Question

4. Explain the most common tool that the Fed use to expand the amount of money in the banking system, and draw balance sheets (of CB and commercial banks) to show the process.

Answer 1

The central bank can increase the money supply in the economy by 3 methods-

Change reserve requirements

Change short-term interest rate

Open market operations

The central bank or the Fed change the reserve requirements to change the money supply in the banking system. Due to fractional reserve system, any change in the reserve requirement has an incremental impact on the total money supply. Suppose, if the current reserves to be required by the bank are 20%, the bank can lend the 80% of the total deposits available with them. Due to fractional reserves system, the money circulating in the economy is 1/0.2= 5 times the deposits. Now, if the Fed decreases the reserve requirements to 19%, the new amount of money circulating in the economy is 1/0.19= 5.26 times which is much higher than the decrease in the minimum reserves requirement by the banks. This approach does not impact the balance sheet of the Fed but of the commercial banks.

Another way to influence the money supply is to change the ST interest rate. TRhe impact from this approach is a bit less direct. When the Fed lowers the ST interest rates, it gives an indication to the commercial banks that the Fed is of the opinion of increasing the money supply. By lowering the interest rates commercial banks pay on the ST loans (e.g. repos, overnight borrowings etc.), the Fed eases the cost of borrowing for the banks and hence, influence them to loan out more amount to the economy. This approach does not impact the balance sheet of the Fed or the commercial banks directly. This however, lowers the cost of capital for the commercial banks and lowers the interest income for Fed over the period.

The most direct approach for Fed to change the money supply in the economy is by conducting open market operations. the Fed buys and sells government securities in the open market i.e. from and to the commercial banks. When the Fed wants to increase the money supply, it will buy government securities from the commercial banks, thereby converting their reserves to cash which they can loan out to the economy. On the other hand, when the fed wants to decrease the money supply, it will sell (and force the commercial banks to buy) the government securities, thereby lowering liquidity on their books. This approach impacts the balance sheet of both the Fed and the commercial banks. Consider partial balance sheets as follows-

Federal reserves					Commercial bank
Assets	Amount (Bn)	Liabilities	Amount (Bn)		Assets	Amount (Bn)	Liabilities	Amount (Bn)
G-secs	100	Currency	120		G-secs	5	Bank deposits	13
Foreign Exchange Reserves	75	Government's Account	55		Loans	10	Cash and equivalent	2
Fed buys government securities worth 4Bn from the bank
New partial balance sheets-
Federal reserves					Commercial bank
Assets	Amount (Bn)	Liabilities	Amount (Bn)		Assets	Amount (Bn)	Liabilities	Amount (Bn)
G-secs	104	Currency	116		G-secs	1	Bank deposits	13
Foreign Exchange Reserves	75	Government's Account	55		Loans	10	Cash and equivalent	6

Thus, the additional 4Bn in cash can be used by the bank to loan out in the economy.