Overview of Module 4, Section 5: The Financial Crisis, which introduces the Federal Reserve's balance sheet and the tools it employs to manage the money supply & influence interest rates.

Main Themes

1. Short-Term Collateralized Financial Products: Repurchase Agreements (Repos) and Reverse Repurchase Agreements (Reverse Repos)

Repo (RP) A financial product involving the purchase of securities (generally Treasury securities) coupled with an agreement to sell them back at a future date for a slightly higher price. It's a short-term lending agreement used to earn a small return on excess cash with low risk.

• Central Banks use repos to inject liquidity into the financial system (increase money supply) and lower interest rates by providing short-term loans to banks (collateralized by securities), increasing the Reserves in the banking system.
• Repos allow financial institutions to borrow for very short time-periods against assets they own.

Reverse Repo (RRP) A financial product that involves the sale of securities coupled with an agreement to purchase them back at a future date for a slightly higher price. It's a short-term borrowing agreement used to manage short-term liquidity needs.

• Central Banks use Reverse Repos to remove liquidity from the financial system (decrease money supply) & raise interest rates by acting as a borrower, taking in money from financial institutions in exchange for securities, thus decreasing the Reserves in the banking system.

2. The Fed’s Balance Sheet

• The Fed's balance sheet has assets (things the Fed owns or that pay it interest) and liabilities (things the Fed owes to others or pays interest on).
• Assets: Primarily include U.S. Treasury securities, Repos, and Other Assets including foreign reserves and gold. During crises, the Fed’s balance sheet can expand to include other assets including asset-backed securities and longer-term loans.
• Liabilities: Primarily include Currency in circulation (a liability as it technically belongs to the government), Reserves held by banks at the Fed (on which interest may be paid), Reverse Repos (the Fed owing money), the Treasury General Account (the U.S. govt's checking account), and other smaller Liabilities including the Capital used to originally fund the Fed.
• The size of the Fed's balance sheet is a key indicator of the money supply. An increasing balance sheet generally indicates an increase in the money supply.

3. Open Market Operations (OMOs)

Under "normal" economic conditions, OMOs are the primary tool the Fed uses to maintain the federal funds rate.

• OMOs involve the sale and purchase (or temporary trade via Repos & Reverse Repos) of primarily Treasury securities to eligible banks in exchange for Reserves.
• To increase the money supply, the Fed purchases Treasuries from banks and increases the Reserves in the system, which banks will likely use for loans.
• To decrease the money supply, the Fed sells Treasuries to banks, which decreases the Reserves in the system as banks pay for the securities.

4. Credit Easing

• Credit easing is employed during periods of heightened risk or a "credit crunch" when lowering the federal funds rate does not significantly increase borrowing & lending. This occurs as lenders become cautious and prefer low-risk assets (like Treasuries) or increased Reserves.
• The Fed acts as the short-term lender of last resort through mechanisms such as purchasing or accepting as collateral a broader range of riskier assets. The goal is to reduce the risk exposure of banks, making them more willing to lend their Reserves.

• Credit Easing with Sterilization: The Fed can implement credit easing without increasing the money supply by selling an equivalent amount of Treasuries, pulling the newly created Reserves back out of the system. The effect is to shift risk from banks to the Fed while providing liquidity without inflationary pressure.

• During the 2007-2008 credit crunch, the Fed initially used normal credit easing measures with sterilization.