APMacro: Fed Balance Sheet

The Fed’s balance sheet helps us understand how the Fed conducts monetary policy. The Fed’s assets and liabilities differ from those found on the balance sheet of a commercial bank. The two main assets of the Federal Reserve Banks are securities and loans to commercial banks. On the liabilities side of the Fed’s balance sheet, we find three items: reserves, Treasury deposits, and Federal Reserve Notes. With this look at the Fed’s balance sheet, we can explore how the Fed can influence the money creating abilities of the commercial banking system. The Fed has three tools of monetary control it can use to alter the reserves of commercial banks: open market operations, the discount rate, and the reserve ratio.

Fed Open Market Operations
When the Fed buys government bonds, the bank give up part of their holdings of securities (a) to the Fed. The Fed, in paying for these securities, place newly created reserves in the accounts of the bank at the Fed. The reserves of the bank goes up by the amount of the purchase of the securities (b). The upward arrow shows that securities have moved from the bank to the Fed. So we enter minus “Securities” in the asset column of the balance sheet of the bank. We enter plus “Securities” in the asset column of the Fed balance sheet. The downward arrow indicates that the Fed provided reserves to the bank. So we enter plus “Reserves” in the asset column of the bank balance sheet. In the liabilities column of the Fed balance sheet, the plus “Reserves” indicates that although bank reserves have increased, they are a liability to the Fed because the reserves are owned by the bank. What is important about this transaction is that when the Fed purchase securities from banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks.

Fed Open Market Operations Sell
When the Fed sells government bonds, the Fed gives up securities (a) that banks acquire. The bank pay for securities by drawing checks against their deposits, that is, their reserves (b). The Fed collects those checks by reducing the bank’s reserves accordingly. The balance sheet changes, identified by (a) and (b), appear as shown above. The reduction in bank reserves is indicated by the minus sign before the appropriate entries.

One of the functions of the central bank is to be a lender of last resort. Occasionally, banks have unexpected and immediate needs for additional funds. In such cases, the Fed will make short-term loans to banks in its district. When a bank borrows, it gives the Fed a promissory note drawn against itself and secured by acceptable collateral, usually U.S. government securities. Just as banks charge interest on their loans, so too the Fed charge interest on loans they grant to banks. The interest rate the Fed charges is called the discount rate.

Fed Loans to Bank
The borrowing bank’s loan is an asset to the Fed and appears on its balance sheet as “Loans to Bank” (a). To the bank, the loan is a liability appearing as “Loans from Fed” (a) on the bank’s balance sheet. In providing the loan, the Fed increases the reserves of the borrowing bank. No required reserves need to be kept against the loans from the Fed. All new reserves acquired by borrowing from the Fed are excess reserves (b). In short, borrowing from the Fed by banks increases the reserves of the banks and enhances their ability to extend credit.

The Fed has the power to set the discount rate at which banks borrow from the Fed. From the bank’s point of view, the discount rate is a cost of acquiring reserves. A lowering of the discount rate encourages banks to obtain additional reserves by borrowing from the Fed. When banks lend new reserves, the money supply increases. An increase in the discount rate discourages banks from obtaining additional reserves through borrowing from the Fed. So the Fed may raise the discount rate when it wants to restrict the money supply.

Fed Reserve Requirement
The Fed can also manipulate the reserve ratio in order to influence the ability of the banks to lend. Suppose a bank’s balance sheet shows that reserves are $5,000 and checkable deposits are $20,000.

Fed Reserve Requirement b
If the reserve ratio is 20 percent, the bank’s required reserves are $4,000. Since actual reserves are $5,000, the excess reserves of this bank is $1,000. On the basis of $1,000 of excess reserves, this one bank can lend $1,000. However, the banking system asa whole can create a maximum of $5,000 of new checkable deposit money by lending.

Fed Reserve Requirement Raised
If the Fed raised the reserve ratio from 20 to 25 percent, the required reserves would jump from $4,000 to $5,000. This shrinks the excess reserves from $1,000 to zero. Raising the reserve ratio increases the amount of required reserves banks must keep. As a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or the find their reserves deficient and are forced to contract checkable deposits and therefore the money supply.

Fed Reserve Requirement Lowered
If the Fed lowered the reserve ratio from the original 20 percent to 10 percent, the required reserve would decline from $4,000 to $2,000. The excess reserves would jump from $1,000 to $3,000. The ban’s lending ability would increase from $1,000 to $3,000 and the banking system’s money creating potential would expand from $5,000 to $30,000. Lowering the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending.

1) Read Chapter 14 pp.259-271



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