at Fed 10B 10 B 0 Sec. -10 B
Dep of NB public -10 B

• The Fed sells 10 B in two-day RPs.
• It therefore prevents the predictable part of the
  swing from affecting NBR. (a) (b) 0, (c)
  (d) 0

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Dynamic Operations

• Suppose that the Fed has decided to raise the
  federal funds rate to head off future inflation.
• To do so, it reduces NBR. (More on this later.)
• Suppose that it needs to reduce NBR by 2 B.
• It sells 2 B in securities outright. The result
  is below

Fed
Banks
A
L
A
L
Securities -2 B
Dep of Banks at Fed -2 B
Securities 2 B Deposits at Fed -2 B

• Banks then try to borrow in the federal funds
  market,
• forcing up the federal funds rate. (More on
  this later.)