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Thursday, August 09, 2007

A "Significant Liquidity Event"

Today there was, as Brad DeLong notes in a series of posts on the topic, a "significant liquidity event." Because of this event, "today the monetary base in the North Atlantic economies is 7% higher than it was yesterday."

Let's back up. From the first post of Brad's linked above:

This morning, the ECB allocated about $130 billion in a one-day quick tender to calm jittery markets. The scramble for liquidity in Europe spilled over into the U.S.: The Fed, in an effort to get the federal funds rate back down to its target 5.25% and meet the spike in demand for cash, twice entered the market today to inject cash.

Just for fun, I thought I'd present a textbook version of this event. Here's the graph of the market for bank reserves:

Reserves8907

The initial equilibrium, before the event, is at E1 where the supply and demand for bank reserves intersect (this is a picture of the federal funds market, i.e. the market for overnight loans of bank reserves between banks). The demand curve slopes downward because the federal funds rate is the opportunity cost of holding bank reserves. Thus, when the cost of holding bank reserves falls (i.e. the ff falls), more reserves are held (as insurance against deposit outflows, and for other purposes).

Reserve supply, shown as vertical lines at R1 and R2 in the diagram is controlled by the Fed through open-market operations. At any point in time, the supply of reserves is fixed, so the line is vertical (or at least approximately so in more general models). 

Banks can borrow money in many different places using different financial instruments, but two places to obtain reserves are the federal funds market and the discount window. So long as the ff-rate is lower than the discount rate, banks will choose the ff market over the discount window. But if the ff-rate tries to rise above the discount rate, banks will switch to the discount window since that will be the cheaper source of funds. In the diagram, this is represented by a vertical supply of reserves up to the discount rate, then a horizontal line at that the discount rate (which is always the ff+1% under current bank operating procedures) since the Fed stands ready to lend as much as banks want through the discount window at the discount rate.

Now let's turn to today. As noted in the quote above (from the WSJ Economics blog), "The scramble for liquidity in Europe spilled over into the U.S." This is shown as an increase in the demand for reserves (i.e. for liquidity) indexed by (a) in the diagram.

If the Fed did not respond, the ff-rate would begin rising, potentially even reaching the discount rate. To avoid this, and maintain a federal funds rate of 5.25%, the "Federal Reserve subsequently poured a little more cash than usual into the U.S. banking system in order to deal with demand spilling over from Europe." The total amount of the injection was $24 billion, and this is represented by the shift in the supply of reserves indexed by (b) in the diagram. The result is a new equilibrium at E2 where reserves have been increased to accommodate the increase in demand, and the ff-rate is at 5.25%. once again.

Update: I should have noted that this was an attempt to illustrate the statement from the WSJ: "The Fed, in an effort to get the federal funds rate back down to its target 5.25% and meet the spike in demand for cash." Demand for reserves would go up, for example, if banks anticipate bad mortgage loans in the future since they would want to have extra reserves on hand as insurance against that eventuality (to the extent they are exposed), or if alternative sources of funds dry up due to the evaporation of liquidity. The graph does not show the effects of the problems in mortgage markets on the supply of reserves, i.e. a fall in the supply of reserves from bad loans would also increase the ff-rate and require an injection of reserves to offset it.

    Posted by on Thursday, August 9, 2007 at 01:17 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (18)

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