The financial crisis caused by the spread of COVID-19

The present financial crisis was caused by the spread of COVID-19. As the larger and larger scale lockdown, more and more business activities are limited, and too many people lose their jobs, the global economy will suffer a very long nightmare. Moreover, if the economy takes too many to recover, some businesses are more likely to be changed forever, and even lead to a more terrible debt disaster.

So, what are the solutions?

Before we try to find the cure, we must know why and how the crisis was affecting us. Obviously, we need the vaccine to fight the virus. But we cannot just wait for it to appear as a gift. We need a plan for the worst situation. We need a plan to recover the tremendous unemployment, lack of confidence, and shrinking populations caused by the deadly virus.

The unemployment caused by the virus, connects closely to the lack of confidence. If firms are afraid to invest, expand, or even shrink their business, the unemployment rate will be higher and higher, to a terrible level. 

However, the Fed does not really an almighty god. Open market operations, discount rate, and reserve requirements are three major tools for the Fed to use on fixing financial issues. Since the discount rate and reserve requirements are not flexible enough, the open market operations are a relatively effective way to do it. 

The open market operations can effectively increase the money supply to the weak economy, but it not enough. As the Fed keeps purchasing securities to fund the system, it also creates tons of reserves on its liabilities. So, money doesn't grow on trees, there are costs. But, it still worth a shot, if the situation is too serious. 

A stimulus plan fund by the government combine with the open market operations are more likely to recover with fewer negative effects. But still, the government's overspending can be a big problem, if it spends way too much. 

I think there are no solutions that are always applicable because our world is changing each and every second. We always have to develop and create new ways to solve new problems.

14.2 Open Market Operations #Notebook

14.2 Open Market Operations #Notebook

The Fed influences the MS via the MB, and control their monetary liabilities, MB, by buying and selling securities, called open market operations. If a central bank wants to increase the MB, it need only to buy securities. 

If the Fed bought a $10,000 bond from a bank, the banking system would lose $10,000 worth of securities but gain $10,000 of reserves. 

The central bank would gain the asset of securities by creating the liability of reserves. The central bank’s liabilities are everyone else’s assets. 

The MB increases by the amount of the purchase because either C (Currency in circulation) or R (Reserves) increases by the amount of the purchase. 

Notice!

*Currency in circulation means cash (like FRN) no longer in the central bank. 

*An IOU in the hands of its maker is no liability.

*Cash in the hands of its issuer is not a liability. 

*Although the money existed physically before people sold his bond, it did not exist economically as money until it left its creator, the central bank. 

However, if the transaction were reversed and someone bought a bond from the central bank with currency, the notes he paid would cease to be money, and currency in circulation would decrease.

When the central bank sells an asset, the MB shrinks because C or R decreases along with the central bank’s securities holdings, and banks or the nonbank public own more securities but less currency or reserves.

The central bank can also control the monetary base (MB) by making loans to banks and receiving their loan repayments. A loan increases the MB and a repayment decreases it.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

14.3 A Simple Model of Multiple Deposit Creation #Notebook

14.3 A Simple Model of Multiple Deposit Creation

The central bank pretty much controls the size of the monetary base and anticipate the fluctuations, although the check clearing process and the government’s banking activities can cause some short-term flutter.

However, money consists of more than just MB. M1 also includes checkable deposits. Each $1 (or €1, etc.) of additional MB creates multiples > 1 of new deposits, a multiple deposit creation.

Suppose the Fed buys $1 million of securities from Citi Bank. 

On the Citi bank's side

Citi bank's asset -1 $1 million securities

                            +1 $1 million reserves

On the Fed's side

The Fed's asset +1 $1 million securities

The Fed's liabilities +1 $milion reserves               

*the Citi Bank suddenly has $1 million in excess reserves.

What will the bank do? Likely what banks do best: make loans. 

So, the Citi bank's balance sheets then become...

Assets: Loans +$1 million  

Liabilities: Deposits +$1 million

Deposits are created in the process of making the loan. So, the bank has effectively increased M1 by $1 million.  

As the deposits flow out of the Citi Bank, its excess reserves decline until Citi Bank has essentially swapped securities for loans:

Citi bank's Assets: Securities −$1 million, Loans +$1 million

The simple deposit multiplier isn’t very accurate. It provides an upper bound to the deposit creation process. Sometimes banks hold excess reserves, and people sometimes prefer to hold cash instead of deposits, thereby stopping the multiple deposit creation process cold. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.