《货币银行学》课程授课教案（英文讲义）Chapter 11 The Central Bank Balance Sheet and the Money Supply Process

Chapter 11TheCentralBankBalanceSheetandtheMoneySupplyProcessChapterOverviewIn this chapter we develop an understanding of how the central bank interacts with thefinancial system and how its balance sheet is connected to the money and credit thatflows through the economy.ImportantPointsoftheChapterOne of the great successes of modern central banking is the story of the U.S. FederalReserve on September 11.Because of its quick action, the Fed kept the financialmarketsafloat,andthefinancial systemreturnedtonearnormal withinweeks.Thisis a marked contrast to what happened in the 1930's, and the difference is that in the30's Fed officials failed to provide the liquidity that sound banks needed to stay inbusiness..In200l,thestatementthat camefromtheFed was:TheFederalReserve is open and operating.The discount window is available to meet liquidityneeds."Application of Core PrinciplesPrinciple #3:Information (page 431)The balance sheet published by the centralbankisprobablythemostimportantinformationthatitmakespublicPrinciple #5:Stability (page 439)In the aftermath of September 11, Fed officialssaw a looming crisis and reacted with a massive injection ofreserves to maintain theliquidity of the financial system.The actions enabled the system to withstand theenormous shock.Principle#2:Risk (page 448)The amount of excess reserves a bank holdsdepends on the costs and benefits of holding them.The cost is the interest foregone;the benefit is the safety in the event that deposits are withdrawn

Chapter 11 The Central Bank Balance Sheet and the Money Supply Process Chapter Overview In this chapter we develop an understanding of how the central bank interacts with the financial system and how its balance sheet is connected to the money and credit that flows through the economy. Important Points of the Chapter One of the great successes of modern central banking is the story of the U.S. Federal Reserve on September 11. Because of its quick action, the Fed kept the financial markets afloat, and the financial system returned to near normal within weeks. This is a marked contrast to what happened in the 1930’s, and the difference is that in the 30’s Fed officials failed to provide the liquidity that sound banks needed to stay in business. In 2001, the statement that came from the Fed was: “The Federal Reserve is open and operating. The discount window is available to meet liquidity needs.” Application of Core Principles Principle #3: Information (page 431) The balance sheet published by the central bank is probably the most important information that it makes public. Principle #5: Stability (page 439) In the aftermath of September 11, Fed officials saw a looming crisis and reacted with a massive injection of reserves to maintain the liquidity of the financial system. The actions enabled the system to withstand the enormous shock. Principle #2: Risk (page 448) The amount of excess reserves a bank holds depends on the costs and benefits of holding them. The cost is the interest foregone; the benefit is the safety in the event that deposits are withdrawn

Principle #5:Stability (page 452) Central bankers need to look at both themonetarybase and themoneymultiplierto figure out whether their policies areworking.As the example from the 1930s illustrates, looking only at the base canlead to the wrong policy at the wrong time, creating more instability.TeachingTips/Student StumblingBlocksStudents will likely have difficulty understanding the impact of differenttransactions on the central bank's balance sheet.Emphasize the rulefrom page433:When the value of an asset on the balance sheet increases, either the valueof another asset decreases (so the net change is zero) or the value of a liabilityrisesbythesameamount (andsimilarlyforanincreaseinliabilities)Featuresinthis ChapterYour Financial World:Why We Still Have Cash (page431)Despite the technological changes that have brought us credit cards and electronicmoney, there is still a tremendous amount of cash in use.The reasons for this areconvenience, tax avoidance, and the anonymity that cash provides.Applying the Concept:The Fed's Response on September 11, 2001 (page 439)In the aftermath of September 11, Fed officials saw a looming crisis and reactedimmediately,providing reserves to anyone who needed them.Reserves increased byan astonishing $145 billion over a two-day period.This massive injection ofreserves was quickly drained out over the next week,as thesystem got back tonormal.Your Financial World: Your Excess Reserves (page 447)Just as banks hold excess reserves, individuals need to have an emergency fund to payforunexpectedexpensesthatcan'tbepostponed.Mostfinancialplannersrecommend that thesefunds should equal a minimum ofthree months'income in cashaccounts.Tools of the Trade:The Irrelevance of Reserve Requirements (page 449)Deposit sweeping allows banks to temporarily move funds from checking accounts(which have reserve requirements) into savings accounts (which do not).Sweeping

Principle #5: Stability (page 452) Central bankers need to look at both the monetary base and the money multiplier to figure out whether their policies are working. As the example from the 1930s illustrates, looking only at the base can lead to the wrong policy at the wrong time, creating more instability. Teaching Tips/Student Stumbling Blocks  Students will likely have difficulty understanding the impact of different transactions on the central bank’s balance sheet. Emphasize the rule from page 433: When the value of an asset on the balance sheet increases, either the value of another asset decreases (so the net change is zero) or the value of a liability rises by the same amount (and similarly for an increase in liabilities). Features in this Chapter Your Financial World: Why We Still Have Cash (page 431) Despite the technological changes that have brought us credit cards and electronic money, there is still a tremendous amount of cash in use. The reasons for this are convenience, tax avoidance, and the anonymity that cash provides. Applying the Concept: The Fed’s Response on September 11, 2001 (page 439) In the aftermath of September 11, Fed officials saw a looming crisis and reacted immediately, providing reserves to anyone who needed them. Reserves increased by an astonishing $145 billion over a two-day period. This massive injection of reserves was quickly drained out over the next week, as the system got back to normal. Your Financial World: Your Excess Reserves (page 447) Just as banks hold excess reserves, individuals need to have an emergency fund to pay for unexpected expenses that can’t be postponed. Most financial planners recommend that these funds should equal a minimum of three months’ income in cash accounts. Tools of the Trade: The Irrelevance of Reserve Requirements (page 449) Deposit sweeping allows banks to temporarily move funds from checking accounts (which have reserve requirements) into savings accounts (which do not). Sweeping

funds over a weekend dramatically reduces the reserves a bank must hold becauseFriday countsfromthreedays incomputingreserves.Atthe sametime,though,cash is being loaded into ATMs anticipating use over the weekend, and that counts asvault cash.The bottom line is that reserve requirements no longer have much of animpact on banks'behavior.Applying the Concept:MonetaryPolicy in the 1930s (page452)One of the important lessons of the Great Depression of the 1930s is that centralbankers need to look at both the monetary base and the money multiplier to figure outwhether their policies are workingIn the News:Record Federal Deficit Forecast; Drastic Increase over White House'sEarlier Estimates for This Year (page 454)A federal government budget deficit results in more borrowing which would suck upcapital and cause consumer and business interest rates to rise."This, in turn, wouldslow spending and lower economic growth.Lessons of the Article: By increasing the supply of bonds, increasedgovernment borrowing drives down the price of bonds, raising interest rates.Federal Reserve Board Chairman Greenspan is concerned about this trend fortworeasons.Thefirst isthat itmakesthejob of stabilizing interestratesmoredifficult, and the second is that it puts pressure on the Fed to purchase the bondsissuedbythegovernment.Whenthecentral bankpurchasesgovernment-issued bonds, its action increases the monetary base and expandsthe quantityof money in the economy,which can eventuallylead to inflationAdditional Teaching ToolsIs the money multiplier a myth?Read this article by Frank Shostak, which arguesthat,banks makeloansfirst and worry about reserves later."http://www.mises.org/fullarticle.asp?control=1118&id=69Some countries, including Canada, Australia, and Sweden have no reserverequirements.Download this PDF file of an article that looks at three countries thatconduct monetary policy without reserve requirements (Canada, the UK, and NewZealand)http://ideas.repec.org/a/fip/fedker/y1997iqip5-30n82(2).htmlVirtualTools

funds over a weekend dramatically reduces the reserves a bank must hold because Friday counts from three days in computing reserves. At the same time, though, cash is being loaded into ATMs anticipating use over the weekend, and that counts as vault cash. The bottom line is that reserve requirements no longer have much of an impact on banks’ behavior. Applying the Concept: Monetary Policy in the 1930s (page 452) One of the important lessons of the Great Depression of the 1930s is that central bankers need to look at both the monetary base and the money multiplier to figure out whether their policies are working. In the News: Record Federal Deficit Forecast; Drastic Increase over White House’s Earlier Estimates for This Year (page 454) A federal government budget deficit results in more borrowing which would “suck up capital and cause consumer and business interest rates to rise.” This, in turn, would slow spending and lower economic growth. Lessons of the Article: By increasing the supply of bonds, increased government borrowing drives down the price of bonds, raising interest rates. Federal Reserve Board Chairman Greenspan is concerned about this trend for two reasons. The first is that it makes the job of stabilizing interest rates more difficult, and the second is that it puts pressure on the Fed to purchase the bonds issued by the government. When the central bank purchases government-issued bonds, its action increases the monetary base and expands the quantity of money in the economy, which can eventually lead to inflation. Additional Teaching Tools Is the money multiplier a myth? Read this article by Frank Shostak, which argues that, “banks make loans first and worry about reserves later.” http://www.mises.org/fullarticle.asp?control=1118&id=69 Some countries, including Canada, Australia, and Sweden have no reserve requirements. Download this PDF file of an article that looks at three countries that conduct monetary policy without reserve requirements (Canada, the UK, and New Zealand). http://ideas.repec.org/a/fip/fedker/y1997iqiip5-30n82(2).html Virtual Tools

Learn more about reserve requirements on this site from the New York FederalReserve Bank:http:/www.newyorkfed.org/aboutthefed/fedpoint/fed45.htmlLearn more about open market operations on this site from the New York FederalReserve Bank:http:/www.newyorkfed.org/aboutthefed/fedpoint/fed32.htmlFor the latest data on the Ml money multiplier, visit this site from the St. LouisFederal Reserve Bank:http://research.stlouisfed.org/fred2/series/MULT/24What happens to all that borrowing by the federal government?Deficits accumulateinto the national debt.Find out how much the debt is “to the penny"at this Treasuryweb site:http:/www.publicdebt.treas.gov/opd/opdpenny.htmForMoreDiscussionHow much cash do we really use?Have students keep a journal for a week trackinghowmuch cashthey spend and wheretheyobtain it, i.e.,how often do theyuseATMs?Howhas the increaseduseofelectronic moneyaffected themultiplier?If theUnitedStatesmovesclosertoacashlesssociety,howwill thataffecttheFed initsconductofmonetary policy?ChapterOutlineTheCentralBank'sBalanceSheet1.The central bank engages in numerous financial transactions, all of whichcause changes in its balance sheet.2.Central banks publish their balance sheets regularly, the Fed and the ECBdo so weekly.Publication is a crucial part of transparency

Learn more about reserve requirements on this site from the New York Federal Reserve Bank: http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html Learn more about open market operations on this site from the New York Federal Reserve Bank: http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html For the latest data on the M1 money multiplier, visit this site from the St. Louis Federal Reserve Bank: http://research.stlouisfed.org/fred2/series/MULT/24 What happens to all that borrowing by the federal government? Deficits accumulate into the national debt. Find out how much the debt is “to the penny” at this Treasury web site: http://www.publicdebt.treas.gov/opd/opdpenny.htm For More Discussion How much cash do we really use? Have students keep a journal for a week tracking how much cash they spend and where they obtain it; i.e., how often do they use ATMs? How has the increased use of electronic money affected the multiplier? If the United States moves closer to a cashless society, how will that affect the Fed in its conduct of monetary policy? Chapter Outline The Central Bank’s Balance Sheet 1. The central bank engages in numerous financial transactions, all of which cause changes in its balance sheet. 2. Central banks publish their balance sheets regularly; the Fed and the ECB do so weekly. Publication is a crucial part of transparency

AssetsThe central bank's balance sheet shows three basic assets:securities, foreignexchange reserves, and loans.Securities: the primary assets of most central banks; independent central banksdetermine the quantity of securities that they purchase.For the U.S.Federal Reserve, these are primarily U.S. Treasury securities.Foreign ExchangeReserves:the central bank'sand government'sbalances offoreign currency and areheld asbonds issued byforeigngovernmentsThesereservesareused inforeignexchangemarket interventionsLoans are extended to commercial banks, and can fall into two categories:discountloansandfloatDiscount loans: the loans the Fed makes when commercial banks needshort-termcashFloat: a byproduct of the Fed's check-clearing business.The Fed creditsthe reserve account of the bank receiving the check before it debits theaccount of thebank on which the check was drawn and this createsfloat.Through its holdings of U.S. Treasury securities the Fed controls the federalfunds rateand theavailability of money and credit.Gold reserves, while still an asset of many central banks, are virtuallyirrelevant.B. LiabilitiesThere are threemajor liabilities:currency,the government's deposit account,andthedepositaccountsofthecommercialbanksThe first two items represent the central bank in its role as the government'sbank,and thethird shows itasthe bankers'bankCurrency:nearly all central banks have a monopoly on the issuance ofcurrency, and currency accounts for over 90 percent of the Fed's liabilities.Government's account:the central bank provides the government with anaccount into which it deposits funds (primarily tax revenues) and fromwhich it writes checks and makes electronic payments.Reserves:Commercial bank reserves consist of cash in the bank's own vaultand deposits at the Fed, which function like the commercial bank'schecking accountCentralbanksruntheirmonetarypolicyoperationsthroughchangesinbankingsystemreservesC.The Importance of Disclosure1.The balance sheet published by the central bank is probably the mostimportant information that it makes public; it is an essential aspect ofcentralbanktransparency

Assets The central bank’s balance sheet shows three basic assets: securities, foreign exchange reserves, and loans. Securities: the primary assets of most central banks; independent central banks determine the quantity of securities that they purchase. For the U.S. Federal Reserve, these are primarily U.S. Treasury securities. Foreign Exchange Reserves: the central bank’s and government’s balances of foreign currency and are held as bonds issued by foreign governments. These reserves are used in foreign exchange market interventions. Loans are extended to commercial banks, and can fall into two categories: discount loans and float. Discount loans: the loans the Fed makes when commercial banks need short-term cash. Float: a byproduct of the Fed’s check-clearing business. The Fed credits the reserve account of the bank receiving the check before it debits the account of the bank on which the check was drawn and this creates float. Through its holdings of U.S. Treasury securities the Fed controls the federal funds rate and the availability of money and credit. Gold reserves, while still an asset of many central banks, are virtually irrelevant. B. Liabilities There are three major liabilities: currency, the government’s deposit account, and the deposit accounts of the commercial banks. The first two items represent the central bank in its role as the government’s bank, and the third shows it as the bankers’ bank. Currency: nearly all central banks have a monopoly on the issuance of currency, and currency accounts for over 90 percent of the Fed’s liabilities. Government’s account: the central bank provides the government with an account into which it deposits funds (primarily tax revenues) and from which it writes checks and makes electronic payments. Reserves: Commercial bank reserves consist of cash in the bank’s own vault and deposits at the Fed, which function like the commercial bank’s checking account. Central banks run their monetary policy operations through changes in banking system reserves. C. The Importance of Disclosure 1. The balance sheet published by the central bank is probably the most important information that it makes public; it is an essential aspect of central bank transparency

D.The MonetaryBaseCurrency in the hands of the public and the reserves of the banking system arethe two components of the monetary base, also called high-poweredmoney.The central bank can control the size of the monetary base and therefore thequantity of money.Changing the Size and Composition of theBalance SheetThe central bank controls the size of its balance sheet.Policymakers canenlarge or reduce their assets and liabilities at will.The central bank can buy things, like a bond, and create liabilities to pay forthem. It can increase the size of its balance sheet as much as it wants.Therearefourspecifictypesoftransactionswhichcanaffectthebalancesheets of both the central bank and the banking system:(1) an openmarket operation, in which the central bank buys or sells a security, (2) aforeign exchange intervention, in which the central bank buys or sellsforeign currency reserves; (3) the central bank's extension of a discountloantoa commercial bank;and(4)thedecisionby an individual towithdrawcashfromabankOpen market operations, foreign exchange interventions, and discount loansall affect the size of the central bank's balance sheet and they change thesize of the monetary base; cash withdrawals by the public create shiftsamong the different components of themonetary base, changing thecomposition of the central bank's balance sheet but leaving its sizeunaffected.One simplerulewill help in understanding the impact ofeachof thesefourtransactions on the central bank's balance sheet:When the value of anassetonthebalancesheet increases,eitherthevalueofanotherassetdecreases (so that the net change is zero) or the value of a liability rises bythe same amount (and similarly for an increase in liabilities).A.OpenMarketOperations1.OMO is when the Fed buys or sells securities in financial markets2.These purchases and sales have a straightforward impact on the Fed'sbalance sheet:its assets and liabilities increase bythe amount of apurchase, and the monetary base increases by the same amount.3.Intermsofthebankingsystem'sbalancesheet,thepurchasehasnoeffecton the liabilities, and results in two counterbalancing changes on the assetside, so the net effect there is zero.4.For an open market sale the effects would be the same but in the oppositedirection

D. The Monetary Base Currency in the hands of the public and the reserves of the banking system are the two components of the monetary base, also called high-powered money. The central bank can control the size of the monetary base and therefore the quantity of money. Changing the Size and Composition of the Balance Sheet The central bank controls the size of its balance sheet. Policymakers can enlarge or reduce their assets and liabilities at will. The central bank can buy things, like a bond, and create liabilities to pay for them. It can increase the size of its balance sheet as much as it wants. There are four specific types of transactions which can affect the balance sheets of both the central bank and the banking system: (1) an open market operation, in which the central bank buys or sells a security; (2) a foreign exchange intervention, in which the central bank buys or sells foreign currency reserves; (3) the central bank’s extension of a discount loan to a commercial bank; and (4) the decision by an individual to withdraw cash from a bank. Open market operations, foreign exchange interventions, and discount loans all affect the size of the central bank’s balance sheet and they change the size of the monetary base; cash withdrawals by the public create shifts among the different components of the monetary base, changing the composition of the central bank’s balance sheet but leaving its size unaffected. One simple rule will help in understanding the impact of each of these four transactions on the central bank’s balance sheet: When the value of an asset on the balance sheet increases, either the value of another asset decreases (so that the net change is zero) or the value of a liability rises by the same amount (and similarly for an increase in liabilities). A. Open Market Operations 1. OMO is when the Fed buys or sells securities in financial markets. 2. These purchases and sales have a straightforward impact on the Fed’s balance sheet: its assets and liabilities increase by the amount of a purchase, and the monetary base increases by the same amount. 3. In terms of the banking system’s balance sheet, the purchase has no effect on the liabilities, and results in two counterbalancing changes on the asset side, so the net effect there is zero. 4. For an open market sale the effects would be the same but in the opposite direction

B. Foreign Exchange Intervention1.The impact of a foreign exchange purchase is almost identical to that of anopen market purchase:the Fed's assets and liabilities increase by thesame amount, as does the monetary base.2.If the Fed buys from a commercial bank,the impact again is like the openmarket purchase,except the assets involved are different.C.DiscountLoans1.TheFed doesnotforcecommercial bankstoborrowmoney:thebanks askfor loans and must provide collateral, usually a U.S. Treasury bond.2. When the Fed makes a loan it creates an asset and a matching increase initsreserveliabilities.3.The extension of credit to the banking system raises the level of reservesand expands the monetary base.4.The banking system balance sheet shows an increase in assets (reserves)and an increase in liabilities (the loan)D. Cash WithdrawalCash withdrawals affect only the composition, not the size, of the1monetary base.When people withdraw cash they force a shift from reserves to currency on2.theFed'sbalancesheet3.The withdrawal reduces the banking system's reserves, which is a decreasein its assets, and if the funds come from a checking account, there is amatching decrease in liabilities4.OntheFed'sbalancesheetbothcurrencyandreservesare liabilities,sothere is just a change between the two with a net effect of zeroIlI.The Deposit Expansion MultiplierA. Deposit Creation in a Single Bank1.If theFed buys a securityfrom a bank,thebank has excess reserves,whichit will seek to lend.2.The loan replaces the securities as an asset on the bank's balance sheetB.Deposit Expansion in a System of Banks1. However, the loan that the bank made was spent and as the checks cleared,reserves were transferred to other banks.2.The banks that receive the reserves will seek to lend their excess reserves,and the process continues until all of the funds have ended up in requiredreserves.3.Assuming noexcess reservesareheldand thatthere areno changes intheamount of currency held by the public, the change in deposits will be the

B. Foreign Exchange Intervention 1. The impact of a foreign exchange purchase is almost identical to that of an open market purchase: the Fed’s assets and liabilities increase by the same amount, as does the monetary base. 2. If the Fed buys from a commercial bank, the impact again is like the open market purchase, except the assets involved are different. C. Discount Loans 1. The Fed does not force commercial banks to borrow money; the banks ask for loans and must provide collateral, usually a U.S. Treasury bond. 2. When the Fed makes a loan it creates an asset and a matching increase in its reserve liabilities. 3. The extension of credit to the banking system raises the level of reserves and expands the monetary base. 4. The banking system balance sheet shows an increase in assets (reserves) and an increase in liabilities (the loan). D. Cash Withdrawal 1. Cash withdrawals affect only the composition, not the size, of the monetary base. 2. When people withdraw cash they force a shift from reserves to currency on the Fed’s balance sheet. 3. The withdrawal reduces the banking system’s reserves, which is a decrease in its assets, and if the funds come from a checking account, there is a matching decrease in liabilities. 4. On the Fed’s balance sheet both currency and reserves are liabilities, so there is just a change between the two with a net effect of zero. III. The Deposit Expansion Multiplier A. Deposit Creation in a Single Bank 1. If the Fed buys a security from a bank, the bank has excess reserves, which it will seek to lend. 2. The loan replaces the securities as an asset on the bank’s balance sheet. B. Deposit Expansion in a System of Banks 1. However, the loan that the bank made was spent and as the checks cleared, reserves were transferred to other banks. 2. The banks that receive the reserves will seek to lend their excess reserves, and the process continues until all of the funds have ended up in required reserves. 3. Assuming no excess reserves are held and that there are no changes in the amount of currency held by the public, the change in deposits will be the

inverse of the required deposit reserve ratio (rp) times the change inrequired reserves, or △D =(1/rp) △RR4The term (1/rp) represents the simple deposit expansion multiplier5.Adecreaseinreserveswillgenerateadepositcontractioninamultipleamounttoo.IV.TheMonetaryBaseandtheMoneySupplyDepositExpansion withExcessReserves and Cash WithdrawalsThe simpledeposit expansionmultiplier was derived assuming no excessreserves are held and that there is no change in currency holdings by thepublic.Theseassumptions arenowrelaxed.The desire of banks to hold excess reserves and the desire of account holdersto withdraw cash both reduce the impact of a given change in reserves onthe total deposits in the system; the two factors operate in the same way asan increase in the reserve requirement.The Arithmetic of the Money MultiplierThe amount of excess reserves a bank holds depends on the costs and1.benefits of holding them, where the cost is the interest foregone and thebenefit is the safetyfromhaving the reserves in casethere is an increase inwithdrawals.2. The higher the interest rate, the lower banks' excess reserves will be; thegreater the concern over possible deposit withdrawals, the higher theexcess reserves will be.3.Similarly,the decision of how much currency to hold depends on the costsand benefits,wherethecost istheinterestforegoneandthebenefit isthelowerriskandgreaterliquidityofcurrency4.As interest rates rise cash becomes less desirable, but ifthe riskiness ofalternative holdings rises or liquidity falls, then it becomes more desirable5. Deriving the money multiplier tells us that the quantity of money in theeconomy depends on the monetary base, the reserve requirement, thedesirebybankstoholdexcessreserveandthedesirebythepublictoholdcurrency.6.The quantity of money changes directly with the base, and for a givenamount of the base, an increase in either the reserve requirement or theholdings of excess reserves will decrease the quantity of money.7. But currency holdings affect both the numerator and the denominator ofthe multiplier, so the effect is not immediately obvious.Logic tells usthat an increase in currency decreases reserves and so decreases the moneysupply

inverse of the required deposit reserve ratio (rD) times the change in required reserves, or ∆D = (1/rD) ∆RR 4. The term (1/rD) represents the simple deposit expansion multiplier. 5. A decrease in reserves will generate a deposit contraction in a multiple amount too. IV. The Monetary Base and the Money Supply Deposit Expansion with Excess Reserves and Cash Withdrawals The simple deposit expansion multiplier was derived assuming no excess reserves are held and that there is no change in currency holdings by the public. These assumptions are now relaxed. The desire of banks to hold excess reserves and the desire of account holders to withdraw cash both reduce the impact of a given change in reserves on the total deposits in the system; the two factors operate in the same way as an increase in the reserve requirement. The Arithmetic of the Money Multiplier 1. The amount of excess reserves a bank holds depends on the costs and benefits of holding them, where the cost is the interest foregone and the benefit is the safety from having the reserves in case there is an increase in withdrawals. 2. The higher the interest rate, the lower banks’ excess reserves will be; the greater the concern over possible deposit withdrawals, the higher the excess reserves will be. 3. Similarly, the decision of how much currency to hold depends on the costs and benefits, where the cost is the interest foregone and the benefit is the lower risk and greater liquidity of currency. 4. As interest rates rise cash becomes less desirable, but if the riskiness of alternative holdings rises or liquidity falls, then it becomes more desirable. 5. Deriving the money multiplier tells us that the quantity of money in the economy depends on the monetary base, the reserve requirement, the desire by banks to hold excess reserve and the desire by the public to hold currency. 6. The quantity of money changes directly with the base, and for a given amount of the base, an increase in either the reserve requirement or the holdings of excess reserves will decrease the quantity of money. 7. But currency holdings affect both the numerator and the denominator of the multiplier, so the effect is not immediately obvious. Logic tells us that an increase in currency decreases reserves and so decreases the money supply

The Limits of the Central Bank's Ability to Control the Quantityof Money1.There is no tight link between changes in interest rates and changes in themoneymultiplier.2. In places like the United States, Europe, and Japan, the link between thecentral bank's balance sheet and the quantity of money circulating in theeconomy has become too weak and unpredictable to be exploitedforpolicy purposes.The Fed, the ECB, and the Bank of Japan have very limited control over3.the quantity of money in their currency areas.4.Instead, modern central banks keep an eye on trends in money growthsince that is what ultimately determines inflation. For short-run policy,interest rates have become the tool of choice.18ChapterOutlineThe Federal Reserve's Monetary PolicyToolboxLike all central banks, the Fed can control the quantity of reserves thatcommercial banks hold.Besides the quantity of reserves, the central bank can control either the size ofthe monetary base or the price of its components.Thetwopricesitconcentratesonaretheinterestrateat whichbanksborrowand lend reserves overnight (the federal funds rate) and the interest rate atwhich banks can borrowreserves from theFed (the discount rate).The Fed has three monetary policy tools, or instruments:the target federalfunds rate, the discount rate, and the reserve requirement.TheTarget Federal Funds Rate and Open Market OperationsThe target federal funds rate is the FOMC's primary policy instrument. FOMCmeetings always end with a decision on the target level, and the statementthat is released after the meeting begins with an announcement of thatdecisionThefederalfundsrateisdetermined inthemarket,ratherthanbeing controlledby the Fed.Thename“federal fundscomesfromthefactthatthefunds bankstradearetheir deposit balancesat theFed

The Limits of the Central Bank’s Ability to Control the Quantity of Money 1. There is no tight link between changes in interest rates and changes in the money multiplier. 2. In places like the United States, Europe, and Japan, the link between the central bank’s balance sheet and the quantity of money circulating in the economy has become too weak and unpredictable to be exploited for policy purposes. 3. The Fed, the ECB, and the Bank of Japan have very limited control over the quantity of money in their currency areas. 4. Instead, modern central banks keep an eye on trends in money growth since that is what ultimately determines inflation. For short-run policy, interest rates have become the tool of choice. 18 Chapter Outline The Federal Reserve’s Monetary Policy Toolbox Like all central banks, the Fed can control the quantity of reserves that commercial banks hold. Besides the quantity of reserves, the central bank can control either the size of the monetary base or the price of its components. The two prices it concentrates on are the interest rate at which banks borrow and lend reserves overnight (the federal funds rate) and the interest rate at which banks can borrow reserves from the Fed (the discount rate). The Fed has three monetary policy tools, or instruments: the target federal funds rate, the discount rate, and the reserve requirement. The Target Federal Funds Rate and Open Market Operations The target federal funds rate is the FOMC’s primary policy instrument. FOMC meetings always end with a decision on the target level, and the statement that is released after the meeting begins with an announcement of that decision. The federal funds rate is determined in the market, rather than being controlled by the Fed. The name “federal funds” comes from the fact that the funds banks trade are their deposit balances at the Fed

If theFed wanted to,it couldforcethemarketfederal funds rateto equal thetarget rate all the time by participating directly in the market for overnightreserves, both as a borrower and as a lender.As a lender, the Fed would need to make unsecured loans to commercial banks,and as a borrower,the Fed would in effect bepaying interest on excessreserves.TheFed has never done this because it does not want the credit riskthat wouldcomewithuncollateralized lending,becausepolicymakersbelievethatthefederal funds market provides valuable information about the health ofspecific banks, and because the Fed has stated it will only pay interest onreserves at the request of Congress.The Fed chooses to control the federal funds rate by manipulating the quantityof reserves through open market operations: the Fed buys or sellssecurities to add or drain reserves as required.Day-to-day control of the supply of federal funds is the job of the OpenMarket trading desk at the New York Federal Reserve Bank.Most days the market rate is close to the target rate, although on occasiontherehavebeen spikes inthemarketrate.These surprises havebecomeless frequent as information systems at banks and at the Fed haveimproved.Chapter 1.Discount Lending, theLender of LastResort and CrisisManagementLending to commercial banks is not an important part of the Fed's day-to-daymonetarypolicyHowever, such lending is the Fed's primary tool for ensuring short-termfinancial stability,for eliminatingbank panics, and preventing the suddencollapse of institutions that are experiencing financial difficultiesThe central bank is the lender of last resort, making loans to banks when noone else can or will, but a bank must show that it is sound to get a loan in acrisis.The current discount lending procedures also help the Fed meet itsinterest-rate stability objective.The Fed makes three types of loans:primary credit, secondary credit, andseasonal credit.Primary creditis extended on averyshort-termbasis,usuallyovernight,tosoundinstitutions.Itisdesignedtoprovideadditionalreservesattimeswhen the day's reserve supply falls short of the banking system's demand.The system provides liquidity in times of crisis, ensures financial stability,and restricts the range over which the market federal funds rate can move(helping to maintain interest-rate stability).Secondary credit is available to institutions that are not sufficiently sound toqualify for primary credit. Banks may seek secondary credit due to a

If the Fed wanted to, it could force the market federal funds rate to equal the target rate all the time by participating directly in the market for overnight reserves, both as a borrower and as a lender. As a lender, the Fed would need to make unsecured loans to commercial banks, and as a borrower, the Fed would in effect be paying interest on excess reserves. The Fed has never done this because it does not want the credit risk that would come with uncollateralized lending, because policymakers believe that the federal funds market provides valuable information about the health of specific banks, and because the Fed has stated it will only pay interest on reserves at the request of Congress. The Fed chooses to control the federal funds rate by manipulating the quantity of reserves through open market operations: the Fed buys or sells securities to add or drain reserves as required. Day-to-day control of the supply of federal funds is the job of the Open Market trading desk at the New York Federal Reserve Bank. Most days the market rate is close to the target rate, although on occasion there have been spikes in the market rate. These surprises have become less frequent as information systems at banks and at the Fed have improved. Chapter 1. Discount Lending, the Lender of Last Resort and Crisis Management Lending to commercial banks is not an important part of the Fed’s day-to-day monetary policy. However, such lending is the Fed’s primary tool for ensuring short-term financial stability, for eliminating bank panics, and preventing the sudden collapse of institutions that are experiencing financial difficulties. The central bank is the lender of last resort, making loans to banks when no one else can or will, but a bank must show that it is sound to get a loan in a crisis. The current discount lending procedures also help the Fed meet its interest-rate stability objective. The Fed makes three types of loans: primary credit, secondary credit, and seasonal credit. Primary credit is extended on a very short-term basis, usually overnight, to sound institutions. It is designed to provide additional reserves at times when the day’s reserve supply falls short of the banking system’s demand. The system provides liquidity in times of crisis, ensures financial stability, and restricts the range over which the market federal funds rate can move (helping to maintain interest-rate stability). Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit. Banks may seek secondary credit due to a