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Chapter 17 The Central Bank Balance Sheet and the Money Supply Process Conceptual and Analytical Problems Follow the impact of a $100 cash withdrawal through the entire banking system, assuming that the reserve requirement is 10 percent and that banks have no desire to hold excess reserves. Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A) needs to increase its reserves by $90 in order to meet the required reserve ratio. To raise the $90, Bank A will sell $90 of securities to someone. The deposit account of the person who purchased the securities will fall by $90, as will the reserve balance of his bank, Bank B. Bank B now needs to increase its reserves by $81 in order to meet the reserve requirements so it will sell $81 of securities. This continues until deposits contract by $100/0.1 = $1,000. Suppose a major bank needs to borrow $20 billion overnight that it cannot obtain from private creditors. The Fed is willing to make a discount loan of $20 billion provided that it will not alter interbank lending rates. How can it do so? Answer: The Fed can make the $20 billion loan to the problem bank if it simultaneously sells $20 billion of securities to the rest of the banking system. These two operations would keep the aggregate supply of reserves to the banking system unchanged; the $20 billion rise in reserves offered to the problem bank is offset by the $20 billion withdrawal of reserves from other banks, which pay for the securities by drawing down their reserve accounts. Compute the impact on the money multiplier of an increase in the currency-to-deposit ratio from 10 percent to 15 percent when the reserve requirement is 10 percent of deposits, and banks’ desired excess reserves are 3 percent of deposits. Answer: When desired currency holdings = 10% of deposits, m = When desired currency holdings = 15% of deposits, m = Does the Federal Reserve frequently purchase or sell gold or foreign exchange as part of its efforts to change the money supply? Answer: No. Fed transactions in foreign exchange and gold are infrequent, and are not used to alter the money supply. The Fed usually purchases and sells foreign exchange only when it implements Treasury decisions to intervene in currency markets. It typically offsets these actions with with a separate open market operation. While the Fed holds gold, it rarely alters its gold holdings and it does not adjust the value of these holdings in response to changes in the market price of gold. Consider an open market purchase by the Fed of $3 billion of Treasury bonds. What is the impact of the purchase on the bank from which the Fed bought the securities? Compute the impact on M1 assuming that: (1) the required reserve ratio is 10 percent; (2) the bank does not wish to hold excess reserves; and (3) the public does not wish to hold currency. Answer: The bank’s securities fall by $3 billion and its reserves rise by $3 billion. Assuming that the required reserve ratio is 10 percent, banks do not want to hold excess reserves, and the public does not wish to hold currency, the simple deposit multiplier will be 1/0.1=10, so the value of deposits (and M1) will rise by $30 billion. When you withdraw cash from your bank’s ATM, what happens to the size of the Fed’s balance sheet? Is there any reason for the Fed to react to your action? Answer: The reserves held by your bank at the Fed decline, but there is a larger volume of currency in the hands of the nonbank public. These changes are offsetting, so there is no impact on the Fed’s total liabilities (or, equivalently, on the size of its balance sheet). However, your action has raised the currency-to-deposit ratio and can lead to a change in the money supply. The Fed may choose to alter policy to offset the impact on the money supply. Why is currency circulating in the hands of the nonbank public considered a liability of the central bank? Answer: Currency issued by the central bank is effectively an IOU to the holder of the currency. The central bank is obliged to pay back the holder of the currency. If the currency were backed by gold, for example, the central bank would be obliged to exchange gold for currency. With fiat money, however, the central bank is obliged only to exchange currency for more currency. How did the financial crisis of 2007–2009 affect the size and composition of the balance sheet of the Federal Reserve? Answer: Between December 2007 and December 2009, the assets on the Federal Reserve’s balance sheet increased by 2.5 times, mostly in the form of securities. The Fed also broadened the range of assets held to include riskier instruments such as extraordinary loans to non-banks and long-term securities (including mortgage-backed instruments and Treasury bonds). On the liability side of the balance sheet, the liquidity crisis led to a surge in commercial bank deposits at the Fed as banks held on to excess reserves. At times, the Treasury also increased its deposits at the Fed to help the Fed limit the increase of bank reserves as its assets rose. Suppose the currency-to-deposit ratio is 0.25, the excess reserve-to-deposit ratio is 0.05, and the required reserve ratio is 0.10. Which will have a larger impact on the money multiplier: a rise of 0.05 in the currency ratio or in the excess reserves ratio? Answer: Initially, the money multiplier is m = If the currency-to-deposit ratio rises to 0.30, the multiplier falls to m = If, instead, the excess reserve-to-deposit ratio rises, the multiplier will be m = So, multiplier falls by more with the increase in the excess reserve ratio. Is the money-multiplier model still useful for policymakers in the United States? If not, why not? Answer: Since the financial crisis began in 2007, the model has been of limited use for policymakers. The reason is that the ratios to deposits of currency and excess reserves – the terms in the multiplier that are beyond the control of the central bank – have become unstable. Consequently, the central bank can no longer predict accurately the level of the money supply when it provides a specific amount of monetary base. Based on Figure 17.10, explain why the multipliers fell sharply with the onset of the financial crisis of 2007–2009. Why did they remain at this lower level after the crisis ended? Answer: The money multipliers plummeted during the financial crisis as banks hoarded excess reserves in the face of the liquidity crisis. Confronted with the possibility of not being able to roll over debts or sell securities when necessary, banks were willing to forego the extra profits from lending out these reserves, especially given the prevailing low interest rates. When the Federal Reserve began paying interest on reserves in 2008, the opportunity cost of holding excess reserves fell, so banks continued to hold these excess reserves even as the crisis receded. Consequently, the multiplier remained low. The U.S. Treasury maintains accounts at commercial banks. What would be the consequences for the money supply if the Treasury shifted funds from one of those banks to the Fed? Answer: The balance sheet for the bank would reflect a decrease in reserves and a decrease in deposits. The decrease in reserves would also appear on the Fed’s balance sheet; however, it would be offset by an increase in the government’s account. The response of the banking system to the decline in bank reserves would be a decline in the quantity of money. Explain how an incomplete understanding at the Federal Reserve of the relationship between the central bank’s balance sheet and the money supply contributed to the Great Depression. How did the Fed’s behavior during the financial crisis of 2007–2009 illustrate that it had learned a valuable lesson from the Great Depression? Answer: During the Great Depression, the central bank was increasing the monetary base at a significant rate. Conditions in the economy and the banking system, however, meant that the money multiplier was declining, so the overall impact was a fall in the quantity of money. This contributed to the contraction of the economy. In contrast, when a similar decline in the money multiplier (due to a surge in demand for excess reserves) emerged during the financial crisis of 2007–2009, the Fed rapidly expanded the supply of reserves, preventing a collapse of the money supply like that seen in the 1930s. Suppose you examine the central bank’s balance sheet and observe that since the previous day, reserves had fallen by $100 million. In addition, on the asset side of the central bank’s balance sheet, securities had fallen by $100 million. What activity did the central bank carry out earlier in the day to lead to these changes in the balance sheet? Answer: The central bank conducted an open market sale of $100 million with a commercial bank. The sale of the securities would involve $100 million of securities being removed from the central bank’s balance sheet. The commercial bank would have paid for the securities from its reserve account, thus leading to a fall of $100 million in reserves on the central bank balance sheet. Do you think the central bank was aiming to increase, decrease, or maintain the size of the money supply by carrying out the changes described to its balance sheet in Problem 14? Explain your answer. Answer: It is most likely that the central bank was aiming to decrease the money supply. An open market sale reduces reserves on the central bank’s balance sheet and so reduces the monetary base. Assuming the money multiplier remains unchanged, this would decrease the money supply. Looking again at the situation described in Problem 14, do you think the size of the banking system’s balance sheet would be affected immediately by these changes to the central bank’s balance sheet? Explain your answer. Answer: No. Reserves and securities both appear on the asset side of the balance sheet of the banking system, so their offsetting changes would affect the composition but not the size of its balance sheet. Over time, the banking system may try to shrink its assets and liabilities in response to the decline of reserves. Do you think the Federal Reserve successfully carried out its role as lender of last resort in the wake of the terrorist attacks on September 11, 2001? Why or why not? Answer: Yes. The Fed successfully acted as lender of last resort and prevented the financial system from collapsing in the wake of the attacks. The system was threatened by the inability to collect checks in the absence of civilian flights. The Fed stepped in and provided huge amounts of liquidity to enable banks to meet their commitments. In carrying out open market operations, the Federal Reserve usually buys and sells U.S. Treasury securities. Suppose the U.S. government paid off all its debt. Could the Federal Reserve continue to carry out open market operations? Answer: In theory, yes. In the absence of Treasury securities, the Federal Reserve would have to switch to other assets to carry out its open market operations. If these alternative assets traded in deep, highly active markets, the Fed could avoid imposing market distortions when conducting open market operations. In which of the following cases will the size of the central bank’s balance sheet change? The Federal Reserve conducts an open market purchase of $100 million U.S. Treasury securities. A commercial bank borrows $100 million from the Federal Reserve. The amount of cash in the vaults of commercial banks falls by $100 million due to withdrawals by the public. Answer: The size of the central bank’s balance sheet will rise in cases (a) and (b). On the liability side in both these cases, reserves rise by $100 million. On the asset side, securities rise by $100 million in case (a) while loans rise by $100 in case (b). In case (c), the composition of liabilities changes, with a shift from reserves to currency, but the overall size of the balance sheet remains unchanged. You read a story reporting a major scandal about the Federal Deposit Insurance Corporation that is likely to undermine the public’s confidence in the banking system. What impact, if any, do you think this scandal might have on the relationship between the monetary base and the money supply? Answer: The scandal is likely to increase the public’s desire to hold currency as the safety of their deposits comes into question; the currency-to-deposit ratio is likely to rise. In addition, banks are likely to hold a higher level of excess reserves in anticipation of the public’s reaction, thus increasing the excess reserve-to-deposit ratio. The changes in both these ratios would reduce the money multiplier, thus reducing the stock of money for a given monetary base. Use your knowledge of the money multiplier to explain why the massive increase in bank reserves that began in the 2007-2009 financial crisis has not resulted in uncontrolled inflation. Answer: While the increase in reserves expanded the monetary base, this did not translate into a massive increase in the money supply because the money multiplier plunged. The two most important causes of the decline in the money multiplier were: (1) impairment of the banking system during the crisis boosted banks’ demand for excess reserves; and (2) the payment of interest on excess reserves reduced the opportunity cost of holding them. The increase in the excess reserve ratio depressed the money multiplier, limiting the impact of the reserve increase on the money supply. Even after the crisis, the low opportunity cost of holding reserves has supported banks’ demand for them, so the multiplier has remained low. Explain the distinction between the “zero lower bound” and the “effective lower bound” on nominal interest rates. If interest rates were pushed below the effective lower bound, what would be the likely impact on the money multiplier and the supply of bank credit? Answer: If there were no transactions costs associated with using cash, its zero rate of return would impose a zero lower bound on nominal interest rates. However, in recent times, nominal rates have declined somewhat below zero in several countries. This is possible because of the costs associated with storing, transferring and insuring cash. The effective lower bound can be defined as the zero lower bound minus those costs. If nominal rates were pushed below the effective lower bound, we would expect depositors to withdraw funds from the banking system in favor of holding cash. This would increase the cash/deposit ratio, which would reduce the money multiplier. As a result, trying to push the interest rate below the effective lower bound would be contractionary because it would diminish the supply of bank credit. Data Exploration Plot on a weekly basis the ratio of currency (FRED code: CURRENCY) to checkable deposits (FRED code: TCD) from the start of 2000 through 2002 and then remove the recession bar. Download the data and identify the week of the downward spike in the graph. Do you think the spike reflects the currency term in the numerator or the deposits term in the denominator? Explain your reasoning. Answer: In the plot below, the downward spike occurred during the week of September 11.Examining the downloaded data, you will see it is due to a sharp, temporary rise in checkable deposits. The rise and subsequent fall in checkable deposits is the result of the disruption to the check-clearing process when airspace throughout the United States was closed. Checks in the clearing process that had been credited to accounts of check recipients were debited to the accounts on which they were drawn only after air travel resumed. Figure 17.10 shows a sharp decline of the M1 money multiplier in 2008. What caused the drop? Using the indicators for currency (FRED code: CURRSL), total reserve balances maintained (FRED code: RESBALNS), reserve balances required (FRED code: RESBALREQ), and checkable deposits (FRED code: TCDSL), plot since 2000 the currency-to-deposit ratio and the excess reserve-to-deposit-ratio. Which one caused the M1 money multiplier to plunge? (Hint: To estimate excess reserves, see footnote 8. Divide RESBALREQ by 1,000 to convert the units to billions of dollars.) Answer: Prior to the financial crisis, excess reserve holdings as a percentage of checkable deposits were negligible. In the crisis, the Federal Reserve massively expanded the supply of excess reserves, partly to meet panic-level liquidity demands. While the currency-to-deposit ratio was gradually falling, it cannot account for the abrupt change in the multiplier. In the Great Depression, the Fed allowed the money supply to decline. To confirm that the Federal Reserve learned from this lesson, plot since 2000 the M2 multiplier – the ratio of M2 (FRED code: M2SL) to the monetary base (FRED code: AMBSL) – and, on the right axis, the level of M2. Explain how the Fed was conducting policy in order to sustain the expansion of M2. Answer: The plot is below. M2 is the product of the M2 multiplier and the monetary base, M2 = m*MB. M2 can rise if a decline in the value of the multiplier is offset by a sufficiently large rise of the monetary base. During the financial crisis of 2007-2009, the Fed’s expansion of the monetary base – through its short-term lending programs and large-scale asset purchases – was sufficient to support the continued rise of M2 (unlike the Great Depression). Prior to the financial crisis of 2007-2009, the Fed seldom reduced its holdings of Treasury securities. Plot for the 2007-2009 period the Fed’s Treasury holdings (FRED code: TREAST) and its total assets (FRED code: WALCL) on a weekly basis. Did the Fed’s practices change during the crisis? If so, how? (Hint: Examine Table 17.1 to help with your response.) Answer: The data plot is below. In 2008, the Fed allowed its short-term Treasury securities to mature without replacement in order to offset the impact on its asset holdings of rapid increases in loans and purchases of other assets (including mortgage-backed securities and other Federal agency debt). After the Lehman failure, the Fed initiated the first round of quantitative easing (QE1), sharply expanding the size of its asset holdings. Thousands of the data series on FRED are provided directly by the Board of Governors of the Federal Reserve System, including hundreds of indicators from the Fed’s weekly balance sheet report (H.4.1 Factors Affecting Reserve Balances). How does this balance sheet transparency affect the conduct of monetary policy? Answer: Public disclosure of information about the balance sheet is crucial for the credibility of a central bank. The Fed’s detailed, high-frequency disclosures add meaningfully to its credibility as manager of the nation’s monetary affairs. The data allow outside observers to see clearly if the Fed’s deeds (in terms of balance sheet changes) match its words (including FOMC statements, congressional testimony, and speeches). Consistency of words and deeds is essential for credibility indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
