Policy Makers and the Money Supply

102

CHAPTER 5

Policy Makers and the Money Supply

L E A R N I N G O BJ E C T I V E S

After studying this chapter, you should be able to do the following: LO 5.1 Describe the U.S. national economic policy objectives and possible confl icts among

these objectives.

LO 5.2 Identify the major policy makers and describe their primary responsibilities. LO 5.3 Discuss how the U.S. government infl uences the economy and how the government

reacted to the 2007–09 perfect fi nancial storm.

LO 5.4 Describe the U.S. Treasury’s cash and general management responsibilities. LO 5.5 Describe the U.S. Treasury’s defi cit fi nancing and debt management responsibilities. LO 5.6 Discuss how expansion of the money supply takes place in the U.S. banking system. LO 5.7 Summarize the factors or transactions that aff ect bank reserves. LO 5.8 Explain the terms monetary base, money multiplier, and the velocity of money and

their relationships to the money supply.

W H E R E W E H AV E B E E N . . . In Chapter 4 we discussed the role of the Federal Reserve System as the central bank in the

U.S. banking system. Money must be easily transferred, checks must be processed and

cleared, banks must be regulated and supervised, and the money supply must be controlled.

The Fed either assists or directly performs all of the activities that are necessary for a

well-functioning fi nancial system. You also learned about the characteristics and require-

ments of Federal Reserve membership and the composition of the Fed Board of Governors.

You were introduced to the Fed’s monetary policy functions—its open-market operations,

the administration of reserve requirements, and the setting of interest rates on loans to depos-

itory institutions. Fed supervisory and regulatory functions were also discussed.

W H E R E W E A R E G O I N G . . . The last chapter in Part 1 focuses on how currency exchange rates are determined and how

international trade is fi nanced. We begin by discussing what is meant by currency exchange

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5.1 National Economic Policy Objectives 103

rates and foreign exchange markets. This is followed by a discussion of factors that determ-

ine exchange rate relationships and changes in those relationships over time. You will then

learn how the fi nancing of international trade takes place, including how exporters fi nance

with a draft or bill of exchange. Financing by the importer and the use of a commercial letter

of credit and a trust receipt are also covered. The last section will introduce you to develop-

ments in international transactions as measured by balance-of-payments accounts. In Part 2

our focus will be on investments, including the securities and other fi nancial markets needed

to market and transfer fi nancial assets.

H O W T H I S C H A P T E R A P P L I E S TO M E . . . The opportunity to vote gives you a way of infl uencing economic and political developments

in this country. The president and members of Congress are policy makers elected by the

people. After reading this chapter, you should have a better understanding of the national

economic policy objectives in the United States and how government offi cials and the Fed

infl uence the economy. You then will be in a more knowledgeable position to make informed

economic decisions about activities that may infl uence your life and career.

Government and private policy makers often are maligned in the press and sometimes even by

themselves. For example, President Ronald Reagan in 1986 said,

The government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.1

While this statement is somewhat humorous to most of us, it also serves to start us thinking

about what should be the country’s broad-based economic objectives and what mechanisms

are needed for achieving these objectives. We need a system of checks and balances to ensure

that policy makers will operate in the best interests of the people of the United States. The

president and Congress pass laws and set fi scal policy, while the Fed sets monetary policy and

attempts to regulate the supply of money and the availability of credit.

5.1 National Economic Policy Objectives Ernest Hemingway said,

The fi rst panacea for a mismanaged nation is infl ation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. Both are the refuge of political and economic opportunists.2

Most of us would agree with Hemingway that currency infl ation and war are not accept-

able economic objectives. While people with diff ering views debate the proper role of gov-

ernment, there is broad agreement that decisions by government policy makers to levy taxes

and make expenditures signifi cantly aff ect the lives of each of us. In addition to the checks and

balances off ered by two political parties, the Fed is expected to operate independently of the

government but also in the best interests of the country and its people. There is also a strong

tradition in the United States that national economic objectives should be pursued with min-

imum interference to the economic freedom of individuals.

The Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978, which is typically referred to as the Humphrey-Hawkins Act, spell out the role of the U.S. government in carrying out the economic goals of economic growth and stable prices. Most

of us also would agree that economic growth is good if it leads to improved living standards

for the people. However, for this to occur, economic growth must be accompanied by stable

1Address, White House Conference on Small Business, August 15, 1986. 2“Notes on the Next War: A Serious Topical Letter,” Esquire, September, 1935.

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104 CHAPTER 5 Policy Makers and the Money Supply

prices and high and stable employment levels. The relationship between the money supply and

demand aff ects the level of prices and economic activity in our market economy. Therefore,

the process by which the money supply is increased and decreased is a very important factor to

the success of the economy. Since we live in a global environment, our economic well-being

also depends on achieving a reasonable balance in international trade and other transactions.

To summarize, our country’s economic policy actions are directed toward these three national

economic policy goals:

• Economic growth

• High employment

• Price stability

Accompanying these economic goals is also a desire for stability in interest rates, fi nancial

markets, and foreign exchange markets.

Economic Growth The standard of living of U.S. citizens has increased dramatically during the history of the

United States as a result of the growth of the economy and its productivity. Of course, growth

means more than merely increasing total output. It requires that output increase faster than

the population so that the average output per person expands. Growth is a function of two

components: an increasing stock of productive resources—the labor force and stock of capital—

and improved technology and skills.

The output of goods and services in an economy is referred to as the gross domestic product (GDP). The United States began the 1980s with a double-dip recession, or economic downturn, in “real” terms (i.e., after price changes have been factored out). A mild economic

decline occurred in 1980, followed by a deeper decline that lasted from mid-1981 through

most of 1982. The GDP then grew in real terms throughout the remainder of the 1980s, before

a mild downturn began in mid-1990 and lasted through the fi rst quarter of 1991. Although

some industries underwent substantial downsizing and restructuring, the economy continued

to grow in real terms throughout the 1990s. As we moved into the twenty-fi rst century, eco-

nomic growth slowed both domestically and worldwide, resulting in a U.S. recession in 2001.

Economic recovery began in 2002 and economic growth continued for a number of years until

the United States entered into the Great Recession of 2008–09. Economic growth through

2015 has only averaged about 2 to 3 percent annually.

High Employment Unemployment represents a loss of potential output and imposes costs on the entire economy.

The economic and psychological costs are especially hard on the unemployed. While there is

some disagreement over what we should consider full employment, it is a stated objective of

the U.S. government to promote stability of employment and production at levels close to the

national potential. This aim seeks to avoid large changes in economic activity, minimizing the

hardships that accompany loss of jobs and output.

The U.S. unemployment rate reached double-digit levels during the early 1980s with a

peak at about 11 percent near the end of 1982. As the economy began expanding, unemployment

levels declined throughout the remainder of the 1980s until the rate fell below 5.5 percent.

The recession that began in mid-1990, along with other job dislocations associated with cor-

porate downsizing and restructuring, resulted in an unemployment rate exceeding 7.5 percent

in 1992. The remainder of the 1990s was characterized by a steady decline in the unemploy-

ment rate to a level below 4.5 percent. As the country entered the twenty-fi rst century, eco-

nomic activity slowed and the unemployment level began rising. With an economic recovery

beginning in 2002, employment opportunities improved for a period of years. However, the

economy began slowing in 2007 and entered into a steep decline in 2008, causing the unem-

ployment rate to exceed the 10 percent level. Even with economic recovery beginning during

the second-half of 2009, the unemployment rate remained at the 10 percent level at the end of

2010, but it has since been reduced to slightly below 5 percent in early 2016.

gross domestic product (GDP) measures the output of goods and

services in an economy

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5.2 Four Policy Maker Groups 105

Price Stability In recent decades, the importance of stable prices has become well accepted but diffi cult to

achieve. Consistently stable prices help create an environment in which the other economic

goals are more easily reached. Infl ation, which we initially defi ned in Chapter 2, occurs when a rise or increase in the prices of goods and services is not off set by increases in the quality of

those goods and services. Infl ation discourages investment by increasing the uncertainty about

future returns. Therefore, high infl ation rates are no longer considered acceptable as a price to

pay for high levels of employment.

Infl ation was at double-digit levels during the early 1980s, and this was refl ected in

record-high interest rates. However, as the economy turned down in the 1981–1982 recession,

infl ation rates also started down and continued down until infl ation fell below 3 percent. After

a brief rise at the beginning of the 1990s, infl ation steadily declined to 2 percent and continued

at very low levels in the early years of the twenty-fi rst century. The Fed began increasing its

federal funds rate target in 2004 because of concern about possible increasing infl ation. After

the housing bubble collapse in mid-2006, the Fed began lowering its federal funds rate target.

Then, in response to the fi nancial crisis and the start of the Great Recession, the Fed reduced

its target for the federal funds rate to a near zero level beginning in late 2008. However, infl a-

tion rates remained below the 2 percent level through early 2016.

Domestic and International Implications The three national economic policy objectives are sometimes in confl ict with each other. For

example, while economic growth generally leads to higher employment, a too rapid growth

rate is likely to lead to higher infl ation. Greater demand relative to supply for workers and

materials could cause prices to rise. On the other hand, a very slow growth rate, or even

economic contraction will lead to higher unemployment rates and little pressure on prices.

Thus, policy makers must attempt to balance these economic goals as they establish eco-

nomic policy.

Actions taken with respect to a country’s own national aff airs also infl uence the econo-

mies of other nations. Thus, it is important for economic policy makers to maintain a world-

view rather than just a narrow nationalistic approach. Nations that export more goods and

services than they import have a net trade surplus, and vice versa. When funds received

from the sale (export) of goods and services to other countries are less than the payments

made for the purchase (import) of goods and services from other countries, these trade defi –

cits must be made up by positive net fi nancial transactions and foreign exchange operations

with the rest of the world. We discuss balance of payments components and implications in

Chapter 6.

5.2 Four Policy Maker Groups Four groups of policy makers are actively involved in achieving the nation’s economic policy

objectives:

• Federal Reserve System

• The president

• Congress

• U.S. Treasury

Figure 5.1 illustrates how the four groups use monetary and fi scal policies, supported by debt management practices, to carry out the four economic objectives of economic growth, stable

prices, high employment, and balance in international transactions.

As discussed in Chapter 4, the Fed establishes monetary policy, including managing the

supply and cost of money. We will see later in this chapter how the money supply is actually

changed. Fiscal policy involves setting the annual federal budget, and it refl ects government

infl ation occurs when an increase in the price of goods or services is

not off set by an increase in quality

fi scal policy government infl uence on economic activity through

taxation and expenditure plans

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106 CHAPTER 5 Policy Makers and the Money Supply

infl uence on economic activity through taxation and expenditure plans. Fiscal policy is carried

out by the president and Congress. The U.S. Treasury supports economic policy objectives

through its debt management practices.

Ethical Behavior in Government ETHICAL Since World War II, 12 individuals served as president of the United States. The decade

of the 1990s included George H. W. Bush and William (Bill) Clinton. The decade of the 2000s

was primarily under the direction of George W. Bush and Barack Obama.

One would expect that the leader of the United States should and would exhibit a very

high level of moral and ethical behavior. We expect the people of our nation to practice sound

ethical behavior by treating others fairly and honestly. Certainly, the president has the oppor-

tunity to lead by example. Two recent presidents, Richard Nixon (who served as president

during 1969–1974) and Bill Clinton (who served as president during 1993–2001), were each

accused of unethical behavior while president. Nixon resigned on August 9, 1974, just before

he was impeached because of the Watergate scandal involving offi ce break-ins. In 1998, Clinton

became the second president to be impeached by the House of Representatives. Clinton’s

handling of personal indiscretions with a White House intern led to his trial in the Senate. He

was found not guilty and completed his second term.3

Unethical behavior in government has not been limited to presidents. There also have

been numerous accounts of unethical behavior on the part of members of Congress. Some

individuals have been impeached and others have been sent to prison. With this said, the vast

majority of members of Congress and past presidents have practiced high ethical behavior,

including fair and honest treatment of their constituents. The other good news is that the U.S.

government and society have overcome the isolated unethical behavior of a few leaders.

Policy Makers in the European Economic Union GLOBAL As in the United States, European governments use monetary and fi scal policies to try

to achieve similar economic goals, such as economic growth and price stability. In December

1991, the members of the European Union (EU) signed the Maastricht Treaty in Maastricht, Netherlands. The objective was to converge their economies, fi x member country exchange

rates, and introduce the euro as a common currency at the beginning of 1999. Monetary

and fi scal policy actions of each country were to focus on maintaining price stability, keep-

ing government budget defi cits below 3 percent of gross domestic product (GDP) and total

government debt below 60 percent of GDP, and maintaining stability in relative currency

exchange rates. Of the 15 EU countries, 12 members formed the European Monetary Union (EMU), ratifi ed the Maastricht Treaty, and qualifi ed to adopt the euro as their common cur- rency with conversion offi cially taking place in 2002. Since then, EU membership has grown

to 28 countries, (although the United Kingdom has recently voted to withdraw from the EU),

with 19 of these countries joining the EMU and adopting the euro as their common currency.

It is striking that initially 12 and now 19 countries with widely diff erent past applica-

tions of monetary and fi scal policies could agree on similar economic and fi nancial object-

ives. While each country continues to formulate its own fi scal policies today, the European

Policy Makers Federal Reserve System

The President

Congress

U.S. Treasury

Types of Policies or Decisions

Monetary Policy

Fiscal Policy

Debt Management

Economic Objectives Economic Growth

High Employment

Price Stability

FIGURE 5.1 Policy Makers and Economic Policy Objectives

3For a further discussion of past U.S. presidents, see Frank Freidel and Hugh S. Sidey, The Presidents of the United States of America, (Willard, OH: R.R. Donnelley and Sons, 1996).

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5.3 Government Influence on the Economy 107

Central Bank (ECB) focuses on maintaining price stability across the 19 eurozone countries. The sheer size of the EMU also means that European policy makers and U.S. policy makers

must work closely together in trying to achieve the worldwide goals of economic growth and

price stability.

DISCUSSION QUESTION 1 How successful have U.S. policy makers been in achieving high employment and low infl ation in recent years?

5.3 Government Influence on the Economy The federal government plays a dual role in the economy. It provides social and economic ser-

vices to the public that cannot be provided as effi ciently by the private sector. The federal gov-

ernment is also responsible for guiding or regulating the economy. Actions by the four policy

maker groups need to be coordinated to achieve the desired national economic objectives. The

president and the Council of Economic Advisors (CEA) prepare an annual federal budget containing revenue and expenditure plans that refl ect fi scal policy objectives concerning

government infl uence on economic activity. Congress reviews, makes changes, and passes

legislation relating to budget expenditures. A budget surplus occurs when tax revenues (receipts) are more than expenditures (outlays). When revenues are less than expenditures,

there is a budget defi cit. The Treasury must borrow funds by selling government (Treasury) securities to cover a defi cit.

A government raises funds to pay for its activities in three ways:

• Levies taxes

• Borrows

• Prints money for its own use

Because the last option has tempted some governments, with disastrous results, Congress

delegated the power to create money to the Fed. Our federal government collects taxes to pay

for most of its spending, and it borrows, competing for funds in the fi nancial system, to fi nance

its defi cits.

To illustrate the complex nature of the government’s infl uence on the economy, consider

the many eff ects of a federal defi cit. To fi nance it, the government competes with other bor-

rowers in the fi nancial system. This absorbs savings, and it may raise interest rates. Private

investment may be reduced if it becomes more diffi cult for fi rms to borrow the funds needed.

On the other hand, a defi cit stimulates economic activity. The government is either spending

more or collecting less in taxes, or both, leaving more income for consumers to spend. The

larger the defi cit, the more total spending, or aggregate demand, there will be. In some circum-

stances, this stimulation of the economy generates enough extra income and savings to fi nance

both the defi cit and additional investment by fi rms.

During periods of war-related budget defi cits (e.g., World Wars I and II), the Fed

engaged in an activity known as monetizing the debt whereby the Fed buys government securities to help fi nance the defi cit and to provide additional bank reserves and increase in

the money supply. The Fed does not practice this activity today since it would be counter to

current monetary policy and would also have a signifi cant impact on the fi nancial markets.

The competition for funds would make it more diffi cult for some borrowers to meet their

fi nancing needs.

Fiscal policy is developed and implemented by the president (with the assistance of the

CEA) and Congress. The president and the CEA prepare annual budgets refl ecting their tax

and expenditure plans. Congress reviews, modifi es, and passes legislation authorizing the

implementation of budget plans. When plans call for expenditures to exceed tax revenues, the

resulting budget defi cit is designed to stimulate economic activity.

The Treasury is responsible for collecting taxes and disbursing funds, and for debt man-

agement, which includes fi nancing current defi cits and refi nancing the outstanding national

debt. As discussed in Chapter 4, the Fed contributes to the attainment of the nation’s economic

federal budget annual revenue and expenditure plans that refl ect

fi scal policy objectives concerning

government infl uence on economic

activity

budget surplus occurs when tax revenues (receipts) are more than

expenditures (outlays)

budget defi cit occurs when tax revenues (receipts) are less than

expenditures (outlays)

monetizing the debt Fed buys government securities to help

fi nance a budget defi cit and to add

to bank reserves and increase the

money supply

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108 CHAPTER 5 Policy Makers and the Money Supply

goals by formulating monetary policy. It uses its powers to regulate the growth of the money

supply and, thus, infl uence interest rates and the availability of loans.

The principal responsibilities of these policy makers have not always been the same.

When the Fed was established in 1913, most of the power to regulate money and credit was

placed in its hands. However, as the public debt grew during World War I, the Great Depres-

sion of the 1930s, and World War II, the Treasury became vitally interested in credit condi-

tions. Policies that aff ect interest rates and the size of the money supply aff ect the Treasury

directly, since it is the largest borrower in the nation. Therefore, the U.S. Treasury took over

primary responsibility for managing the federal debt. In managing the large public debt and

various trust funds placed under its jurisdiction, the Treasury has the power to infl uence the

money market materially. The Fed came back into its own in the 1950s and is now the chief

architect of monetary policy.

It should not be surprising that the policy instruments of the various policy makers

at times put them at cross purposes. A long-standing debate continues over the balance

between full employment and price stability. A particular policy that leads toward one may

make the other more diffi cult to achieve, yet each objective has its supporters. As with

all governmental policy, economic objectives are necessarily subject to compromise and

trade-off s.

Government Reaction to the Perfect Financial Storm CRISIS As we briefl y discussed in earlier chapters, a “perfect fi nancial storm” developed in

the midst of the 2007–08 fi nancial crisis and 2008–09 Great Recession. In 2008, the U.S.

economy was on the verge of fi nancial collapse. The housing price “bubble” burst in 2006 and

home prices began a sharp and prolonged decline. Stock market prices peaked in 2007 and

fell sharply until mid-2009. The economy began slowing in 2007, with economic contraction

beginning in early 2008. The resulting 2008–09 recession turned out to be the steepest U.S.

recession since the Great Depression of the 1930s. Individuals were defaulting on their home

mortgages in increasing numbers due to falling home prices and increasing unemployment.

Business fi rms and fi nancial institutions, who had borrowed heavily during years of easy

money and low interest rates, were faced with their own fi nancial diffi culties as economic

activity slowed markedly. Many of the debt securities issued and backed by home mortgage

loans, called mortgage-backed securities, became diffi cult to value and quickly became known

as “troubled” or “toxic” assets.

Many major fi nancial institutions and business corporations were on the verge of col-

lapse or failure. Some of the very largest fi nancial institutions were deemed as being “too big

to fail” because their failure would cause cascading negative repercussions throughout the

United States and many foreign economies. As discussed in Chapter 4, the Federal Reserve

moved to increase liquidity in the monetary system and reduced its target federal funds rate

to below the .25 percent level. The Fed also worked with the U.S. Treasury to help facilitate

the merging of fi nancially weak institutions with those that were fi nancially stronger. For

example, in March 2008, the Fed and Treasury assisted in the acquisition of Bear Sterns by

JPMorgan Chase & Co.

The Federal National Mortgage Association (Fannie Mae) and the Federal Home

Mortgage Association (Freddie Mac), briefl y discussed in Chapter 4 as being major par-

ticipants in the secondary mortgage markets, were on the verge of fi nancial insolvency

and possible collapse in mid-2008. Fannie Mae was actively creating and packaging

mortgage-backed securities, many of which became troubled assets as home owners

began defaulting on the underlying mortgages. Freddie Mac purchased home mortgages,

including lower-quality subprime mortgages, attempting to support the mortgage markets

and home ownership. In an attempt to avoid a meltdown, the Fed provided rescue funds

in July 2008 and the U.S. government assumed control of both Fannie Mae and Freddie

Mac in September 2008.

In addition to the eff orts of the Fed and the Treasury, the U.S. Congress and the president

responded with the passage of the Economic Stabilization Act of 2008 in early October of that year. A primary focus of this legislation, which became known as the Troubled Asset Relief Program (TARP), was to allow the U.S. Treasury to purchase up to $700 billion of troubled

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5.4 Treasury Cash and General Management Responsibilities 109

or toxic assets held by fi nancial institutions. Then, in an eff ort to stimulate economic activity,

Congress and the president passed the $787 billion American Recovery and Reinvestment Act of 2009 in February 2009, with the funds to be used to provide tax relief, appropriations, and direct spending. In part, as a result of these actions, economic activity in the United States

began recovering in the second half of 2009.

As it turned out, the U.S. Treasury purchase of troubled bank-held assets developed

slowly. In fact, passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 amended the Emergency Economic Stabilization Act of 2008. Title XIII, known as the “Pay It Back Act,” reduced the availability of TARP funds from $700 billion to $475 billion

and mandated that any unused funds could not be used in new programs.

As a result of these fi scal stimulus packages and modifi cations, along with the three

quantitative easing eff orts by the Fed in 2008, 2010, and 2012, the U.S. economy achieved

moderate growth through 2015. The unemployment rate also declined from the 10 percent

level at the end of 2010 to below 5 percent in early 2016.

5.4 Treasury Cash and General Management Responsibilities The U.S. Treasury promotes economic growth, overseas the production of coins and currency,

and is responsible for collecting taxes, paying bills, and managing its cash balances so that

its day-to-day operations have a stable impact on bank reserves and the money supply. The

Treasury is also responsible for borrowing funds to fi nance budget defi cits and for managing

the national debt. The Treasury played an important role during the 2007–09 perfect fi nancial

storm by helping fi nancial institutions merge and through administering government legisla-

tion designed to prevent fi nancial institutions and some business fi rms from failing. We will

cover defi cit fi nancing and debt management by the Treasury in the next section.

The magnitude of Treasury operations dictates that it must play as defensive or neutral a

role as possible in its infl uence on the supply of money and credit. While the power to regulate

the money supply has been placed primarily in the hands of the Fed, close cooperation between

the Treasury and the Fed must exist if Treasury operations are not to disrupt the money supply.

Consider the impact on monetary aff airs of a massive withdrawal of taxes from the bank-

ing system without off setting actions. The decrease in bank deposits would result in a tempor-

ary breakdown of the system’s ability to serve the credit needs of the public. Yet, the federal

government periodically claims taxes without signifi cant impact on lending institutions. In

like manner, borrowing by the government or the refunding of maturing obligations could

be traumatic in their eff ect on money and credit, but such is not the case. In short, the Fed

Government Financing Assistance for Small Businesses

Small businesses can seek fi nancing help from both the federal

and state or from local levels. The Small Business Administra-

tion (SBA) was created in 1953 by the federal government. The

SBA provides fi nancial assistance to small fi rms that are unable to

obtain loans from private lenders at reasonable terms and interest

costs. We discuss the SBA in greater detail in Chapter 16.

Small business investment companies (SBICs) are chartered

and regulated by the SBA. SBICs help fi nance small businesses by

making both equity investments and loans. SBICs get their funds

(to be lent or invested in small businesses) from privately invested

capital and long-term bonds purchased or guaranteed by the SBA.

These bonds typically have ten-year maturities. A small business

is currently defi ned as a fi rm with less than $6 million in net worth

or net income of less than $2 million.

At the state and local level, there also are possible sources

of fi nancing help for small businesses. For example, most states

have Small Business Development Centers (SBDCs) that can

help small businesses fi nd sources of fi nancing. Small busi-

nesses also may fi nd sources of fi nancing help by contacting their

state’s Department of Economic Development or Department of

Commerce.

Small Business Practice

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110 CHAPTER 5 Policy Makers and the Money Supply

effi ciently manages these dynamic aspects of money and credit, while the Treasury largely

limits its actions to taxing, borrowing, paying bills, and refunding maturing obligations. The

Treasury carries out these functions with as little interference with the conduct of monetary

aff airs as possible. This is no small challenge.

Managing the Treasury’s Cash Balances Treasury operations involve spending over $3 trillion a year. It is necessary to maintain a large

cash balance, since Treasury receipts and payments do not occur on a regular basis throughout

the year. This makes it critical for the Treasury to handle its cash balances in such a way that it

will not create undesirable periods of credit ease or tightness. To aff ect bank reserves as little

as possible, the Treasury has developed detailed procedures for handling its cash balances.

Treasury Tax and Loan Accounts The Treasury’s primary checkable deposit ac- counts for day-to-day operations are kept at Reserve Banks. Most cash fl ows into the Treasury

through Treasury Tax and Loan Accounts of banks, S&Ls, and credit unions (referred to here

as banks, for short). Employers deposit the income taxes, Social Security, and railroad retire- ment taxes they withheld in their Treasury Tax and Loan Accounts. They have the option of

depositing these government receipts with either Reserve Banks or one of the other banks.

Most employers make their payments to the latter.

The Treasury may also pay income and eligible profi ts taxes into Tax and Loan Accounts.

Many excise taxes may also be paid either to a Reserve Bank or to a qualifi ed bank with a Tax

and Loan Account. The proceeds from a large portion of the sales of new government secur-

ities also fl ow into Tax and Loan Accounts. If the Treasury feels its balances at the Reserve

Banks are too large, it can transfer funds to its accounts at the banks.

Treasury Receipts and Outlays The Treasury tries to handle its cash receipts, outlays, and balances to avoid large changes in bank reserves. To do this, the Treasury tries

to keep balances in its accounts at the Reserve Banks relatively stable. Almost all Treasury

disbursements are made by checks drawn against its deposits at the Reserve Banks. Most

Treasury receipts are deposited in Tax and Loan Accounts at the various banks, but some

are deposited directly in the Treasury accounts at the Reserve Banks. The Treasury adjusts

its withdrawals to keep its balances at the Reserve Banks as stable as possible. This means

that the funds shifted from banks and the funds deposited directly in Reserve Banks must

closely correspond to the volume of Treasury checks that are likely to be presented to the

Reserve Banks.

If the Treasury accounts at the Reserve Banks are kept at a stable level, bank reserves

are not changed. This is possible only if accurate forecasts are made of the daily receipts and

spending from the Treasury account so that funds from the Tax and Loan Accounts may be

shifted in the right amounts at the right time. If the forecasts were not worked out with a reas-

onable degree of success, Treasury operations would cause bank reserves to change a great

deal over short periods. Despite these precautions, the Treasury’s account frequently does

fl uctuate by as much as several billion dollars from day to day. The Fed closely monitors the

Treasury account and takes any changes into consideration in conducting daily open-market

operations to minimize the eff ect on bank reserves.

Powers Relating to the Federal Budget and to Surpluses or Deficits The government may also infl uence monetary and credit conditions indirectly through tax-

ation and expenditure programs, especially by having a signifi cant cash defi cit or surplus.

Budget-making decisions rest with Congress and are usually based on the needs of the gov-

ernment and on political considerations, without giving much weight to monetary and credit

eff ects. Because of the magnitude of the federal budget, government income and spending

may be one of the most important factors in determining credit conditions.

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5.4 Treasury Cash and General Management Responsibilities 111

General Economic Eff ects of Fiscal Policy Economic activity depends largely on aggregate demand, which is the total demand for fi nal goods and services in the economy at a point in time. An increase in aggregate demand will, generally, cause an increase in

production and employment but may also cause prices to rise. If the economy is already

close to full employment, increases in aggregate demand will likely increase prices more

than output. Similarly, decreases in aggregate demand will result in lower employment and

reduced prices.

Fiscal policy signifi cantly aff ects aggregate demand and economic activity. Not only is

government spending itself a large component of aggregate demand, but also, any change in

government spending has a multiplied eff ect on aggregate demand. An increase in government

spending increases employment and incomes and, thus, also increases consumer spending. In

a downturn, not only does spending decrease, but tax receipts of all types—including those

for Social Security—also decrease when fewer people are at work, because these taxes are

based on payrolls. Changes in taxes also directly aff ect both disposable income and aggregate

demand through consumer spending.

Various federal government programs act to stabilize disposable income and economic

activity in general. Some act on a continuing basis as automatic stabilizers. Other govern- ment fi scal actions, such as actions taken to continue federal programs that stabilize economic

activity, are discretionary and depend on specifi c congressional actions. Automatic stabilizers

include the following:

• Unemployment insurance program

• Welfare payments

• Pay-as-you-go progressive income tax

The unemployment insurance program is funded largely by the states. Under this program,

payments are made to workers who lose their jobs, providing part of their former incomes.

Another stabilizer is welfare payments under federal and state aid programs. Both unem-

ployment and welfare benefi ts are examples of transfer payments, or government income payments for which no current productive service is rendered.

Another important automatic stabilizer is the pay-as-you-go progressive income tax.

Pay-as-you-go refers to the requirement that tax liabilities of individuals and institutions be

paid on a continuing basis throughout the year. The progressive nature of our income tax

means that as income increases to various levels the tax rate increases also. In other words,

as incomes increase, taxes increase at a faster rate. The reverse is also true: at certain stages

of decreased income, the tax liability decreases more quickly. The result is, generally, imme-

diate since, for most wages subject to withholding taxes, tax revenues change almost as soon

as incomes change.

These programs are a regular part of our economy. In times of severe economic fl uctu-

ations, Congress can help stabilize disposable income. Income tax rates have been raised to

lower disposable income and to restrain infl ationary pressures; they have been lowered during

recessions to increase disposable income and spending. Government spending can also be

increased during recessions to increase disposable income. Likewise, it could be cut during

prosperity to reduce disposable income, but for political reasons attempts to do this have not

been successful.

When a recession is so severe that built-in stabilizers or formulas are not adequate to

promote recovery, there is seldom complete agreement on the course of action to take. A

decision to change the level of government spending and/or the tax rates must be made.

Increased spending or a comparable tax cut would cost the same number of dollars ini-

tially, but the economic eff ects would not be the same. When income taxes are cut, dispos-

able income is increased almost immediately under our system of tax withholding. This

provides additional income for all sectors of the economy and an increase in demand for

many types of goods.

Congress may decide to increase government spending, but the eff ects of increased gov-

ernment spending occur more slowly than those of a tax cut, since it takes time to get programs

started and put into full operation. The increased income arises fi rst in those sectors of the

economy where the money is spent. Thus, the initial eff ect is on specifi c areas of the economy

rather than on the economy as a whole.

aggregate demand total demand for fi nal goods and services in the

economy at a point in time

automatic stabilizers continuing federal programs that stabilize

economic activity

transfer payments government payments for which no current

services are given in return

Copyright © 2017 John Wiley & Sons, Inc.

 

 

112 CHAPTER 5 Policy Makers and the Money Supply

The secondary eff ects of spending that result from a tax cut or from increased govern-

ment spending depend on how and what proportion the recipients spend. To the extent that

they spend it on current consumption, aggregate demand is further increased in the short run.

The goods on which recipients spend the income determine the sectors of the economy that

receive a boost. If they invest the added income and later use it to purchase capital goods,

spending is also increased. In this case, however, there is a time lag, and diff erent sectors of

the economy are aff ected. If the money is saved, thus added to idle funds available for invest-

ment, there is no secondary eff ect on spending.

The eff ects must also be considered if economic activity is to be restrained by a decrease

in government spending or by a tax increase. A decrease in spending by the government will

cut consumer spending by at least that amount; the secondary eff ects may cut it further. A tax

increase may not cut spending by a like amount, since some taxpayers may maintain their level

of spending by reducing current saving or by using accrued savings. A tax increase could,

however, cut total spending more if it should happen to discourage specifi c types of spending,

such as on home building or on credit purchases of consumer durable goods. This could lead to

a spending cut that is substantially greater than the amount of money taken by the higher taxes.

Eff ects of Tax Policy The tax policy and tax program of the federal government have a direct eff ect on monetary and credit conditions that may work in several ways. The level

of taxes in relation to national income may aff ect the volume of saving and, thus, the funds

available for investment without credit expansion. The tax structure also determines whether

saving is done largely by upper-income groups, middle-income groups, or all groups. This

can aff ect the amount of funds available for diff erent types of investment. Persons in middle-

income groups may be more conservative than those with more wealth. They tend to favor

bonds or mortgages over equity investments. Persons in high tax brackets, on the other hand,

tend to invest in securities of state and local governments because income from these invest-

ments is not subject to federal income taxes. They also may invest for capital gains, since taxes

on the gains may be deferred until the asset is sold.

Changes in corporate tax rates also may aff ect the amount of funds available for short-

term investment in government bonds and the balances kept in bank accounts. The larger the

tax payments, the less a corporation has available for current spending. Also, if tax rates are

raised with little warning, a corporation may be forced to use funds it had been holding for

future use. Businesses that are short of funds may be forced to borrow to meet their taxes. In

either case, a smaller amount of credit is available for other uses.

Recent Financial Crisis Related Activities CRISIS The U.S. Treasury, under the leadership of Treasury Secretary Henry Paulson, played

an important role in helping the United States survive the 2007–08 fi nancial crisis and the sub-

sequent recession. The Treasury, sometimes working closely with the Fed, helped bring about

the acquisition of Bear Sterns by JPMorgan Chase & Co. in March 2008. Under the leadership

of Henry Paulson, the Treasury was actively involved in assisting fi nancial institutions on

the brink of collapse to fi nd help through mergers with fi nancially stronger institutions. In

September 2008, Bank of America acquired Merrill Lynch. However, during the same month,

Lehman Brothers declared bankruptcy when no viable fi nancial alternatives surfaced. Shortly

thereafter, American International Group (AIG) was “bailed out” by the Federal Reserve and

Treasury eff orts, with the U.S. government receiving an ownership interest in AIG.

The Economic Stabilization Act of 2008 provided the Treasury with funds to purchase troubled or toxic assets held by fi nancial institutions. However, much of the Troubled Asset Relief Program (TARP) funds were used to invest capital in banks with little equity on their balance sheets, as well as to rescue large “too big to fail” fi nancial institutions and even large

nonfi nancial business fi rms—such as General Motors and Chrysler—that were on the verge

of failing.

LEARNING ACTIVITY Go to the U.S. Treasury’s website, http://www.treasury.gov, and identify the mission and goals of the U.S. Department of the Treasury. Write a brief summary.

tax policy setting the level and structure of taxes to aff ect the

economy

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5.5 Treasury Deficit Financing and Debt Management Responsibilities 113

5.5 Treasury Deficit Financing and Debt Management Responsibilities The U.S. government collects taxes (receipts) and makes expenditures (outlays) for national

defense, social programs, and so forth. When receipts total more than outlays over a time

period, such as a year, a budget surplus occurs. A budget defi cit exists when outlays are greater

than receipts. Defi cit fi nancing involves the U.S Treasury borrowing funds by selling govern- ment (Treasury) securities to cover revenue shortfalls relative to expenditures. Large budget

defi cits can result in government competition for private investment funds. Crowding out occurs when there is a lack of funds for private borrowing due to the sale of Treasury secur-

ities to cover large budget defi cits. When defi cit fi nancing is so large that the private sector

cannot or will not absorb the Treasury obligations off ered, the Fed may purchase a signifi cant

portion of the issues.

Annual government expenditures have exceeded annual tax receipts each fi scal year

(October 1 through September 30) since the end of the 1960s, with the exception of the four-

year period 1998–2001. For fi scal year 2001, receipts totaled $1,991,082 million and outlays

were $1,862,846 million resulting in a surplus of $128,236 million, or $128.2 billion. In the

eff ort to recover from the fi nancial crisis and the Great Recession, the fi scal 2009 budget

defi cit peaked at more than $1.4 trillion, and annual defi cits remained above the $1.0 trillion

level in fi scal years 2010, 2011, and 2012. Defi cits declined to under $700 billion in fi scal

2013 and to less than $500 billion in fi scal year 2014. For fi scal year 2015, receipts totaled

$3,249,886 million compared to outlays of $3,688,292 million for a defi cit of $438,406 million,

or $438.4 billion.4 Specifi c sources of federal government receipts and specifi c types of outlays

will be discussed in Chapter 7.

The U.S. national debt is the total debt owed by the government and consists of debt held by the public and intergovernmental holdings. The cumulative amount of historical annual

defi cits and surpluses resulted in a national debt of about $5.8 trillion at the end of fi scal

2001. Since then, the cumulative impact of large annual defi cits has caused the national debt

to increase to $18.1 trillion by the end of fi scal 2015, and then the national debt surpassed the

$19 trillion level by early 2016.5 This more than $13 trillion increase in the national debt in

less than 15 years has kept the Treasury busy issuing more and more government securities to

fi nance the underlying annual defi cits. The ownership of the U.S. public debt, as well as the

maturities of the debt, will be discussed in Chapter 8.

Debt management involves funding budget defi cits and refi nancing maturing Treasury securities previously issued to fund the national debt. The Treasury has formulated three debt

management goals:

• Fund defi cits and refi nance maturing debt at the lowest cost to taxpayers over time.

• Manage Treasury’s cash fl ows in an uncertain environment.

• Manage the risk profi le of outstanding debt.

The Treasury carries out its debt management policy by operating in a “regular and pre-

dictable” manner to minimize disruption in the fi nancial markets and to support fi scal and

monetary policies formulated by the other policy-making groups. Treasury security auctions

are scheduled and announced well in advance of the actual auctions to allow investors to plan

their security purchases.6

The last surplus federal budget occurred in fi scal 2001. Since then, the Treasury has been

actively involved in defi cit fi nancing each year. As discussed earlier, the national debt increased

from less than $6 trillion at the end of fi scal 2001 to a little over $18 trillion by the end of fi scal

2015, meaning that the Treasury had to fi nance cumulative annual budget defi cits of more than

$13 trillion. At the same time, the Treasury had to refi nance trillions of dollars of maturing

defi cit fi nancing borrowing of funds by selling Treasury securities

to meet revenue shortfalls relative

to expenditures

crowding out occurs when there is a lack of funds for private

borrowing due to the sale of

Treasury securities to cover budget

defi cits

national debt total debt owed by the government

debt management involves funding budget defi cits and

refi nancing maturing Treasury

securities used to fund the national

debt.

4Historical budget results are available at www.whitehouse.gov/omb/budget/. 5Historical data about the levels of the national debt are available at www.treasurydirect.gov/. 6Debt management goals are stated in, “The Meaning and Implications of ‘Regular and Predictable’ (R&P) as a Tenet

of Debt Management,” (August, 2015), https://www.treasury.gov.

Copyright © 2017 John Wiley & Sons, Inc.

 

 

114 CHAPTER 5 Policy Makers and the Money Supply

government securities that were previously issued to fund prior levels of the national debt. The

Treasury set a formidable goal of conducting these new fi nancing needs and the refunding of

existing Treasury securities while attempting to minimize the interest costs on the national debt.

The Treasury’s second debt management goal involves effi ciently managing the Treas-

ury’s cash fl ows associated with its fi nancing and refunding activities in an uncertain environ-

ment. Debt management operations have to be conducted within an environment where there

are uncertainties relating to the size of net fi nancing needs, auction market demand conditions,

fi nancial market liquidity, economic conditions, and Fed monetary policy actions.

Market interest rates on Treasury securities fl uctuate, or change over time, with changes

in economic conditions and expectations, and with the Fed’s monetary policies. The Treasury

could adjust the size and timing of its auctions to attempt to mitigate this economic/monetary

policy risk. Market interest rates, at a point in time, are generally lower for shorter-maturity

Treasury securities and higher for longer-maturity Treasury securities. In essence, the longer

the maturity of a debt security, the greater the uncertainty the investor will feel concerning

future economic and fi nancial market conditions at maturity. As a consequence, investors

require a higher expected return for investing in longer-maturity debt securities. This is some-

times referred to as term structure, or maturity risk. Furthermore, the values of longer-maturity

debt securities will change more (relative to shorter-maturity securities) given changes in mar-

ket interest rates. We explore the term, or maturity structure, of interest rates in Chapter 8 and

the impact on bond values given changes in market interest rates in Chapter 10.

The Treasury must continually make the trade-off decision of whether to issue shorter-

maturity Treasury securities at generally lower interest rates and accept more frequent refund-

ing of these securities at times when the then-existing market interest rates may be at higher

levels due to changing economic conditions and Fed actions. The alternative would be to issue

longer-term Treasury securities at relatively higher interest rates in exchange for not having to

refund these securities until much further in the future.

The Treasury has benefi tted in its eff orts to manage its fi nancing budget defi cits and the

national debt in recent years due to the unusually low interest rates that are the result of, in

part, the Fed’s easy money and quantitative easing eff orts initiated in late 2008. However, as

interest rates move back to more “normal” levels, and given the current size of the national

debt, concern is being expressed about how very large annual interest payments on the national

debt will impact on economic activity and the fi nancial markets.

DISCUSSION QUESTION 2 How will the U.S. government be able to repay the amount of national debt that is currently outstanding?

LEARNING ACTIVITY Go to the U.S. Treasury’s Bureau of Fiscal Service website at http://www.treasurydirect. gov/. Go to “Reports” and then to “Historical Debt Outstanding.” Find information on the changing size of the national debt during the past fi ve years. Write a brief summary of what has happened.

How Does the Fed Aff ect Me?

Suppose you hear on the radio that the Fed has moved to cut

interest rates. Such a rate cut does not aff ect just banks or large

corporate borrowers; it can have an impact on individuals, too. So

how might a rate cut aff ect you?

If you have savings at a depository institution, the eff ect may

be negative. Attempts to lower interest rates in the economy may

lead to lower interest rates on your checking account, your savings

account, or the next CD you invest in.

Of course, there is a potential benefi t on the borrowing side.

An attempt to lower rates can lead to lower loan rates for a car

loan, student loan, home equity loan, or a home mortgage. If

someone has a variable or adjustable rate mortgage, his or her

interest payments may fall as rates decline. Some interest rates

on credit card balances are linked to a market interest rate, so as

market interest rates fall, the interest rates on credit card balances

will fall, too.

Lower interest rates can help investors in stocks and bonds,

too. As we will see in Chapter 10, an economic environment

with lower interest rates can lead to increases in stock and bond

prices, thus increasing the value of an investor’s stock and bond

holdings.

Personal Financial Planning

Copyright © 2017 John Wiley & Sons, Inc.

 

 

5.6 Changing the Money Supply 115

5.6 Changing the Money Supply As we saw in Chapter 2, the M1 money supply consists of currency (including coins), demand

deposits, other checkable deposits, and traveler’s checks. Currency is in the form of Federal

Reserve notes and is backed by gold certifi cates, Special Drawing Rights (SDRs), eligible paper, or U.S. government and agency securities. SDRs are a form of reserve asset, or “paper

gold,” created by the International Monetary Fund. Their purpose is to provide worldwide

monetary liquidity and to support international trade. Eligible paper in the form of business

notes and drafts provides little collateral today. Instead, Federal Reserve notes have been

increasingly backed by government securities.

Demand deposits and other checkable deposits at commercial banks, S&Ls, savings

banks, and credit unions comprise about one-half of the M1 money supply and are collectively

termed checkable deposits. To simplify further discussion of money supply expansion and contraction, we will refer to checkable deposits simply as deposits in the banking system, which includes all of the depository institutions. The word bank also is used generically to refer to a depository institution.

The banking system of the United States can change the volume of deposits as the need

for funds by individuals, businesses, and governments change. This ability to alter the size of

the money supply is based on the use of a fractional reserve system. In the U.S. fractional reserve system, banks and other depository institutions must hold funds in reserve equal to a

certain percentage of their deposit liabilities. Vault cash and funds held at regional Reserve

Banks comprise bank reserves. To understand the deposit expansion and contraction process,

one must study the operations of banks as units in a banking system and the relationship of

bank loans to deposits and to bank reserves.

In analyzing deposit expansion, it is helpful to distinguish between primary deposits

and derivative deposits. For example, the deposit of a check drawn on the Fed is a primary deposit because it adds new reserves to the bank where deposited and to the banking system. A derivative deposit occurs when reserves created from a primary deposit are made available to borrowers through bank loans. Borrowers then deposit the loans so they can write checks

against the funds. When a check is written and deposited in another bank, there is no change

in total reserves of the banking system. The increase in reserves at the bank where the check

is deposited is off set by a decrease in reserves at the bank on which the check is drawn. Banks

must keep reserves against both primary and derivative deposits.

Checkable Deposit Expansion When reserves were fi rst required by law, the purpose was to assure depositors that banks

had the ability to handle withdrawals of cash. This was before the establishment of the

Federal Reserve System that made it possible for a healthy bank to obtain additional

funds in time of need. Depositor confi dence is now based on deposit insurance and more

complete and competent bank examinations by governmental agencies. Today, the basic

function of reserve requirements is to provide a means for regulating deposit expansion

and contraction.

Deposit creation takes place as a result of the operations of the whole system of banks,

but it arises out of the independent transactions of individual banks. To explain the pro-

cess, therefore, we will consider the loan activities of a single bank. First, we will focus on

the bank itself; then we will examine its relationship to a system of banks. This approach

is somewhat artifi cial since a bank practically never acts independently of the actions of

other banks, but it has been adopted to clarify the process. Furthermore, it helps explain

the belief of some bankers that they cannot create deposits, since they only lend funds

placed on deposit in their banks by their depositors. This analysis shows how a system

of banks, in which each bank is carrying on its local activities, can do what an individual

banker cannot do.

For illustration, let us assume that a bank receives a primary deposit of $10,000

and that it must keep reserves of 20 percent against deposits. The $10,000 becomes a

cash asset to the bank as well as a $10,000 liability, since it must stand ready to honor a

fractional reserve system banking system where depository institutions

must hold funds in reserve equal to

a certain percentage of their deposit

liabilities

primary deposit deposit that adds new reserves to a bank

derivative deposit deposit of funds that were borrowed from the

reserves of primary deposits

Copyright © 2017 John Wiley & Sons, Inc.

 

 

116 CHAPTER 5 Policy Makers and the Money Supply

withdrawal of the money. The bank statement, ignoring all other items, would then show

the following:

Assets Liabilities Reserves $10,000 Deposits $10,000

Against this new deposit of $10,000, the bank must keep required reserves of 20 percent,

or $2,000. Therefore, it has $8,000 of excess reserves available. Excess reserves are reserves

above the level of required reserves.

It may appear that the banker could proceed to make loans for $40,000, since all that is

needed is a 20 percent reserve against the resulting checkable deposits. If this were attemp-

ted, however, the banker would soon be in a diffi cult situation. Since bank loans are usually

obtained just before a demand for funds, checks would very likely be written against the

deposit accounts almost at once. Many of these checks would be deposited in other banks, and

the bank would be faced with a demand for cash as checks were presented for collection. This

demand could reach the full $40,000. Since the bank has only $8,000 to meet it, it could not

follow such a course and remain in business.

The amount that the banker can safely lend is the $8,000 of excess reserves. If more is

lent, the banker runs the risk of not being able to make payments on checks. After an $8,000

loan, the books show the following:

Assets Liabilities Reserves $10,000 Deposits $18,000

Loans $ 8,000

If a check were written for the full amount of the derivative deposit ($8,000) and sent to

a bank in another city for deposit, the lending bank would lose all of its excess reserves. This

may be seen from its books, which would appear as follows:

Assets Liabilities Reserves $2,000 Deposits $10,000

Loans $8,000

In practice, a bank may be able to lend somewhat more than the $8,000 in this example,

because banks frequently require customers to keep an average deposit balance of about

15 to 20 percent of the loan. The whole of the additional $1,500 to $2,000 cannot be lent

safely, because an average balance of $1,500 to $2,000 does not prevent the full amount of the

loan from being used for a period of time. With an average balance in each derivative deposit

account, however, not all accounts will be drawn to zero at the same time. Therefore, some

additional funds will be available for loans.

It may be argued that a banker will feel sure that some checks written against the bank

will be redeposited in the same bank and, therefore, larger sums can be lent. However,

because any bank is only one of thousands, the banker cannot usually count on such rede-

positing of funds. Banks cannot run the risk of being caught short of reserves. Thus, when

an individual bank receives a new primary deposit, it cannot lend the full amount of that

deposit but only the amount available as excess reserves. From the point of view of an indi-

vidual bank, therefore, deposit creation appears impossible. Because a part of every new

deposit cannot be lent out due to reserve requirements, the volume of additional loans is less

than new primary deposits.

It is important to recognize that what cannot be done by an individual bank can be done by the banking system. This occurs when many banks are expanding loans and deriv- ative deposits at the same time. To illustrate this point, assume that we have an economy

with just two banks, A and B. This example can be realistic if we assume, further, that

Copyright © 2017 John Wiley & Sons, Inc.

 

 

5.6 Changing the Money Supply 117

Bank A represents one bank in the system and Bank B represents all other banks com-

bined. Bank A, as in our previous example, receives a new primary deposit of $10,000

and is required to keep reserves of 20 percent against deposits. Therefore, its books would

appear as follows:

Bank A Assets Liabilities

Reserves $10,000 Deposits $10,000

A loan for $8,000 is made and credited as follows:

Bank A Assets Liabilities

Reserves $10,000 Deposits $18,000

Loans $ 8,000

Assume that a check is drawn against this primary deposit almost immediately and

deposited in Bank B. The books of the two banks would then show the following:

Bank A Assets Liabilities

Reserves $2,000 Deposits $10,000

Loans $8,000

Bank B Assets Liabilities

Reserves $8,000 Deposits $8,000

The derivative deposit arising out of a loan from Bank A has now been transferred

by check to Bank B, where it is received as a primary deposit. Bank B must now set aside

20 percent as required reserves and may lend or reinvest the remainder. Its books after such a

loan (equal to its excess reserves) would appear as follows:

Bank B Assets Liabilities

Reserves $8,000 Deposits $14,400

Loans $6,400

Assume a check is drawn against the derivative deposit of $6,400 that was created due to

the loan by Bank B. This reduces its reserves and deposits as follows:

Bank B Assets Liabilities

Reserves $1,600 Deposits $8,000

Loans $6,400

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118 CHAPTER 5 Policy Makers and the Money Supply

The check for $6,400 will most likely be deposited in a bank, in our example in Bank A or

Bank B itself, since we have assumed that only two banks exist. In the U.S. banking system, it

may be deposited in one of the thousands of banks or other depository institutions.

Deposit expansion as when a bank makes a loan can take place in the same way when it

buys securities. Assume, as we did in the case of a bank loan, the following situation:

Bank A Assets Liabilities

Reserves $10,000 Deposits $10,000

Securities costing $8,000 are purchased and the proceeds credited to the account of the

seller, giving the following situation:

Bank A Assets Liabilities

Reserves $10,000 Deposits $18,000

Loans $ 8,000

Assume that a check is drawn against the seller’s deposit and is deposited in Bank B. The

books of the two banks would then show as follows:

Bank A Assets Liabilities

Reserves $2,000 Deposits $18,000

Loans $8,000

Bank B Assets Liabilities

Reserves $8,000 Deposits $8,000

As in the case of a loan shown earlier, the derivative deposit has been transferred to Bank B,

where it is received as a primary deposit.

At each stage in the process, 20 percent of the new primary deposit becomes required

reserves, and 80 percent becomes excess reserves that can be lent out. In time, the whole of the

original $10,000 primary deposit will have become required reserves, and $50,000 of deposits

will have been credited to deposit accounts, of which $40,000 will have been lent out.

Table 5.1 further illustrates the deposit expansion process for a 20 percent reserve ratio. A primary deposit of $1,000 is injected into the banking system, making excess reserves of

$800 available for loans and investments. Eventually, $5,000 in checkable deposits will be

created.

Multiple expansions in the money supply created by the banking system through its

expansion of checkable deposits also can be expressed in formula form as follows:

Change in checkable deposits = Increase in excess reserves

Required reserves ratio (5.1)

We defi ne the terms excess reserves and the required reserves ratio in the next section. For our purposes, the maximum increase in the amount of checkable deposits is determined

by dividing a new infl ow of reserves into the banking system by the percentage of checkable

deposits that must be held in reserves.

Copyright © 2017 John Wiley & Sons, Inc.

 

 

5.6 Changing the Money Supply 119

In the example presented in Table 5.1, the maximum expansion in the checkable deposits

component of the money supply, which is the same as the fi nal-stage fi gure shown for checkable

deposit liabilities, would be, as follows:

Change in checkable deposits = $1,000 ÷ .20 = $5,000

The maximum increase in deposits (and money supply) that can result from a specifi c increase

in excess reserves is referred to as a money multiplier. In our very basic example, the money multiplier (m) is equal to one divided by the required reserves ratio, or m = 1 ÷ .20 = 5. However, in the complex U.S. economy there are several factors or “leakages” that reduce

the ability to reach the maximum expansion in the money supply depicted in this simplifi ed

example. We will discuss a more realistic money multiplier ratio in the last section of this

chapter.

Off setting or Limiting Factors Deposit creation can go on only to the extent that the activities described actually take place. If

for any reason the proceeds of a loan are withdrawn from the banking system, no new deposit

arises to continue the process. A new deposit of $10,000 permits loans of $8,000 under a

20 percent required reserve, but if this $8,000 were used in currency transactions without

being deposited in a bank, no deposit could be created. The custom of doing business by

means of checks makes deposit creation possible.

TABLE 5.1 Multiple Expansion of Deposits—20 Percent Reserve Ratio

Assets Liabilities Reserves Loans and

Investments Checkable DepositsTotal Required Excess

Initial

Reserves $1,000 $ 200 $800 $ 0 $1,000

Stage 1 1,000 360 640 800 1,800

Stage 2 1,000 488 512 1,440 2,440

Stage 3 1,000 590 410 1,952 2,952

Stage 4 1,000 672 328 2,362 3,362

Stage 5 1,000 738 262 2,690 3,690

Stage 6 1,000 790 210 2,952 3,952

Stage 7 1,000 832 168 3,162 4,162

Stage 8 1,000 866 134 3,330 4,330

Stage 9 1,000 893 107 3,464 4,464

Stage 10 1,000 914 86 3,571 4,571

. . . . . .

. . . . . .

. . . . . .

Final

Stage $1,000 $1,000 $ 0 $4,000 $5,000

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120 CHAPTER 5 Policy Makers and the Money Supply

In the examples above, no allowance was made for either cash leakage or currency

withdrawal from the system. In actual practice, as the volume of business in the economy

increases, some additional cash is withdrawn for hand-to-hand circulation and to meet the

needs of business for petty cash.

Money may also be withdrawn from the banking system to meet the demand for payments

to foreign countries, or foreign banks may withdraw some of the money they are holding on

deposit in U.S. banks. The U.S. Treasury may withdraw funds it has on deposit in banks. All

of these factors reduce the multiplying capacity of primary deposits.

Furthermore, this process can go on only if excess reserves are actually being lent by the

banks. This means that banks must be willing to lend the full amount of their excess reserves

and that acceptable borrowers who have a demand for loans must be available.

The nonbank public’s decisions to switch funds between checkable deposits and time or

savings deposits also will infl uence the ability to expand the money supply and credit. This is

explored later in the chapter.

Contraction of Deposits When the need for funds by business decreases, deposit expansion can work in reverse.

Expansion takes place as long as excess reserves exist and the demand for new bank loans

exceeds the repayment of old loans. Deposit contraction takes place when old loans are being

repaid faster than new loans are being granted and banks are not immediately investing these

excess funds.

Assuming that Bank A has no excess reserves, let us see the eff ect of a loan being repaid.

Before the borrower began to build up deposits to repay the loan, the bank’s books showed

the following:

Bank A Assets Liabilities

Reserves $2,000 Deposits $10,000

Loans $8,000

Government or Not-for-Profit Organizations

Opportunities The federal government is the largest employer in the United States.

In addition, state and local governments also hire thousands of work-

ers across the nation. Not-for-profi t organizations, such as hospitals,

employ numerous workers with backgrounds in business and fi nance.

Many job seekers, however, never consider that government and

not-for-profi t organizations need the same fi nancial services as busi-

nesses do. Therefore, jobs available in this fi eld often go unnoticed.

All federal and state jobs are listed at your local state employment

services offi ce and online at http://usajobs.opm.gov/. You may also

contact your state or regional Federal Employment Information Cen-

ter for more information on federal jobs (your state or federal repres-

entative will know how to get in touch with these offi ces).

Jobs Financial manager

Financial analyst

Financial planner

Responsibilities A fi nancial manager manages cash funds, makes asset acquisition decisions, controls costs, and obtains borrowed funds. A fi nancial

manager with either a government or a not-for-profi t organization

must also stay abreast of current legislation and public and private

grant opportunities.

A fi nancial analyst assesses the short- and long-term fi nancial performance of a government or not-for-profi t organization.

A fi nancial planner uses fi nancial analysis to develop a fi nancial plan.

Education Knowledge of economics and fi nance is necessary for these jobs,

and an understanding of the executive and legislative process is

helpful. In addition, a primary way in which government and

not-for-profi t groups obtain funds is by getting grants. Therefore,

strong research and writing skills for grant proposals also are

essential.

Career Opportunities in Finance

Copyright © 2017 John Wiley & Sons, Inc.

 

 

5.7 Factors Aff ecting Bank Reserves 121

The borrower of the $8,000 must build up his or her deposit account by $8,000 to be able

to repay the loan. This is refl ected on the books, as follows:

Bank A Assets Liabilities

Reserves $10,000 Deposits $18,000

Loans $8,000

After the $8,000 is repaid, the books show the following:

Bank A Assets Liabilities

Reserves $10,000 Deposits $10,000

If no new loan is made from the $10,000 of reserves, deposit contraction will result. This

is true because $8,000 of funds have been taken out of the banking system to build up deposits

to repay the loan and are now being held idle by Bank A as excess reserves. Furthermore,

taking out $8,000 of reserves from the banking system may be cumulative on the contraction

side just as it was during expansion.

5.7 Factors Aff ecting Bank Reserves The level of a bank’s excess reserves determines the extent to which deposit expansion (or

contraction) takes place. This is true for an individual bank or other depository institution, and

for the banking system as a whole. Therefore, the factors that aff ect the level of bank reserves

are signifi cant in determining the size of the money supply. Bank reserves for a depository institution are its vault cash and funds held at its regional Federal Reserve Bank and used to

meet reserve requirements. Bank reserves for the banking system are the cumulative total of

the individual depository institution bank reserves.

Bank reserves can be divided into two parts. The fi rst, required reserves, is the min- imum amount of reserves that a depository institution must hold against its deposit liabilities.

The percentage of deposits that must be held as reserves is called the required reserves ratio. When bank reserves diff er from required reserves, a depository institution has either excess

reserves or defi cit reserves. Excess reserves occur when the amount of a depository institu- tion’s bank reserves exceed required reserves. If required reserves are larger than the bank

reserves of an institution, the diff erence is called defi cit reserves. The banking system will have excess reserves if the cumulative amount of bank reserves for all depository institutions

exceeds the total required reserves amount.

Two kinds of factors aff ect total reserves: those that aff ect the currency holdings of the

banking system and those that aff ect deposits at the Fed. Currency fl ows in response to changes

in the demand for it by households and businesses. Reserve balances are aff ected by a variety

of transactions involving the Fed and banks, and that may be initiated by the banking system or

the Fed, the Treasury, or other factors. Although the Fed does not control all of the factors that

aff ect the level of bank reserves, it does have the ability to off set increases and decreases. Thus,

it has broad control over the total reserves available to the banking system. Figure 5.2 provides a summary of the transactions that aff ect bank reserves. Discussion of these transactions follows.

Changes in the Demand for Currency Currency fl ows into and out of the banking system aff ect the level of reserves of the banks

receiving the currency for deposit. Let’s assume that an individual or business fi nds they have

bank reserves a depository institution’s vault cash and funds

held at its regional Federal Reserve

Bank

required reserves minimum amount of reserves that a

depository institution must hold

against its deposit liabilities

required reserves ratio percentage of deposits that must be held as

reserves by a depository institution

excess reserves amount by which a depository institution’s bank

reserves are greater than required

reserves

defi cit reserves amount by which a depository institution’s bank

reserves are less than required

reserves

Copyright © 2017 John Wiley & Sons, Inc.

 

 

122 CHAPTER 5 Policy Makers and the Money Supply

excess currency of $100 and deposit it in Bank A. Deposit liabilities and the reserves of Bank

A are increased by $100. The bank now has excess reserves of $80, assuming a 20 percent

level of required reserves. These reserves can be used by the banking system to create $400 in

additional deposits. If the bank does not need the currency but sends it to its Reserve Bank, it

will receive a $100 credit to its account. The volume of Federal Reserve notes in circulation is

decreased by $100. These transactions may be summarized as follows:

1. Deposits in Bank A are increased by $100 ($20 in required reserves and $80 in excess reserves). 2. Bank A’s deposit at its Reserve Bank is increased by $100. 3. The amount of Federal Reserve notes is decreased by $100.

The opposite takes place when the public demands additional currency. Let us assume that a

customer of Bank A needs additional currency and cashes a check for $100. The deposits of

the bank are reduced by $100, and this reduces required reserves by $20. If the bank has no

excess reserves, it must take steps to get an additional $80 of reserves by borrowing from its

Reserve Bank, demanding payment for a loan or not renewing one that comes due or selling

securities. When the check is cashed, the reserves of the bank are also reduced by $100. If the

bank has to replenish its supply of currency from its Reserve Bank, its reserve deposits are

reduced by $100. These transactions may be summarized thus:

1. Deposits in Bank A are reduced by $100 ($20 in required reserves and $80 in excess reserves). 2. Bank A’s deposit at its Reserve Bank is reduced by $100. 3. The amount of Federal Reserve notes in circulation is increased by $100.

Changes in the components of the money supply traditionally have occurred during hol-

iday periods, with the most pronounced change taking place during the year-end holiday sea-

son. These changes are beyond the immediate control of the Fed, which must anticipate and

respond to them to carry out possible money supply growth targets. Generally, there has been

an increase in currency outstanding between November and December and a subsequent par-

tial reversal during January. An increase in circulating currency prior to the Christmas holi-

days requires adjustment by the Fed to control the money supply. As large amounts of cash are

withdrawn from depository institutions, deposit contraction might occur unless the Fed moves

to off set it by purchasing government or other securities in the open market.

Also there traditionally has been an increase in demand deposits between November and

December and a subsequent decline in demand deposits during the early part of the next year.

This also seems to refl ect the public’s surge in spending during the Christmas holiday season

and the payment for many of the purchases early in the next year by writing checks on demand

deposit accounts. The Fed, in its eff ort to control bank reserves and the money supply, also

must take corrective actions to temper the impact of these seasonal swings in currency and

checking account balances. Of course, the increasing use of credit cards and debit cards con-

tinues to alter the use of currency and the writing of checks.

Federal Reserve System Transactions Transactions between banks and the Fed and changes in reserve requirements by the Fed also

aff ect either the level of total reserves or the degree to which deposits can be expanded with

FIGURE 5.2 Transactions Aff ecting Bank Reserves

Nonbank Public Federal Reserve System U.S. Treasury Change in the non-bank public’s

demand for currency to be

held outside the banking

system

Change in required reserves ratio

Open-market operations

(buying and selling government

and other securities)

Change in bank borrowings

Change in float

Change in foreign deposits

held in Reserve Banks

Change in other Federal

Reserve accounts

Change in Treasury

spending out of accounts

held at Reserve Banks

Change in Treasury

cash holdings

Copyright © 2017 John Wiley & Sons, Inc.

 

 

5.7 Factors Aff ecting Bank Reserves 123

a given volume of reserves. Such transactions are initiated by the Fed when it buys or sells

securities, by a depository institution when it borrows from its Reserve Bank, or by a change

in Federal Reserve fl oat. These are examined here in turn, and then the eff ect of a change in

reserve requirements is described. Finally, we will look at Treasury transactions, which can

also aff ect reserves in the banking system.

Open-Market Operations When the Fed, through its open-market operations, pur- chases securities such as government bonds it adds to bank reserves. The Fed pays for the

bonds with a check. The seller deposits the check in an account and receives a deposit account

credit. The bank presents the check to the Reserve Bank for payment and receives a credit to

its account. When the Fed buys a $1,000 government bond, the check for which is deposited

in Bank A, the transactions may be summarized, as follows:

1. Bank A’s deposit at its Reserve Bank is increased by $1,000. The Reserve Bank has a new asset—a bond worth $1,000.

2. Deposits in Bank A are increased by $1,000 ($200 in required reserves and $800 in excess reserves).

The opposite takes place when the Fed sells securities in the market.

In contrast to the other actions that aff ect reserves in the banking system, open-market oper-

ations are entirely conducted by the Fed. For this reason, they are the most important policy tool

the Fed has to control reserves and the money supply. Open-market operations are conducted

virtually every business day, both to smooth out ups and downs caused by other transactions and

to implement changes in the money supply called for by the Federal Open Market Committee.

Depository Institution Transactions When a bank borrows from its Reserve Bank, it is borrowing reserves, so reserves are increased by the amount of the loan. Similarly,

when a loan to the Reserve Bank is repaid, reserves are reduced by that amount. The trans-

actions when Bank A borrows $1,000 from its Reserve Bank may be summarized as follows:

1. Bank A’s deposit at its Reserve Bank is increased by $1,000. The assets of the Reserve Bank are increased by $1,000 by the note from Bank A.

2. Bank A’s excess reserves have been increased by $1,000. It also has a new $1,000 liability, its note to the Reserve Bank.

This process is reversed when a debt to the Reserve Bank is repaid.

Federal Reserve Float Changes in Federal Reserve fl oat also aff ect bank reserves. Float arises out of the process of collecting checks handled by Reserve Banks. Federal Reserve fl oat is the temporary increase in bank reserves that results when checks are credited to the reserve account of the depositing bank before they are debited from the account of the

banks on which they are drawn. Checks drawn on nearby banks are credited almost immedi-

ately to the account of the bank in which they were deposited and debited to the account of the

bank on which the check was drawn. Under Fed regulations, all checks are credited one or two

days later to the account of the bank in which the check was deposited. It may take longer for

the check to go through the collection process and be debited to the account of the bank upon

which it is drawn. When this happens, bank reserves are increased, and this increase is called

fl oat. The process by which a $1,000 check drawn on Bank B is deposited in Bank A and cred- ited to its account before it is debited to the account of Bank B may be summarized, as follows:

1. Bank A transfers $1,000 from its Cash Items in the Process of Collection to its account at the Reserve Bank. Its reserves are increased by $1,000.

2. The Reserve Bank takes $1,000 from its Deferred Availability Account and transfers it to Bank A’s account.

Thus, total reserves of banks are increased temporarily by $1,000. They are reduced when

Bank B’s account at its Reserve Bank is reduced by $1,000 a day or two later.

Changes in reserve requirements change the amount of deposit expansion that is pos-

sible with a given level of reserves. With a reserve ratio of 20 percent, excess reserves of $800

can be expanded to $4,000 of additional loans and deposits. If the reserve ratio is reduced to

Federal Reserve fl oat temporary increase in bank reserves from

checks credited to the reserve

accounts of depositing banks

but not yet debited to the reserve

accounts of those banks from which

the checks were drawn

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124 CHAPTER 5 Policy Makers and the Money Supply

10 percent, it is possible to expand $800 of excess reserves to $8,000 of additional loans and depos-

its. When the reserve ratio is lowered, additional expansion also takes place because part of the

required reserves becomes excess reserves. This process is reversed when the reserve ratio is raised.

Bank reserves are also aff ected by changes in the level of deposits of foreign central banks

and governments at the Reserve Banks. These deposits are maintained with the Reserve Banks

at times as part of the monetary reserves of a foreign country and may also be used to settle

international balances. A decrease in such foreign deposits with the Reserve Banks increases

bank reserves; an increase in them decreases bank reserves.

Treasury Transactions The transactions of the Treasury also aff ect bank reserves. They are increased by spending and making payments, and decreased when the Treasury

increases the size of its accounts at the Reserve Banks. The Treasury makes almost all of its

payments out of its accounts at the Reserve Banks, and such spending adds to bank reserves.

For example, the recipient of a check from the Treasury deposits it in a bank. The bank sends

it to the Reserve Bank for collection and receives a credit to its account. The Reserve Bank

debits the account of the Treasury. When a Treasury check for $1,000 is deposited in Bank A

and required reserves are 20 percent, the transactions may be summarized as follows:

1. The deposits of Bank A are increased by $1,000, its required reserves by $200, and excess reserves by $800.

2. Bank A’s reserves at the Reserve Bank are increased by $1,000. 3. The deposit account of the Treasury at the Reserve Bank is reduced by $1,000.

Treasury funds from tax collections or the sale of bonds are generally deposited in its

accounts in banks. When the Treasury needs payment funds from its accounts at the Reserve

Banks, it transfers funds from commercial banks to its accounts at the Reserve Banks. This

process reduces bank reserves. When $1,000 is transferred from the account in Bank A and

required reserves are 20 percent, transactions may be summarized as follows:

1. The Treasury deposit in Bank A is reduced by $1,000, required reserves by $200, and excess reserves by $800.

2. The Treasury account at the Reserve Bank is increased by $1,000, and the account of Bank A is reduced by $1,000.

The Treasury is the largest depositor at the Fed. The volume of transfers between the account

of the Treasury and the reserve accounts of banks is large enough to cause signifi cant changes in

reserves in the banking system. For this reason, the Fed closely monitors the Treasury’s account

and often uses open-market operations to minimize its eff ect on bank reserves. This is accom-

plished by purchasing securities to provide reserves to the banking system when the Treasury’s

account increases and by selling securities when the account of the Treasury falls to a low level.

The eff ect on bank reserves is the same for changes in Treasury cash holdings as it is for

changes in Treasury accounts at the Reserve Banks. Reserves are increased when the Treasury

decreases its cash holdings, and reserves are decreased when it increases such holdings.

DISCUSSION QUESTION 3 Is monetary policy or fi scal policy more important in achieving the U.S. national policy objectives?

5.8 The Monetary Base and the Money Multiplier Earlier in this chapter we examined the deposit multiplying capacity of the banking system.

Recall that, in the example shown in Table 5.1, excess reserves of $1,000 were introduced into

a banking system having a 20 percent required reserves ratio, resulting in a deposit expansion

of $5,000. This can also be viewed as a money multiplier of 5.

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5.8 The Monetary Base and the Money Multiplier 125

In our complex fi nancial system, the money multiplier is not quite so straightforward.

It will be useful to focus on the relationship between the monetary base and the money

supply to better understand the complexity of the money multiplier. The monetary base is defi ned as banking system reserves plus currency held by the public. More specifi c-

ally, the monetary base consists of reserve deposits held in Reserve Banks, vault cash or

currency held by depository institutions, and currency held by the nonbank public. The

money multiplier is the number of times the monetary base can be expanded or magni- fi ed to produce a given money supply level. Conceptually, the M1 defi nition of the money

supply is the monetary base (MB) multiplied by the money multiplier (m). In equation form we have, as follows:

M1 = MB × m (5.2)

The size and stability of the money multiplier are important because the Fed can control

the monetary base but it cannot directly control the size of the money supply. Changes in the

money supply are caused by changes in the monetary base, in the money multiplier, or in

both. The Fed can change the size of the monetary base through open-market operations or

changes in the reserve ratio. The money multiplier is not constant. It can and does fl uctuate

over time, depending on actions taken by the Fed, as well as by the nonbank public and the

U.S. Treasury.

At the end of December 2015, the money multiplier was approximately .81, as determ-

ined by dividing the $3,093.8 billion M1 money stock by the $3,835.8 billion monetary base.7

Taking into account the actions of the nonbank public and the Treasury, the formula for the

money multiplier in today’s fi nancial system can be expressed as,8

m = (1 + k)

[r (1 + t + g) + k] (5.3)

where

r = the ratio of reserves to total deposits (checkable, noncheckable time and savings, and government)

k = the ratio of currency held by the nonbank public to checkable deposits t = the ratio of noncheckable deposits to checkable deposits g = the ratio of government deposits to checkable deposits

Let’s illustrate how the size of the money multiplier is determined by returning to our previous

example of a 20 percent reserve ratio. Recall that in a more simple fi nancial system, the money

multiplier would be determined as 1 ÷ r or 1 ÷ .20, which equals 5. However, in our complex system we also need to consider leakages into currency held by the nonbank public, noncheck-

able time and savings deposits, and government deposits. Let’s further assume that the reserve

ratio applies to total deposits, a k of 40 percent, a t of 15 percent, and a g of 10 percent. The money multiplier then would be estimated, as follows:

m = (1 + .40)

[.20(1 + .15 + .10) + .40] =

1.40

.65 = 2.15

Of course, if a change occurred in any of the components, the money multiplier would adjust

accordingly, as would the size of the money supply.

In Chapter 2 we briefl y discussed the link between the money supply and economic activ-

ity. You should be able to recall that the money supply (M1) is linked to the gross domestic

product (GDP) via the velocity, or turnover, of money. More specifi cally, the velocity of money measures the rate of circulation of the money supply. It is expressed as the average number of

monetary base banking system reserves plus currency held by the

public

money multiplier number of times the monetary base can be expanded

to produce a given money supply

level

velocity of money average number of times each dollar is spent on

purchases of goods and services

7Federal Reserve Bank of St. Louis, Federal Reserve Economic Database (FRED), http://stlouisfed.org. As the 2007–08

fi nancial crisis worsened, the money multiplier ratio dropped below 1.0 in late 2008 and has continued below 1.0

through 2015. This very low multiplier refl ects the high liquidity in the banking system brought about by the Fed’s

easy money and quantitative easing policies. 8The reader interested in understanding how the money multiplier is derived will fi nd a discussion in most fi nancial

institutions and markets textbooks.

Copyright © 2017 John Wiley & Sons, Inc.

 

 

126 CHAPTER 5 Policy Makers and the Money Supply

times each dollar is spent on purchases of goods and services, and is calculated as nominal GDP

(GDP in current dollars) divided by M1. Changes in the growth rates for money supply (M1g) and money velocity (M1Vg) aff ect the growth rate in real economic activity (RGDPg), and the rate of infl ation (Ig) and can be expressed in equation form as follows:

M1g + M1Vg = RGDPg + Ig (5.4)

For example, if the velocity of money remains relatively constant, then a link between

money supply and the nominal GDP should be observable. Likewise, after nominal GDP

is adjusted for infl ation, the resulting real GDP growth can be examined relative to M1

growth rates. Changes in money supply have been found, in the past, to lead to changes in

economic activity. However, a relationship between money supply and economic activity

has been questioned during the recent perfect fi nancial storm. In an eff ort to thwart a pos-

sible collapse of the fi nancial system, recall that the Fed moved to force short-term interest

rates to near zero and provided massive amounts of money liquidity. Furthermore, the Fed

introduced the use of a nontraditional monetary tool called quantitative easing to further

support the economic recovery eff orts after the 2007–08 fi nancial crisis and the 2008–09

Great Recession. These eff orts have distorted the traditional money multiplier and velocity

of money relationships.

The Fed continues to emphasize easy money, although the target for the federal funds

rate which was set in late 2008 at .00-.25 percent was increased to .25-.50 percent in Decem-

ber 2015. Of course, economic activity also is aff ected by government actions concerning

government spending, taxation, and the management of our public debt. Thus, it is important

that monetary and fi scal policy work together to achieve the United States’ national economic

policy objectives.

LEARNING ACTIVITY Go to the St. Louis Federal Reserve Bank’s website, http://www.stlouisfed.org, and access the Federal Reserve Economic Database (FRED). Find monetary base, money supply, and gross domestic product data. Calculate the money multiplier and the velocity of money.

Applying Finance To… • Institutions and Markets Policy makers pass laws and imple- ment fi scal and monetary policies. A change in law, as noted in

Chapter 3, allows U.S. commercial banks again to engage in both

commercial banking and investment banking activities and become

universal banks. Policy makers infl uence and change the types of

fi nancial institutions and their operations. The operations of deposi-

tory institutions are directly infl uenced by monetary policy decisions

relating to reserve requirements and Fed discount rates. The ability of

fi nancial institutions to carry out the savings-investment process also

is aff ected by the actions of policy makers.

• Investments The prices of securities, typically, refl ect economic activity and the level of interest rates. Real growth in the economy,

accompanied by high employment and low interest rates, makes

for attractive investment opportunities. Individual and institutional

investors usually fi nd the values of their investments rising during

periods of economic prosperity. However, there are times when

policy makers fear that the loss of purchasing power associated with

high infl ation outweighs the value of economic expansion. During

these times, securities prices suff er.

• Financial Management The operations of businesses are directly aff ected by policy makers. Fiscal and monetary policies that constrain

economic growth make it diffi cult for businesses to operate and make

profi ts. Financial managers must periodically raise fi nancial capital

in the securities markets. Actions by policy makers to constrain the

money supply and to make borrowing more costly will give fi nancial

managers many sleepless nights. On the other hand, expansive mon-

etary policy accompanied by low infl ation usually is conducive to

business growth, lower interest rates, and higher stock prices—making

it easier for fi nancial managers to obtain, at reasonable costs, the fi nan-

cial capital needed to grow their businesses.

Summary LO 5.1 The three major U.S. national economic policy objectives are economic growth, high employment, and price stability. On occa-

sion, confl icts among these objectives can develop. For example,

too rapid economic growth could result in materials and/or labor

shortages that, in turn, could lead to price instability associated with

infl ation.

Copyright © 2017 John Wiley & Sons, Inc.

 

 

Review Questions 127

LO 5.2 There are four major policy maker groups: Federal Reserve System, the president, Congress, and the U.S. Treasury. The Fed is

responsible for formulating monetary policy and the president and

Congress determine fi scal policy. Debt management practices are

established by the Treasury.

LO 5.3 The federal government provides social and economic services to the public that cannot be provided as effi ciently by the private sector, and

it is also responsible for guiding or regulating the economy. The presid-

ent and the Council of Economic Advisors prepare annual budgets and

formulate fi scal policy. Congress reviews, makes changes, and passes

legislation relating to budget expenditures. Funds are raised by the gov-

ernment by levying taxes, and when necessary, the Treasury borrows to

cover budget defi cits. Government reaction to the 2007–09 perfect fi nan-

cial storm included the Fed providing rescue funds to institutions to help

avoid bankruptcy and the Fed working with the Treasury to merge fi nan-

cially weak fi nancial institutions with stronger institutions. Congress and

the president passed legislation to stabilize and grow economic activity.

LO 5.4 The U.S. Treasury’s cash and general management respons- ibilities include collecting taxes, paying bills, and managing its cash

balances so that its day-to-day operations have a stable impact on

bank reserves and the money supply. During fi nancial crises and eco-

nomic downturns, the Treasury may be called upon to help fi nancial

institutions merge, and to administer government legislation intended

to keep fi nancial institutions from failing.

LO 5.5 The Treasury is responsible for fi nancing budget defi cits and for fi nancing and managing the national debt. The Treasury’s debt

management goals include funding defi cits and refi nancing maturing

debt at the lowest interest cost to taxpayers; managing the Treasury’s

cash fl ows in uncertain economic, fi nancial market, and Fed policies

environment; and managing risk associated with interest rate costs

and the maturities of outstanding debt. The Treasury carries out its

debt management policy by operating in a “regular and predictable”

manner to minimize disruption in the fi nancial markets and to support

fi scal and monetary policies.

LO 5.6 The U.S. banking system is a fractional reserve system where depository institutions must hold funds at their regional Reserve

Banks equal to a certain percentage of their deposit liabilities. Since

an individual depository institution is required to hold only a portion

of its deposits as reserves, the remaining funds from a new deposit can

be lent to borrowers who, in turn, may deposit the funds they receive

in the same or another bank in the banking system, and so forth. An

estimate of the potential change in checkable deposits, a component

of the M1 money supply, can be made by dividing the amount of an

increase (or decrease) in excess reserves by the required reserves ratio.

LO 5.7 The factors or transactions that aff ect bank reserves include changes in the demand for currency by the nonbank public; Fed trans-

actions, such as changes in the required reserves ratio, open-market

operations, and changes in bank borrowings; and U.S. Treasury

actions involving changes in Treasury spending from its accounts

held at Reserve Banks and changes in its cash holdings.

LO 5.8 The monetary base consists of banking system reserves plus currency held by the public, while the money multiplier is the number

of times the monetary base can be expanded to produce a money sup-

ply level. Multiplying the monetary base times the money multiplier

produces the amount of the M1 money supply. The velocity of money

is the average number of times each dollar is spent on purchases of

goods and services. By dividing nominal gross domestic product by

M1 produces a measure of the velocity of money.

Key Terms aggregate demand

automatic stabilizers

bank reserves

budget defi cit

budget surplus

crowding out

debt management

defi cit fi nancing

defi cit reserves

derivative deposit

excess reserves

federal budget

Federal Reserve fl oat

fi scal policy

fractional reserve system

gross domestic product (GDP)

infl ation

monetary base

monetizing the debt

money multiplier

national debt

primary deposit

required reserves

required reserves ratio

tax policy

transfer payments

velocity of money

Review Questions 1. (LO 5.1) List and describe briefl y the economic policy objectives of the nation.

2. (LO 5.2) Describe the relationship among policy makers, the types of policies, and their economic objectives.

3. (LO 5.3) Discuss how the U.S. government infl uences the economy and how the government responded to the 2007–09 perfect fi nancial storm.

4. (LO 5.4) Describe the eff ects of tax policy on monetary and credit conditions.

5. (LO 5.5) Federal government defi cit fi nancing may have a very great infl uence on monetary and credit conditions. Explain.

6. (LO 5.5) Discuss the various objectives of debt management.

7. (LO 5.6) Explain how Federal Reserve notes are supported or backed in our fi nancial system.

8. (LO 5.6) Why are the expansion and contraction of deposits by the banking system possible in our fi nancial system?

9. (LO 5.6) Trace the eff ect on its accounts of a loan made by a bank that has excess reserves available from new deposits.

10. (LO 5.6) Explain how deposit expansion takes place in a banking system consisting of two banks.

11. (LO 5.6) Explain the potential for deposit expansion when required reserves average 10 percent and $2,000 in excess reserves

are deposited in the banking system.

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128 CHAPTER 5 Policy Makers and the Money Supply

Exercises 1. Go to the St. Louis Federal Reserve Bank’s website at http://www. stlouisfed.org, and access current economic data.

a. Find M1 and the monetary base, and then estimate the money multiplier.

b. Determine the nominal gross national product (GNP in current dollars). Estimate the velocity of money using M1 from (a) and

nominal GNP.

c. Indicate how the money multiplier and the velocity of money have changed between two recent years.

2. Important policy objectives of the federal government include economic growth, high employment, and price stability. The achieve-

ment of these objectives is the responsibility of monetary policy,

fi scal policy, and debt management carried out by the Federal Reserve

System, the president, Congress, and the U.S. Treasury. Describe the

responsibilities of the various policy makers in trying to achieve the

three economic policy objectives.

3. An economic recession has developed, and the Federal Reserve Board has taken several actions to retard further declines in economic

activity. The U.S. Treasury now wishes to take steps to assist the Fed

in this eff ort. Describe the actions the Treasury might take.

4. The president and members of Congress are elected by the people and are expected to behave ethically. Let’s assume that you are a

recently elected member of Congress. A special-interest lobbying

group is off ering to contribute funds to your next election campaign

in the hope that you will support legislation being proposed by others

that will help the group achieve its stated objectives. What would

you do?

Problems 1. Assume that Banc One receives a primary deposit of $1 million. The bank must keep reserves of 20 percent against its deposits. Pre-

pare a simple balance sheet of assets and liabilities for Banc One

immediately after the deposit is received.

2. Assume that Bank A receives a primary deposit of $100,000 and that it must keep reserves of 10 percent against deposits.

a. Prepare a simple balance sheet of assets and liabilities for the bank immediately after the deposit is received.

b. Assume Bank A makes a loan in the amount that can be “safely lent.” Show what the bank’s balance sheet of assets and liabilities

would look like immediately after the loan.

c. Now assume that a check in the amount of the “derivative de- posit” created in (b) was written and sent to another bank. Show

what Bank A’s (the lending bank’s) balance sheet of assets and li-

abilities would look like after the check is written.

3. Rework Problem 2 assuming Bank A has reserve requirements that are 15 percent of deposits.

4. Assume that there are two banks, A and Z, in the banking system. Bank A receives a primary deposit of $600,000, and it must keep

reserves of 12 percent against deposits. Bank A makes a loan in the

amount that can be safely lent.

a. Show what Bank A’s balance sheet of assets and liabilities would look like immediately after the loan.

b. Assume that a check is drawn against the primary deposit made in Bank A and is deposited in Bank Z. Show what the balance sheet

of assets and liabilities would look like for each of the two banks

after the transaction has taken place.

c. Now assume that Bank Z makes a loan in the amount that can be safely lent against the funds deposited in its bank from the transac-

tion described in (b). Show what Bank Z’s balance sheet of assets

and liabilities would look like after the loan.

5. The SIMPLEX fi nancial system is characterized by a required reserves ratio of 11 percent; initial excess reserves are $1 million, and

there are no currency or other leakages.

a. What would be the maximum amount of checkable deposits after deposit expansion, and what would be the money multiplier?

b. How would your answer in (a) change if the reserve requirement had been 9 percent?

6. Assume a fi nancial system has a monetary base of $25 million. The required reserves ratio is 10 percent, and there are no leakages

in the system.

a. What is the size of the money multiplier? b. What will be the system’s money supply?

7. Rework Problem 6 assuming the reserve ratio is 14 percent? 8. The BASIC fi nancial system has a required reserves ratio of 15 per- cent; initial excess reserves are $5 million, cash held by the public is

12. (LO 5.7) Trace the eff ect on bank reserves of a change in the amount of cash held by the public.

13. (LO 5.7) Describe the eff ect on bank reserves when the Federal Reserve sells U.S. government securities to a bank.

14. (LO 5.7) Summarize the factors that can lead to a change in bank reserves.

15. (LO 5.8) What is the diff erence between the monetary base and total bank reserves?

16. (LO 5.8) Briefl y describe what is meant by the money multiplier and indicate the factors that aff ect its magnitude or size.

17. (LO 5.8) Defi ne the velocity of money, and explain why it is important to anticipate changes in money velocity.

18. (LO 5.8) Why does it seem to be important to regulate and con- trol the supply of money?

Copyright © 2017 John Wiley & Sons, Inc.

 

 

Problems 129

$1 million and is expected to stay at that level, and there are no other

leakages or adjustments in the system.

a. What would be the money multiplier and the maximum amount of checkable deposits?

b. What would be the money supply amount in this system after deposit expansion?

9. Rework Problem 8, assuming that the cash held by the public drops to $500,000 with an equal amount becoming excess reserves and the

required reserves ratio drops to 12 percent.

10. The COMPLEX fi nancial system has these relationships: the ratio of reserves to total deposits is 12 percent, and the ratio of noncheck-

able deposits to checkable deposits is 40 percent. In addition, cur-

rency held by the nonbank public amounts to 15 percent of checkable

deposits. The ratio of government deposits to checkable deposits is

8 percent, and the monetary base is $300 million.

a. Determine the size of the M1 money multiplier and the size of the money supply.

b. If the ratio of currency in circulation to checkable deposits were to drop to 13 percent while the other ratios remained the same,

what would be the impact on the money supply?

c. If the ratio of government deposits to checkable deposits in- creases to 10 percent while the other ratios remained the same,

what would be the impact on the money supply?

d. What would happen to the money supply if the reserve require- ment increased to 14 percent while noncheckable deposits to check-

able deposits fell to 35 percent? Assume the other ratios remain as

originally stated.

11. Challenge Problem ABBIX has a complex fi nancial system with the following relationships: the ratio of required reserves to

total deposits is 15 percent, and the ratio of noncheckable deposits

to checkable deposits is 40 percent. In addition, currency held by the

nonbank public amounts to 20 percent of checkable deposits. The

ratio of government deposits to checkable deposits is 8 percent. Initial

excess reserves are $900 million.

a. Determine the M1 multiplier and the maximum dollar amount of checkable deposits.

b. Determine the size of the M1 money supply. c. What will happen to ABBIX’s money multiplier if the reserve requirement decreases to 10 percent while the ratio of noncheckable

deposits to checkable deposits falls to 30 percent? Assume the

other ratios remain as originally stated.

d. Based on the information in (c), estimate the maximum dollar amount of checkable deposits, as well as the size of the M1 money

supply.

e. Assume that ABBIX has a target M1 money supply of $2.8 bil- lion. The only variable that you have direct control over is the

required reserves ratio. What would the required reserves ratio

have to be to reach the target M1 money supply amount?

Assume the other original ratio relationships hold.

f. Now assume that currency held by the nonbank public drops to 15 percent of checkable deposits and that ABBIX’s target

money supply is changed to $3.0 billion. What would the

required reserves ratio have to be to reach the new target M1 money

supply amount? Assume the other original ratio relationships hold.

Copyright © 2017 John Wiley & Sons, Inc.

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