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Can the FED Do More?

This Page authored by James Dulgeroff, San Bernardino Community College, and is based on an op-ed article from the Wall Street Journal by Alan Blinder (former Vice Chairman of the Board of Governors of the Federal Reserve System)
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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)


Teaching Notes and Tips

It should occur to students that as M2 is increasing and the Velocity is decreasing, the two effects are off-setting each other. Hopefully the students hypothesize that the increase in reserves and the decrease in Velocity of Circulation are correlated, meaning that monetary policy may result in less of an increase in the overall money supply than the money multiplier suggests. Blinder's assertion is that the excess reserves are held (see the FRED graph) at precisely the time when the fed begins paying interest on excess reserves. Start charging banks for those excess reserves and bank have more of an incentive to move that trillion dollars of excess reserves into lending and capital markets. Therefore the FED could do more to push money into the hands of businesses that employ workers, even without further action on the federal funds rate, or other traditional tools of monetary policy. The answer to whether the excess reserves are significant hinges on an old debate in macroeconomics. On the one side we hear that the reserves are only a tool to achieve the targeted federal funds rate. If interest rates (prices) rather than expectations are what determine investment, then reserves (i.e., the repo market and bank balance sheet accounting identities) really do not matter. While it may be true that reserves do not determine loans, loans do determine reserves. Right now, short term commercial paper is at 0.14 percent, and the reserve interest is at 0.25 percent. The rate of return is safe on reserves is safe, and anyone in your classroom would love 0.25 on a trillion dollars. However, if banks were charged 0.25 on excess reserves, it could push banks to change their credit restrictions for new loans and more money could be pushed into loans that might not otherwise be made to medium-sized, new businesses. New loans would expand employment in the middle-class, leading to more positive expectations even at the zero lower bound. This views puts emphasis on positive expectations, not interest rates. Also, it has a parallel in the old savings-investment line of causation dilemma. Economists should always be concerned with the motives of economic actors. It is only by thinking through who does what and why that we can actually learn anything about the actual implications of an accounting identity. Ask students how the line of causation runs: does savings cause investment? do reserves determine loans? There are plenty of small businesses that want to expand in the economy. They need a loan. Banks think it's too risky. Even a small movement toward releasing those reserves might allow a small portion of the excess reserves to flow into the loan market. Investment causes growth, growth shifts expectations, more loans cause more reserves. Currently, banks are sitting on excess reserves. Could the change in policy nudge them in the right direction? Clearly this is open to debate. Are expectations (i.e., getting credit to businesses) more important than the interest rate?

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