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# Can the FED Do More?

This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

#### Summary

Students evaluate the total potential expansion of the money supply and availability of credit by using the simple equation of exchange. After considering recent changes in Federal Reserve policy that allows the Federal Reserve to pay interest on excess bank reserves, students predict the impact of the policy change on excess reserves held, and the subsequent effect of the policy on the Velocity of Circulation. They read two articles published by the Federal Reserve Bank of San Francisco as background to inform their predictions. After examining FRED data on excess reserves and the velocity of circulation (using M2 as the measure of the money supply) they are asked to evaluate the effect of the policy change and whether their prediction is consistent with the actual data.

## Learning Goals

The point of the exercise is to get the students to see that there were no excess reserves before the federal reserve started the policy of paying interest on excess reserves, and thereby reduced the velocity of circulation, as well as the total potential expansion in the money supply which would be predicted by the simple quantity theory (and as predicted by the text book version of the "money multiplier." Banks would rather hold the excess reserves (earning low interest, than loan it out at higher interest and bear the risk–money as a store of value).

Students should have a better appreciation of monetary policy effectiveness, the velocity of circulation, the equation of exchange, the simple quantity theory of money, and the difference between required reserves and excess reserves.

## Context for Use

This activity is best suited for two one hour class sessions with readings assigned ahead of the class and handouts distributed during the class session. Students use the text book theories (quantity theory of money and the reserve multiplier model) and read the two assigned articles. In class, they receive the handout with the actual data for excess reserves and velocity of circulation. Do the students' predictions square with the actual data? The final big question is: "could the federal reserve be more effective in promoting macroeconomic stimulus if, instead of paying interest on excess reserves, it began to charge a small (percentage) fee on bank holdings of excess reserves?" Accord to Alan Blinder's article this policy reversal could release potentially a trillion (with a T) dollars of excess reserves into the credit system for business lending by banks that now hold substantial excess reserves.

## Description and Teaching Materials

This lesson follows the lecture on the simple quantity theory of money and the reserve multiplier (money multiplier) model.
Instructor should review and reference the two federal reserve bank of San Francisco articles linked below:
1. The FRBSF Economic Letter included in our information packet by John Williams, Economics instruction and the Brave New World of Monetary Policy,

2. Dr. Econ resource

Instructor should distribute 2 hand outs:
1. The Alan Blinder quote (resource handout below) which argues that if the federal reserve were to stop paying interest on reserve, and instead, charge a fee to depository institutions that hold excess reserves, it could potentially release over a trillion dollars out of the excess reserves. He presumes excess reserves would be released into new loans and capital markets.
2. The FRED Graphs (labeled Fred_Graphs_dulgeroff in resources below)

Have the students inspect the graphs on money expansion M2, Velocity of Circulation, and Excess Reserves.

Discussion questions to follow:
1. Use the equation of exchange the explain the simple quantity theory of money? Looking at the data, why is the velocity still decreasing, even after the US economy is in a recovery, with national income increasing? The gray areas of the FRED graphs indicate periods of recession.
2. Write out the equation for the reserve multiplier (or money multiplier). Given the behavior of excess reserves, do you think that the total expansion in the money supply, as given by the reserve multiplier, is being achieved in the real economy? Why or why not?
3. One of the reasons that the excess reserves have risen is the change in policy that allows banks to earn interest on their excess reserves. The increase in reserves has what effect on the velocity of circulation? What does this imply about the effectiveness of monetary policy?
4. If the federal reserve bank were to follow the advice of Alan S. Blinder, and begin to charge interest on excess reserves, predict the impact on the excess reserves being held by banks and the effect on the velocity of circulation.
5. Do you think that Blinders suggestion that charging interest on excess reserves would lead to greater expansion in the macro-economy? Why or why not?
Alan Blinder Quote about Excess Reserves Handout (Microsoft Word 2007 (.docx) 15kB Oct19 13)
FRED Graphs on M2 excess reserves and Velocity (Microsoft Word 2007 (.docx) 68kB Oct19 13)

## Assessment

I hand out clickers and ask about the FRED graphs and the direction and impacts given the discussion questions above. I use the above discussion questions as a segue into a general question concerning how effective the traditional tools of monetary policy are and if the federal reserve could do more by relying on other policies at its disposal. Is federal reserve policy a blunt tool? Maybe it is true that small changes in reserve policy do not matter. But then this throws into question the entire social purpose of a bank–to provide loans to small and medium sized businesses that could jump-start the economy–not simply make money on fees and exploiting arbitrage opportunities.

## References and Resources

1. The FRBSF Economic Letter included in our information packet by John Williams,
Economics instruction and the Brave New World of Monetary Policy,
Economics instruction and the Brave New World of Monetary Policy
and,
2. Dr. Econ resource
and,
3. Alan S Blinder in the Wall Street Journal, July 22, 2012