The Federal Reserve’s Balance Sheet and Monetary Base Determination

1. The Federal Reserve’s Balance Sheet and Monetary Base Determination • Balance sheet of either one of the district banks, or the aggregate of all district banks (“The Federal Reserve Bank”)

2. The Federal Reserve’s Balance Sheet Securities Held Federal Reserve Discount Loans Notes Gold Certificates Bank Deposits SDR Certificates US Treasury Coin Held by Fed Deposits Float Foreign and Other Holdings of Deposits Foreign Currency Physical Capital Capital Account

3. Federal Reserve Assets • Securities Held -- mostly T-Bills, used for open market operations • Discount Loans -- loans advanced to banks at the discount rate • Gold Certificates -- Fed converts gold obtained by US Treasury • SDR Certificates -- Fed converts Special Drawing Rights obtained in international trade.

4. More Fed Assets • Coin Held by the Fed • Float -- cash items in the process of collection minus deferred availability cash items (check clearing) • Holdings of Foreign Currency -- used in exchange rate intervention • Physical Capital

5. Federal Reserve Liabilities and Equity • Federal Reserve Notes Outstanding -- currency held by the public (C) + vault cash inside banks • Bank Deposits at the Federal Reserve -- especially helpful in check clearing

6. The Monetary Base and the Fed’s Balance Sheet • Consider the sum of the first two components. (Federal Reserve Notes Outstanding) + (Bank Deposits at the Fed) = (C + Vault Cash Inside Banks) +(Bank Deposits at the Fed)

7. = (C) + (Vault Cash Inside Banks + Bank Deposits at the Fed) = (C) + (R) = H

8. The Fed’s Balance Sheet: Another Representation Securities Held Currency Held Discount Loans by the Public (C) Gold Certificates Bank Reserves (R) SDR Certificates US Treasury Coin Held by Fed Deposits Float Foreign and Other Holdings of Deposits Foreign Currency Physical Capital Capital Account

9. Still Another Representation Securities Held Monetary Base (H) Discount Loans US Treasury Gold Certificates Deposits SDR Certificates Foreign and Other Coin Held by Fed Deposits Float Holdings of Foreign Currency Physical Capital Capital Account

10. Other Federal Reserve Liabilities + Equity • US Treasury Deposits • Foreign and Other Deposits -- deposits of some foreign governments and central banks, world organizations. • Capital Accounts (Fed Equity) -- Federal Reserve is a profit maker, but not profit maximizer, allowed an equity-asset ratio of 3%.

11. The Federal Reserve as a Check Clearinghouse • Example -- Suppose you get a check of $100 from your parents, who bank at Citibank (within the NY district). You deposit it in your checking account (D) at your bank, Chase, in Syracuse.

12. Balance Sheet Description: The Banks Citibank R -$100 D -$100 Chase R +$100 D +$100

13. Balance Sheet Description: The Federal Reserve Federal Reserve Bank of New York R -$100 (Citibank) R +$100 (Chase) Any change in Bank Reserves is noted on the liability side of the Federal Reserve

14. Monetary Base Determination Identity -- Fed’s balance sheet. Securities Held + Discount Loans + Gold Certificates + SDR Certificates + Coin Held by the Fed + Float + Holdings of Foreign Currency + Physical Capital = H + US Treasury Deposits + Foreign and Other Deposits + Equity

15. The Monetary Base Equation Solve equation for H. (Securities Held + Discount Loans + Gold Certificates + SDR Certificates + Coin Held by the Fed + Float + Holdings of Foreign Currency + Physical Capital) – (US Treasury Deposits + Foreign and Other Deposits + Equity) = H

16. Monetary Base -- Sources • Sourcesof the Monetary Base -- Items whose increase increases the monetary base. • Example -- Securities Held  H

17. The Balance Sheet Description Fed buys a $100 bond from Chase. Federal Reserve Securities +$100 R + $100 Held H = C + R = $0 + $100 = $100

18. Monetary Base -- Uses • Usesof the Monetary Base -- Items whose increase decreases the monetary base. • Example -- US Treasury Deposits  H

19. The Balance Sheet Description The Federal Government collects $100 in taxes (people paying from their checkable deposits at Chase). Chase R - $100 D - $100

20. The Federal Reserve’s Balance Sheet Federal Reserve US Treasury Deposits + $100 R - $100 (Chase) H = C + R = $0 + -$100 = -$100

21. Can the Fed Reasonably Control the Monetary Base? (Securities Held + Discount Loans + Gold Certificates + SDR Certificates + Coin Held by the Fed + Float + Holdings of Foreign Currency + Physical Capital) – (US Treasury Deposits + Foreign and Other Deposits + Equity) = H

22. Yes -- They Can Reasonably Control the Monetary Base • The monetary base has components both controlled by the Fed and not controlled by the Fed. • But, Securities Held is the largest component within the equation. • And, while changes in the other components may be large, they tend to be isolated and fairly predictable.

23. Sterilization of Undesired Changes in H The Federal Reserve can use open market operations to offset undesired changes in the monetary base -- sterilization

24. Sterilization -- An Example • Suppose that the Federal Reserve wishes to sterilize the decrease in H due to tax collection. US Treasury Deposits + $100  H -$100, Securities Held + $100  H +$100, Net effect: H = $0.

25. Application -- Exchange Market Intervention • Suppose that the Federal Reserve is concerned about an excessive downward movement of the US exchange rate. It intervenes by using its holdings of foreign currency to buy dollars (then remove the dollars from the system).

26. Sterilized Versus Unsterilized Intervention • Holdings of Foreign Currency  H • Sterilized Intervention -- Fed performs an open market operation to offset this effect, Securities Held  H • Unsterilized Intervention -- Fed does nothing, allows H to decrease.

27. Types of Open Market Operations • Defensive Open Market Operation -- Open market operations done to offset an undesired change in the monetary base. • Dynamic Open Market Operation -- Open market operations done to initiate monetary policy.