Lecture 25: Monetary base

1. Lecture 25: Monetary base Mishkin Ch 13 – part A page 333-341

2. Introduction • Money supply affect interest rates and the overall health of the economy and thus affect us all. • How money supply is determined? Who controls it? • The money supply process. • Deposits at banks are the largest component of money supply, so we first look at this. • Monetary base and money multiplier

3. Players in the money supply process • Central bank (Federal Reserve System) • Banks and other depository institutions • Depositors (individuals and institutions) • Borrowers (individuals and institutions) The Fed is the most important player.

4. Fed’s balance sheet • Currency in circulation: money in hands of the public, not including those in banks. • Reserves: vault cash and commercial bank deposits at the Fed. • Government securities: e.g. T-bills • Discount loans: lending to commercial banks

5. Monetary base • The Fed controls monetary base via open market operations and through its extension of discount loans to banks. • Monetary base is about the amount of monetary liabilities on the Fed’s balance sheet.

6. Open market operations • The primary way for the Fed to change monetary base is via open market operations • Open market purchase: the Fed purchases bonds  increase MB • Open market sale: the Fed sells bonds  decrease MB

7. Open market purchase from a bank • Suppose the Fed buys $100 bonds from the bank with check. • Net result: reserves (R) have increased by $100; currency (C) is unchanged. • Monetary base (MB = C + R) has risen by $100.

8. Open market purchase from nonbank public – case one • Suppose a person or a firm sells bonds of $100 to the Fed and then deposits the Fed’s check in a local bank. • Identical result as the Fed purchases from a bank: reserves increases $100, monetary base increases $100.

9. Open market purchase from nonbank public – case two • The person/firm selling the bonds cashes the Fed’s check for currency. • Net result: reserves are unchanged; currency in circulation increases by the amount of the open market purchase. • Monetary base increases by the amount of the open market purchase.

10. Open market purchase: summary • The effect of an open market purchase on the monetary basealways increases the base by the amount of the purchase. • The effect of an open market purchase on reservesdepends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits.

11. Open market sale • Suppose an individual buys the bonds from the Fed with $100 cash (currency). • Reduces the monetary base and currency by the amount of the sale, reserves remain unchanged. • If the individual buys with check, reserve reduces, monetary base reduces, currency unchanged.

12. Shifts from deposits into currency

13. Discount loans • Suppose the Fed makes a $100 discount loan to a bank. • Monetary liabilities of the Fed increases by $100 • Monetary base also increases by $100

14. Discount loans - cont’d • Suppose the bank pays off the $100 discount loan. • Net effect on monetary base is a reduction of $100. • Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System.

15. Other factors affecting the monetary base • Does the Fed have complete control of the monetary base through its open market operations and discount loans? • Float • Treasury deposits at the Federal Reserve

16. Float • When the Fed clears checks for banks, it often credits the amount of the check to a bank that has deposited it (increases the bank’s reserves) but only later debits (decreases the reserves of) the bank on which the check is drawn. • The resulting temporary net increase in the total amount of reserves in the banking system (and hence in the monetary base) occurring from the Fed’s check-clearing process is called float. • Float is affected by random events such as the weather, which affects how quickly checks are presented for payment, is not controlled by the Fed, but affects the monetary base.

17. U.S. Treasury deposits • When the U.S. Treasury moves deposits from commercial banks to its account at the Fed, leading to a rise in Treasury deposits at the Fed, it causes a deposit outflow at these banks and thus causes reserves in the banking system and the monetary base to fall. • Thus Treasury deposits at the Fed is determined by the U.S. Treasury’s actions and affects the monetary base but are not fully controlled by the Fed.

18. Overview of the Fed’s ability to control the monetary base • Float and Treasury deposits at the Federal Reserve which are not in control of the Fed can cause short-term (a week) fluctuations in monetary base. • But the Fed can offset these short-term fluctuations by its open market operations maintain its control over monetary base.