Open Market Purchase from a Bank• Net result is that reserves have increased by $100• No change in currency• Monetary base has risen by $100Banking System Federal Reserve SystemAssets Liabilities Assets LiabilitiesSecurities -$100 Securities +$100 Reserves +$100Reserves +$100Open Market Purchase from Nonbank Public I• Person selling bonds to the Fed deposits the Fed’s check in the bank• Identical result as the purchase from a bankBanking System Federal Reserve SystemAssets Liabilities Assets LiabilitiesReserves +$100 Checkable deposits+$100 Securities +$100 Reserves +$100Open Market Purchase from Nonbank Public II• The person selling the bonds cashes the Fed’s check• Reserves are unchanged• Currency in circulation increases by the amount of the open market purchase• Monetary base increases by the amount of the open market purchaseNonbank Public Federal Reserve SystemAssets Liabilities Assets LiabilitiesSecurities -$100 Securities +$100 Currency in circulation+$100Currency +$100Open Market Sale• Reduces the monetary base by the amount of the sale• Reserves remain unchanged• The effect of open market operations on the monetary base is much more certain than the effect on reservesNonbank Public Federal Reserve SystemAssets Liabilities Assets LiabilitiesSecurities +$100 Securities -$100 Currency in circulation-$100Currency -$100Shifts from Deposits into Currency Net effect on monetary liabilities is zeroReserves are changed by random fluctuationsMonetary base is a more stable variableNonbank Public Banking SystemAssets Liabilities Assets LiabilitiesCheckable deposits-$100 Reserves -$100 Checkable deposits-$100Currency +$100Federal Reserve SystemAssets LiabilitiesCurrency in circulation+$100Reserves -$100Making a Discount Loan to a Bank• Monetary liabilities of the Fed have increased by $100• Monetary base also increases by this amountBanking System Federal Reserve SystemAssets Liabilities Assets LiabilitiesReserves +$100 Discount loans+$100 Discount loan+$100 Reserves +$100(borrowing from Fed) (borrowing from Fed)Paying Off a Discount Loan from the Fed• Net effect on monetary base is a reduction• Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve SystemBanking System Federal Reserve SystemAssets Liabilities Assets LiabilitiesReserves -$100 Discount loans-$100 Discount loans-$100 Reserves -$100(borrowing from Fed) (borrowing from Fed)Deposit Creation: Single Bank (Following Fed OMO purchase)Excess reserves increaseBank loans out the excess reservesCreates a checking accountBorrower makes purchasesThe money supply has increasedFirst National Bank First National BankAssets Liabilities Assets LiabilitiesSecurities -$100 Securities -$100 Checkable deposits+$100Reserves +$100 Reserves +$100Loans +$100First National BankAssets LiabilitiesSecurities -$100Loans +$100Deposit Creation: The Banking Systemassume deposit stays in Bank ABank A Bank AAssets Liabilities Assets LiabilitiesReserves +$100 Checkable deposits+$100 Reserves +$10 Checkable deposits+$100Loans +$90Bank B Bank BAssets Liabilities Assets LiabilitiesReserves +$90 Checkable deposits+$90 Reserves +$9 Checkable deposits+$90Loans +$81Table 1 Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves)Summary Table 1 Money Supply ResponseFIGURE 2 Excess Reserves Ratio and Currency Ratio, 1929–1933Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.FIGURE 3 M1 and the Monetary Base, 1929–1933: declining money multiplier, mSource: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960(Princeton, NJ: Princeton University Press, 1963), p. 333.Fed and Financial Crisis and MoneyThe TED Spread (LIBOR– T-Bill)The Fed Reverses Course• On August 7, 2007, the Federal Open Market Committee decided to stand pat, making no change in its interest rate policy. • On September 18, the Fed cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” • This was only the first of several cuts. Given the increases in interest rates prior to 2007, this was a reversal of previous policy: previously the Fed had generally been raising rates, not reducing them, out of concern that inflation might become a problem (more on that later in this chapter). • Starting in September 2007, fighting the financial crisis took priority.The Fed Reverses CourseFF Rate11/23/09 0.12%The Fed Responds tothe CrisisThe Fed’s Balance Sheet, Normal and AbnormalBase Money (MB = C + R)Fed’s Balance Sheet: How MB is growingQE2: Fed pulls the trigger…againQueen Mary 2 (QM2) and Queen Elizabeth 2 (QE2) set sail from South Hampton, UK in 2008…not related to Fed’s QE2!M1: How Base Money is leading to higher M1 growth…rise and fallCurrency + Deposits = M1…but Money Multiplier is falling (M1/MB)Banks are not lending…slowing loans/deposits/money/spendingM2 Level and yr/yr Growth RateVelocity is a ratio of nominal GDP to a measure of the money supply v =