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Liabilities
The two liabilities on the balance sheet, currency in circulation and reserves, are often
referredto as the monetary liabilitiesOfthe Fed, Theyare an importantpart of the
money supply story because increases in either or both will lead to an increase in the
money supply (everything else being constant). sum of t,heFeclkmonetary liabili-
ties (currency in circulat.ionand reserves) and the U.S.freasury's monetary liabilities
('Il•easurycurrency in circulation, primarily coins) is called the monetary base. When
discussing the monetary base, we will focus only on the monetary liabilities of the Fed
because the monetary liabilities Ofthe 'Il•eæsuryaccount for less than of the base.2
'It is also safe to ignore the freasuryk monetary liabilities when discussing the monetary base because
the 'freasury cannot actively supply its monetary liabilities to the economy due to legal restrictions.
"The currency item on the balance sheet refers only to currency in circulation. that is, the
amount in the hands Ofthe public. Currency that has been printed by the U.S. Bureau OfEngraving and
Printing is not automatically a liability or the Fed. For example, consider the importance or having
Sl million of your own IOUsprinted up. You give out SIOOworth to other people and keep the other
5999.900 in your pocket. The S999,900 OfIOUsdoes not make you richer or poorer and does not affect
your indebtedness. Youcare only about the $100 01 liabilities from the or circulated 10tJtu The
same reasoning applies for the Fed in regard to its Federal Reserve notes.
For similar reasons, the currency component of the money supply, no matter how it is defined,
includes only currency in circulation, It does not include any additional currency that is not yet in
hands or public. The fact that currc•ncyhas been printed but is not circulating means that it is not
anyonek asset or liability and thus cannot affect anyone's behavior. Therefore, it makes sense not to
include it in the money supply.
4 Central Banking and the Conduct Of Monetary policy
Assets
The two assets on the balance sheet are important for two reasons. First,
changes in the asset items lead to changes in reservesand consequentlyto changes
in the money supply.Second, because these assets (government securitiesand dis-
count loans) earn interest whilethe liabilities(currency in circulationand reserves)
do not, the Fed makes billionsof dollarseveryyear—itsassets earn income,and
its liabilitiescost nothing.Althoughit returns most of its earnings to the federal
government, the Fed does spend some of it on "worthycauses,"such as supporting
economic research.
When the bank receivesthe check, it credits the depositor'saccount with the
$100and then depositsthe check in its account with the Fed, thereby adding to its
reserves. The banking system's T-account becomes
Banking System
Liabilities
Reserves +$ 00 Checkabledeposits *$100
Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 217
The effect on the Fedk balance sheet is that it has gained $100of securities
in its assets column,whilereserves have increased by $100,as shownin its lia-
bilitiescolumn:
Fderal ReserveSysEm
Liabihties
Securities +$ 100 Reserves +$100
Discount Lending
Open market operations are not the only way the Federal Reserve can affect the amount
of reserves. Reserves are also changed when the Fed makes a discountloan to a bank
For example, suppose that the Fed makes a $100 discount loan to the First National Bank.
The Fed then credits $ 100 to the bankk reserve account. The effects on the balance
sheets of the banking system and the Fed are illustrated by the followmgT-accounts:
or eserves
The analysis of the market for reserves proceeds in a similar fashion to the analysis
or the bond market we conclucted in Chapter 4, We derive a demand and supply curve
for reserves. Then the market equilibrium in which the quantity of reserves
demanded equals the quantity of reserves supplied determines the federal funds rate,
the interest rat.e charged on the loans of these reserves.
Demand Curve derive the demand for leset•VeS,we need to ask What happens
to the quantity of reserves demanded, holding ewrything else constant, as the federal funcLs
changes. Recall from the previous section that the amount of reserves can be split
up into two components: ( I ) requirul tvserves, which equal the wquirv•d reserve ratio times
the amount ol' deposits on which resetVeSare required, and (2) excess reserves, the acldi-
[ional reserves choose to hold. Therefore, the quantity of reserves demandecl equaLs
required resetVes plus the quantity of excess demanded, Excess reserves am insur-
ance against deposit outflows, and the cost of holding these eXcvss reserves is their oppor-
[unity cost, the interest rate that could have been ranted on lending these reserves out,
minus the interest rate that is earned on these reserves, in.
Before 2008, the Federal Reserve did not pay interest Oti reserves, but Since the
autumn Of2008, the Fed has paid interest on reserves at a level that is set at a fixed
amount below the federal funds rate target therefore changes when the target
changes (see the Inside the Fed box. "Why[)oes the Fed Need to pay Interest on
Reserv•eg?"). When t.he federal funds rate is above the rate paid on excess reserves, O,
as federal rate decreases. the opportunity cost of holding excess reserves
falls. Holding everything else constant, including the quantity of required reserves, the
quantity of reserves demanded rises, Consequently. the demand curve for resetVeS,RI,
slopes downwardin Figure 10.1when the federal rate is above If however,
the federal funds rate begins to fall below the interest rate paid on excess reserves
banks would lend in the overnight market at a lower interest rate. Instead, they would
just keep on adding to their holdings of excess reserves indefinitely. The result is that the
demand curve for reserves, RI, becomes flat (infinitely elastic) at in Figure 10.1,
Supply Curve The supply Ofreserves, R', can be broken up into two components:
the amount or reserves that are supplied by the open market. operations, called
(NBR) , and t,he amount Ofreserves borrowed from the Fed,
called borrowed reserve'S (BR), The primary cost Of borrowing from the Fool is
tho interest rate the Fed charges on these loans, the discount rate (ia), Because bor-
rowing federal funds from other banks is a substitute for borrowing (taking out
discount loans) from the Fed, il the federal funds rate is below the discount rate
in, then banks will not borrow from the Fed and borrowed reserves will be zero
Federal
Funds Rate
Rd
Jazz 36 4:45 PM 65%
Done E_Book_FinanciaI-Markets-an...
Federal
is Rate
260 of 709
Rd
because borrowing in the federal funds market is cheaper. Thus, as long as G remains
below ia, the supply Ofreserves will just equal the amount of nonborrowed reserves
supplied by the Fed, ,'VBR,and so the supply curve will be vertical, as shown in
Figure 10.1.However,as the federal funds rate begins to rise above the discount
rate, banks would want [o keep borrowing more and more at and then lending out
the proceeds in [he federal funds market at the higher rate, Tile result is that
the supply curve becomesflat (infinitely elastic) at iu, as shownin Figure 10.l.
Market Equilibrium Market equilibrium occurs where the quantity Of reserves
clernanded equals the quantity supplied, R' = Rd. Equilibrium therefore occurs at the inter-
section Ofthe clernancl curve and the supply curve R' at point I , with an equilibrium
IOderalfunds rate of When [he IOderal l'uncls rate is above the equilibliurn rate at i},
there are Inore reserves supplied titan demanded (excess supply) and so the federal
fiands rate Kills to as shown by the downward arrow. When [he federal funds rate is
below the equilibrium rate at. there are more reserves demandecl than supplied (excess
demand) and so the fr'deral funds rate rises, as shown by the upwiml arrow. (Note that
Figure 10.1 is drawn so that is above because the Federal Reserve typically keeps
the discount rate substantially above the target for the federal funds rate.)
4 Central Of policy
Chapter Conduct Of Monetary policy: Goals, Strategy, and Tactica 221
Federal Federal
Funds Rate Funds Rate
Federal Federal
Funds Rate Funds Rate
Federal
Funds Rate
CASE
How the Federal Reserve's Operating
Procedures Limit Fluctuations in the
Federal Funds Rate
An important advantage of the Pedk current procedures for operating the discount win-
clow and pi!ving interest on reserves is that they limit fluctuations in the federal funds
rate. We can use our supply-and-demand analysis of the market for reserves to see wlw.
target of in Figure 10.5. [f the demand for reserves has a large unexpected increase,
the demand curve would shift. to the right to R", where it now intersects the supply
curve for reserves on the flat portion where the equilibrium federal funds rate,
ia , equals the discount rate, No matter how far the demand curve shifts to the right,
the equilibriumfederalfunds rate, i; , willjust stay at id becauseborrowedreserves
will just continue to increase, matching the increase in demand. Similarly,if the
demand for reserves has a large unexpected decrease, the demand curve would shift
to the left to , and the supply culve intersects the demand curve on its flat por-
tion where the equilibrium federal funds rate, it},equals the interest rate paid on
reserves No matter how far the demandcurve shifts to the left, the equilibriurn
federalfundsrate willstay at becauseexcess resenreswilljust keep on increas-
ing so that the quantity demandedof reserves equals the quantity of nonborrowed
reserves supplied.
Our analysistherefore shows that the Federal Reserve's operating
procedureslimit thefluctuations of thefederal funds rate to between
and id. If the range between ie, and ia is kept narrow enough, then the fluctuations
around the target rate will be small.