Lecture Notes 22 October 2012

Reserve Banking

So we spent all of Monday on the monetary base and money supply calculations. It feels like we should at least spend a few minutes of class talking about reserve banking as it is fundamental to the operation of the markets currently.

One could/should think about depositing money in the bank as lending the bank money.

Let’s first look at an alternative. Imagine that a bank were required to match its assets and liabilities terms exactly. If it took a deposit from you and gave you on demand access to that deposit it would need on demand access from its lendings to be able to match its terms. Of course this would not be practical so it would be forced to put the cash into its vault in case you wanted it. If it wanted to lend out over a longer period then it would need to tie your money up for a longer period. For example it could pay you significantly more in interest to persuade you to tie up your money for longer.

The current banking system in the US solves some of these problems. For example, a bank is only required to hold 10% of your deposits as reserves. It can then lend out the excess over whatever period that it likes. In fact it could lend out 10 times the amount that you originally deposited.

What are the problems? First it could be that too many people want their money back at once. This would cause a run on the bank as it would not have enough cash to return the funds to depositors.

How do we avoid runs? There are several parts to the solution

  1. The Federal Reserve offers to lend with no questions asked to solvent institutions. This allows a bank to access cash immediately if it experiences a run. Because the bank has immediate access to cash and can always get more this prevents runs in the first place
  2. The FDIC. Since Glass-Steagall there has been deposit insurance on “small” deposits. This means that no one needs to get their money out immediately because they are always insured against loss…

If the Fed were called upon to satisify either of these obligations and did not have money put aside what would it do?

Goals of Monetary Policy

The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

The various goals of monetary policy can be in conflict with one another at given times. Generally speaking though in the long run central banks believe that the goal of stable prices will promote growth in the economy that will in turn increase employment. In addition long-term interest rates are driven in part by inflation expectations. Therefore the best way to moderate long-term interest rates is to control of inflation and to have the market perceive that the Fed will do what it takes to control it.

Thus the Fed generally sees price stability as the primary medium to long-term goal of monetary policy.

The Fed though has a time inconsistency problem in trying to control inflation. Time inconsistency problems arise when choices that appear optimal today appear sub-optimal once those choices are made. Before we go into how this applies to inflation let’s look at a more straightforward example.

Consider a borrower who would like to borrow money to buy a house. Two obvious questions are:

1 – would the borrower like to receive the loan to buy the house?

2 – would the borrower like to not have to repay the loan?

The answer to both of these questions is clearly yes. Now ask a separate question

1 – at the time of borrowing would the borrower like there to be an enforcement agency that ensures that the loan is repaid

2 – at the time of repayment would the borrower like there to be an enforcement agency that ensures that the loan is repaid.

The answer to the second question is probably no as the borrower would prefer not to repay the loan. The answer to the first question is probably yes because it increases the probability that the loan will be made available and probably reduces the cost of the loan.

The time-inconsistency is that the borrower changes his opinion about the enforcement agency.

Controllng inflation has a similar problem. When the Fed decides that Inflation is too high they will look to target a higher Fed Funds rate:

Through what type of open market operation could the Fed attempt to raise the Fed Funds rate?

If they decide to raise Fed Funds the economy may suffer as a result of the Fed trying to lower inflation expectations. Thus having decided to control inflation they are creating a situation in which higher Fed funds rates cause a slow-down in the economy and the optimal short-term solution is to lower Fed Funds rates.

Inflation Targeting

One of the key ways in which central banks attempt to achieve their long-term goals is through inflation targeting. This was introduced by New Zealand in 1988. Since New Zealand introduced an inflation target it has moved from being one of the worst.

Given this experience many other countries have introduced an inflation target – the Fed formally set a public inflation target in January of 2012 at 2%.

Advantages of Inflation Targeting

  1. It is readily understood by the public
  2. Increases accountability of the central bank and places an emphasis on transparency by the Fed.
  3. Helps avoid the time-inconsistency problem since the public can hold the central bank accountable.
  4. Allows for better private sector planning since the central bank is communicating
  5. Inflation goals
  6. Regular measures of inflation
  7. How to achieve the goals given current conditions.
  8. Explanations of deviations from targets.
  9. Performance has been good.

There is a feedback mechanism from the statement of the policy into inflation expectations. Because I know that the Fed is targeting a particular inflation level I can expect that long-term interest rates will reflect this. There may be fluctuations around this level in the short term.

Disadvantages of Inflation Targeting

  1. In the short-term inflation is not easily controlled and there is a significant lag between changes in monetary policy and changes in inflation.
  2. Too much rigidity. A central bank that pursues a short-term inflation target above all else will cause larger fluctuation in output in order to maintain its target.
  3. Low economic growth – during the period of disinflation (the reduction of inflation) one would expect lower than average growth. This might be too big a cost for an economy. For example in the early 1980’s recession the Central Bank was probably a bit fortunate that inflation reduced as significantly as it did in the time it did. Another couple of years of recession might have caused serious questions to be asked about its strategy.

The Fed Carries out Monetary Policy

Generally speaking the central bank controls the tools of monetary policy but first they have to decide what they are looking to target. If the goal of monetary policy is price stability in the medium term then one might consider long-term interest rates or a measure of money supply growth like M2 as the “intermediate target.”

The intermediate target is the target that the Fed believes will influence in a predictable way their target.

This is a challenge as there is not direct linkage between

  1. The intermediate target and the goal.
  2. The tool of monetary policy and the intermediate target.

Next the Fed has to choose a policy instrument that focuses on their target.

Criteria for choosing a policy instrument

1 – Observability and Measurability – one of the reasons for this is that the Fed is signaling to the market its policy stance.

2 – Controllability – The Fed must be able to exercise effective control over the policy instrument.

3 – Predictable effects on goals.

Generally the Fed has chosen the Fed Funds rate as the best instrument for setting monetary policy. There are some issues – it’s a nominal rate rather than a real rate.

During the Great Depression nominal rates were very low historically but real rates were very high because

Right now the Fed has used the interest on reserves to set a lower bound on the Fed Funds rate and has been targeting longer term interest rates through asset purchases.

Lender of Last Resort

One of the other key functions of the Fed is as lender of last resort. As I mentioned the discount rate is generally set to a level at which it is un-economic to borrow from the Fed. The facility is used though and is part of the function as a lender of last resort – namely a bank can borrow reserves from the Fed in situations when no one else will lend to them.

Let’s go back to our example where we had an individual with $1000 in cash deposited in a checking account and the bank has leant out $500 dollars of this which also sits in a checking account. In this situation the bank has assets and liabilities.

Assets|Liabilities

Cash 850Deposits1,500

Reserves150

Loan500

Clearly this bank could be in trouble if both depositors request to take out any amount over $850. Theoretically if the first depositor asked for $1,000 back then the bank could rescind the loan and pay back the $1,000 but this may be very difficult to do on short notice. Generally what the bank might do is borrow reserves from elsewhere in the banking system. Thus the picture would change to:

Assets|Liabilities

Cash 850Deposits1,500

Reserves650Borrowed Reserves500

Loan500

They can then turn the excess reserves into cash and pay the depositors the cash that is requested. In the end they will have assets and liabilities that look like:

Assets|Liabilities

Cash 0Deposits0

Reserves0Borrowed Reserves500

Loan500

On the other hand if one is worried that the bank is insolvent then other banks will not lend reserves to the bank. Thus the bank would have to go to the Fed Reserve and borrow at the discount window. The effect would be the same but the bank would have significantly greater borrowing costs.

Things to know about the lender of last resort function of the Fed Reserve.

  1. Financial panics are extremely damaging to an economy. In particular bank runs can cause serious problems. Reserve Banking depends on all depositors not attempting to take their money out at the same time. When there are rumors of a bank insolvency it can actually cause insolvency because of the run. As a depositor you are much better off being first in line to take your money out rather than last in line.
  2. The Fed Reserve has not always used the discount window to prevent bank runs – a significant number of banks failed in the 1920’s and this accelerated into the early 1930’s. These runs greatly increased the severity of the ensuing depression.
  3. The FDIC should alleviate some but not all risk of bank runs. It is important to recognize that the FDIC insurance fund only covers around 1% of the deposits outstanding and only covers $250K per account holder. In a serious crisis banks might need more support.
  4. The Fed Reserve sees this function not only as lender of last resort to the banking industry but lender of last resort to the financial system as a whole. In the 2007 crisis the Fed stepped in to provide this function to money market funds and other types of “deposits” even though these were not explicitly insured.

During the recent financial crisis some of the lender of last resort style actions of the Fed were to:

  1. Significantly reduce the discount rate from 1% above the Fed Funds target to 0.25% above the target.
  2. Extend the length of discount loans from overnight to 90 days.
  3. Created a temporary Term Auction Facility to make discount loans to banks. This reduced the stigma of the discount loans. As the crisis worsened the amount outstanding through this facility was greater than $400bn.
  4. Extended currency swap lines to foreign central banks. This allowed these banks to extend dollar loans to their domestic banks.
  5. Facilitated the purchase of Bear Stearns by JP Morgan.

We will hopefully spend some time in the last couple of weeks of the course talking more about the recent financial crisis.