Lesson 13: Changes in the Monetary Base

Upon completion of this lesson, you should be able to do the following:

  • Define the major items on the Fed's balance sheet.
  • Describe how the Fed clears a check between two banks.
  • Describe all the factors that influence the Fed's balance sheet, which influence the monetary base and money supply.
  • Describe how the actions of the U.S. Treasury affect the Fed's monetary policy.

Introduction

This lesson examines changes in the monetary base. The monetary base can fluctuate particularly in a short time horizon. The Fed has to control the monetary base and prevent it from fluctuating. When the monetary base fluctuates, the money supply will also fluctuate.

Federal Reserve System Balance Sheet

To begin the discussion, we have to look at the Fed's balance sheet. The Fed has assets, which are anything of value that is owned by the Fed. The Fed has liabilities, which are obligations and debt the Fed owes to another party. When the Fed's total assets are subtracted from total liabilities, then the remainder is the Fed's net worth. The Fed's balance sheet information is available to the public and published in the Federal Reserve Bulletin. The Federal Reserve Bulletin is a monthly publication of the Board of Governors and also includes money supply numbers, interest rates, and other economic data. The Fed's assets are listed below:

The FED's Assets.
  1. Securities - the largest amount of the Fed's assets and consists of U.S. government securities: T-bills, T-notes, and T-bonds. When the Fed uses open market operations, it is buying and selling securities.

  2. Discount Loans - the Fed loans to banks, helping the bank overcome short-term liquidity problems. The Fed controls the interest rate on these loans which influence the amount of loans that banks need. The interest rate is called the discount rate.

  3. Cash Items in the Process of Collection (CIPC) - these are assets that arise from the check clearing process by the Fed. More will be said about this topic later.

  4. Gold Certificates - when the U.S. Treasury buys gold, it issues certificates that are claims to this gold. The Fed buys these certificates and credits the U.S. Treasury account at the Fed.

  5. Special Drawing Rights (SDRs) - SDRs are issued by the International Monetary Fund (IMF). The IMF allocates SDRs to various countries around the world. More information on SDRs are available in Lesson 17.

  6. Coins - this is U.S. Treasury currency held by the Fed.

  7. Other assets - this includes assets such as foreign-exchange reserves, deposits and bonds denominated in foreign currencies, and buildings and equipment owned by the Fed.

The Fed's Liabilities and Capital Accounts.

  1. Currency Outstanding - currency issued by the Fed in the form of Federal Reserve Notes, i.e. U.S. money.

  2. Deposits by Depository Institutions - banks must hold required reserves in the form of vault cash and deposits at the Fed. These deposits are assets to the depository institutions, but liabilities to the Fed.

  3. U.S. Treasury Deposits - when the U.S. Treasury receives tax payments, collects fees, and sells U.S. government securities, the money is deposited at commercial banks. When the U.S. Treasury pays expenditures, it transfers funds from its commercial bank accounts to its accounts at the Fed. Then the Treasury Department writes checks on its Fed account.

  4. Foreign and Other Deposits - the Fed holds deposits from foreign governments, IMF, World Bank, United Nations, and U.S. government agencies such as FDIC.

  5. Deferred Availability Cash Items (DACI) - these are liabilities that arise from the Fed's role in the check-clearing process. More will be said about this topic later.

  6. Other Federal Reserve Liabilities and Capital Accounts - this category contains whatever is left over when total assets are subtracted from total liabilities. This category is substantial and is approximately $15 billion a year. If this was a corporation, then profits and the value of outstanding stock would be around $15 billion. However, the Fed is a nonprofit organization. The Fed's capital includes stock of the Fed, which was sold to member commercial banks.

The Fed has the authority to clear checks. The check clearing process can cause bank reserves to fluctuate through the Federal Reserve float. The Federal Reserve float is the difference between cash items in the process of collection (CIPC) and deferred availability cash items (DACI). The float is always positive and when the float changes, bank reserves change, causing the money supply to change.

1. For example, you sent a $1,000 check to a firm in New York City to buy a computer. The computer firm will deposit the check in his bank account. His bank will present the check to the Fed so the Fed can clear the check with your bank. The Fed gives the computer firm's bank a $1,000 asset called the DACI and the Fed must collect $1,000 from your bank, which is called the CIPC. Below is the computer firm's bank and Fed's T-accounts:

The Computer Firm's Bank
Assets Liabilities
+$1,000 DACI +$1,000 Deposits

The Fed
Assets Liabilities
+$1,000 CIPC +$1,000 DACI

2. The computer firm's bank cannot touch the asset, DACI. This asset is simply an acknowledge that the Fed is collecting money for the computer firm's bank. After two days, the Fed converts the DACI into bank reserves. Now the bank can loan out the reserves.

The Fed
Assets Liabilities
-$1,000 DACI 

+$1,000 Reserves for computer firm's bank

The Computer Firm's Bank
Assets Liabilities
-$1,000 DACI

+ $1,000 Reserves at the Fed

If the Fed still has not collected $1,000 from your bank with two days, the Fed is extending credit to the computer firm's bank. The total reserves of the banking system increases, because no other bank has lost reserves. That $1,000 check you wrote now exists as a $1,000 in your bank account and the computer firm's bank account. The float from your check is $1,000.

Float = CIPC - DACI = $1,000 - 0 = $1,000

3. The Fed collects the $1,000 from your bank. Now the float now goes to zero, and your checking account decreases by $1,000. Your check for $1,000 no longer exists in two places. The reason why check clearing is a long-drawn out process is because if you write a check for $100 and have only $10 in your checking account, this check will not clear! That is why the Fed gets permission to lower the bank's reserves to clear the check; instead of automatically doing it. The transaction is listed below:

The Fed
Assets Liabilities
-$1,000 CIPC - $1,000 Reserves at your bank


Your Bank
Assets Liabilities
-$1,000 Reserves at the Fed - $1,000 Your checking account

Usually the float changes predictably at the midmonth (when people pay their bills). The float also changes in December and April, because people are writing checks to buy Christmas presents or to pay their taxes. Bad weather and transportation strikes can cause the float to increase significantly as the Fed is delayed in check collections. Changes in the float causes bank reserves to change. The Fed must off-set the float by selling or buying U.S. government securities.

Influencing the Fed's Balance Sheet

When the Fed's balance sheet changes, the monetary base also changes, causing the money supply to change.

  • First, list the Fed's assets, liabilities, and capital, and substitute the monetary base formula into liabilities.

Total Assets: U.S. gov. securities + discount loans + gold certificates + SDRs + CIPC

Total Liabilities + capital: Currency outstanding + deposits by depository institutions + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital

  • The monetary base equals currency outstanding plus deposits by depository institutions (B = C + R). You can substitute the monetary base into the total liabilities.

Total Liabilities + capital: Monetary base + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital

Total Assets = Total Liabilities + Capital

  • Substitute total assets and total liabilities plus capital into the accounting equation. Then solve for the monetary base.

Monetary base = U.S. gov. securities + discount loans + gold certificates + SDRs +

CIPC - DACI - U.S. Treasury deposits - Foreign and other deposits - Capital

The equation shows how changes in the Fed's balance sheet affects the monetary base.

  1. When the Fed purchases an asset, the monetary base increases, causing bank reserves to increase. When banks have more reserves, they grant more loans, potentially causing the money supply to increase.

  2. If the Fed sells an asset, the monetary base, bank reserves, and money supply all decrease.

  3. When the Fed acquires a liability listed in the equation above, the monetary base decreases, bank reserves decrease, and the money supply potentially decreases.

  4. If the Fed pays off a liability, the monetary base increases, bank reserves increase, and the money supply potentially increases.

As you can see, many things can alter the Fed's balance sheet and the Fed cannot control most of them. For example, the Fed has no control over the Treasury deposits, the float (CIPC - DACI), gold certificates, SDRs, and foreign government deposits. These items can change and the Fed has to do a balancing act to keep the monetary base stable. 

Over the last 30 years, the federal government has been running budget deficits. The U.S. government spends more than what it collects in taxes. The U.S. government can finance the budget deficit in three ways. First, the U.S. government can decrease its spending. Second, the U.S. government can raise taxes. Finally, the U.S. can sell U.S. government securities. Can the U.S. federal government affect the monetary base?

  • For example, the U.S. government increases taxes, so now you are paying a total of $2,000. You send the U.S. government a check for $2,000. Below are the T-accounts for you, your bank, the Fed, and U.S. Treasury Department.

You
Assets Liabilities
- $2,000 Deposit -$2,000 Taxes due

Your Bank
Assets Liabilities
- $2,000 Reserves -$2,000 Deposits

The Fed
Assets Liabilities
- $2,000 Reserves
+$2,000 U.S. Treasury deposits

The U.S. Treasury Department
Assets Liabilities
-$2,000 Taxes due
+ $2,000 Deposits at the Fed
  • Now the U.S. Treasury spends your $2,000 to buy more paper for a government agency. The $2,000 goes to a company and the company deposits the funds into the company's bank account. Even though you paid higher taxes, your money is returned to the economy. When the government raises taxes, there is no impact on the monetary base and money supply.

  • For this next example, let the U.S. Treasury finance a budget deficit by selling T-bills. You decided to buy a $20,000 T-bill. Below are the T-accounts for you, your bank, the Fed, and U.S. Treasury.

You
Assets Liabilities
-$20,000 Deposit
+ $20,000 T - bill

Your Bank
Assets Liabilities
- $20,000 Reserves -$20,000 Deposits

The Fed
Assets Liabilities
- $20,000 Reserves
+$20,000 U.S. Treasury deposits

The U.S. Treasury Department
Assets Liabilities
+$20,000 Deposits at the Fed + $20,000 U.S. T-bill
  • Now the U.S. Treasury has your $20,000 and will buy something with it. When the Treasury pays a bill, the $20,000 is paid to a company and the company will deposit the $20,000 into its bank account. The $20,000 is returned to the economy and the change in bank reserves will be zero. When the U.S. Treasury issues new securities, the new securities have no affect on the monetary base and money supply.

If the U.S. Treasury sold government securities directly to the Fed, then the Fed is financing budget deficits, which is called monetizing the debt. The media calls this strategy "printing money." The Fed is not required to buy U.S. government securities and is not required to help the U.S. Treasury finance budget deficits. The Fed and U.S. Treasury are independent.

There is a way for the Fed to finance budget deficits indirectly. If the Fed wants to stabilize interest rates, then the Fed may end up monetizing the debt. For example, when the U.S. Treasury issues new securities, the market price of the securities decrease, causing the interest rate to increase. If the Fed wants the original interest rate, the Fed has to buy U.S. government securities to decrease the interest rates. In many developing countries, the central banks and finance ministries are not independent. The central bank is required to help finance budget deficits. When central banks monetize the debt, it always leads to inflation. Many developing countries have high inflation rates.

 

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