Central bank balance sheet

1
Central bank balance sheet

• Central Bank gold standard
• __________________________________________________
  ___________________________
• Gold ( value PgG) Banknotes
• Loans Commercial bank deposits
• The Federal Reserve System fiat money
• __________________________________________________
  ________________________________
• Government securities (GS) Federal Reserve
  notes (CV)
• Loans to financial institutions (DL)
  Commercial bank deposits (BD)
• Foreign exchange reserves (FX, value) Other
  liabilities (e.g Treas. Deposits)
• Other assets
• C Federal Reserve notes held by non-bank public
  (currency in circulation)
• V Federal Reserve notes held by banks in vaults
  or ATM
• BD Commercial bank deposits at the Fed
• R Bank reserves V BD
• B Monetary base C R (the Feds primary
  liabilities)

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US Monetary System

• Fed
• __________________________________________________
  ________________________________
• Government securities (TS) Currency (C) (Base
  money)
• Discount loans (DL) Reserves (R) (Base
  money)
• Foreign exchange reserves (FX) Other
  liabilities (e.g. Treas. Deposits)
• Other assets
• Link to current Fed balance sheet http//www.fede
  ralreserve.gov/releases/h41/Current/
• Of note
• Securities held outright
• TAC and discount loans
• Maiden Lane
• Other assets
• Currency in circulation
• Other liabilities include Treasury deposits
• Reserves

3
US Monetary System

• Fed
• __________________________________________________
  ________________________________
• Government securities (GS) Currency (C) (Base
  money)
• Discount loans (DL) Reserves (R) (Base money)
• Foreign exchange reserves (FX) Other
  liabilities (Treasury Deposits)
• Other assets
• Commercial Banks
• __________________________________________________
  _______________________________
• Reserves (R) Checkable deposits (D)
• Bank loans (L) Loans from the central bank
  (DL)
• Other assets (e.g. govt securities) Capital
  (ownership claims)
• Private sector (non-bank
  public)
• __________________________________________________
  __________________________
• Checkable deposits (D) (Money) Bank loans (L)
  
• Currency (C) (Money) Other liabilities
• Other assets (e.g. physical capital) Net worth

4
US Monetary System
MONEY SUPPLY
BASE MONEY
5
US Monetary System

• Money supply Base Multiplier
• Multiplier is the multiple by which the money
  supply exceeds the base. Under a fractional
  reserve system with bank loans and credit money,
  this will be greater than 1.
• A simple model of the money supply process
• Fed ? Base (through its balance sheet)
• Fed, banks, public ? Multiplier (and independent
  of the base)

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The Feds control of the monetary base

• The following cause the base to rise (all other
  factors the same)
• Purchase of government securities
• Increase in discount loans
• Increase in foreign reserves
• Increase in other assets
• Decrease in other liabilities

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The Feds control of the monetary base

• T-bill purchase by the Fed
• FED
• __________________________________________________
  ____
• T-bills 1000 1000 Base
• Increase in Treasury deposits (e.g. public pays
  taxes)
• FED
• __________________________________________________
  ____
• -1000 Base
• 1000 Treas. Dep.
• Sterilized discount loan
• FED
• __________________________________________________
  ____
• T-bills -1000 0 Base
• DL 1000

8
The Feds control of the monetary base

• The Fed and banks accommodate the publics demand
  for currency. This reflects the publics
  preference for the composition of money it holds.
  But the base can be independent of this
  preference.
• FED
• __________________________________________________
  ____
• 1000 Currency
• -1000 Reserves

9
The monetary base and the governments budget

• The governments budget constraint
• Government expenditures during the year tax
  revenues treasury securities sold to banks and
  the public treasury securities sold to the Fed.
• Budget deficits increase the monetary base
  (monetization) only if the Fed buys new
  securities

10
The monetary base and the governments budget

• Government deficit 100 billion during the
  year. Fed purchases half of the security issue
• The purchase FED
• __________________________________________________
  ____
• T-bills 50 billion 50 billion Treas.
  Deposits
• Treasury spends FED
• __________________________________________________
  ____
• 50 billion Base
• -50 billion Treas. Deposits

11
The money multiplier

• Fed
• _______________________________________________
• GS C
• R

• Commercial Banks
• ______________________________________________
• R D
• L

• M C D
• B C R
• L D R (assuming other assets/liabilities DL
  0)
• M/B m (CD)/(CR) (k1)/(kq) 1
• L/B ? (DR)/(CR) (1q)/(kq)
• M mB ? ?M m?B
• L ?B ? ?L ??B

12
The money multiplier

• m is the money multiplier. We assume it is
  determined independently of the base.
• ? is the loan multiplier. It is also independent
  of the base.
• k is the currency-deposit ratio, determined by
  the preferences of the non-bank public.
• q is the desired reserve ratio, determined partly
  by the Fed and partly by banks.
• We assume that both k and q are independent of
  the quantity of base money.

13
The money multiplier

• Example Fed purchase of t-bill
• ?B 1,000
• q 0.10
• k 0.50
• ? m 2.50
• ? ? 1.50
• ?M 2.501000 2,500
• ?L 1.501000 1,500

• ?M ?C?D (1k)?D
• ?D ?M/(1k) 1,667
• ?C ?M ?D 833
• ?R ?B ?C 167

14
The multiplier process in a simple case

• Assume k0 (no currency) and q 10. Consider
  balance sheet effects of a t-bill purchase
• Central Bank
• __________________________________________________
  ____________________
• T-bills 1000 1000 Reserves (R)
• Bank of America
• __________________________________________________
  ____________________
• Reserves (R) 1000 1000 Deposits (D)
• Bank of America
• __________________________________________________
  ____________________
• Loans (L) 900
• Reserves (R) -900
• Bank of America (net effect)
• __________________________________________________
  ____________________
• R 100 1000 D
• L 900

15
The multiplier process in a simple case

• Goldman Sachs
• __________________________________________________
  ____________________
• R 900 900 D
• Goldman Sachs
• __________________________________________________
  ____________________
• L 810
• Reserves (R) -810
• Goldman Sachs (net effect)
• __________________________________________________
  ____________________
• R 90 900 D
• L 810

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The multiplier process in a simple case

• Citi
• __________________________________________________
  ____________________
• R 810 810 D
• Citi
• __________________________________________________
  ____________________
• L 729
• Reserves (R) -729
• Citi (net effect)
• __________________________________________________
  ____________________
• R 81 810 D
• L 729
• and so on

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The multiplier process in a simple case

• Summary of the entire process involving the
  banking system
• ?R 1000
• ? L 900 810 729 9,000
• ? D 1000 900 810 10,000
• m (1/q) 10
• ? D 10?R 1000 (which is the change in M
  given no currency).
• The money supply increases by a multiple of the
  initial injection of reserves because of bank
  lending.
• Removing reserves from the banking system will
  have the opposite effect (negative signs).

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Factors determining the reserve ratio, q

• q is determined by Fed and optimizing behavior by
  banks. Desired reserves consist of required
  reserves and excess reserves.
• Required reserves (determined by the Fed)
• Likelihood of net deposit withdrawals (excess
  reserves determined by banks)
• Higher deposit variability, higher the
  likelihood of net cash outflows ? higher is q.
• Perceived risk of loans/alternative investments
  (excess reserves determined by banks).
• Interest rate on loans relative to interest rate
  paid by Fed on reserves (excess reserves
  determined by banks). This spread reflects the
  opportunity cost of reserves higher the spread,
  lower q.

19
Change in q

• The money multiplier is negatively related to q.
• If q .25 (instead of .10, with k.50) in the
  previous example, m 2.
• As banks accumulate reserves, the monetary base
  can support a smaller amount of deposits and thus
  money because banks make fewer loans for any
  given injection of reserves.

20
Change in q

• Suppose market interest rates on loans rise.
• q .10, k 0 Banking system
• __________________________________________________
  ____
• R 1000 10,000 D
• L 9000
• q .20, k0 Banking system
• __________________________________________________
  ____
• R 1000 5,000 D
• L 4000
• m falls from 10 to 5. As loans are paid off,
  banks will make fewer loans, so that deposits
  decrease. Remember that total reserves are
  determined by Fed.

21
Factors determining the currency ratio, k

• k is determined by optimal behavior of the
  private sector, in this case households (the
  non-bank sector).
• Interest rates on deposits (negative effect)
• Risk of bank deposits (positive effect)
• Transactions costs of cash versus checks (the
  more convenient is cash relative to checks,
  higher k)

22
Change in k

• The money multiplier is negatively related to k.
  (A change in k has a larger proportional effect
  on the denominator.)
• m (k1)/(kq)
• k .50, q .10 ? m 2.5
• k .60, q .10 ? m 2.3

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Change in k

• q .10, k .40 ? m 2.8
• Fed
• ___________________________________________
• GS 10000 8000 C
• 2000 R
• Banking system
• ___________________________________________
• R 2000 20000 D
• L 18000
• B 10,000
• M 28,000

• Banking panic
• q .10, k .90 ? m 1.9
• Fed
• ___________________________________________
• GS 10000 9000 C
• 1000 R
• Banking system
• ___________________________________________
• R 1000 10000 D
• L 9000
• B 10,000
• M 19,000
• Note The composition of the base has changed as
  public converts deposits to cash. The initial
  withdrawal of 1000 leads to a large change in D
  and M because of the decline in bank lending.

24
Change in k

• How could the Fed respond to 9,000 decline in M?
  To stabilize M, open market purchase would work
  (reserve compensation).
• ?M m ?B
• ?B ?M / m 9000/1.9 4,737
• Fed
• __________________________________________
• GS 14,737 13,263 C
• 1,474 R
• Banking system
• __________________________________________
• R 1,474 14,737 D
• L 13,263
• In current environment, q and k are rising, the
  multiplier is falling. Thus some of the recent
  increase in base money is compensation for
  falling multiplier, and not necessarily
  inflationary

25
Money during the Great Depression

• Stock market crash in 1929, and other factors,
  led to banking panic and runs from October 1930
  to March 1933 loss of confidence in the system.
• Beginning Oct. 1930, we see C rising quickly, and
  D falling, as the public rushed to banks.
• Reserves and monetary base fairly steady.
• Money stock fell drastically from 1930 to 1933,
  despite steady growth in the monetary base.

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The Check Tax

• In 1932, in the midst of the contraction of money
  and credit, Congress imposed a 2 cent tax on
  checks written (independent of the amount of the
  check). This increased the costs of using checks,
  and thus reduced the relative cost of using cash.
  We estimated an additional 10-15 decline in
  money caused by this tax.
• Justification for the tax to balance the
  federal budget.

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Current trends

• Currency-checkable deposit ratio has risen
• Financial innovations reducing value of demand
  deposits at banks.
• Foreign demand for US currency.
• This has caused instability in M1, but M2 growth
  has been steady.

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2008 data
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2008 data
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Private banknotes and the multiplier

• Since 1914, private banks have not issued
  banknotes Fed has monopoly over currency. As we
  have seen, the quantity of money supply is
  sensitive to changes in the composition of money,
  through the currency ratio k.
• However, private banknote issue can alleviate
  this problem in the face of currency runs (as
  opposed to redemption runs).

38
Private banknotes and the multiplier

• An example assume Fed issues only reserves, no
  currency. Banknotes serve as currency. Banks hold
  same fraction of reserves on banknotes as on
  deposits.
• k 1/3 Banking system
• ______________________________________________
• R 1000 2500 Banknotes
• L 9000 7500 D
• M 10,000 B 1000
• k 1/2 Banking system
• ______________________________________________
• R 1000 5000 Banknotes
• L 9000 5000 D
• M 10,000 B 1000 ? change in composition
  affects neither the base nor the multiplier.

39
Balance sheet analysis of TARP

• US Treasury
• __________________________________________
• Tr. Dep. 500 500 T-bills

• Public
• __________________________________________
• T-bills 500
• D -500

• Banking system
• __________________________________________
• R -500 -500 D

• Fed
• __________________________________________
• -500 R
• 500 Tr. Dep.

40
Balance sheet analysis of TARP

• US Treasury
• __________________________________________
• Tr. Dep. -500
• Toxic assets 500

• Public
• __________________________________________
• 0 0

• Banking system
• __________________________________________
• R 500
• Toxic assets -500

• Fed
• __________________________________________
• 500 R
• -500 Tr. Dep.

41
Balance sheet analysis of TARP

• US Treasury
• __________________________________________
• Tr. Dep. 300
• Toxic assets -500
• TPL 200
• TPL taxpayer liability

• Public
• __________________________________________
• Assets 300 200 TPL
• D -300 -200 NW

• Banking system
• __________________________________________
• R -300 -300 D

• Fed
• __________________________________________
• -300 R 300 Tr. Dep.

42
Balance sheet analysis of TARP

• US Treasury
• __________________________________________
• Tr. Dep. -300 -500 T-bills
• TPL -200

• Public
• __________________________________________
• T-bills -500 -200 TPL
• D 300

• Banking system
• __________________________________________
• R 300 300 D

• Fed
• __________________________________________
• 300 R -300 Tr. Dep.

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Balance sheet analysis of TARP

• US Treasury
• __________________________________________
• 0 0

• Public
• __________________________________________
• Assets 300 -200 NW
• D -500
• (If Treasury sells assets for, say, 600, then
  assets go up by 600, D goes down by 500, and NW
  increases by 100.)

• Banking system
• __________________________________________
• Toxic assets -500 -500 D

• Fed
• __________________________________________
• 0 0
• Summary Ultimately, Public converts deposits
  into assets, but loses 200 of wealth (because
  Treasury sells at a loss). Banks assets and
  liabilities fall, so asset-to-capital ratio
  rises.

44
Balance sheet analysis of capital infusion plan

• US Treasury
• __________________________________________
• Tr. Dep. 250 250 T-bills

• Public
• __________________________________________
• T-bills 250
• D -250

• Banking system
• __________________________________________
• R - 250 - 250 D

• Fed
• __________________________________________
• -250 R
• 250 Tr. Dep.

45
Balance sheet analysis of capital infusion plan

• US Treasury
• __________________________________________
• Tr. Dep. - 250
• Bank equity 250

• Public
• __________________________________________

• Banking system
• __________________________________________
• R 250 250 Equity

• Fed
• __________________________________________
• 250 R
• -250 Tr. Dep.

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Balance sheet analysis of capital infusion plan

• US Treasury
• __________________________________________
• Bank equity 250 250 T-bills

• Public
• __________________________________________
• T-bills 250
• D -250

• Banking system
• __________________________________________
• -250 D
• 250 Equity

• Fed
• __________________________________________
• 0 0
• Summary Ultimately, Public (through the
  Treasury) converts bank liabilities into bank
  equity. Banks asset-to-debt ratio increases. (If
  the Fed monetizes, it buys 250 t-bills from
  public, but R would go up by 500. )

47
The Federal Reserve System

• Federal Reserve Act of 1914 created the Federal
  Reserve system in three parts
• Federal Reserve Board (US Treasury Secretary,
  Comptroller of the Currency, plus five),
  headquartered in D.C.
• 12 district banks (Atlanta, NY, Boston, etc.).
  Board of each elects a President.
• member commercial banks, which buy stock in the
  Fed. (Hence, the Fed is privately owned!)
  National banks must be members.
• Amendments in 1933, 1935
• Reconstituted FRB as Board of Governors of the
  Fed, with 7 members appointed by the President,
  each for 14 year terms.
• Created FOMC, and authorized open market
  operations. Consists of 7 Board members plus 5
  presidents who serve on a rotating basis (as
  voting members). NY Fed President always on as
  voting member.
• Authorized reserve requirements on demand
  deposits of member banks (now on all banks, since
  1980 DIDMCA).
• Section 13(3) In unusual and exigent
  circumstances, the Board of Governors of the
  Federal Reserve System, by the affirmative vote
  of not less than five members, may authorize any
  Federal reserve bank to discount for any
  individual, partnership, or corporation, notes,
  drafts, and bills of exchange when such notes,
  drafts, and bills of exchange are indorsed or
  otherwise secured to the satisfaction of the
  Federal Reserve bank.
• This section has been invoked recently to allow
  the Fed to buy commercial paper and make loans to
  JPMorgan and AIG.
• The Federal Reserve Act. http//www.federalreserve
  .gov/aboutthefed/fract.htm

48
Fed Independence

• Although Fed is technically privately owned, it
  is run by the government. But it has been set up
  to be independent of the branches of government.
  This is important because of the pressures for
  manipulating the money stock for political
  reasons.
• An independent central bank is (potentially) a
  good substitute for a commodity money standard. A
  credible central bank can provide monetary
  discipline in the absence of an underlying
  commodity.

49
Tools of monetary policy

• The Fed has the following tools to control the
  money supply (and thereby influence interest
  rates, output and inflation)
• Reserve requirements
• Open market operations
• Discount policy (very old)
• Interest payments on bank reserves (brand new)

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Reserve requirements

• 0 on checkable deposits up to 9.3 million, 3 on
  deposits between 9.3 million and 43.9 million,
  and 10 beyond.
• An increase in reserve requirements will reduce
  the money multiplier and the money stock
  (assuming desired excess reserves do not change
  to offset).
• The Fed seldom systematically changes reserve
  requirements for policy purposes.

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Reserve Requirements

• 1 7 14 31 38
  45
• ----------------------------------------------
  -------------
• Tu M M Th
  W
• Computation period Maintenance period
• Computation period daily average balance on
  checking accounts and vault cash ? required
  reserves determined.
• Maintenance period must hold average daily
  balance as deposit at the fed equal to difference
  between required reserves and vault cash.

52
Reserve Requirements

• Computation period Tuesday, May 27 to Monday,
  June 9.
• Average daily balance of banks checking accounts
  75
• Average daily vault cash 1 million.
• Required reserves (0.03)(43.9 9.3) (0.10)
  (75 43.9) 4.12 million.
• Required reserve balance to be held as Fed
  deposit during the maintenance period (beginning
  June 26) 3.12 million.

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Reserve requirements

• Until recently, reserves paid no interest. In
  this case, a reserve requirement is just like a
  tax.
• Assume a bank holds no reserves, and thus lends
  all deposits. If r is the interest rate charged
  on loans (L) and i the rate charged on deposits
  (D), then the banks profits are
• Profit rL iD (r i)D
• With a reserve requirement (q) on deposits
• Profit r(D R) iD r(D qD) iD r(1
  q) i D
• Example r 8, i 2, and q 10, instead of
  6 return, banks earn 5.2

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Open market operations

• Purchases and sales of government securities on
  the open market (i.e. just like everyone else who
  buys and sells securities). They give the Fed
  direct control over bank reserves.

FOMC
Policy directive
Trading Desk
Securities markets
Purchases/sales
Target level for reserves
55
Open market operations

• Outright purchases or sales
• Repurchase agreements (repos) buy govt
  securities from a dealer, who agrees to
  repurchase at a given price.
• Dynamic active change in policy.
• Defensive sterilization of other changes in base
  or multiplier.
• Feds balance sheet (again) http//www.federalres
  erve.gov/releases/h41/Current/

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Discount policy

• The Feds oldest tool, and means of serving as
  lender of last resort.
• Fed
• _____________________________________
• DL 1 million 1 million R
• Banking system
• _____________________________________
• R 1 million 1 million DL
• The discount loan shows up as a liability to the
  bank, but provides the bank additional liquidity
  (reserves) to make loans or pay of other
  liabilities. Alternatively, the Fed might require
  collateral.

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Discount policy

• Primary credit for healthy banks in need of
  temporary liquidity funds are unrestricted but
  are charged a penalty rate (say 25 basis points
  above the federal funds rate). Prior to 2003,
  discount rate was set below fed funds rate.
• Secondary credit for less healthy banks who
  dont qualify for primary credit rate set at 50
  basis points above federal funds rate, and funds
  are restricted.
• For primary and seasonal credit, the Fed sets a
  discount rate, then banks request a loan amount.
• http//www.federalreserve.gov/releases/h41/C
  urrent/

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New discount policy tools

• Term Auction Facility (Dec. 12, 2007)
• Primary Dealers Credit Facility (Dec. 2007)
• Term Securities Lending Facility (Dec. 2007)
• Asset-backed Commercial Paper MMMF Facility
  (Sept. 2008)
• Commercial Paper Funding Facility (Oct. 7, 2008)
• Another facility to buy assets/make loans to MMMF
  (Oct. 21, 2008)
• Prior to these dates, primary and secondary
  credit were extended to banks, for overnight
  loans backed by safe and secure collateral. These
  new tools broadly extend the scope of discount
  lending to non-banks, non-financial institutions,
  for longer terms (30 to 85 days), and secured by
  potentially distressed assets.
• The injections of funds through these facilities
  has been massive
• http//research.stlouisfed.org/fred2/series/BORRO
  W?cid122

60
Term Auction Facility

• Fed sets the amount of the funds it is willing to
  lend, and lets banks anonymously bid for these
  funds. The bid includes the amount requested and
  an interest rate. The Fed accepts bids from those
  banks offering the highest yields until the funds
  run out. Originally set up as temporary, but it
  is likely to remain permanent.
• For example, suppose the Fed offers 20 billion
  for auction, and receives bids totaling 30
  billion. Then, it orders the bids from highest
  yield to lowest, and chooses the offers with the
  highest yields until the 20 is allocated. The
  actual rate charged is the lowest accepted bid
  rate.

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Term Auction Facility
Rate
5
4
3
bid
20
30
62
Sterilization of lending facilities

• To a large extent, the Fed has sterilized new
  lending, to prevent reserves from rising too
  much.
• This can be seen from the Feds balance sheet
  large decreases in t-bills held outright.
• Selected balance sheet items http//research.stlo
  uisfed.org/publications/usfd/page16.pdf

63
Sterilization of lending facilities

• To sterilize, Fed needs enough t-bills to sell.
  The Treasury has been issuing securities to the
  Fed for this purpose. In effect, the Fed buys
  t-bills issued by Treasury, but pays for them by
  crediting the Treasurys deposits, not by
  creating reserves.
• See Feds balance sheet Treasury deposits,
  special financing account.
• Fed
• __________________________________________________
  ___
• T-bills 459 billion 459 billion Treas.
  Dep.
• Fed
• __________________________________________________
  ___
• T-bills -100 billion -100 billion Reserves

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An additional new tool

• As part of the Emergency Economic Stabilization
  Act of 2008, the Fed was given authority to pay
  interest on bank reserves.
• Allows the Fed to set interest rate policy
  independently of liquidity policy.
• Open market operations will become less important
  as a tool, because adjustments in reserves will
  not be necessary to target interest rates.