The Federal Reserve and Money Supply * Takes sections for chapters 10, 14, & 15 from the Mishkin text (9th edition), Federal Reserve reader, and www.federalreserve.gov Chpt 10 3 key players 1. Depositors 2. Banks 3. Federal Reserve Depositors are the most important providers of funds and they are the biggest users of fundsIf depositors lose confidence  bank runs can occur, causing banks to lose their sources of funds If depositors have confidence  banks have an increase amount of funds Banks are the keepers of depositors funds As before  our deposits are their biggest liabilities, but their greatest assets Balance Sheet is the most important document to understand the banking system It is made up of two broad categories Liabilities (Sources of Funds) Assets (Uses of Funds) Listed from most liquid to least liquid Liabilities are simply the sources of funds Checkable deposits Payable on demand Considered to be an asset for depositor (us) Lowest cost of sources for banks  we want easy access to liquidity Only 6% of total liabilities (per the Fed) Nontransaction deposits CDs Owners cannot write checks against such accounts Primary source of bank funds (53% of bank liabilities) Checkable deposits  intterest paid on deposits has accounted for 25% of total bank operating expenses while the costs involved in servicing accounts (employee salaries, building, rent) has roughly 50% of operating expenses! Liabilities Cont. Discount Loans / Fed Fund (31% of liabilities) Discount loans are loans from the Federal Reserve (also known as advances) Typically 1%-pt above the fed funds rate Banks typically do not want to borrow from the Fed unless absolutely necessary! Fed Funds loan (overnight loans) Federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve Transactions in the federal funds market allow banks with excess reserve balances  to lend reserves to banks with deficient reserves These loans are usually made for one day only (‘overnight’). Bank Capital (10% of liabilities) Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Typically referred to as the uses of fundsThe interest payments earned on them are what enable banks to make profits. Reserve Requirements These are deposits plus currency that is physically held by banks. Reserves are made up by required reserves and excess reserves Required Reserves: For every dollar of checkable deposits at a bank (a fraction must be kept as reserves) Excess Reserves: The most liquid of all bank assets and the bank can use them to make other loans to banks (through the fed funds market) or other loans. Cash Items in Collection Process Checks in process of being cleared from another bank Correspondent banking Common in small banks Small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange tran ...

1. The Federal Reserve and Money Supply
*
Takes sections for chapters 10, 14, & 15 from the Mishkin text
(9th edition), Federal Reserve reader, and
www.federalreserve.gov
Chpt 10
3 key players
1. Depositors
2. Banks
3. Federal Reserve
Depositors are the most important providers of funds and they
bank runs can occur, causing banks to lose their sources of
amount of funds

2. Banks are the keepers of depositors funds
greatest assets
Balance Sheet is the most important document to understand the
banking system
It is made up of two broad categories
Liabilities (Sources of Funds)
Assets (Uses of Funds)
Listed from most liquid to least liquid
Liabilities are simply the sources of funds
Checkable deposits
Payable on demand
Considered to be an asset for depositor (us)
ant easy access to
liquidity
Only 6% of total liabilities (per the Fed)
Nontransaction deposits
CDs
Owners cannot write checks against such accounts
Primary source of bank funds (53% of bank liabilities)
s accounted
for 25% of total bank operating expenses while the costs
involved in servicing accounts (employee salaries, building,
rent) has roughly 50% of operating expenses!
Liabilities Cont.
Discount Loans / Fed Fund (31% of liabilities)

3. Discount loans are loans from the Federal Reserve (also known
as advances)
Typically 1%-pt above the fed funds rate
Banks typically do not want to borrow from the Fed unless
absolutely necessary!
Fed Funds loan (overnight loans)
Federal funds are overnight borrowings by banks to maintain
their bank reserves at the Federal Reserve
Transactions in the federal funds market allow banks with
excess reserve balances to lend reserves to banks with deficient
reserves
These loans are usually made for one day only (‘overnight’).
Bank Capital (10% of liabilities)
Banks keep reserves at Federal Reserve Banks to meet
their reserve requirements and to clear financial transactions.
Typically referred to as the uses of fundsThe interest payments
earned on them are what enable banks to make profits.
Reserve Requirements
These are deposits plus currency that is physically held by
banks.
Reserves are made up by required reserves and excess reserves
Required Reserves: For every dollar of checkable deposits at a
bank (a fraction must be kept as reserves)
Excess Reserves: The most liquid of all bank assets and the
bank can use them to make other loans to banks (through the fed
funds market) or other loans.
Cash Items in Collection Process

4. Checks in process of being cleared from another bank
Correspondent banking
Common in small banks
Small banks hold deposits in larger banks in exchange for a
variety of services, including check collection, foreign
exchange transactions and securities purchases. Securities
Most banks are not allowed to hold stock
Tend to hold state and local bonds because then local
government would do business with themLoans
Loans are least liquid
The lack of liquidity and relatively high default risk offers
banks the highest source of profits.
Most important notion is that ASSETS must equal LIABILITIES
When a bank receives additional deposits, it gains an equal
amount of reserves
When it loses deposits, it loses an equal amount of reserves
If there is a $100,000.00 deposit, with a required reserve of
25%, show what will happen: Note that the 75,000 can be
loaned out to other banks or consumersNote that bank cannot
lend out more than it’s excess reserve
amountAssetsLiabilitiesRequired
Reserves25,000Deposits100,000Excess Reserves75,000Bank
Capital15,000Securities15,000

5. Central bank of the US
Considered to be the most important bank in the world
Controls the so-called monetary base (broadest definition of
All national banks are required to be members/participants of
the Fed.
Local banks are not.
Independent of govt and private sector
Board of Governors have 14 year terms
Fed does not cater to pressure from banks (say to lower interest
rates or push for deregulation)
Extremely profitable (avg earnings of $40 bil a year!)
Bretton Woods!
The Federal Reserve Bank of the United States (FED)
Controls the money supply for the US through the use of
monetary policy
selling for T-Bonds to banks, investors, public, etc…
The Fed has one main goal: Price Stability
economy, which affects economic growth

6. 1. Low Unemployment
Resources are maximized, misery index is low, consumer
spending (in the US at least) is relatively high and stable
3 Types of unemployment
set
eason
2. Economic Growth
3. Stability in the Financial Market (Liquidity!!!)
4. Interest Rate Stability
Monetary Liabilities
Currency in circulation: in the hands of the public
Reserves: bank deposits at the Fed and vault cashFederal
Reserve SystemAssetsLiabilitiesGovernment securitiesCurrency
in circulationDiscount loansReserves
Assets
Government securities: holdings by the Fed that affect money
supply and earn interest

7. Positive relationship between govt securities and money supply
Discount loans: provide reserves to banks and earn the discount
rate
Positive relationship between discount loans and money supply.
These are considered to be liabilities for a member bank!
2 ways that the Fed changes the monetary base in the economy
1. Open Market Purchases
Fed buys bonds
Increases money in the economy (interest rates fall)
2. Open Market Sales
Fed sells bonds
Decreases money in the economy (interest rates rise)
The effect of an open market purchase on the monetary base is
always the same whether the seller of the bonds.
An Open Market Purchase takes in securities and gives out cash
The liquidity effect of an OMP is directly correlated with the
reserve ratio
Net result is that reserves have increased by $100No change in
currencyMonetary base has risen by $100Banking
SystemFederal Reserve
SystemAssetsLiabilitiesAssetsLiabilitiesSecurities-
$100Securities+$100Reserves+$100Reserves+$100

8. Net result is that reserves have decreased by $100No change in
currencyMonetary base has decreased by $100An Open Market
Sale takes in cash and gives out securitiesBanking
SystemFederal Reserve
SystemAssetsLiabilitiesAssetsLiabilitiesSecurities+$100Securit
ies+$100Reserves+$100Reserves-$100

9. 1. OMOs occur at the Fed’s whim (no political influence)
2. OMOs are flexible and precise
3. OMOs are easily reserved
4. OMOs can be implemented quickly
While the Fed is key on providing liquidity, it must find a
delicate balance in replenishing its reserve base.
Currently, the Fed uses the reserve requirement to satisfy this
goal.
If the reserve requirement is constantly changing, banks and the
population will become worried.
T H E R E G I O N A L E C O N O M I S T | J U L Y 2 0 1 0
Flight to Safety and U.S. Treasury Securities
By Bryan J. Noeth and Rajdeep Sengupta
Government debt of the United States is typically issued in the
form of U.S. Treasury securities. These securities—simply
called Treasuries—are widely regarded to be the safest
investments because they lack significant default risk.
Therefore, it is no surprise that investors turn to U.S. Treasuries
during times of increased uncertainty as a safe haven for their

10. investments. This happened once again during the recent
financial crisis. In fact, the increase in the demand for
Treasuries was sufficiently large so that prices actually rose
with an
increase in the supply of government securities.
Supply of Government Securities
In the latter half of 2008, the Treasury auctioned a large amount
of securities to cover the cost of the Emergency Economic
Stabilization Act.1 After the act was passed, holdings of
U.S. marketable Treasury securities continued to increase over
the next year and a half, from $4.9 trillion in August 2008 to
$7.4 trillion in February 2010. Figure 1 shows the levels of
short- and long-term securities outstanding from 2006 to 2009.
Figure 1
Levels of U.S. Treasuries Outstanding
SOURCE: Haver
NOTE: Monthly Data
Click to enlarge [back to text]
Short-term securities are also known as Treasury bills; they
have maturity dates of less than a year.2 In August 2008,
approximately $1.2 trillion in T-bills was outstanding. By
November 2008, that number had almost doubled, to about $2
trillion in outstanding short-term debt.
Long-term Treasury securities, which include Treasury notes,
Treasury bonds and Treasury Inflation Protected Securities
(TIPS), are defined as having a maturity date of over a year.3
Before the onset of the current financial crisis, there was a
slight upward trend in the volume of these securities. Since
October 2008, there has been a significantly large upward surge

11. in the amount of T-notes issued, while the level of TIPS and T-
bonds has remained relatively unchanged.
In sum, financial markets have witnessed a significant increase
in the supply of Treasuries (level of debt issued by the
government) in recent times (Figure 1).
Interest Rate Response
Interest rate activity after the mortgage crisis of 2007 also
seems to provide evidence that would suggest that investors
found safety in U.S. Treasuries, especially T-bills. Figure 2
shows the yields on the three-month and 10-year Treasuries, as
well as those on Moody's Aaa and Baa corporate bonds.4
Corporate bonds carry a risk that the corporation issuing
this debt security will default on its obligations. For taking this
relatively higher risk, investors are rewarded with a higher yield
than they would get if they had invested in long-term
Treasuries. As seen in Figure 2, there was no significant change
in this difference of yields (spread) before the onset of the
current financial crisis.
Figure 2
Selected Yields
SOURCE: Haver
NOTE: Daily Data
Click to enlarge [back to text]
Flight to Safety and U.S. Treasury Securities
http://www.stlouisfed.org/publications/re/articles/?id=1984
1 of 2 6/15/2011 4:43 PM

12. However, when the mortgage market began to slide in August
2007, yields on short-term Treasuries fell sharply. Although the
supply of Treasuries was relatively con-
stant in the second half of 2007 and the first half of 2008, yields
on both short-term and long-term government securities
continued to fall. The larger decline in the short-term
Treasuries reflects the greater demand for liquidity during this
period as investors were increasingly reluctant to buy longer-
term assets. The uncertainty in the mortgage market also
encouraged investors to switch from other debt instruments,
such as mortgage-backed securities, into government securities.
All this while, changes in the yields on corporate bonds
were smaller because investors believed that the increased
credit risk was primarily concentrated in the mortgage market.
Nonetheless, the collapse of Lehman Brothers on Sept. 15,
2008, signaled the beginning of a financial panic. Increased
selling pressure by panic-stricken investors lowered prices and
raised yields on corporate bonds (Figure 2). At the same time,
investors increased their demand for safer assets, namely U.S.
Treasuries, and this led to a further decline in the yields
on U.S. Treasuries. Yields on short-term U.S. securities
decreased sharply to near zero in November (Figure 2).
However, the movement in long-term Treasury yields was
sluggish
—hovering about 4 percent before falling to about 2 percent in
December 2008. In part, this later decline was also prompted by
the Federal Reserve's measures to buy long-term
Treasuries under its large-scale asset purchase programs.
In summary, there has been a large expansion in the amount of
Treasury security offerings while yields on Treasuries have
actually declined. Stated differently, the prices on Treasury
securities have actually increased in the face of a rapidly

13. expanding supply of these securities. This anomalous behavior
in the market for Treasuries can be explained by a significant
increase in the demand for Treasuries—"the flight to safety" in
the event of a financial crisis. Evidently, the effect of the
increase in the supply of securities in government auctions was
more than offset by the increase in investors' demands for safer
investments.
Who Holds This Debt?
Figure 3 shows the quarterly flow of funds data on the holdings
of U.S. Treasuries by various sectors of the economy. Prior to
the crisis, the proportion of Treasury securities held by
each sector of the economy was roughly unchanged over the
early part of this decade. The largest shares of available
Treasury securities have been held by the domestic financial
sector and the rest of the world. Post-crisis, these two sectors
saw the most dramatic increases in their share of Treasury
securities holdings. Interestingly, it seems that although the
U.S. was at the epicenter of the financial crisis, both foreign
and domestic investors still sought the safety of U.S.
government debt instruments. These data present evidence in
support of the hypothesis that investors see U.S. Treasuries as
relatively risk-free. However, it will be interesting to see how
investors view U.S. securities in the future as debt levels
continue to rise.
Figure 3
Holders of U.S. Debt
SOURCE: Haver
NOTE: Quarterly Data
Click to enlarge [back to text]
Write a Letter to the Editor | Read Letters to the Editor

14. Endnotes
The Emergency Economic Stabilization Act was passed Oct. 3,
2008. It was a $700 billion program aimed at getting bad assets
off the books of firms in the U.S. financial sector. [back to
text]1.
Treasury bills (T-bills) have maturities of about a month, three
months, six months or a year. These are generally auctioned by
the Treasury once a week. [back to text]2.
Treasury bonds (T-bonds) have maturities from 20 to 30 years.
Treasury notes (T-notes) have maturities that range between one
and 10 years. TIPs have maturities between five and 30
years. The Treasury has various auctions of these securities
throughout the year. [back to text]
3.
The yield (to maturity) is defined as the interest rate that makes
the present value of a bond's payments equal to its price.
Therefore, the higher the price on the bond, the lower is its
yield.
[back to text]
4.
RATE THIS ARTICLE:
<< back to top
Flight to Safety and U.S. Treasury Securities
http://www.stlouisfed.org/publications/re/articles/?id=1984
2 of 2 6/15/2011 4:43 PM