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. 

14.1 The Central Bank’s Balance Sheet #Notebook

14.1 The Central Bank’s Balance Sheet #Notebook

Ultimately the money supply is determined by the interaction of 4 groups, commercial banks, depositors, borrowers, and the central bank. 

The central bank’s balance sheet is composed of assets and liabilities. Its assets include government securities and loans. 

Its assets provide incomes and liquidity. Its assets can use to buy and sell to alter its balance sheet. 

Its liabilities are loans made to commercial banks, but it differs from those of common banks. Its most important liabilities are currency in circulation and reserves.

Currency and reserves are the assets of commercial banks, but not for the central bank.                    

The Federal Reserve notes (FRN), are assets, we owned. But for the central bank, they are liabilities, promissory notes (IOU).

Commercial banks own their deposits in the Fed (reserves), but the Fed owes these reserves to commercial banks.

If Currency in circulation = C , Reserves = R , the monetary base = MB , then the MB = C + R

In the United States, C includes FRN and coins issued by the U.S. Treasury, a relatively small percentage of the MB.

Any FRN in banks is called vault cash and is included in R, which also includes bank deposits with the Fed. 

Reserves include required by the central bank (RR), and additional reserves (ER) that banks hold.

Central banks are highly profitable institutions because their assets earn interest but their liabilities are costless.

Central banks anachronistically own prodigious quantities of gold. Gold is no longer part of the MB. It's a commodity with an unusually high value-to-weight ratio.

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. 

11 The Economics of Financial Regulation

Public Interest versus Private Interest #Notebook

Governments face a budget constraint and opportunity costs, it can’t afford to monitor everyone all the time, officials are not the angels. 

Most of the time, private interest prevails, in the government. Could regulators stop bad activities, events, and people even if they wanted to? No! It's the old nemesis, asymmetric information. Democracy is also no guarantee that governments will serve the public interest.  

Most major economic foul-ups stem from a combination of market and government failures, it's hybrid failures. 

Bank panics can further the increase in asymmetric information, and further declines in economic activity followed by an unanticipated decline in the price

level. 

During the Great Depression, per GDP shrank, the number of bankruptcies soared, M1 and M2 declined, and so did the price level. 

Normally, only the government had the resources and institutions to stop the Great Depression. The Federal Reserve could have deflated the asset bubble before it grew to enormous proportions and burst.

Whatever the cause of the crisis, it shattered confidence in the banking system. However, the Federal Deposit Insurance Corporation (FDIC), did restore confidence, inducing people to stop running on the banks and thereby stopping the economy’s death spiral. 

However, the deposit insurance is NOT cost-free. Insurance also reduces depositor monitoring, and allows bankers to take on added risk. With deposit insurance, depositors often ignore the warnings and shift their funds to fetch the most interest.

The Security and Exchange Commission’s (SEC) stated goal, to increase the transparency of America’s financial markets.

If somebody has no capital, no skin in the game, moral hazard will be extremely high because the person is playing with other people’s money. 

CAMELS is an international rating system used by regulatory banking authorities to rate financial institutions, according to the six factors represented by its acronym, "Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity."

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. 

 

Which of The Monetary Tools Available to The Federal Reserve Is Most Often Used?

Which of The Monetary Tools Available to The Federal Reserve Is Most Often Used? 

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate, and reserve requirements. Recently, open market operations are the most frequently used tool of monetary policy.

The Three Instruments of Monetary Policy Briefly Intro: 

I. Open market operations involve the buying and selling of government securities primarily U.S. Treasury securities on the open market to regulate the supply of money. The Federal Reserve purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money. By trading securities, the Fed influences the amounts of bank reserves, and affects the federal funds rate, or the lending rate of interbank markets.

The Federal Open Market Committee (FOMC) is the entity that carries the Federal Reserve's policy. 

II. The Federal discount rate is the interest rate the Federal Reserve charges banks to borrow funds, allows Federal Reserve to control the supply of money, known as a monetary policy, to stabilize the financial markets. When the discount rate falls, it's cheaper for financial institutions to borrow money. More loans are made, the money supply increased. When the discount rate climbs, it's more expensive for financial institutions to borrow money which would be less money in the economy.

III. Reserve requirements are the portions of deposits that banks must maintain on deposit at a Federal Reserve Bank. The requirements are the amounts of funds that banks hold in reserve to ensure sudden withdrawals are able to be met. It's a tool used by the Fed to increase or decrease the money supply in the economy and influence interest rates.

So, why The Federal Reserve Used Open Market Operations Most Often?

Open market operations, the discount rate, and reserve requirements all capable of controlling the money supply effectively. However, the Fed frequently used open market operation tools as the primary monetary policy because of the flexibility. The open market operations are easily reversible. Discount loans and reserve requirement changes are more difficult to reverse quickly.  

The open market operations are also very efficient. The Fed can implement whatever it wants rapidly, with no administrative delays. But, changing the discount rate or reserve requirements require much more time to discuss.

How Expansionary Activities Conducted by The Federal Reserve Impact Credit Availability, The Money Supply, Interest Rates, and Security Prices

When the Fed uses its monetary policy tools to stimulate the economy, it increases the money supply, lowers interest rates, increases the demand, and boosts economic growth. When consumers expect prices to increase, they are more likely to buy more now. However, if the Fed puts too much liquidity into the banking system, it risks triggering inflation.

Credit Availability

Credit availability means how much money can be borrowed, given the current balance on the account. If there is a limit on the total, the credit of this account is likely to be less liquid. For example, just like your credit card account, if all available credit has been used, the credit limit has been reached, then the available credit will become zero, and you cannot purchase anything until you repay the bill to gain the credit amounts. It is kind of a risk management tool for financial institutions to limit their risk. However, the Fed also can narrow the credit rate to reduce some risky activities.

The Money Supply

The money supply is the total amount of money like cash, coins, and balances in circulation. As we already know, the Federal Reserve’s three instruments of monetary policy, the open market operations, the discount rate, and reserve requirements, can increase or reduce the money supply. 

During the expansion periods, the Fed tends to supply more money into the economy to keep it work smoothly. Reversely, reduce the money supply can limit unhealthy and overtop inflation.

Interest Rates

The Fed can lower or higher the rate it charges commercial banks while they need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate.

During the expansion periods, if the Fed wants to give banks more reserves, it can reduce the interest rate it charges, thereby tempting banks to borrow more since it's cheaper. Alternatively, it can top up reserves by raising its rate, to achieve its goal. The expensive cost will hit the banks to reduce borrowing. 

Security Prices

Consumers tend to stock up something to avoid higher prices later, and then drives demand. Triggering businesses to produce more, and hire more workers. As income gets higher, the additional income tempting people to spend more, stimulating more demand. 

If businesses can't produce enough, they start raising prices. Securities prices are the same. Most of the time, securities prices influence how we spend our money quietly. Therefore, through open market operations, and the discount rate, the Fed tends to keep reasonable securities prices.

Reference

Federal Reserve Actions to Support the Flow of Credit to Households and Businesses. (2020, March 15). Retrieved October 06, 2020, from https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm

Monetary Policy Basics. (n.d.). Retrieved October 05, 2020, from https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy

13.4 Central Bank Independence #Notebook

13.4 Central Bank Independence #Notebook

In principle, Central Banks are independent of the dictates of government, the freedom to conduct monetary policies. And by experiences, as a country’s central bank becomes more independent, its average inflation rate drops. Many Latin American and African countries had very high rates of inflation when their central banks were ruled by dictators.

If a central bank has control of its own budget, as the Fed and ECB do, then the bank is quite independent because it is beholden to no one. 

The Fed is slightly less independent than the ECB because its existence is not constitutionally guaranteed. Congress could change or abolish the Fed by passing a law or it could override his veto. The ECB was formed by an international treaty, any changes to which must be ratified by all the signatories.

The Bank of Canada’s independence is limited by the Bank Act of 1967 made the government ultimately responsible for Canada’s monetary policy. 

Central bankers are tougher on inflation than governments, politicians, or the general populace because they represent bank, business, and creditor interests, all of which are hurt if prices rise quickly and unexpectedly. 

Businesses tend to dislike inflation because it increases uncertainty and makes long-term planning difficult. 

Many households are net debtors, they owe money to some financial institutions. Inflation will decrease the real burden of their debts. 

Politicians also tend to stand on the side of higher rather than lower inflation since they always writing checks to win their votes. In addition, increasing the money supply quickly or lowering the interest rate, can stimulate a short burst of economic growth that will make people happier and more willing to give returns.

After all, should everything be democratic? Would you want the armed forces run by majority vote? 

Another knock against independent central banks is that they are not very transparent. The Fed has long been infamous for its secrecy. 

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. 

Other Important Central Banks #Notebook

13.3 Other Important Central Banks #Notebook

The Maastricht Treaty created the European Central Bank (ECB), the central bank of the euro area.

The ECB was consciously modeled on the Fed and their structures are similar. However, the ECB is more decentralized than the Fed because the NCBs control their own budgets and conduct their own open market operations. 

The ECB does not regulate financial institutions, left the duty to each member's government. 

Other important central banks, the Bank of England, the Bank of Japan, and the Bank of Canada are unitary institutions with no districts. 

Despite the structural differences, the Bank of Japan implement monetary policy in ways very similar to the Fed and ECB.

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. 

13.2 The Federal Reserve System’s Structure #Notebook

13.2 The Federal Reserve System’s Structure #Notebook

The Federal Reserve is composed of twelve district banks: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. 

The twelve district banks all have to do their duties.

Issue new Federal Reserve notes (FRNs) in place of worn currency.

Clear checks

Lend to banks within their districts.

Connect the Fed and the business community.

Collect data on regional business and economic conditions

Conduct monetary policy research

Evaluate bank merger and new activities applications

Examine bank holding companies and state-chartered member banks. 

The Fed’s headquarters is located in Washington, DC. Except for Boston and Philadelphia, each of those district banks also operates one or more branches. 

The districts don’t seem to be evenly balanced economically. Missouri is the only state with two federal reserve district banks. This was thought necessary to secure the votes of Missouri congressional representatives for the bill. 

Each Federal Reserve bank is owned by the commercial banks in its district, and they are chosen to join, own restricted shares in the Fed. 

The FRBNY (Federal Reserve Bank of New York)

The FRBNY (Federal Reserve Bank of New York) is the most important of the district banks because it also conducts open market operations, buying and selling government bonds on behalf of the Federal Reserve System, and doing International Settlements (BIS).

The FRBNY even safeguards tons of gold owned by the world’s major central banks. 

The FOMC is composed of the seven members of the Board of Governors. The FRBNY’s president is the only permanent member of the Federal Open Market Committee (FOMC).

The FOMC meets every six weeks or so to decide on monetary policy and open market operations.

Until recently, the Fed had only two other tools for implementing monetary policy, the discount rate that district banks lend directly to member banks and reserve requirements. 

The head of the Fed is appointed by the president of the United States, confirmed by the U.S. Senate.

The researchers provide the chairperson and the entire FOMC with new data, qualitative assessments of economic trends, and quantitative output from the latest and greatest macroeconomic models. 

Fed economists also help the district banks to investigate markets and competition conditions, and educational programs.

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. 

13.1 America’s Central Banks #Notebook

13.1 America’s Central Banks #Notebook

Central banks generally charged with:

Controlling the money supply

Stabilizing the major prices

Improving economic output and employment

Regulating financial institutions

Stabilizing the economy

Providing a payments system

Central banks can be useful as an official systemwide lender of last resort, to increase the money supply or reduce the interest rates during a crisis period. 

Episodes in the history of the US convinced many Americans that the time had come to create a new central bank lest private financial institutions hold too much power.