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August of 2014, almost all of the U.S. government securities held by the Fed were long-term
securities, with maturities of greater than one year.
Quantitative easing has also led to a large increase in the money supply (M1). At the end of 2008,
the money supply was around $1,600 billion. By the end of July, 2014, the money supply was
over $2,800 billion.
Like traditional open market operations, quantitative easing increases bank reserves. This would
normally be expected to stimulate the economy by increasing bank lending. However, banks have
chosen to hold much of the newly created reserves as excess reserves.
Example 19: In August of 2008, bank excess reserves totaled less than $2 billion. By July of
2014, bank excess reserves totaled more than $2.6 trillion. (Information from the Federal Reserve
Bank of St. Louis.)
Since banks have chosen to hold a large amount of excess reserves, quantitative easing has not
stimulated the economy as much as hoped. The large amount of excess reserves accumulated
also creates the risk of significant inflation in the future.
Study Guide for Chapter 11
Chapter Summary for Chapter 11
The Federal Reserve System (Fed) is the U.S. central bank. The governing body of the Fed is the
Board of Governors, headed by the Chair of the Board of Governors (Janet Yellen). The Fed
performs a number of important functions, including; (1) control the money supply, (2) supervise
and regulate banking institutions, (3) serve as the lender of last resort, (4) hold banks’ reserves,
(5) supply the economy with currency, and (6) provide check-clearing services.
The Fed influences the money supply by changing the monetary base, which is currency in
circulation plus bank reserves. When the Fed makes a purchase or a sale, the monetary base
changes. When the monetary base changes, the money supply changes by a multiplied amount.
The actual money multiplier is equal to the change in the money supply divided by the change in
monetary base.
The Fed’s primary tool for controlling the money supply is open market operations; the Fed
buying and selling U.S. government securities in the open market. If the Fed buys securities in
the open market, bank reserves increase, which leads to money creation. To reduce the money
supply, the Fed would sell securities.
The Fed can also control the money supply by changing the reserve requirement or by changing
the discount rate. Lowering the reserve ratio would increase the money supply. Lowering the
discount rate would increase the money supply.
The economy entered into a recession in December of 2007. Real GDP, the unemployment rate,
the stock market, and the federal budget were all strongly affected by the recession.
The primary cause of the recession was the credit crisis arising from the bursting of the housing
bubble. The four primary causes of the housing bubble were; (1) low mortgage interest rates, (2)
low short-term interest rates, (3) relaxed standards for mortgage loans, and (4) irrational
exuberance.
Mortgage interest rates in the U.S. were kept low by an influx of savings from other countries.
Much of this saving was invested in mortgage-backed securities issued by investment banks. The
low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage
payments affordable for more buyers even as home prices rose.
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The Federal Reserve System 11 - 12