In July of this year (2015), Janet Yellen said the following in her testimony be

Question

In July of this year (2015), Janet Yellen said the following in her testimony before the House Committee on Financial Services:

If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate target, thereby beginning to normalize the stance of monetary policy.

In raising the federal funds rate, the Fed would likely start to sell some of the Treasury securities that it holds.

a. How would this change in policy affect the size of the Fed’s balance sheet? In your answer, discuss how each side of the balance sheet (assets and liabilities) would change. Would one or both sides increase or decrease?

b. Suppose the Fed sells $1 billion worth of Treasury securities to banks. How would this action change the size of the the monetary base? If banks are required to hold 10% of their deposits as reserves, what would be the final change in the money supply (assume we’re talking about M1) as implied by the “money multiplier”?

c. Is the change in the money supply that you calculated in part (b) likely to occur in reality? Why or why not? Would you expect the actions of the Fed to have any meaningful influence on the size of money supply at this point in time? Hint: For the last part of this question, you might think about the factors that influence a banks decision to lend as well as the current supply of excess reserves in the banking system (see https://research.stlouisfed.org/fred2/series/EXCSRESNS).

Explanation / Answer

(a) If Federal Reserve starts selling the securities it holds to the public, the revenues (in terms of the currency, dollar) or assets of the Federal reserve would go up and the supply of currency form the market will fall and thereby reducing credit. The fall in the money supply will stabilize infaltionary pressure in the economy.

With selling the securities which are the assets of the Federal Reserve, the assets would go down and currecny received from selling of securities would also increase the assets by the amount of securities sold. Only assets side would be affected. If the value of securities are worth the selling price then there would be no effect on the assets balance.

(b) If the Federal Reserve sells $1 billion worth of Treasury securities to banks, the lending capacity of the banks will go down or the money supply in the nation would go down by $1 billion. The monetary base of the economy would go down. Usuallly Federal Reserve do this to counter inflationary pressures.

Suppose a bank 1 lends $1,000 to X, who then pays his supplier, Y, the amount of the loan; Y deposits the money in its own account at Bank Y; Bank Y lends out 90% of the deposit, or $900, to Z, who pays its suppliers, D, the $900, and so on. In this way the money creation or the credit creation process goes on. The effect will be 10 times the money supply. The same contraction of supply affects the credit creation.

D = RR / r

Hence, if the reserve ratio is 10%, then increasing the reserves multiplies the increase in potential deposits by 10.

(c) In reality it may not always be possible that the money supply increases by 10 times. It may be lesser than that. Because sometimes the borrower may or may not deposit in the bank and may hold it idle or for other transactionary purposes. The Federal Reserve would therefore appeal to the commercial banks of the nationa to deal in financial instruments and if the money supply is reduced in the economy the banks would be asked to lend more to the public.

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