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CHAPTER 11 THE POLICY INSTRUMENTS |
- Fiscal Policies
- The Federal Government's Budget
- Automatic Stabilizers
- Discretionary Expenditure Policies
- Discretionary Tax Policies
- The High Employment Surplus Budget
- Monetary Policies
- The Federal Reserve Balance Sheet
- The Bank Reserve Equation
- The Monetary Base
- General Monetary Policy Controls
- The Federal Funds Market
- Federal Reserve Credit and the Discount Rate
- Federal Reserve Credit and Open Market Operations
- Reserve Requirements
- Selective Monetary Policy Controls
- Debt Management Policies
- Incomes Policies
- Supply Management Policies
- Supply-Side Economic Policies
- Summary
Readings
Websites
I. Fiscal Policies
Fiscal policies are budgetary policies. They involve altering governmental income (tax collections) and expenditure flows to generate balanced, surplus, or deficit budgets which influence the level of macroeconomic activity. Changing the balance in the federal government's budget changes the velocity of money flows to influence macroeconomic activity.
A budget shows the income and expenditure for an individual or institution over a period of time, generally one year. An ex post budget shows realized income and expenditures from past decisions. It provides a record or a history of income and spending activity over some past fiscal period. An ex ante budget shows planned income and expenditures for the future. It is a program or a plan for income and spending activity over some future designated fiscal period.
The ex ante and ex post budgets are separate and distinct, yet they are linked in the following sense. Plans for the future cannot be made independent of where we are today and depend on realizations of the past. Much of the ex ante budget is a result of decisions taken in the past, whereby the individual or institution becomes locked into a fixed pattern of revenues and expenditures. For the government, planned tax revenue or income depends on the tax structure legislated some time in the past, and planned expenditures tend to follow from commitments and promises made to constituents in periods past. Since most of the federal government is operated through a well-entrenched bureaucracy of quasi-independent agencies, appropriations for these agencies tend to be perpetuated in subsequent budgets. In much the same fashion, the government has an ongoing legal responsibility to fund such social programs as Social Security and a fiduciary responsibility to service the interest on the national debt. Thus, the ex post budget becomes the model for the ex ante budget.
II. The Federal Government's Budget
The federal government budget lists the sources of funds on the left and the uses of funds on the right. The source of funds or income for the federal government is principally tax revenues, which are listed by type of tax. The uses of funds or the expenditures can be listed either by function or by agency. A functional budget allocates funds according to their use: to the program or function of the expenditure. A departmental budget allocates funds according to the user: to the agency or department which is responsible for such expenditure. The federal government's fiscal (accounting) year starts October 1 and ends September 30.
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III. Automatic Stabilizers
Automatic stabilizers are legislative measures that have been built into the budget and operate automatically as income rises and falls without further legislative action.
The Income Tax
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| Expansionary Deficit | Contractionary Surplus |
| Assume that government expenditures (G) are planned exogenously by political forces, regardless of the level income (G). As income (Y) falls, tax collections (T) fall and the government is forced to run an expansionary budget deficit (D) to prevent economic collapse. The tendency of the government to automatically run an expansionary budget deficit during a contraction is called a fiscal dividend. The more progressive is the tax rate structure, the larger is the expansionary budget deficit as income falls. | Assume that government expenditures (G) are planned exogenously by political forces, regardless of the level income (G). As income (Y) rises, tax collections (T) rise and the government is forced to run a contractionary budget surplus (S) to dampen an economic boom. The tendency of the government to automatically run a contractionary budget surplus during an expansion is called a fiscal drag. The more progressive is the tax rate structure, the larger is the contractionary budget surplus as income rises. |
Proportional Income Tax With a proportional income tax and a constant marginal tax rate, tax revenues increase in proportion to income increases (tax curve Tprop):
and
Tax revenue = tYProgressive Income Tax With a progressive tax, tax revenues go up when income goes up, but revenues rise more than in proportion to the increase in income, because higher incomes push individuals and corporations into higher marginal tax brackets and the tax rate (t) rises also (tax curve Tprog):
and
Tax revenue = t YThe progressive income tax is a better automatic stabilizer than the proportional income tax. As income rises and falls, the progressive income tax creates larger budget deficits (D2) and surpluses (S2) than does the proportional income tax (D1, S1).
Unemployment Compensation
Unemployment compensation is designed to supplement the income of persons who are temporarily laid off during a downturn in economic activity. Because these declines are expected to be short-lived, the payments are scheduled to be paid for only 26 weeks. If a downturn is especially protracted, Congress may extend the payment period to 39 weeks.
Payments into the fund are made by those who are currently employed at a flat rate, T = tLe. Payments out of the fund are made to those who are currently unemployed at a flat rate, G = gU. As employment and income rise (and unemployment falls), tax payments into the unemployment compensation fund rise in proportion to the increase in employment and tax payments out of the unemployment compensation fund fall in proportion to the decrease in unemployment. The unemployment compensation fund automatically runs a contractionary budget surplus (S). As employment and income fall (and unemployment rises), tax payments into the unemployment compensation fund fall in proportion to the decrease in employment and tax payments out of the unemployment compensation fund rise in proportion to the increase in unemployment. The unemployment compensation fund automatically runs an expansionary budget deficit (D).
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Agricultural markets are subject to erratic weather conditions, the vagaries of demand and supply, and are extremely price competitive. Downturns in economic activity hit farm incomes harder than those of workers in the manufacturing or service sectors, where prices are administered. The agricultural price support programs are designed to supplement farm incomes when aggregate demand declines.
If there were no price supports, farm income would be Y0 = p0q0 when demand is D0. If demand declines to D1, farm income falls to Y1 = p1q1. With price support pf, farm income is stabilized at Yf = pfqs. When demand is D0, farm income from private sales is pfq2 and the government provides the difference in the form of a subsidy. When demand falls to D1, farm income from private sales falls to pfq3, and the government's subsidy to farmers is increased to make up the difference. Thus, payments to farmers and government expenditure on agriculture rise as income falls and fall as income rises.
IV. Discretionary Expenditure Policies
Discretionary expenditure policies are legislative measures that require special legislative action. Each year, during the budget process, Congress and the President can alter the amount that is spent on individual programs and in the aggregate. Countercyclical fiscal policy calls for increasing government expenditures during a contraction and decreasing government expenditures during an expansion.
During a contraction, when income is falling (from Y1 to Y0), the government should increase its expenditures from G0 to G1 to incur an expansionary budget deficit (D). During an expansion, when income is rising (from Y0 to Y1), the government should decrease its expenditures G1 to G0to incur a contractionary budget surplus (S).
Direct Income Payments
The government may offer to make direct income payments to unemployed persons. This type of program is easiest and quickest to implement in a downturn and is also the easiest and quickest to stop when the economy recovers. Payments may be in the form of unemployment compensation or welfare grants. Direct income payments help keep spending from falling during a downturn, but may be debilitating where the work ethnic is pronounced. They may also discourage persons from seeking gainful employment as long as the payments last.
Public Works Programs
The government may volunteer to provide gainful employment during contractions. The biggest problem is that programs tend to be mediocre and jobs are generally menial, e.g. picking up papers in Central Park.
If the public works programs are substantial and the jobs are significant, they may be pro-cyclical. Building bridges, roads, and dams requires extensive preparation: from finding the available engineers to architectural design and blue-printing to contracting for supplies to completed construction. By the time construction gets underway, business activity may have picked up, in which case, the labor units being used on the public works project are needed by business. Both the government and business end up spending at the same time, thus accentuating booms. They also end up competing for resources in the same factor markets and financing in the same capital markets. The government will end up "crowding out" private spending as factor costs and interest rates are bid up.
To avoid this "crowding out" of private spending in the resource markets and financing in the capital markets, the government should stop work on the project immediately and wait for another downturn. This stop-and-go would leave half-finished projects all over the country, possibly decaying until work is resumed. By the same token, if a public works project is worthwhile, it should be considered part of the budget and social overhead spending, regardless of the state of the economy. Alternatively, the government should maintain a "file" of projects to be started the minute a recession is recognized. This "file" would have to be updated periodically to keep projects current. Unfortunately, even economists have no way of knowing ahead of time how long or deep a downturn will be. This inability to forecast accurately the future adds to the constraints in terms of choosing an appropriate public works project for stabilization.
Cutting Government Expenditures
The government may find that cutting expenditures to offset an expansion is equally impossible, given prior legal and fiduciary commitments and responsibilities of government. The entitlement programs, like social security and interest payments on the national debt, are two of these built-in structural biases that keep expenditures from falling. Besides, once individuals become accustomed to a certain level of government benefits, they are likely to vote out of office those public officials who cut these benefits. Elected officials who demand extensive reductions in federal spending and public benefits are committing political suicide.
V. Discretionary Tax Policies
Discretionary tax policies are legislative measures that require special legislative action. Congress and the President can change the aggregate amount of tax revenues by changing the level of tax rates, by changing the structure of tax rates, by changing tax credits and incentives, and by changing the taxable base. Countercyclical fiscal policy calls for decreasing tax revenues during a contraction and increasing tax revenues during an expansion.
Changing the Overall Level of Tax Rates and Collections
Countercyclical fiscal policy calls for lowering tax rates to reduce tax revenue during a recession and for raising tax rates to raise tax revenue during a boom.
If tax rate system is proportional, then a reduction in tax rates from t0 to t1 shifts the tax function down from T0 to T1 creating a deficit (D) during a recession at Y0. An increase in tax rates from t1 to t0 shifts the tax function up from T1 to T0 creating a surplus (S) during a boom at Y1.
Changing the Progressivity of Tax Rates
Changing the progressivity of the tax will not affect current tax revenues, if the shift is "revenue neutral." A "revenue neutral" shift in the tax rates will raise rates for some tax payers and lower them for others. Thus, the loss in revenues from those whose tax rates were lowered is offset by additional tax revenue from those for whom rates were raised. The shift from a proportional tax to a progressive tax (and vice versa) is "revenue neutral" at Yn, but not so at either a higher income level YH or a lower income level YL. In subsequent years, however, changes in income will affect the tax revenues of the government.
A shift from a flatter set of tax rates to a more progressive set of tax rates will tend to generate larger surpluses and smaller deficits as the economy expands and contracts. A shift from a more progressive set of tax rates to a flatter set of tax rates will tend to generate smaller surpluses and smaller deficits as the economy expands and contracts. If the shift is from less progressive tax rates to more progressive tax rates, the government will have a tendency to run larger surpluses (S2) in years when income rises and to run larger deficits (D2) in years when income falls. If the shift is from more progressive tax rates to less progressive tax rates, then the government will have a tendency to run smaller surpluses (S1) in years when income rises and to run smaller deficits (D1) in years when income falls.
Changing Tax Credits and Incentives
A tax credit is a direct reduction to the income tax liability, as opposed to deductions or exemptions that reduce the tax liability only indirectly by reducing taxable income:
and
Tax revenue = tY + (-TC).An increase in tax credits reduces the tax revenue of the government and forces an expansionary budget deficit. A reduction or elimination of tax credits raises the tax revenue of government and forces a contractionary budget surplus.
Changing the Taxable Base
The principal tax base for federal revenues is the income of households and corporations. To the earned and unearned income of these units, the government permits certain deductions and exemptions:
and
Tax revenue = T = t(Y+(-(D + E))) + (-TC)By increasing the number and value of deductions and exemptions, the government reduces the taxable base and subsequently its own revenues. By reducing or eliminating deductions and exemption, the government increases the taxable base and subsequently its own revenues. In the first instance, the government will be forces to run an expansionary budget deficit, and in the second instance, the government will be forced to run a contractionary budget surplus.
VI. The High Employment Surplus Budget
The High Employment Surplus Budget (HES) or Full-Employment Budget measures the potential deficit, surplus, or balance that would occur if the economy were at full employment (Yf). The impact or the state of balance in the federal budget at full employment indicates whether the actual budget surplus (deficit) is contractionary (expansionary) or expansionary (contractionary). How expansionary (contractionary) a budget deficit (surplus) is depends on the nature of balance at full employment rather than the actual balance.
The HES Budget is calculated by estimating tax revenue from what would have been full-employment income and subtracting the level of government expenditures. If the HES Budget is in surplus (SHES), then the actual deficit (Da) at Y0 is contractionary. If the HES Budget is in deficit (DHES), then the actual deficit (Da) at Y0 is expansionary.
VII. Monetary Policies
Monetary policies involve changing the money supply and interest rates. Unlike fiscal policy, which uses the flow variables of taxing and spending to influence macroeconomic activity, monetary policy uses the stock variable, money supply, and its price, the interest rate, to influence macroeconomic activity. The interest rate is the annualized percentage of principal that is paid for the use of money.
Money is a generalized claim on all other assets both now and in the future. Money supply is that asset or group of assets that acts as money. The Federal Reserve calculates several monetary aggregates in order to keep track of an appropriate money supply.
VIII. The Federal Reserve Balance Sheet
The first step in understanding monetary policy is understanding the balance sheet of the Federal Reserve. A balance sheet is the financial picture of an individual or institution at a point in time.
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Assets
Gold certificate account Except for some actual gold certificates district banks use for educational displays, all "gold certificates" are simply bookkeeping entries. When the U.S. Treasury buys gold and wants to replenish its dollar balances, it "monetizes" the gold by issuing gold certificate credits to the Federal Reserve. To sell gold which has been monetized, the Treasury must redeem gold certificate credits by reducing its balances at the district banks.
Special Drawing Rights certificate account (SDRs) The SDR is an international monetary reserve asset created by the International Monetary Fund in 1970 for use by governments only in official balance-of-payments transactions. The Treasury monetizes these SDRs through its Exchange Stabilization Fund (ESF), included in the "Deposits: Other" liability account. The ESF, established by the Gold Reserve Act of 1934, is used primarily as a vehicle to help counter disorderly foreign exchange market conditions and to finance exchange-related, short-term credit arrangements with foreign governments. In monetizing SDRs, the Treasury issues SDR certificate credits (bookkeeping credits) to the Federal Reserve Bank of New York (FRBNY), for which it receives an equal amount of dollars credited to its ESF account at the New York Reserve Bank. These SDR credits are ultimately distributed by the New York Reserve Bank to other district banks.
Cash Cash consists of coin and paper currency. District banks periodically buy coins minted at face value from the Treasury's Bureau of the Mint and paper currency (Federal Reserve notes) from the Treasury's Bureau of Printing and Engraving. This activity enables the district banks to maintain inventories of coin and paper currency at levels, which permit them to fill orders from depository institutions to meet currency demands. Inventory levels are based upon historical demand patterns with additional provision for normal demand growth. The district banks arrange, in advance, for shipments of new coin and paper currency in amounts and on a schedule to maintain inventories at required levels. The district banks pay for this currency by increasing the deposit accounts of the Treasury.
In addition, the Federal Reserve acts as a last resort depository for surplus currency of the banking system. When commercial banks accumulate excess amounts of currency from daily transactions, they ship the surplus to their respective district banks and take credit in their reserve deposit accounts. When the banks run short of currency, they simply call their respective district banks and have the additional currency shipped to them. They pay for the new currency from their reserve deposit accounts.
Loans Loans are extensions of credit, in the form of either discounts or advances, by the Federal Reserve to depository institutions and other selected individuals and institutions, including partnerships, corporations, foreign governments, and foreign central banks.
The Federal Reserve Act originally enabled borrowers to obtain credit only through the rediscount of eligible paper. In this manner, borrowers endorsed and sold to the district banks' customers short-term commercial, industrial, or agricultural paper. However, the detail involved in rediscounting large numbers of individual notes and other kinds of paper was burdensome. For administrative convenience, to effect economies in operation, and presumably to aid in the financing of World War I, Congress, in 1916, amended the Federal Reserve Act to permit district banks to make short-term advances to member banks against their own notes secured by eligible paper, bonds or notes of the U.S. Eligible paper includes U.S. government securities (T-bills, T-notes, and T-bonds), federal agency securities, municipal securities, bankers' acceptances, some commercial paper issues, and mortgage loans covering one-to-four-family residences. Many banks keep eligible paper at their district bank or a branch, thus making collateral, particularly residential mortgage loans, on their own premises for periods not in excess of 21 days or at an off-premises location under custody.
Acceptances Acceptances are letters of credit which have been accepted by banks as their own obligations. In 1955, the FOMC authorized the FRBNY to deal in prime bankers' acceptances for its own account. In 1977, the FOMC modified this authorization to include repurchase agreements only. All purchases are conducted through a select group of approximately forty primary dealers. Although bankers' acceptances are bought and sold at a discount prior to maturity, they are carried on the FRBNY's books at face value.
Federal Agency Securities These securities, also carried at face value, are issued by federal agencies established by law. They were called to life to implement, primarily, the U.S. government's farm and home lending programs.
Each agency has power to issues its own securities. Most agency securities are not guaranteed by the U.S. government, but are obligations only of the agencies. However, in the event of a cash shortage, these agencies have the authority to borrow directly from the U.S. Treasury. Such authority ensures that they are almost as risk-free as U.S. government securities. These securities are now issued in book-entry form rather than as paper certificates. All purchases are conducted through the primary dealers. Eligible OMO securities include issues of the Federal Home Loan Banks, the Federal National Mortgage Association, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks for Cooperatives, and the Federal Financing Bank. Ineligible OMO securities include issues of the General Services Administration, the U.S. Postal Service, the Washington Metropolitan Transit Authority, the Export-Import Bank, the Farmers Home Administration, and the Government National Mortgage Association.
In 1966 an amendment to the Federal Reserve Act authorized district banks to buy and sell federal agency securities under repurchase and matched sale-purchase agreements. In 1971, the FOMC extended this authorization to outright purchases and sales to widen the base of OMO operations and to add breadth to the market for agency securities. In April 1972 the FOMC authorized the OMO to use competitive bidding when buying agency securities under repo agreements. In 1977, the FOMC restricted outright purchases and sales to issues of those agencies which are unable to borrow from the Federal Financing Bank.
U.S. Government Securities These securities, also carried at face value, include the Treasury bills, notes, and bonds issued by the U.S. government and, on occasion, Treasury certificates issued by the Treasury directly to the Federal Reserve to provide temporary financing. Except for the T-certificates held outright, the Federal Reserve holds U.S. government securities under both outright and repurchased agreements. Almost all transactions are conducted through the primary dealers. Sometimes securities are bought from foreign official accounts. Except for acquisitions in exchange for maturing issues, direct purchases from the Treasury are permitted only for short periods and for relatively small amounts. All marketable U.S. government securities are issued in book-entry form rather than as paper certificates.
Cash items in the process of collection This category is composed of checks and other items (negotiable orders of withdrawal and matured corporate and municipal coupons) from depository institutions payable on demand which the Federal Reserve accepts as cash items. These items have been received by district banks and, on the date of the statement, are in the process of being collected, or transported to the institutions on which they are drawn. On individual district bank balance sheets this category includes items to be collected from other district banks. On the consolidated statement, items in transit between district banks are deleted. To include them would be double counting.
Bank Premises and Equipment This category includes the value of the land and buildings, at initial cost, of district banks and branches, less an allowance for depreciation on buildings.
Other assets consist of accumulated interest and other accounts receivable, premiums paid on securities bought outright, U.S. notes, silver certificates, and assets denominated in foreign currencies, including "swap" drawings and funds "warehoused" for the Treasury and the ESF.
Liabilities
Federal Reserve Notes Outstanding These notes are debt obligations of the Federal Reserve Banks and include the total amount of these notes in circulation, including those held at depository institutions and the U.S. Treasury.
Deposits
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Depository Institutions Reserves These accounts are demand balances that banks and other institutions (Edge Act Corps. and the U.S. agencies and branches of foreign banks) are legally required to hold against customer demand, time, and savings deposits and other deposits against which marginal reserve requirements have been applied, e.g. Eurodollar borrowings.
U.S. Treasury General Account This account is the official checking account of the Treasury, from which virtually all U.S. government disbursements are made. It is the total of all demand balances held by the Treasury at the various district banks and their branches.
Foreign Official Accounts These accounts are the demand balances of foreign governments, foreign central banks, and the Bank for International Settlements. While transactions for these accounts are handled by the FRBNY, the deposits are allocated among all district banks.
Other deposits include demand balances for international organizations such as the International Monetary Fund, the United Nations, and the International Bank for Reconstruction and Development (World Bank); the special checking account of the ESF; and demand balances of certain U.S. government agencies.
Other Liabilities and Accrued Dividends consists of accrued dividends on paid-in capital stock by member banks, unearned discounts on securities bought outright, sundry items payable, accrued expenses, and reserves against foreign exchange contracts which have not been booked.
Capital Accounts
Capital Paid In Capital paid in is the amount paid for Federal Reserve capital stock. Member banks are shareholders by law and must subscribe to shares of the Reserve Bank of their district in an amount equal to 6% of their own paid-in capital stock and surplus. Of this amount, 3% must be paid in and 3% remains subject to call by the BOG. When a member bank changes its capital and surplus, its ownership of district bank stock is altered accordingly.
Surplus After necessary expenses are paid and the statutory cumulative 6% dividend on paid-in capital is met, district banks are required by law to pay net earnings into a surplus fund. This surplus must be equal in size to the amount of paid-in capital.
IX. The Reserve Equation
The reserve equation yields a first approximation for determination of reserves for the banking system. It is derived from the Federal Reserve balance sheet.
The Reserve Equation as an Identity
The balance sheet accounting identity (
) shows that the two sides of a balance sheet must always balance. As an identity, the reserve equation shows that the two sides of the Federal Reserve's balance sheet always balance: Reserves + Other Liabilities + Net WorthThe Reserve Equation as an Functional Equation
A functional equation (=) rearranges an identity into cause and effect. As a functional equation, the reserve equation shows that the determination of reserves is a residual from other changes in the Federal Reserve's balance sheet.
Anything that increase assets or decreases other liabilities and net worth increases reserves, ceteris paribus. Anything that decreases assets or increases other liabilities and net worth decreases reserves, ceteris paribus.
In addition to reserves held in deposits at the Fed, banks are permitted to count, as part of their reserve requirement, cash in bank vaults. However, cash in bank vaults is fluid and moves back and forth between banks and deposits at the Fed and between banks and the public. Consequently, there are actions that can be taken by individuals and institutions outside the Fed that have an impact on the reserves of the banking system.
X. The Monetary Base
Monetary Base
The monetary base (B), also known as high powered money, takes into consideration all perfectly substitutable assets that provide potential reserve bases for money creation by the banking system:
RF + Cb + Cp RT + Cp RF + CTwhere RF is reserves at the Fed, Cb is cash in bank vaults, and Cp is cash in the hands of the public are perfect substitutes and simply by changing ownership can effect the amount of reserves in the banking system. Total reserves (RT) include reserves at the Fed (RF) plus cash in bank vaults (Cb). Total Treasury currency outstanding (CT) includes cash in bank vaults (Cb) plus cash in the hands of the public (Cp). Therefore, an analysis of the reserve position of banks requires knowledge of the factors that both supply and drain portions of the monetary base from the system.
Factors Supplying Reserves
Federal Reserve Credit
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Open market operations When the Trading Desk buys securities, it takes securities from the banks and the public and, in return, pays for the securities with injections of new reserves. If the Trading Desk buys securities from banks, it directly credits their reserve accounts. If the Trading Desk buys securities from the public, it gives them checks. They deposit the checks in their banks and, upon presentment to the Fed, the banks receive credit in their reserve accounts. When the Trading Desk sells securities, it gives securities to the banks and the public and, in return, withdraws reserves from the system. If the Trading Desk sells the securities to banks, it directly debits their reserve accounts. If the Trading Desk sells securities to the public, it receives their checks, and upon presentment to the paying banks, debits their reserve accounts.
Discounts and advances When a district bank lends to a bank, it does so by giving the bank credit in its reserve account. When the bank repays its loans, the district bank debits the bank's reserve account.
Gold stock When the Treasury opts to monetize portions of the gold stock, it issues new gold certificates to the Fed, who, in turn, credits the Treasury's General Account. When the Treasury spends these balances, reserves are added to the banking system. When the Treasury sells gold, it can use the proceeds to retire or buy back gold certificates, draining reserves from the banking system. Monetizing the gold stock is a discretionary action of the Treasury, not the Fed.
Special Drawing Rights certificates When the Treasury opts to settle official account balances with other countries, it can "spend" SDRs. The Treasury issues SDRs to the Fed, who, in turn, credits the Treasury's General Account. These balances are initially transferred to official foreign balances; however, as foreigners buy commodities and assets from the U.S., these balances are transferred to the reserve accounts of banks. Monetizing SDRs is a discretionary action of the Treasury, not the Fed.
Miscellaneous Federal Reserve assets Any increase in accumulated interest and other accounts receivable, premiums paid on securities bought outright, U.S. notes, silver certificates, and assets denominated in foreign currencies, including swap drawings and funds warehoused by the Treasury and the Exchange Stabilization Fund (ESF), will increase reserves, ceteris paribus. Any decrease in accumulated interest and other accounts receivable, premiums paid on securities bought outright, U.S. notes, silver certificates, and assets denominated in foreign currencies, including swap drawings and funds warehoused by the Treasury and the ESF, will decrease reserves.
Treasury currency outstanding By definition, all Treasury currency is legal tender and considered payment for debts, public and private. Whenever the Treasury issues new currency, it adds to total currency outstanding. If the new currency remains in the hands of the public, no new reserves are created; however, when it is deposited in banks, it becomes part of bank reserves. Banks can either hold this currency in their vaults or deposit it with the Federal Reserve. Under the Constitution, the federal government has only the power to mint coin. In times past, the Treasury issued gold and silver certificates that represented deposits of gold and silver with the Treasury. Today, the Treasury only mints coin for circulation. The Federal Reserve is responsible for putting paper notes into circulation. How much of either remains in circulation or is deposited in banks depends upon the currency requirement of the public.
Factors Absorbing Reserves
Treasury deposits at the Fed Treasury deposits at the Fed will vary as taxes are collected and monies expended. The Treasury maintains Tax and Loan Accounts at the commercial banks. These accounts facilitate the collection of taxes as well as minimize the impact on reserves. By simply transferring funds within the banking system from the accounts of the tax-paying public to the Tax and Loan accounts of the Treasury, no reserves are lost. When the Treasury wants to spend its tax receipts, it transfers funds from its Tax and Loan accounts to its General Account at the Fed. This transfer drains reserves from the banks, but only temporally, until such time as spending by the Treasury returns deposits and reserves to the banks and the public.
Foreign deposits at the Fed In the course of international trade and finance, payments are made by Americans to foreigners, and vice versa. When Americans make payments to foreigners, balances are transferred from the reserve accounts of banks to foreign official accounts, thus draining reserves from the banking system. When Americans receive payments from foreigners, balances are transferred from foreign official accounts to the reserve accounts of banks, thus increasing reserves to the banking system. Since these actions are a result of the normal course of international business activity, they are outside Fed control.
Other deposits at the Fed Again, other deposits at the Fed, which include demand balances for international organizations and government agencies, will rise and fall as the owners receive and expend balances in the normal course of economic activity.
Treasury cash holdings When the Treasury recalls a previous currency issue, as it has with its "greenbacks" and the gold and silver certificates, or when the Treasury receives cash as payment for taxes, fees, fines, or other remittances, total currency outstanding declines. This reduces the potential reserves of the banking system at the option of the paying agent, not the Fed.
Miscellaneous Federal Reserve liabilities As the Fed records accrued dividends on paid-in capital stock by member banks, unearned discounts on securities bought outright, sundry items payable, accrued expenses, and reserves against foreign exchange contracts which have not been booked, its miscellaneous liabilities will rise, at the expense of reserves; and vise versa. Miscellaneous liabilities are generally outside the direct control of the Fed: the dividend on paid-on capital is fixed; discounts on securities bought depend upon financial market conditions at the time of purchase; accounts payable and accrued expenses result from ongoing operations; and reserves against foreign exchange contracts which have not been booked depend upon international financial movements.
Total Reserves
Total reserves depend upon potential reserves; namely, upon the factors supplying reserves and the factors absorbing reserves.
Out of potential reserves, the amount of total reserves depends upon the currency requirement of the public. Actual total reserves are then divided into required reserves (Rr), which are used to support existing deposit liabilities, and excess reserves (Re), which can be used by banks to make loans, extend deposit liabilities, and increase the money supply. Actual total reserves are either the result of deposits and open market operations (non-borrowed reserves (Rn)) or of borrowing at the discount window (borrowed reserves (Rb)).
Net Free Reserves
Net free reserves (Rf) are the non-borrowed excess reserves of the banking system:
XI. General Monetary Policy Controls
General controls are theoretically the non-discriminatory tools of monetary policy. They include changing the monetary base and/or changing the money multiplier.
All money supplies take the same form: Ms = mB, where Ms is the money supply, B is the monetary base (or high powered money), and m is the money multiplier. The monetary base includes reserves at the Federal Reserve, cash in bank vaults, and cash in the hands of the public:
RF + Cb + Cp RT + Cp RF + CTThe money multiplier includes all of the assets in the designated money supply in the numerator and all of the restrictions on its expansion in the denominator. These restrictions include reserve requirements, currency requirements and bank policies regarding excess reserve holdings. The number and types of restrictions depend on the technical definition of the money supply.
If Ms = C, where C = currency, and there are no demand deposits or possibilities for monetary expansion through lending excess reserves, then m = 1 and Ms = 1B.
If Ms = D, where D = demand deposits and banks can expand the money supply by lending excess reserves, then m = {1/(r + e)}, where r = reserve requirement and e = ratio of excess reserves to demand deposits, and Ms = {1/(r + e)}B.
If Ms = D + C, where both currency and demand deposits circulate as money, then m = {(1 + c)/(r + e + c)}, where c = C/D, the public's desired currency ratio, and Ms = {(1 + c)/(r + e + c)}B.
If Ms = D + C + T, where T = savings and time deposits, then m = {(1 + c + t)/(rd + trt + e + c)}, where t = T/D, the public's desired savings deposit ratio and rt is any reserve requirement against savings and time deposits, and Ms = {(1 + c + t)/(rd + trt + e + c)}B.
Changes in Federal Reserve credit, discount rate policy (d) and open market operations (OMO), change the monetary base (B) and changes in reserve requirements (r) change the money multiplier (m).
General controls are considered to be general, and, therefore, non-discriminatory, in that they are applied independent of their effect on specific economic participants or specific markets. Rather, they are designed to affect the money supply in the aggregate and interest rates across-the-board. However, even general controls may be discriminatory in that interest-sensitive sectors of the economy will be more reactive than will sectors that are not sensitive to or dependent upon interest rates for their general level of economic activity. Markets for capital goods, housing, automobiles, and other consumer durables are generally more heavily affected by changes in the general controls than are markets for food and clothing. The financial markets are also heavily influenced by changes in the general controls, because financial asset prices depend upon interest rates for discounting future income flows and capital gains.
XII. The Federal Funds Market
The federal funds market is the market in which banks with excess reserves lend to banks with deficient reserves.The federal funds rate is the inter-bank lending rate in the federal funds market.
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The federal funds rate increases when either the demand for reserves increases or the supply of reserves decreases. The federal funds rate decreases when either the demand for reserves decreases or the supply of reserves increases.
The Federal Reserve can influence the federal funds rate by changing federal reserve credit and reserve requirements. When the Federal Reserve changes the discount rate, it influences total reserves by changing the amount of borrowed reserves. When the Federal Reserve conducts open market operations, it influences total reserves by changing the amount of non-borrowed reserves. When the Federal Reserve changes reserve requirements, it affects the demand for reserves.
XIII. Federal Reserve Credit and the Discount Rate
Federal Reserve Credit
Of the factors supplying and absorbing reserves from the banking system, the Fed has control over only Federal Reserve credit. Federal Reserve credit consists of loans (discounts and advances) made by the district banks through their discount windows and open market operations conducted by the Trading Desk at the New York Federal Reserve Bank.
Discount Window
The discount window is the place where depository institutions can borrow reserves. When Congress passed the Federal Reserve Act in 1913, it was concerned with providing a liquidity valve for preventing credit crunches, financial panics, and economic collapses. Congress assumed that the discount window and the discount rate would play a major role in preventing such occurrences. Furthermore, since economic and credit conditions were expected to vary by district, the Boards of Directors of the individual district banks were given the power to set the discount rate in accordance with local economic and credit conditions. By acting as a lender of last resort, the district banks were to maintain liquidity according to economic and credit conditions in each district.
Prior to the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 ("DIDMCA"), borrowing at the discount window was a privilege generally restricted to commercial banks that were members of the Federal Reserve System. Since DIDMCA, all depository institutions are eligible to borrow at their district bank's discount window. The price that depository institutions pay for their borrowing is called the discount rate.
Discount Rate (d)
The discount rate is the base rate at which the Federal Reserve district banks lend to depository institutions in their respective districts. It is expressed in annual terms (i.e., a 365- or 366-day year) and interest charges are computed on the basis of the number of days funds are actually advanced. Interest on borrowings from the discount window is payable when the loan is repaid.
The effective rate depends upon the kind of credit being extended by the Federal Reserve district bank to the depositiory institution. The district banks offer four kinds of credit: primary, secondary, seasonal, and emergency.
Primary credit is available to generally sound depository institutions on an overnight or a very short-term basis as a backup rather than as a regular source of funding. On August 17, 2007, the primary credit program was temporarily changed to allow loans for terms of up to 30 days to ensure sufficient liquidity in light of the "mortgage meltdown" crisis.
Prior to January 9, 2003, the primary credit rate was set below the FOMC's target for the federal funds rate. Depository institutions were required to exhaust all other sources of funds before coming to the discount window and their purpose(s) for borrowing were restricted. On January 9, 2003, the Federal Reserve repositioned the discount rate from below the FOMC's target for the federal funds rate to above the FOMC's target for the federal funds rate. The repositioning was intended to improve the discount window's operation as a mechanism for implementing monetary policy. Since the repositioning, depository institutions do not need to exhaust all other sources of funds before coming to the discount window and they are not restricted to the purpose(s) for borrowing.
From January 9, 2003, to August 17, 2007, the primary credit rate was set 100 basis points above the FOMC's target for the federal funds rate. The goal of the 100 basis point spread was to encourage depository institutions to obtain regular funding from market sources rather than from the discount window and to discourage depository institutions from borrowing at the discount window to lend in the federal funds market. However, the "mortgage meltdown" crisis in August 2007 persuaded the Federal Reserve to reduce this spread to 50 basis points and to encourage borrowing. On August 17, 2007, the Board of Governors approved district bank requests to lower the primary credit rate by 50 basis points to effect the lower spread. On September 18, 2007, the primary credit rate was lowered by another 50 basis points to 5.25% (at the same time that the FOMC lowered the federal funds target rate to 4.75%).
Secondary credit is extended on a very short-term basis to depository institutions not eligible for primary credit. It is available to meet backup liquidity needs when its use is consistent with a timely return to market sources of funding or the orderly resolution of a troubled institution. The secondary credit rate is set 50 basis points above the primary credit rate. As of September 18, 2007, the secondary credit rate is 5.75%.
Seasonal credit is available to help relatively small depository institutions meet regular seasonal needs for funds that arise from a clear pattern of intrayearly movements in their deposits and loans and that cannot be met through special industry lenders. The discount rate on seasonal credit takes into account rates charged by market sources of funds and ordinarily is reestablished on the first business day of each two-week reserve maintenance period. As of September 18, 2007, the secondary credit rate is 5.35%.
Emergency credit is available in unusual and exigent circumstances. The Board of Governors may authorize a district bank to provide emergency credit to banks, individuals, partnerships, and corporations that are not depository institutions. The rate charged to qualified depository institutions is one to two points above the primary credit rate. The rate charged to other institutions is generally set three points above the primary credit rate.
The actual rate depends on the collateral pledged by borrowing institutions and/or surcharge attachments. A borrower is charged the base rate (by credit type) when pledging Treasury securities, federal agency securities and eligible paper as collateral. A surcharge of at least one-half a percentage point is added to the base rate when other paper is pledged.
The discount rate is set by the directors of each district bank every 14 days, subject to review and approval by the Board of Governors. Any change is usually effective the day after the BOG's action, regardless of whether the following day is a business day. Prior to World War II, each district generally had a different discount rate. Since World War II and the consolidation of the Federal Reserve, the discount rate at all district banks is identical, except for periods of a few days depending upon when the district bank's Board meets to reset the rate.
Function of the Discount Rate
The function of the discount rate is to regulate the amount of reserves in the banking system by regulating borrowing at the discount window. The district banks raise and lower the discount rate to decrease and increase the amount of borrowed reserves in the banking system. An increase in the discount rate decreases reserves via repayment of discount loans and a decrease in the discount rate increases reserves via new borrowings at the discount window. An increase in the discount rate raises the cost of funds to banks and therefore discourages borrowing to increase reserves and expand the money supply. A decrease in the discount rate lowers the cost of funds to banks and therefore encourages borrowing to increase reserves and expand the money supply. As the amount of borrowed reserves in the banking system decreases and increases, total reserves decrease and increase. As total reserves decrease and increase, the federal funds rate rises and falls.
Raising and lowering the discount rate raises and lowers the federal funds rate. The federal funds rate is the inter-bank lending rate in the federal funds market. The federal funds market is the market in which banks with excess reserves lend to banks with deficient reserves.
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Whether the district banks were unable or unwilling to stem the money supply contraction with its use of the discount rate during the Depression, Congress decided to shift the rate-making authority to the BOG. While the district banks are still responsible for proposing rates and rate changes, the BOG must approve district bank requests and is ultimately responsible for the discount rate, as part of monetary policy.
As a tool of monetary policy, a change in the discount rate affects the cost of borrowing and the availability of funds for loans in three ways. First, it changes the banks' cost of funds when borrowing directly from the discount window. Second, it affects the whole structure of interest rates by altering the opportunity cost to banks of obtaining reserves from securities to raise reserves. If the rate goes up, banks will liquidate short-term securities; this will put downward pressures on prices and upward pressure on short-term interest rates. The gap between short- and long-term rates will narrow. As the gap narrows, investors will sell long-term securities and buy short-term securities, finally pushing longer-term rates higher. Third, a change in the discount rate can be interpreted as a signal by the Fed of its future intentions. If the discount rate is raised, banks may begin to restrict loans to customers in anticipation of higher rates. If the discount rate is lowered, banks may push aggressively for new loan applications by offering lower rates.
Strengths of the Discount Rate
Changes in the discount rate provide a temporary means of adjustment for reserve deficiencies that occur at times of pressure on reserves. It allows the Manager of the Trading Desk to be more aggressive in pursuing, especially, a "tight" money policy, knowing that banks can correct deficient reserve positions by borrowing at the discount window.
Changes in the discount rate have an announcement effect. They signal both banks and the general public as to the general direction of Federal Reserve policy. Unfortunately, the announcement effect may be bad if the signal is misinterpreted. As the Fed tries to align rates, a change in the discount rate may be interpreted as a directional shift in monetary policy, when, in fact, the Fed has simply changed the rate to reflect already existing market conditions.
Changes in the discount rate serve as a guide to the Manager in conducting open market operations. Since the Fed tries to keep the discount rate and the fed funds rate in close proximity of one another, a change in the discount rate that opens the gap between the two rates signals the Manager to conduct open market operations so that the fed funds rate gravitates toward the discount rate.
Changing the discount rate gives monetary policy decision-makers another option, should open market operations become unworkable. The importance of the discount rate as a tool of monetary policy has fallen to second place behind open market operations. However, it may have to act as a very important secondary tool in an emergency. If, for example, the securities markets should collapse, the discount rate may be the only practical way of providing or withdrawing reserves from the system.
Weaknesses of the Discount Rate
Changes in the discount rate cannot force banks to borrow. The demand for new reserves depends directly upon the opportunities for lending. If the demand for bank loans is low, the demand for borrowing at the discount window will be low. A decrease in the discount rate will not have the desired effect of increasing reserves, if banks already have excess reserves because the demand for bank loans is low.
Changes in the discount rate cannot force banks to stop borrowing. Again, the demand for new reserves depends directly upon the opportunities for lending. If the demand for bank loans is high, the demand for borrowing at the discount window will be high. An increase in the discount rate will not have the desired effect of reducing reserves, if banks can lend the new reserves at a substantial premium.
Changes in the discount rate may create balance-of-payments problems. The discount rate generally sets the base for all interest rates in the country. If the discount rate is too low, money may flow out of the country in search of higher returns abroad. This outflow of money defeats the purpose of lowering the rate to expand the domestic money supply. If the rate is too high, money may flow into the country. This inflow of money defeats the purpose of raising the rate to contract the domestic money supply. Moreover, the consequent increase in the demand for dollars to buy the higher interest-bearing U.S. assets will worsen the trade balance.
The Appropriate Level for the Discount Rate
The Fed has been criticized often for the level of the discount rate. One problem has to do with whether the discount rate is too high or too low for the current economic conditions. This criticism was more relevant when open market operations were not a significant tool of monetary policy. However, since the discount rate is generally tied to the federal funds rate (the target of open market operations), this criticism would justifiably hold for the federal funds rate as well.
A second problem is the gap between the discount rate and the T-bill rate. The Federal Reserve was designed to be a lender of last resort and not a cheap source of borrowing to support bank investment portfolios or speculation in T-bills. If the discount rate is above the T-bill rate, banks will readily sell T-bills to raise reserves. However, if the discount rate is below the T-bill rate, banks would prefer to borrow at the discount window rather than sell T-bills to raise reserves. The Fed must consistently monitor bank borrowing to ensure against the window's use for carrying securities and speculation. It has been often suggested that to avoid banks' use of the discount window to support securities activities the discount rate be tied to the T-bill rate and that it set slightly above --- 1/8 to 1/4% --- the T-bill rate. While this would discourage use of the window for securities activities, such a "golden rule" would limit the usefulness of the discount rate as a tool of monetary policy.
A third problem is the gap between the discount rate and the federal funds rate. Prior to January 2003, the discount rate was set 25-100 basis points below the target for the federal funds rate. For example, in December 2002, the federal funds target was 1.25% and the discount rate was .75%. The lower discount rate allowed depository institutions to borrow reserves at the lower discount rate and then lend these reserves at the higher federal funds rate. Total reserves always consisted of non-borrowed reserves which are added to the banking system through open market operations and borrowed reserves. In assessing how many securities to buy and sell to achieve a specific federal funds target, the Trading Desk had to guess at how many reserves would be borrowed by depository institution. In January 2003, the Federal Reserve changed its discount lending programs. Discount rate policy was changed to set the discount rate 100 basis points above the federal funds target rate. For example, in January 2003, the target for the federal funds rate was 1.0% and the discount rate was set at 2.0%. When the discount rate is above the federal funds rate, depository institutions have much less incentive to borrow reserves at the discount windows, except in an extreme emergency. Instead, they will borrow reserves in the federal funds market at the lower federal funds rate. As a result, the Trading Desk has much better control over total reserves, because the only reserves in the banking system are the non-borrowed reserves supplied through open market operations conducted by the Trading Desk. This change in discount rate policy should give the Federal Reserve much better control over money supply and interest rates.
Borrowing at the Discount Window is a Privilege, Not a Right
Borrowing at the discount window is considered a privilege, not a right. Amounts and frequency of borrowing by depository institutions is closely monitored. If an institution seeks credit too often, district bank officials will discuss the matter with officers and directors of the offending institution to determine the underlying cause and to urge them to remedy their liquidity situation. In the limit, the Fed has the power to eject and replace bank management.
Because of its weaknesses and the alternative of using open market operations to change reserves on a short-term basis, the discount rate is viewed as an intermediate-term tool. Even though it may be changed as often as every two weeks, historically it has been changed, on average, only twice a year.
XIV. Federal Reserve Credit and Open Market Operations
Federal Reserve Credit
Of the factors supplying and absorbing reserves from the banking system, the Fed has control over only Federal Reserve Credit: discounts and advances, through manipulation of the discount rate, and open market operations.
Open Market Operations (OMO)
Open market operations is the purchase and sale of securities to regulate non-borrowed reserves, credit expansion, and the money supply. Securities purchased by the Fed are carried at face value. Premiums paid are carried as "other assets" and discounts received are carried as "other liabilities" on the balance sheet. Both are amortized over time.
Function of Open Market Operations
The function of open market operations is to influence economic activity by changing the amount of non-borrowed reserves in the banking system. Unlike discount rate policy, which is passive reserve management because it relies on banks' initiatives to borrow at the discount window, open market operations is active reserve management, undertaken at the Fed's initiative. To stimulate the economy, the Fed buys securities. When the Federal Reserve buys securities, it pays for them by crediting reserves. With new reserves, banks can extend credit and expand the money supply. To slow down the economy, the Fed sells securities. When the Federal Reserve sells securities, it reduces reserves. With fewer reserves, banks are forced to either recall loans or refuse additional loans, contracting credit and the money supply.
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Eligible securities for OMO
Prime bankers' acceptances A banker's acceptance is a draft or bill of exchange that a bank has "accepted" as its own potential liability, having pledged its credit on behalf of its customer. In 1955, the FOMC authorized the New York Reserve Bank to deal in prime bankers' acceptances for its own account. In 1977, the FOMC modified this authorization to include only repurchase agreements under ordinary circumstances. The policy was changed because the acceptance market had matured and become efficient and no longer required support by the Federal Reserve.
Federal agency obligations Not all fed agency obligations are eligible for OMO. Agency securities eligible for open market operations are issues of the Federal Home Loan Banks, Federal National Mortgage Association, Federal Land Banks, Federal Intermediate Credit Banks, the Banks for Cooperatives, and the Federal Financing Bank. Ineligible securities include those of the General Services Administration, U.S. Postal System, Washington Metropolitan Area Transit Authority, Export-Import Bank, Farmers Home Administration, and the Government National Mortgage Association.
U.S. government securities U.S. government securities are obligations of the federal government, issued by the Treasury. They are traded through primary dealers in U.S. government securities or are bought from foreign official accounts. Except for acquisitions in exchange for maturing issues and temporary short-run financing, the Fed cannot buy securities directly from the Treasury. Treasury bills, sold at discount, have maturities not exceeding one year. Certificates of Indebtedness, carrying an interest coupon, have maturities not exceeding one year. Treasury notes, which have an interest coupon, have maturities of not less than one nor more than 10 years. Treasury bonds, also bearing an interest coupon, are issued with maturities in excess of 10 years. While purchases and sales affect the overall level of reserves, trading in the various maturities affect the term structure of interest rates. Federal government securities may be either bought outright or bought and sold through repurchase and matched sale-purchase agreements.
Today, all U.S. government securities and federal agency securities are issued in computerized book-entry form rather than certificate form. By eliminating certificates, the securities are better safeguarded and more rapidly transferred throughout the financial system. They are less vulnerable to theft and loss, cannot be counterfeited, and do not require recording by certificate number. Owners need not "clip" coupons to obtain interest payments or present the certificates for redemption. Interest is automatically paid on the due date and the securities are automatically redeemed at maturity.
Types of Purchases and Sales
In conducting open market operations, the Fed can make outright purchases and sales or engage in repurchase and matched sale-purchase agreements.
Outright purchases and sales An outright purchase or sale of securities is a dynamic operation used to make a longer-term permanent change in the reserve position of the banking system. Although continuous, orderly, well-organized markets exist for these securities, the transaction is considered to be not easily reversed in the short-run. U.S. government and federal agency securities are eligible for outright purchase and sale. Ownership of outright holdings are allocated among the several district banks and adjusted annually to reflect movements of deposits among the Reserve Banks.
Repurchase agreements (RPs) An RP is an agreement to buy back. It is a defensive operation used to keep the federal funds rate from deviating from its target rate. The RP is used to provide a temporary and self-reversing injection of reserves into the banking system. When the Fed conducts a repurchase agreement it buys securities from a dealer with an agreement that obligates the dealer to buy the securities back on a specific date. RPs may be for a period of up to 15 days. Most multi-day contracts can be terminated at the dealer's option. The Fed also has this option, but rarely exercises it. Some contracts, however, are arranged for fixed periods and may not be shortened by either party. Acceptable securities for repurchase agreements include U.S. government securities, federal agency securities, and prime bankers' acceptances.
Matched sale-purchase agreements (MSPs) An MSP is an agreement to sell back. It is also a defensive operation used to keep the federal funds rate from deviating from its target rate. The MSP is used to provide a temporary and self-reversing withdrawal of reserves from the banking system. When the Fed conducts a matched sale-purchase agreement it sells securities to a dealer with an agreement that obligates the dealer to sell back the securities on a specific date. MSPs may be for a period of up to 15 days. Most multi-day contracts can be terminated at the dealer's option. The Fed also has this option, but rarely exercises it. Some contracts, however, are arranged for fixed periods and may not be shortened by either party. Acceptable securities for matched sale-purchase agreements include U.S. government securities, federal agency securities, and prime bankers' acceptances.
A Short History of Open Market Operations
When the Federal Reserve Act was passed in 1913, the government had very little outstanding debt. In fact, the open market operations function of the Fed was to act as an underwriter for Treasury issues, buying and selling Treasury securities to ensure adequate financing at low rates. Not until World War I did the Treasury float enough debt to make open market operations a viable alternative to the discount rate for controlling money and credit in the banking system. But, after World War I, the Treasury, true to its liberal classical (laissez-faire) tradition, began to repay its debt.
Before the government could complete its repayment, the economy slid into its most serious depression. Tax revenues, no longer tied to imports as they were in the 19th century but rather to income (since ratification of the 16th Amendment in 1913), declined, forcing ever larger budget deficits and mandating additional debt issues to cover government expenditures. The political issue facing Hoover and Roosevelt in the 1932 election was the restoration of a balanced budget. After his election, however, Roosevelt and the Congress went on a spending spree, adding to the national debt at an unprecedented rate for a peacetime government. Then, with the outbreak of World War II and the massive military build up, the government borrowed even more.
At the end of World War II, the federal government had over $250 billion in debt outstanding. While this figure pales against today's $5.7 trillion national debt, it was ten times as large as the $25 billion in debt outstanding at the end of World War I and over one hundred times as large as the national debt in 1915. In retrospect, fifty-five years after World War II, our national debt is just over twenty times as large as it was in 1946, while the debt after World War II was ten times as large as the debt only 26 years earlier at the end of World War I. In other words, the federal government has accumulated debt since World War II in proportion to what it accumulated in the years between the World Wars.
After World War II, the Federal Reserve actively pursued open market operations as a tool of monetary policy, as well as a means for creating liquid reserves for the banking system. Its operations were thwarted in the early 1950s by the Treasury's demand to obtain low-cost financing in the credit markets for the Korean conflict. The Fed wanted slightly higher interest rates; the Treasury did not. In order to accommodate the Treasury, the Fed was forced to buy up much of the Treasury's debt, adding to the reserves of the banking system and increasing the money supply. In 1951, the dispute between the Treasury and the Federal Reserve came to a head, and, after much public dickering, the two parties agreed to an Accord, whereby the Fed was freed of the shackles of financing Treasury offerings. However, the ties were loosened only slowly, and for many years after, part of the Fed's open market operations were conducted with one eye toward favorable financing terms for the Treasury.
While arguments for cooperation between the Treasury and the Federal Reserve are convincing, excessive accommodation eliminates the effectiveness of open market operations as a tool of monetary policy. Today, open market operations are conducted principally with achievement of the ultimate goals in mind. Open market operations are considered the most powerful and effective tool of monetary policy and are relied on especially to "fine tune" monetary targets.
Strengths of Open Market Operations
Open market operations is the most flexible tool. The amount, magnitude, and timing of securities trades is at the discretion of the Manager of the Trading Desk.
Open market operations is the tool over which the Fed has the most control in altering reserves. While borrowing at the discount window in response to discount rate policy is at the initiative of the banks, open market operations is at the initiative of the Fed.
Open market operations can be used to support the discount rate policy. An increase in the discount rate may be ineffective in contracting or slowing the rate of credit and money growth, if banks have excess reserves. To support the higher discount rate, open market operations, through the sale of securities, will drain the excess reserves and force banks to ration credit. A decrease in the discount rate may be ineffective in expanding the rate of credit and money growth, if banks have no excess reserves. To support the lower discount rate, open market operations, through the purchase of securities, will add reserves and permit banks to extend more credit and increase the money supply.
Open market operations can be used to supplement reserve requirements. Sometimes reserve requirements are changed for structural rather than stabilization purposes. Open market operations can be used to offset undesired changes in the reserve position of the banking system.
Open market operations can be used to affect different interest rates in various ways. Because of the variety of maturities on securities, the Fed can buy and sell securities of different maturities to alter the term structure of interest rates.
Weaknesses of Open Market Operations
Open market operations lack an announcement effect. Open market operations are conducted on an ongoing, daily basis. Almost every day, the Trading Desk is authorizing either purchases or sales of U.S. government securities to stabilize the federal funds rate around the FOMC target rate. Target rates are only announced after the FOMC has a meeting or telephone conference call initiating a change in the federal funds target rate.
Open market operations fail to signal the stance of Fed policy. The public cannot distinguish between purchases and sales for dynamic purposes and purchases and sales for defensive purposes. The stance of Fed policy can be determined only from dynamic operations.
The initial impact of open market operations is concentrated in the money market centers, where the primary dealers are located. It may take some time for this impact to filer through the economy. On the other hand, this filtration time is decreasing given the vast network of correspondent banks, computerization of the fed funds market, and the use of electric funds transfer systems.
Overall, the strengths and weaknesses of OMO make it an ideal tool for short-term fine-tuning of monetary policy.
XV. Reserve Requirements
Reserve requirements are percentages that set the fraction of deposit liabilities the banks must have on hand in the form of acceptable reserves. Originally, reserve requirements were imposed to maintain liquidity in the banking system. They were designed to ensure that banks had sufficient cash (or specie) to pay out on demand to their depositors. However, by their very nature, required reserves are unavailable to be paid out. Therefore, banks must have excess reserves on hand to meet depositors' withdrawal needs.
Function of Reserve Requirements
Today, the function of the reserve requirements is to control the amount of money supply which can be created by the banks through their lending processes. If the percentage is zero, then no reserves are required and banks can extend credit, create deposits, and expand the money supply ad infinitum. Only sound lending policies will prevent excessive money creation and liquidity problems. If the percentage is 100%, then the banks must hold all of their deposits in the form of reserves and no money supply expansion can take place. The money supply will consist solely of monetary base. If the percentage is somewhere between 0% and 100%, banks are required to keep some fraction of deposits in reserves, but are free to lend out any excess reserves. This "fractional reserve" system permits some credit extension, but sets an upper limit to credit creation, deposits liabilities, and the money supply.
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Three Types of Reserve Requirements
- Basic reserve requirements against traditional deposits---demand and savings accounts (Regulation D)
- Marginal reserve requirements against large negotiable CDs and bank-related commercial paper (Regulation D)
- Reserve requirements governing foreign activities of U.S. banks (Regulations A, D, and N).
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The Banking Act of 1935 made the reserve requirement a permanent instrument of control by the Federal Reserve and eliminated the President's approval. The actual reserve requirements were set between 7% for net demand deposits up to $2 million and 16.25% for net demand deposits in excess of $400 million. In 1974, the Fed decided to vary the reserve requirement on time deposits by maturity, reducing the requirement as maturity lengthened.
In 1969, the Fed extended requirements to foreign activities---deposits due from domestic banks to foreign branches, deposits lent to U.S. banks by foreigners, and borrowings from unrelated banks abroad. In 1973 and 1975, reserve requirements on borrowing from foreign banks were cut sharply to improve the position of the dollar, and effective August 24, 1978, these requirements were dropped from 4%, 1%, and 4%, respectively to 0%. Also, managed liabilities---large time deposits, Eurodollar borrowings, repurchase agreements against U.S. government and federal agency securities, federal funds borrowings from nonmember institutions, and certain other obligations---have been subject to reserve requirements. Starting with the reserve maintenance period for October 25, 1979, a marginal reserve requirement of 8% was levied against managed liabilities above $100 million. The marginal requirement was raised to 10% beginning April 3, 1980, decreased to 5% beginning June 12, 1980, and eliminated beginning July 24, 1980.
Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA)
DIDMCA changed the whole structure of reserve requirements.
Reclassified Deposit Types New types of deposits, especially checkable interest-bearing accounts, blurred the old distinction between demand and time deposits. The Fed reclassified deposit accounts as transaction accounts, personal time deposits, non-personal time deposits, and Eurodollar liabilities.
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Transaction accounts include all deposits on which the account holder is permitted to make withdrawals by negotiable or transferable instruments, payment orders of withdrawal, and telephone and pre-authorized transfers (in excess of three per month) for the purpose of making payments to third persons others.
Personal time deposits, including savings deposits, are all time accounts held by natural persons.
Non-personal time deposits, including savings deposits, are those held by depositors that are not natural persons---corporations institutions, governments, etc.
Eurodollar liabilities include all dollar-denominated borrowings by U.S. banks from foreign banks holding dollars.
Lowered Reserve Requirements The marginal rate for transaction accounts (now 10%) may be varied between 8% and 14%. Reserve requirements were eliminated for all personal time deposits and for non-personal time deposits with maturities of 2.5 years or more. On non-personal time deposits with maturities less than 2.5 years, the requirement (now 3%) can be varied between 0% and 9%.
Extended the Fed's authority to include nonmember banks and thrift institutions.
Impact or effectiveness of reserve requirements
Basic reserve requirements affect the size of the money multiplier. Given any monetary base (B), the higher the reserve requirements, the smaller the multiplier (m) and the smaller the money supply (Ms). As the reserve requirement is raised, banks must set aside a larger percentage of each deposit, leaving less excess reserves for lending. With less lending, the money supply is contracted. The lower the reserve requirements are, the larger the multiplier and the money supply are. As the reserve requirement is lowered, banks can set aside a smaller percentage of each deposit, leaving more excess reserves for lending. With more lending, the money supply is expanded.
Marginal reserve requirements and reserve requirements against foreign activity can be used to influence the availability of funds or liquidity of banks. Changes in these requirements can affect the amount of total reserves in the banking system. When these requirements are lowered, banks can increase their liquidity and reserves more easily by issuing large negotiable CDs and commercial paper, or by borrowing from abroad. These activities increase total reserves for the banking system. When these requirements are raised, bank liquidity and reserves are reduced because issuing large negotiable CDs and commercial paper or borrowing from abroad becomes more expensive. These activities reduces total reserves for the banking system.
Strengths of Reserve Requirements
Changing reserve requirements is the most powerful tool available to the Federal Reserve. A small 1% change in reserve requirements affects billions of dollars in reserves. For this reason, any proposed increase must be announced two weeks prior to its implementation to allow banks to adjust their reserve positions.
Changes in reserve requirements affect all banks and do so directly and immediately. In contrast to open market operations, which are concentrated in a few banks and whose impact is then gradually transmitted to the rest of the banking system, and to changes in the discount rate, which affect only borrowers at the discount window, changes in reserve requirements affect all banks equally.
Imposition of reserve requirements is available to all economies at all times. They can be used when securities markets in developed countries are not functioning properly and they can be used in lieu of open market operations in countries where securities markets are not sufficiently developed to permit successful open market operations.
Weaknesses of Reserve Requirements
Reserve requirements are a clumsy instrument of control. Because a small 1% change in reserve requirements affects billions of dollars in reserves, requirements cannot be changed frequently. To do so would wreak havoc on the banks deposits and loan portfolios. Generally, reserve requirements are used to represent the structural (long-term) stance of monetary policy and are changed infrequently. When they are changed, banks view the change in the reserve position as permanent and tend to adjust their long-term assets accordingly.
An increase could embarrass banks that are not sufficiently liquid and cannot meet easily the higher reserve requirements. Although banks are given a two-week adjustment period when requirements are to be raised, some may not be able to adjust so quickly.
Changes in reserve requirements hamper monetary control over short periods. Because reserve requirements affect the money multiplier, any change creates instability in the multiplier. With an unstable money multiplier, control of the money supply (through control of the monetary base-open market operations) is lost.
Although changes in reserve requirements can be used as a counter-cyclical tool, and important reductions in legal ratios were made in years of economic slack-1953-54, 1958, 1970, 1974, and 1980, the Fed has been reluctant to lower them during periods of slack, because they would have to raise them during periods of prosperity. Bankers would prefer that the Fed lower requirements as a stimulatory tool because lower reserve requirements increase the percentage of assets of banks earning income and improve the banks international competitive position. The U.S. Treasury, however, would prefer open market purchases which reduce interest rates directly and lower the cost of the national debt. In general, reserve requirements have trended downward over the years.
XVI. Selective Monetary Policy Controls
Selective controls are the discriminatory tools of monetary policy. They include interest rate controls, credit controls, and jawboning. Selective controls are considered to be selective, because they are applied to specific economic participants or specific markets. They are designed to target a particular credit problem. However, even selective controls may be non-discriminatory in that other economic and financial sectors may be affected by particular controls. For example, consumer or mortgage credit controls that restrict household borrowing may leave banks with excess reserves at going interest rates. In order to lend these excess reserves to businesses, the banks may lower interest rates. Similarly, the financial markets are heavily influenced by changes in margin requirements. If higher margin requirements make leveraged securities purchases less attractive, people may use their money to buy real goods and services. If lower margin requirements make leveraged securities purchases more attractive, people may buy less real goods and services.
Interest Rate Controls on Deposits
Interest rate controls on deposits are the maximum rates banks can pay on deposit liabilities (Regulation Q). Regulation Q was not initially intended as a stabilization tool. Originally, the ceilings were intended to curb competition among banks. It was believed that competition for deposits had raised bank costs, encouraged investment in high risk assets to cover deposit interest costs, weakened the banking system, and led to the large number of bank failures during the Great Depression. Subsequently, they were used to influence the flow of funds to various credit markets. On savings deposits, for example, ceiling rates for thrift institutions were set 0.25% above the ceiling rates for commercial banks to attract funds to the residential real estate market.
As a tool of monetary policy, raising interest rate ceilings on deposits has the effect of intermediation-the increased flow of funds into depository institutions-and of influencing other interest rates and the availability of total credit. The more funds flow through depository institutions, the greater control the Fed has on the money supply. So long as ceiling rates are in line with money market rates, they can be used to subtly influence the flow of funds among credit markets. However, if they are substantially below market rates, then disintermediation — the outflow of funds from depository institutions directly into the credit markets — will place depository institutions at a disadvantage, creating liquidity problems, credit crunches, and discriminatory lending in specific markets. Controls distort the pattern of the flow of funds. As of April 1986, after a six-year phase-out period under DIDMCA, all interest rate ceilings at depository institutions had been eliminated.
Consumer Credit Controls
Consumer credit controls set the minimum downpayment, maximum repayment period, and sometimes the interest rates charged on consumer purchases (formerly, Regulation W). The larger the minimum downpayment, the shorter the repayment period, and the higher the interest rate, the more difficult it is for consumers to finance new purchases; hence, the less spending in the economy. The smaller the downpayment, the longer the repayment period, and the lower the interest rate, the easier it is for consumers to finance new purchases; hence, the more spending in the economy.
As a stabilization tool, consumer credit controls influence directly the purchase of consumer goods, especially durables, and indirectly the rest of the economy. If they are relaxed, bank lending increases and the money supply is expanded, as a consequence. If they are tightened, bank lending is reduced, the money supply contracts, more spending generates more income and less spending produces less income.
The main reason for imposing consumer credit controls is to smooth out the flow of consumer spending to keep the economy from inflating. Most credit controls have been imposed during wartime. However, the last time the Fed imposed consumer credit controls was in 1980. On March 14, 1980, with the inflation rate still rising, the FOMC, at the direction of Chairman Paul Volcker, imposed credit controls. Credit card use was curtailed and other forms of consumer borrowing were discouraged. The restrictions worked. Inflation began to fall, but a recession developed. In the summer of 1980, most of the credit controls were scrapped. Currently, the Fed maintains no consumer credit controls.
Mortgage Credit Controls
Mortgage credit controls set the minimum downpayment and maximum repayment period on residential mortgages (formerly, Regulation X). The larger the minimum downpayment and the shorter the repayment period, the more difficult it is for buyers to finance new homes; hence, the less spending in the economy. The smaller the minimum downpayment and the longer the repayment period, the easier it is for buyers to finance new homes; hence, the more spending in the economy.
As a stabilization tool, mortgage credit controls influence directly the purchase of real estate and indirectly the rest of the economy. If they are relaxed, bank lending increases and the money supply is expanded. If they are tightened, bank lending is reduced and the money supply contracts. If they are relaxed, more spending generates more income. If they are tightened, less spending produces less income.
The main reason for imposing mortgage credit controls is to smooth out the flow of consumer spending to keep the economy from inflating. Among all of the selective controls, mortgage credit controls have had the shortest life. They were imposed in 1950 at the start of the Korean conflict and suspended in 1952. The Fed no longer maintains mortgage credit controls.
Margin Requirements
Margin requirements set the minimum downpayment on securities purchases (Regulations T, U, and X). The Fed may set this requirement between 50%-100% on equity securities (stocks). Margin stocks, for which the regulatory limitations apply, are all corporate stocks registered on the national exchanges plus selected NASDAQ stocks. Regulations apply also to convertible bonds and short sales. If the price of a security declines after the loan is made, the law does not require the borrower either to put up additional collateral or to reduce his indebtedness. But the lender, on his own, may require additional collateral. Common maintenance requirements at the major brokerage houses are 30%-35%.
The main reason for imposing margin controls is to reduce fluctuations in stock prices caused by the extension of unregulated credit for securities purchases. As stabilization tool, however, margin requirements have broader effects. The higher the requirement, the more difficult it is to buy securities; the lower the requirement, the easier it is to buy securities. By the same token, the higher (lower) the requirement, the more difficult (easy) it is for firms to obtain financing for capital improvements. As margin requirements are lowered, the demand for securities increases and securities prices rise. Capital gains, whether realized or only on paper, have the effect of inducing consumption through the wealth effect. As margin requirements are raised, the demand for securities decreases and securities prices fall. Capital losses, whether realized or only on paper, have the effect of reducing consumption through the wealth effect.
Jawboning
Jawboning (moral suasion) is verbal pressure on the banks and other financial institutions to ensure compliance with monetary goals. Paul Volcker, a former Chair of the Fed, used verbal pressure on business and labor to keep prices and wages down. He applied verbal pressure on the banks to refinance the Third World debt. He jawboned the Administration and Congress continually to reduce the federal budget deficit. Actually, jawboning is a pressure technique used by all of the policy-making bodies. President Reagan put verbal pressure on the Federal Reserve and the banks to lower interest rates. Through out the 1980s, the President, the Congress, and Mr. Volcker tried to "talk" down the foreign exchange value of the dollar. And, ever since his appointment as the Fed's Chair, in 1987, Alan Greenspan has been jawboning the Congress into reducing the federal budget deficit. It finally worked!!!
XVII. Debt Management Policies
Debt management policies involve changing the maturities on the various government security issues to influence interest rates in the different securities markets by maturity. Manipulation of the supply of securities to the different maturity markets influences the term structure of interest rates and the yield curve. By changing the term structure of interest rates, the government changes the relative attractiveness of different kinds of borrowing to influence macroeconomic activity.
Debt Instruments
The Treasury issues securities for two purposes: to finance the current annual deficit and to refund or "roll over" outstanding debt as it matures. The Treasury can make a cash offering in which buyers simply pay cash for any securities they receive, or it can make an exchange offering, whereby it offers new debt to holders of maturing issues. Since not all current holders desire to renew their lending to the federal government, portions of exchange offerings have been sold on a cash basis. Because of problems in refunding the debt with exchange offerings, the Treasury has elected to use only cash offerings since 1973.
Most Treasury securities are marketable, which means they may be traded any number of times before reaching maturity. The rest are non-marketable which means they are held by the original purchaser until maturity or redemption by the Treasury. It is the marketable debt over which the Treasury exercises the greatest measure of control and which has the greatest impact on the cost and availability of credit in the nation's financial markets.