No Such Thing as a Free Lunch: Principles of Economics (Part 124)

The ultimate purpose of economics, of course, is to understand and promote the enhancement of well-being.

Ben Bernanke

The Money Supply and the Federal Reserve System

(Part G)

by

Charles Lamson

The Discount Rate

Banks may borrow from the Fed. The interest rate they pay the Fed is the discount rate. When banks increase their borrowing, the money supply increases. To see why this is true, assume there is only one bank in the country and the required reserve ratio is 20 percent. The initial position of the bank and the Fed appear in panel 1 of Table 3, where the money supply (currency + deposits) is $480. In panel 2, the bank has borrowed $20 from the Fed. By using this $20 as a reserve, the bank can increase its loans by $100, from $320 to $420. (Remember from part 121, the money multiplier = 1/required reserve ratio. So, a required reserve ratio of 20 percent gives a money multiplier of 5; having excess reserves of $20 allows the bank to create an additional $20 * 5, or $100, in deposits.) The money supply has thus increased from $480 to $580. Therefore:

Bank borrowing from the Fed leads to an increase in the money supply.

TABLE 3

The Fed can influence bank borrowing, and thus the money supply, through the discount rate: The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

If the Fed wants to curtail the growth of the money supply, for example, it raises the discount rate and discourages banks from borrowing from it, restricting the growth of reserves (and ultimately deposits).

Historically, the Fed has not used the discount rate to control the money supply. Prior to 2003 it usually set the discount rate lower than the rate that banks had to pay to borrow money in the private market. Although this obviously provided an incentive for banks to borrow from the Fed, the Fed discouraged borrowing by putting pressure in various ways on the banks not to borrow. This pressure was sometimes called moral suasion.

On January 9th, 2003, the Fed announced a new procedure. Henceforth the discount rate would be set above the rate that banks pay to borrow money in the private market, and moral suasion would no longer be used. Although banks can now borrow from the Fed if they wish to, they are unlikely to do so except in unusual circumstances because borrowing is cheaper in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis.

Open Market Operations

By far the most significant of the Fed's tools for controlling the supply of money is open market operations. Congress has authorized the Fed to buy and sell U.S. government securities in the open market. When the Fed purchases a security, it pays for it by writing a check that, when cleared, expands the quantity of reserves in the system, increasing the money supply. When the Fed sells a bond, private citizens or institutions pay for it with a check that, when cleared, reduces the quantity of reserves in the system.

To see how open market transactions and reserve controls work, we need to review several key ideas.

Two Branches of Government Deal in Government Securities The fact that the Fed is able to buy and sell government securities---bills and bonds---may be confusing. In fact, two branches of government deal in financial markets for different reasons, and you must keep the two separate in your mind.

First, keep in mind that the Treasury Department is responsible for collecting taxes and paying the federal government's bills. Salary checks paid to government workers, payments to General Dynamics for a new Navy ship, Social Security checks to retirees and so forth are all written on accounts maintained by the Treasury. Tax receipts collected by the Internal Revenue Service, a Treasury branch, are deposited to these accounts.

If total government spending exceeds tax receipts, the law requires the treasury to borrow the difference. Recall that the government deficit is (G - T), or government purchases minus net taxes. (G - T) is the amount the treasury must borrow each year to finance the deficit.

The Fed is not the treasury. Instead, it is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market. The bonds and bills initially sold by the treasury to finance the deficit are continuously resold and traded among ordinary citizens, firms, banks, pension funds, and so forth. The Fed's participation in that trading affects the quantity of reserves in the system, as we will see. 

Because the Fed owns some government securities, some of what the government owes, it owes to itself. The Federal Reserve System's largest single asset is government securities. These securities are nothing more than bills and bonds initially issued by the treasury to finance the deficit. They were acquired by the Fed over time through direct open-market purchases that the Fed made to expand the money supply as the economy expanded.

The Mechanics of Open Market Operations How do open market operations affect the money supply? Most of the fed's assets consist of the government securities we have just been talking about.

Suppose the Fed wants to decrease the supply of money. If it can reduce the volume of bank reserves on the liability side of its balance sheet, it will force banks in turn to reduce their own deposits (to meet the required reserve ratio). Since these deposits are part of the supply of money, the supply of money will contract.

What will happen if the Fed sells some of its holdings of government securities to the General Public? The Fed's holdings of government securities must decrease, because the securities it sold will now be owned by someone else. How do the purchasers of securities pay for what they would have bought? By writing checks drawn on their banks and payable to the Fed.

Let us look more carefully at how this works, with the help of Table 4. In panel 1, the Fed initially has $100 billion of government securities. Its liabilities consist of $20 billion of deposits (which are the reserves of commercial banks) and $80 billion of currency. With the required reserve ratio at 20 percent, the $20 billion of reserves can support $100 billion of deposits in the commercial banks. The commercial banking system is fully loaned up (actual reserves are equal to required reserves). Panel 1 also shows the financial position of a private citizen, Jane Q. Public. Jane has assets of $5 billion (a large checking account deposit in the bank) and no debts, so her net worth is $5 billion.

Now imagine that the Fed sells $5 billion in government securities to Jane. Jane pays for the securities by writing a check to the Fed, drawn on her bank. The Fed then reduces the reserve account of her bank by $5 billion. The balance sheets of all the participants after this transaction are shown in panel 2. Note that the supply of money (currency plus deposits) has fallen from $180 billion to $175 billion.

This is not the end of the story. As a result of the Fed sale of securities, the amount of reserves has fallen from $20 billion to $15 billion, while deposits have fallen from $100 billion to $95 billion. With a required reserve ratio of 20 percent, banks must have .20 * 95 billion, or $19 billion in reserves. Banks are under their required reserve ratio by $4 billion [$19 billion (the amount they should have) minus $15 billion (the amount they do have)]. To comply with the federal regulations, banks must decrease their loans and their deposits.

The final equilibrium position is shown in panel 3, where commercial banks have reduced their loans by $20 billion. Notice that the change in deposits from panel 1 to panel 3 is $25 billion, which is 5 times the size of the change in reserves that the Fed brought about through its $5 billion open-market sale of securities. This corresponds exactly to our earlier analysis of the money multiplier. The change in money (-$25 billion) is equal to the money multiplier (5) times the change in reserves (-$5 billion).

Now consider what happens when the Fed purchases a government security. Suppose I hold $100 in Treasury bills, which the Fed buys from me. The Fed writes me a check for $100, and I turn in my Treasury bills. I then take the $100 check and deposit it in my local bank. This increases the reserves of my bank by $100 and begins a new episode in the money expansion story. With a reserve requirement of 20 percent, my bank can now lend out $80. If that $80 is spent and ends up back in a bank, that bank can lend $64, and so forth. The Fed can expand the money supply by buying government securities from people who own them, just the way it reduces the money supply by selling these securities.

Each business day, the open market desk in the New York Federal Reserve Bank buys or sells millions of dollars' worth of securities, usually to large security dealers who act as intermediaries between the fed and the private markets. We can sum up the effect of these open market operations this way:

• An open market purchase of Securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

•  An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

Open market operations are the Fed's preferred means of controlling the money supply for several reasons. First, open market operations can be used with some precision. If the Fed needs to change the money supply by just a small amount, it can buy or sell a small volume of government securities. If it wants a larger change in the money supply, it can buy or sell a large amount. Second, open market operations are extremely flexible. If the Fed decides to reverse course, it can easily switch from buying securities to selling them. Finally, open market operations have a fairly predictable effect on the supply of money. Because banks are obliged to meet their reserve requirements, an open-market sale of $100 in government securities will reduce reserves by $100, which will reduce the supply of money by $100 times the money multiplier.

Where does the Fed get the money to buy government securities when it wants to expand the money supply? The Fed creates it. In effect, it tells the bank from which it has bought a $100 security that its reserve account (deposit) at the Fed now contains $100 more than it did previously. This is where the power of the Fed, or any central bank, lies. The Fed has the ability to create money at will. In the United States, the Fed exercises this power when it creates money to buy government securities.

The Supply Curve for Money

Thus far we know how the Fed can control the money supply by controlling the amount of reserves in the economy. If the Fed wants the quantity of money to be $1,200 billion on a given date, it can aim for this target by changing the discount rate, by changing the required reserve ratio, or by engaging in open market operations. In this sense, the supply of money is completely determined by the Fed, and the money supply curve in Figure 5 is a vertical line.

Because the Fed, through open market operations, can choose whatever value of the money supply that it wants, it is useful to begin with the case in which the Fed picks a value independent of anything in the economy. In other words, we are assuming for now that the Fed's choice of the value of the money supply does not depend on things like inflation, unemployment, and aggregate output. This assumption is released in upcoming posts. We will see in these upcoming posts that in practice the Fed chooses a value of the money supply to hit a particular value of the interest rate, where the Fed's choice for the target interest rate depends on things like inflation and unemployment. But this is jumping ahead of the story. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 492-495*

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