Lesson 13: Changes in the Monetary Base |
||||||||||||||||
Upon completion of this lesson, you should be able to do the following:
|
||||||||||||||||
IntroductionThis lesson examines changes in the monetary base. The monetary base can fluctuate particularly in a short time horizon. The Fed has to control the monetary base and prevent it from fluctuating. When the monetary base fluctuates, the money supply will also fluctuate. Federal Reserve System Balance SheetTo begin the discussion, we have to look at the Fed's balance sheet. The Fed has assets, which are anything of value that is owned by the Fed. The Fed has liabilities, which are obligations and debt the Fed owes to another party. When the Fed's total assets are subtracted from total liabilities, then the remainder is the Fed's net worth. The Fed's balance sheet information is available to the public and published in the Federal Reserve Bulletin. The Federal Reserve Bulletin is a monthly publication of the Board of Governors and also includes money supply numbers, interest rates, and other economic data. The Fed's assets are listed below: |
||||||||||||||||
The FED's Assets.
|
||||||||||||||||
The Fed's Liabilities and Capital Accounts.
|
||||||||||||||||
The Fed has the authority to clear checks. The check clearing process can cause bank reserves to fluctuate through the Federal Reserve float . The Federal Reserve float is the difference between cash items in the process of collection (CIPC) and deferred availability cash items (DACI) . The float is always positive and when the float changes, bank reserves change, causing the money supply to change. 1. For example, you sent a $1,000 check to a firm in New York City to buy a computer. The computer firm will deposit the check in his bank account. His bank will present the check to the Fed so the Fed can clear the check with your bank. The Fed gives the computer firm's bank a $1,000 asset called the DACI and the Fed must collect $1,000 from your bank, which is called the CIPC. Below is the computer firm's bank and Fed's T-accounts: |
||||||||||||||||
The Computer Firm's Bank
The Fed
|
||||||||||||||||
2. The computer firm's bank cannot touch the asset, DACI. This asset is simply an acknowledge that the Fed is collecting money for the computer firm's bank. After two days, the Fed converts the DACI into bank reserves. Now the bank can loan out the reserves. |
||||||||||||||||
The Fed
The Computer Firm's Bank
|
||||||||||||||||
If the Fed still has not collected $1,000 from your bank with two days, the Fed is extending credit to the computer firm's bank. The total reserves of the banking system increases, because no other bank has lost reserves. That $1,000 check you wrote now exists as a $1,000 in your bank account and the computer firm's bank account. The float from your check is $1,000. Float = CIPC - DACI = $1,000 - 0 = $1,000 3. The Fed collects the $1,000 from your bank. Now the float now goes to zero, and your checking account decreases by $1,000. Your check for $1,000 no longer exists in two places. The reason why check clearing is a long-drawn out process is because if you write a check for $100 and have only $10 in your checking account, this check will not clear! That is why the Fed gets permission to lower the bank's reserves to clear the check; instead of automatically doing it. The transaction is listed below: |
||||||||||||||||
The Fed
Your Bank
|
||||||||||||||||
Usually the float changes predictably at the midmonth (when people pay their bills). The float also changes in December and April, because people are writing checks to buy Christmas presents or to pay their taxes. Bad weather and transportation strikes can cause the float to increase significantly as the Fed is delayed in check collections. Changes in the float causes bank reserves to change. The Fed must off-set the float by selling or buying U.S. government securities. Influencing the Fed's Balance SheetWhen the Fed's balance sheet changes, the monetary base also changes, causing the money supply to change.
|
||||||||||||||||
Total Assets: U.S. gov. securities + discount loans + gold certificates + SDRs + CIPC Total Liabilities + capital: Currency outstanding + deposits by depository institutions + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital |
||||||||||||||||
|
||||||||||||||||
Total Liabilities + capital: Monetary base + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital Total Assets = Total Liabilities + Capital |
||||||||||||||||
|
||||||||||||||||
Monetary base = U.S. gov. securities + discount loans + gold certificates + SDRs + CIPC - DACI - U.S. Treasury deposits - Foreign and other deposits - Capital |
||||||||||||||||
The equation shows how changes in the Fed's balance sheet affects the monetary base.
As you can see, many things can alter the Fed's balance sheet and the Fed cannot control most of them. For example, the Fed has no control over the Treasury deposits, the float (CIPC - DACI), gold certificates, SDRs, and foreign government deposits. These items can change and the Fed has to do a balancing act to keep the monetary base stable. Over the last 30 years, the federal government has been running budget deficits. The U.S. government spends more than what it collects in taxes. The U.S. government can finance the budget deficit in three ways. First, the U.S. government can decrease its spending. Second, the U.S. government can raise taxes. Finally, the U.S. can sell U.S. government securities. Can the U.S. federal government affect the monetary base?
|
||||||||||||||||
You
Your Bank
The Fed
The U.S. Treasury Department
|
||||||||||||||||
|
||||||||||||||||
You
Your Bank
The Fed
The U.S. Treasury Department
|
||||||||||||||||
If the U.S. Treasury sold government securities directly to the Fed, then the Fed is financing budget deficits, which is called monetizing the debt . The media calls this strategy "printing money." The Fed is not required to buy U.S. government securities and is not required to help the U.S. Treasury finance budget deficits. The Fed and U.S. Treasury are independent. There is a way for the Fed to finance budget deficits indirectly. If the Fed wants to stabilize interest rates, then the Fed may end up monetizing the debt. For example, when the U.S. Treasury issues new securities, the market price of the securities decrease, causing the interest rate to increase. If the Fed wants the original interest rate, the Fed has to buy U.S. government securities to decrease the interest rates. In many developing countries, the central banks and finance ministries are not independent. The central bank is required to help finance budget deficits. When central banks monetize the debt, it always leads to inflation. Many developing countries have high inflation rates. |