# CORE Insights Financing American Government

The authors of this Insight are:
Martina Jasova: Barnard College, Columbia University.
Rajiv Sethi: Barnard College, Columbia University and Santa Fe Institute.

10 December 2020

### CORE Insights

Concepts in the insight are related to material in:

Unit 10, Unit 14, Unit 15, and Unit 17 of The Economy.

Unit 9 and Unit 10 of Economy, Society, and Public Policy.

Highlights

• In the United States, the power to authorize federal taxation and expenditure—the power of the purse—lies with Congress.
• When Congress authorizes major increases in expenditure that are not funded by taxation—as with the CARES Act of 2020 or TARP in 2008—it does not typically specify how the increase in the government’s deficit (the gap between its spending and its revenue) will be financed.
• The task of securing funding for authorized expenditures in excess of tax revenues falls to the Treasury.
• To secure funds, the Treasury borrows from the public and financial institutions by issuing a range of securities, called treasury securities or simply treasuries.
• Treasuries are sold at weekly auctions where bidders specify the lowest interest rates they are willing to accept; the market clearing rate is determined through this process.
• Demand for treasuries comes from institutions worldwide; they are considered to be among the most secure of assets, with negligible likelihood of default.
• A key player affecting the demand for treasuries in both normal times and in a crisis is the Federal Reserve or Fed.
• The interest rate on treasuries is directly connected to the policy interest rate—the federal funds rate—which the Fed controls.
• Other things equal, an increase in borrowing needs would result in higher market clearing interest rates at auction; however, policy choices by the Fed can keep the interest rate low.
• Treasuries have historically played a central role in how the Fed implements its policy interest rate, although the manner in which monetary policy is conducted has changed since 2008.
• Because of its monopoly in the creation of central bank money (known as reserves) the Fed has essentially unlimited capacity and legal authority to buy treasuries on the open market.
• In ‘unusual and exigent circumstances’, the Fed also has the power to purchase a broad range of other assets; it used this power during the global financial crisis and again in response to the COVID-19 pandemic when it wanted to support economic activity but was unable to lower the federal funds rate further.

## Introduction

CARES Act
The Coronavirus Aid, Relief, and Economic Security Act is a $2.2 trillion economic stimulus bill passed by the US government in response to the health and economic fallout of the COVID-19 pandemic in the United States. In late March, 2020, as the terrible human and economic costs of the COVID-19 pandemic were starting to become apparent in the United States, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act to stem the fallout. This single piece of legislation called for$2 trillion in new expenditures, including direct payments to households, forgivable loans to businesses, and expanded unemployment insurance benefits. The expenditure authorized by the Act amounted to about one-tenth of the country’s annual gross domestic product.

How was this new expenditure financed? Not by raising taxes, which would have been quite undesirable under the circumstances. The CARES Act was designed to allow households and businesses to survive in the face of a collapse in earnings. A tax increase would have reduced disposable income, prevented households from smoothing their consumption over time, and thus defeated the purpose of the legislation.

In addition, raising taxes to cover the increased expenditure would have been essentially impossible. Total federal tax revenues for 2019 were less than $3.5 trillion, and changes to the tax code do not take effect immediately in any case. Accordingly, the increase in spending was financed by new borrowing. But who lent this money to the US government and on what terms? And how did Congress know that the funding would be forthcoming as needed? Is there a limit on how much the government can borrow? Can we be certain that the debt will be repaid as it comes due? This CORE insight addresses questions such as these, with particular emphasis on the distinction between the Treasury and the Fed, and their respective roles in promoting economic stability and responding to crises. ## The Treasury US Department of the Treasury The executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. Source: U.S. Department of the Treasury. The US Department of the Treasury is the government agency responsible for the ‘disbursement of payments to the American public, revenue collection, and the borrowing of funds necessary to run the federal government’. Like households, firms, and other organizations, the government receives and spends income, borrows to cover the difference, and repays debt as it comes due. Tax revenues flow in, and expenditures on unemployment, disability, and social security benefits, building and maintaining infrastructure, weapons for the military, administrative salaries, and all manner of other payments authorized by Congress flow out. When revenues are insufficient to cover expenditures, the government has a budget deficit and must borrow to finance the shortfall. This leads to an accumulation of debt on which interest must be paid. If revenues exceed expenditures, there is a budget surplus and a fall in the total amount of outstanding debt. Annual surpluses and deficits for the United States federal government since 1939, relative to the nation’s GDP, are shown in Figure 1. We see deficits in almost all years, with especially large deficits during recessions (shown in grey) and times of war. The deficit in 2020 is projected to be$3.7 trillion, or about 18% of the GDP, which would be the largest recorded since the end of the Second World War.

When the government borrows money to finance a deficit, it accumulates debt. Figure 2 shows the federal debt as a percentage of the GDP since 1939. We see that when the deficit is large, the debt tends to rise. This is especially clear during the Second World War and the global financial crisis. Once 2020 is behind us, we will see that the public debt of the United States will be greater than at any time in modern history.

As Figures 1 and 2 make clear, the ratio of debt to GDP declined steadily for several decades after the war, despite the fact that there were deficits in most years. This is because the economy was growing faster than the debt was accumulating over this period.

It appears, therefore, that the government of the United States can have a budget deficit year after year without encountering problems financing it. Is this really the case? And if so, what makes it possible? To answer these questions, we first need to look at the mechanics of the federal borrowing process, and the role of the nation’s central bank, the Federal Reserve.

### Question 1 Choose the correct answer(s)

Use Figures 1 and 2 to select all of the statements below that are correct.

• From 1990 to the present, there was only one year in which the US government ran a surplus.
• In 2009, during the global financial crisis, the US government ran a deficit of $9 trillion. • At its lowest point during the 1970s and early 1980s, the US debt to GDP ratio was close to 30%. • In 1962, the US government ran a deficit but saw a reduction in the debt to GDP ratio. • From 1990 to the present, the US government ran a surplus in four years: 1998, 1999, 2000 and 2001. • The chart in Figure 1 measures surpluses and deficits as a percentage of GDP not in trillions of dollars. • Between 1970 and 1982, the US debt to GDP ratio stayed close to 30%. • You can see that the government ran a deficit in 1962 in Figure 1 and you can see the reduction in the debt to GDP ratio in Figure 2. ### Exercise 1 Debt as a percentage of gross domestic product Why do we ‘normalize’ and measure debt in relation to GDP? ## The mechanics of government borrowing In some respects, government borrowing is very similar to that of households and firms who borrow to buy cars, homes, machinery, and equipment. That is, the government borrows money from lenders to pay for its activities, and it promises to pay them back the borrowed amount plus interest in the future. treasuries The collective name for the bills, bonds, and notes issued by the US Treasury on behalf of the federal government. Source: Federal Reserve Bank of St. Louis Education Glossary. treasury bill A security issued by the US Department of the Treasury with original maturity up to one year. treasury note A security issued by the US Department of the Treasury with original maturity of 1 to 10 years. treasury bond A security issued by the US Department of the Treasury with original maturity of more than 10 years. Specifically, the United States Treasury borrows money by selling government debt securities called treasuries. The date on which the loans are to be repaid is called the maturity date. The length of time between the issue date and the maturity date—the initial time to maturity—can be as short as four weeks or as long as thirty years. Three types of treasuries comprise most of the US debt: those that mature within one year, called treasury bills, those maturing in two to ten years, called treasury notes, and those with even longer maturities, called treasury bonds. coupon payments The regular payments received by the buyer of a bond. Source: Federal Reserve Bank of St. Louis Education Glossary. Treasury bills are extremely simple contracts: a lender pays money to the government at the time of issue and gets paid back a larger amount at the time of maturity; no payments are made in the interim. Notes and bonds are different: they promise a stream of semiannual payments throughout the term of the loan, called coupon payments, in addition to the repayment of the loan amount on the maturity date. Figure 3 illustrates the maturity composition of US debt as of 30 April 2020. More than half of the government debt at this time was issued as notes, with about a quarter issued as bills. The figure shows the maturity composition at origination (that is, when the securities were first issued). Since many of the notes and bonds were issued years ago, some have maturity dates that lie within the next few months and will be due for repayment before some of the bills that are currently being issued. secondary markets and primary markets The primary market is where goods or financial assets are sold for the first time. For example, the initial sale of shares by a company to an investor (known as an initial public offering or IPO) is on the primary market. The subsequent trading of those shares on the stock exchange is on the secondary market. The terms are also used to describe the initial sale of tickets (primary market) and the secondary market in which they are traded. monetary policy Central bank (or government) actions aimed at influencing economic activity through changing interest rates or the prices of financial assets. open market operation The purchase and sale of securities in the open market by the Federal Reserve. A key tool used by the Federal Reserve in the implementation of monetary policy. Source: Federal Reserve Board. Treasury auctions are the markets through which securities enter the economy, and they are called primary markets. Once these securities have been issued, they can be bought and sold on secondary markets. Essentially, the government has borrowed money in exchange for promises to pay, and these promises can be freely bought and sold. The Federal Reserve is an important participant in the secondary market and has the legal authority to buy and sell treasuries without limit. Prior to 2008, the Fed would buy and sell treasuries in order to conduct monetary policy by maintaining its interest rate target, a process called open market operations. Since then, it has shifted to setting the interest rate paid on commercial bank reserves, a process we describe later in the insight. In either case, Fed interest rate policy directly affects the behavior of bidders in the primary market for treasuries and can prevent interest rates from rising even when the borrowing needs of the government rise sharply. Each year, the Treasury organizes more than 300 auctions that are open to the public. In a treasury auction, individuals and financial institutions bid for securities by specifying the minimum acceptable interest rate. These bids, together with the government’s borrowing needs, determine the market clearing interest rate, at which supply and demand are equated. Lenders who are willing to accept this rate are able to buy the securities, and all receive the same rate regardless of their individual bids. A detailed look at the workings of a treasury auction is provided in the Treasury auctions section. Understanding how treasury auctions work helps us to see the hypothetical effects on the interest rate of an increase in borrowing needs (the actual effect will depend on the Fed’s response, as we shall see later in the insight). In the example in the Treasury auctions section, if the borrowing needs were$70 billion, the market clearing rate would have been 0.14%. If the borrowing needs were $180 billion, all bidders would have been successful, and the market clearing rate would have been slightly higher at 0.16%. And if the government needed to borrow even more than this, the auction would have failed: the borrowing needs could not have been met. Federal Reserve Bank One of 12 regional Banks providing services to commercial banks, serving as fiscal agents for the US government, and conducting economic research on its region and the nation. Source: Federal Reserve Bank of St. Louis Education Glossary, https://tinyco.re/1203900 The failure of a treasury auction would precipitate a political and financial crisis, and is extremely unlikely to happen, in part because the Federal Reserve Bank has the power to buy as much government debt as it feels is necessary to maintain financial stability. In practice, the Fed does not need to involve itself in the market for treasuries directly: its monetary policy targets and announcements can provide enough incentives for private bidders to demand treasuries in vast quantities at rates only slightly higher than the Fed’s policy interest rate. This makes the debt very secure, with bidders quite certain that they will be repaid in full and on time. Consequently, the market for US Treasury debt involves participants from around the world. ### Treasury auctions A treasury auction begins with an offering announcement that specifies the auction date, issue date, and maturity date, as well as the amount of the security on offer. On 21 May 2020, for instance, the Treasury announced an auction for a 13-week bill, with issue date 28 May, maturity date 27 August, and an offering amount of$63 billion. This amount was based on the borrowing needs of the government at that time.

Bidders name their price, which in the case of treasuries is the interest rate they would be willing to accept to lend the government a specific amount of money. The auction was held on 26 May, and the total demand for bills was about three times the amount on offer. Bids came in as low as 0.09% at an annual rate, and the market clearing rate was 0.13%. A summary of this information is in Figure 4, where the market clearing rate is referred to as the ‘high rate’ and the lowest bid received as the ‘low rate’.

Treasury auction results
Term and type of security 91-day bill
CUSIP number
912796XG9

High rate
0.130%
Allotted at high
80.97%
Price
99.967139
Investment rate
0.132%

Median rate
0.120%
Low rate
0.090%

Issue date 28 May 2020
Maturity date 27 August 2020

Figure 4 Results from a treasury bill auction.

Data from TreasuryDirect.

The manner in which these prices and rates are determined at an auction is as follows. Bidders submit the lowest interest rate that they are willing to accept, as well as the amount of the security that they want to buy. What they are buying is a promise of payment on the maturity date. The bids are sorted from lowest to highest, and those with the lowest bids get the requested securities until the government’s demand for borrowing has been met. The market clearing bid is the one that pushes the total demand for securities just above the available supply, and this is the interest rate that all bidders receive. The bidder (or bidders) who submit exactly the market clearing rate may not get the full loan amount requested.

To see exactly how this works, consider the following set of hypothetical bids that is roughly consistent with this data (all quantities are in billions of dollars):

Bidder Bid Rate (%) Quantity
A 0.09 10
B 0.11 15
C 0.10 10
D 0.12 20
E 0.14 30
F 0.14 15
G 0.14 25
H 0.16 10
I 0.15 35
J 0.13 10

Total   180

Suppose that the offering amount is $63 billion so not all bidders will get securities. To see who does, and in what amounts, we sort the bidders based on their bid rates to get: Bidder Bid Rate (%) Quantity Allocation A 0.09 10 10 C 0.10 10 10 B 0.11 15 15 D 0.12 20 20 J 0.13 10 8 E 0.14 30 0 F 0.14 15 0 G 0.14 25 0 I 0.15 35 0 H 0.16 10 0 Total 180 63 Now we see that bidders A, C, B, and D are the lowest four bidders and collectively want bills amounting to$55 billion, so they get their requested amounts in full. Bidder J is next, and gets the remaining $8 billion which is somewhat less than the requested amount. In the actual auction shown in Figure 4, those who bid exactly the market clearing rate received about 81% of their demand, as indicated on the line ‘Allotted at High’. The market clearing bid comes from this bidder, and is equal to 0.13%. Once this rate is determined, it is offered to all successful bidders, regardless of what they would have been willing to accept. Those bidding more than this rate get no bills; they are asking for an interest rate that is too high. Treasury notes and bonds are a little more complicated: the promise being purchased is a stream of semiannual payments, and a larger payment on the maturity date. But the process of allocation is much the same: individuals bid for the securities, the market clearing bid is the interest rate at which demand and supply are equated, and those with this bid or lower get the securities. ### Question 2 Choose the correct answer(s) Use the information provided in the Treasury auction section to select all of the statements below that are correct. • Bidder A and Bidder C will receive the same payment after 13 weeks. • At the end of 13 weeks, Bidder B will get back$15 billion plus interest calculated at an annual rate of 0.11%.
• Bidder G did not have a successful bid, and therefore, will not get any treasury bills in this auction.
• Bidder B is willing to pay 0.11% in interest to buy $15 billion worth of bonds. • Bidder A and Bidder C both purchased$10 billion in securities at the market clearing rate of 0.13%. Their payments after 13 weeks will, therefore, be the same.
• Although Bidder B’s bid rate was 0.11%, the market clearing rate is 0.13%. Therefore, at the end of 13 weeks, Bidder B will get back $15 billion plus interest calculated at an annual rate of 0.13%. • Bidder G’s bid rate of 0.14% was above the market clearing rate of 0.13%. Bidder G, therefore, will not get any treasuries in this auction. • The bid rate is not what the bidder is willing to pay, it is rather the interest they will accept in exchange for loaning money to the treasury. Figure 5 shows the ownership distribution of treasuries in June 2020. Foreign investors hold approximately 29% of the US debt, with Japan and China having the most significant holdings. The Fed and other government accounts such as the Social Security Trust Fund hold about 36%. Much of the rest is owned by private investors in the US, either directly or indirectly through mutual funds and pension funds. Depository institutions such as banks, and state and local governments also have significant treasury holdings. About 11% of the debt is held by the Federal Reserve. In fact, this figure underestimates the role of the Fed in the market for treasuries, for reasons that we consider next. ## The Federal Reserve System inflation An increase in the general price level in the economy. Usually measured over a year. See also: deflation, disinflation. While central banks around the world differ in their precise specific functions and objectives, in most advanced economies, central banks are charged with promoting price stability, managing economic fluctuations, and averting financial crises. That is, they pursue the goals of low and stable inflation, steady growth of the nation’s output, and stability of the nation’s financial infrastructure. They are often politically independent from the rest of the government; this is certainly the case in the United States. In times of crisis, however, there can be close coordination between the Treasury and the Fed, which is permitted under the ‘unusual and exigent circumstances’ clause of the Federal Reserve Act. We shall consider crisis conditions at a later stage, but begin with a look at monetary policy in ordinary circumstances. In normal times, most central banks set policy interest rates to target inflation and unemployment. By influencing interest rates, they can control the cost of borrowing and lending and hence the level of aggregate demand in the economy, which affects unemployment and inflation. Such actions taken by central banks to achieve macroeconomic goals fall under the umbrella of conventional monetary policy. Federal Reserve System The central bank system of the United States. Source: Federal Reserve Bank of St. Louis Education Glossary. Federal Open Market Committee (FOMC) The main monetary policymaking body of the Federal Reserve System. A Committee consists of 12 voting members; the 7 members of the Board of Governors; the president of the Federal Reserve Bank of New York; and, on a rotating basis, the 4 presidents of other Reserve Banks. In the United States, the role of the central bank is performed by the Federal Reserve System. As the name suggests, this is a system of institutions, consisting of: The Board of Governors, 12 Federal Regional Reserve Banks, and the Federal Open Market Committee (FOMC). The Board of Governors, based in Washington D.C., is an independent agency of the federal government which provides guidance to the entire System and oversees the 12 regional Federal Reserve Banks. Regional Reserve Banks are responsible for the implementation of monetary policy, and regulation and supervision of financial institutions. Finally, the Federal Open Market Committee (FOMC) sets monetary policy in line with its mandate from Congress to promote maximum employment, stable prices, and moderate long-term interest rates in the United States. The Federal Reserve conducts monetary policy by targeting a key policy interest rate, the federal funds rate. Changes in the federal funds rate are associated with changes in the interest rates that banks charge households and businesses. As a result, during downturns, provided that inflation is low, the Fed can stimulate the economy by lowering the federal funds rate. Prior to 2008, this was done through open market operations, which involved active participation in the secondary market for treasuries. Since then, it has been done through setting the interest rate on commercial bank deposits (reserves) held at the Fed, which now vastly exceed required holdings. We describe both approaches here since it is entirely possible that at some point in the future there will be a return to open market operations as the primary channel through which monetary policy operates. To see how open market operations work, we start with a simplified version of the Fed’s balance sheet. A balance sheet is a financial statement that summarizes the assets and liabilities of an organization at any specific point in time. In any balance sheet, the asset side includes the sum of what the institution owns, and the liability side summarizes what it owes to others. base money Cash held by households, firms, and banks, and the balances held by commercial banks in their accounts at the central bank, known as reserves. Also known as: high-powered money. Figure 6a shows a simplified balance sheet for the Federal Reserve. The most important assets are debt securities, specifically government treasuries such as bills and bonds. The liability side of the Fed balance sheet shows currency in circulation and reserves, where the latter quantity refers to deposits held at the Fed by the nation’s commercial banks. Taken together, currency and reserves are referred to as base money. Assets Liabilities Securities (incl. treasuries) 4,106 Currency 1,759 Gold 11 Reserves 2,027 Other assets 56 Other liabilities 349 Total assets 4,173 Total liabilities 4,135 Net Worth (Equity) 39 Figure 6a Simplified balance sheet of the Federal Reserve in 2019 (USD billions). reserve requirement The amount of funds that a bank must hold by law at the Federal Reserve. It is expressed as a ratio of bank reserves to checkable deposits. excess reserves The amount of funds held by a bank at the Federal Reserve Bank in excess of its reserve requirement. To ensure financial stability and protect banks from panic-induced withdrawals, commercial bank deposits (up to a maximum amount, currently$250,000) are protected by deposit insurance, which is ultimately guaranteed by the US government. In return, the Federal Reserve regulates the banking sector. Specifically, it requires all banks to hold part of their funds in the form of reserves placed at the central bank. Until recently, commercial banks in the US were required to hold at least 10% of the value of their deposits as reserves, but in March 2020 the Fed abolished this requirement lowering required reserves to zero. In addition to these mandatory minimum reserve requirements, banks can also hold excess reserves at the Fed.

Assets   Liabilities
Cash and deposits at banks & Fed 264 Deposits 1,562
Fed funds sold and reverse repo lending 249 Federal funds purchased and repo 184
Loans 947 Short-term borrowing 41
Treasuries and other trading assets 411 Long-term borrowing 291
Investment securities 398 Trading liabilities 119
Other assets 419 Other liabilities 228
Total assets 2,687 Total liabilities 2,426

Net worth (equity) 261

Figure 6b Simplified balance sheet of JPMorgan Chase in 2019 (USD billions).

Figure 6b illustrates a simplified balance sheet for one of the largest banking institutions in the United States, JPMorgan Chase. Banks are important financial intermediaries that collect deposits and issue loans to firms and households. As a result, deposits serve as JPMorgan’s liabilities, and loans are the bank’s assets. Like the Federal Reserve, JPMorgan also holds treasuries (along with other securities).

bank money
Money in the form of bank deposits created by commercial banks when they extend credit to firms and households.

Importantly, JPMorgan is required to hold reserves at the Fed. These reserves appear in the first item of the asset side of the balance sheet (Cash and deposits at banks & Fed). As discussed in The Economy, banks create money through the process of lending. The loans appear on the asset side of the balance sheet, and the deposits, or bank money, on the liability side. As is clear from the balance sheet, bank money vastly exceeds base money in this balance sheet, and for commercial banks more generally.

fed funds market
The market where banks lend and borrow reserves on an overnight basis.
fed funds rate
The overnight interest rate determined by the equilibrium in the fed funds market. This interest rate is also the key monetary policy rate in the US.

Commercial banks must meet their reserve requirements on a daily basis. To make sure that each bank holds sufficient reserves, banks borrow from one another on the interbank market. In the United States, the market for reserves is called the fed funds market. At the end of each day, banks with excess reserves can lend to banks with a shortage of reserves. These loans are overnight and unsecured (borrowing banks do not need to provide any collateral for the loan). The interest rate on the fed funds market is called the fed funds rate.

Figure 7 shows the evolution of the fed funds rate since 1982. Prior to 2009, the Fed had a target rate, and after that, a target range with upper and lower limits. Notice in particular the period after the global financial crisis when the lower limit for this rate reached zero, and remained at or close to this for several years. When interest rates in the economy get this low, the Fed loses the ability to meet its mandate by further reductions in rates and is forced to turn to alternative policy levers, as we discussed.

Note that the rate of interest that the government pays on treasury bills, as determined through auction, cannot rise significantly above the fed funds rate. Otherwise, a bank with excess reserves will prefer to buy short-term treasuries rather than lend in the interbank market. Similarly, the rate on notes and bonds cannot rise too far above the fed funds rate, otherwise there will be strong incentives to bid in these markets too. But long-term securities are imperfect substitutes for bills and overnight lending, so some deviation in rates can and does occur.

The Federal Reserve closely monitors conditions in the fed funds market. During regular Federal Open Market Committee (FOMC) meetings, the Fed sets the target rate for the fed funds rate in order to affect bank lending, inflation, and the economy more broadly. The fed funds target rate is the key policy rate of the US central bank and the main tool of monetary policy. In the next section, we explore how exactly this transmission mechanism works.

### Question 3 Choose the correct answer(s)

In Figure 6a, base money is equal to which of the following?

• $4,135 billion •$4,117 billion
• $3,786 billion • not enough information to say • Base money is not the same as total liabilities. • Base money is not the combined total of items on the asset side of the FEDs balance sheet. • Base money is equal to currency plus reserves. • There is sufficient information in Figure 6a to answer this question. ## Open market operations Prior to 2008, the Fed implemented monetary policy by conducting open market operations. That is, the central bank decided on a target for the fed funds rate based on its judgment about aggregate demand in relation to its mandate, and adjusted the purchase or sale of treasuries to meet this target. expansionary open market operation The purchase of government securities in the open market by the Federal Reserve. This action is taken to decrease interest rates in the economy. contractionary open market operation The sale of government securities in the open market by the Federal Reserve. This action is taken to increase interest rates in the economy. If the Fed chooses to conduct expansionary open market operations, it lowers interest rates by purchasing treasuries on the open market. For instance, if it purchases treasuries from banks, it deposits reserves to their accounts at the Fed Banks, and therefore ends up holding more reserves (base money). The increased supply of reserves lowers rates in the fed funds market and allows banks to lower the rates they charge on loans to businesses and households, including mortgage loans. Instead, if the Fed chooses to increase interest rates, it sells treasuries, and hence runs a contractionary open market operation. The reduced supply of reserves raises rates in the fed funds market, and this is passed on to borrowers through higher rates on loans. Expansionary open market operations work well under normal conditions but can fail to be effective if interest rates are already close to zero (and therefore cannot be pushed down further). In fact, this condition has held for much of the period since the global financial crisis of 2008, so the Fed has shifted to an alternative mechanism for influencing the fed funds rate—by paying and adjusting interest rates on reserves held at the Fed by commercial banks. ### Question 4 Choose the correct answer(s) Under traditional monetary policy, using open market operations, what would the Fed do in order to lower interest rates, increase loanable funds, and stimulate the economy? • purchase treasuries on the open market • sell treasuries on the open market • By purchasing treasuries on the open market, the Fed would be conducting an expansionary policy that would lower interest rates, increase loanable funds, and stimulate the economy. • Selling treasuries on the open market (a contractionary policy) would have the opposite effects of what is described in the question. ## A new monetary policy mechanism Prior to 2008, banks did not receive interest on deposits held at the Fed, so excess reserves were lent out through the fed funds market, or used to buy assets, including treasuries. But this situation changed dramatically during the crisis, as can be seen in Figure 8. The Fed began to pay banks for excess reserves held in their accounts, and the banks, in turn, chose to maintain substantial deposits at the Fed, instead of using the surplus to buy assets on the open market. interest rate on excess reserves (IOER) The interest paid on funds that are above the reserve requirement. IOER is determined by the Federal Reserve and it is used as an additional tool for the conduct of monetary policy. With interest rates on excess reserves, the Fed had a new monetary policy tool that could be used to affect the fed funds rate, and through that the entire range of rates in the economy. If the fed funds rate fell below the interest rate on reserves, banks would deposit excess reserves in their Fed accounts instead of lending them in the interbank market, and the reduced supply would raise the fed funds rate. Similarly, if the fed funds rate rose above the interest rate on reserves, banks would withdraw excess reserves from their Fed accounts and lend them in the fed funds market. In this case, the increased supply of money in the fed funds market would bring the fed funds rate down. Through this effect, the two rates track each other very closely. For similar reasons, interest rates in the market for treasuries would be anchored by the fed funds rate. If treasury bills were offering higher interest rates, banks could borrow in the fed funds market (or withdraw reserves from Fed accounts) to buy treasuries on the open market, or bid for them at auction. With the Fed targeting this key interest rate, the rate of treasury bills is pinned down, even when government borrowing needs rise. As a result, a surge in the deficit need not result in costlier borrowing for the government. This is all true provided that the Fed does not begin to fear inflation. Were it to do so, it would raise its target for the fed funds rate, thus raising the cost of borrowing for households, firms, and the Treasury itself. Deficits can result in higher interest rates if they lead to increased fears of inflation. And this is unlikely in crisis conditions when unemployment is high and aggregate demand low. Expansionary monetary policy works by lowering the interest rates banks charge on loans to households and businesses, which can stimulate borrowing and aggregate expenditure. This works well if rates can indeed be lowered, and demand for borrowing is responsive to the lower rates. In crisis conditions, neither of these conditions may hold: interest rates may already be close to zero, or lowering them may do little to stimulate borrowing. In this case, the Fed may engage in unconventional policies: buying treasuries with longer maturities, or other assets in the economy. We consider this next. ### Question 5 Choose the correct answer(s) Use Figure 8 and the information you have just read to select all of the correct statements below: • Prior to the 2007–2008 global financial crisis, excess reserves held by banks never exceeded$40 billion.
• In May of 2020, the value of excess reserves held by banks exceeded $3.2 trillion. • The amount of excess reserves held by banks increased dramatically from 2008 onwards because the Fed increased its reserve requirements. • The amount of excess reserves held by banks increased dramatically from 2008 onwards because the Fed introduced a new policy where they began paying and adjusting interest on excess reserves instead of relying primarily on open market operations to change interest rates. • Prior to the 2007–2008 global financial crisis, excess reserves never exceeded$40 billion in any week.
• In the week ending 27 May 2020 excess reserves were $3.252 trillion. • It was not changes in the reserve requirement but rather a new policy of paying interest on excess reserves that contributed to the dramatic increase observable in Figure 8. • A new policy of paying and adjusting interest on excess resulted in the increase in excess reserves. ## The Fed’s role in a crisis Section 13(3) of the Federal Reserve Act allows for measures under ‘unusual and exigent circumstances’ that involve lending to nonbanks, including municipalities and businesses, as well as purchases of a broad range of assets. This power was aggressively exercised during the global financial crisis of 2008, and again in response to the COVID-19 pandemic in 2020. Figure 9 shows the evolution of the asset side of the Fed balance sheet since 2003. Prior to the global financial crisis, treasuries were the only significant class of asset held, and holdings of treasuries were relatively stable. As a reaction to the 2008 crisis, the Fed sharply increased its purchases of treasuries, and also began to buy large quantities of mortgage-backed securities guaranteed by governmental agencies. As a result, the size of the balance sheet increased significantly, in a manner that was not reversed after the crisis. A further sharp increase occurred as the economic effects of COVID-19 began to be felt, and this process remains ongoing. liquidity Ease of buying or selling a financial asset at a predictable price. While Figure 9 shows assets purchased outright by the Fed, it does not reveal a number of aggressive lending actions that were conducted through newly created liquidity facilities that channeled funding directly to businesses and municipalities. These appear on the balance sheets as loans, with amounts shown in Figure 10. credit The granting of money or something else of value in exchange for a promise of future repayment. Source: Federal Reserve Bank of St. Louis Education Glossary. Figure 10 adds together loans made by the Fed to financial and non-financial institutions, including state and local governments, through the creation of so-called facilities designed specifically for this purpose. Some of these loans, for instance to businesses that go bankrupt, will never be repaid. In this case, the Treasury would have to cover the losses of the Fed. During the 2008 global financial crisis, the facilities were used primarily to channel funding to financial institutions to maintain liquidity. Currently, in the face of the pandemic, the goal is to provide credit to cities, states, and businesses whose revenues have fallen sharply. These unconventional programs are temporary but can be large, with a$100 billion in outstanding loans at the highest point in 2020 to date. Alongside Congress and the Treasury, the Federal Reserve has been trying to use its powers ‘forcefully, proactively, and aggressively’.

Despite these efforts, the American economy contracted by about 33% (at an annual rate) in the second quarter of 2020, and the unemployment rate is in double digits, higher than at any point since the Great Depression. The economic calamity that we would have faced in the absence of such aggressive intervention is simply unfathomable.

### Exercise 2 The Fed’s role in a crisis

1. Have a look at the Fed’s asset purchasing behavior using the information in Figure 9 as a guide. How do the types of assets and the speed of purchases differ as a reaction to the 2008 global financial crisis and the 2020 COVID-19 pandemic?
2. Discuss why, in an emergency situation, the Fed must step in and use liquidity and credit facilities to uphold the economy.

## Conclusion

In closing, let us return to some of the questions posed in this insight, and provide an overview of the answers.

### Who lends money to the US government, and on what terms?

Lenders are individuals and institutions worldwide, but the terms of lending are largely determined by the interest rate targets of the Fed. The rate of interest on short-term treasury bills cannot deviate significantly from the fed funds rate. The rates on longer term notes and bonds can differ from this, but again there are limits to the divergence, since people can borrow at one maturity to lend at another if interest rate differences get too large.

### How did Congress know that funding for the CARES Act would be forthcoming as needed?

Congress knew that the Fed would hold interest rates low to fulfil its mandate, with unemployment high and inflation low. Given this, treasuries could be issued at low rates in the primary market. Banks could borrow in the fed funds market or use their excess reserves to bid for treasuries and make a profit even at relatively low rates.

### Is there a limit on how much the government can borrow?

Although there is a statutory limit in the United States called the debt ceiling, this is generally raised by Congress whenever expenditure needs demand it. Aside from this, there is no fixed limit, since the Fed can issue base money without bound. However, the government cannot force the Fed to buy treasuries, and the failure of a Treasury auction cannot be ruled out. If the Fed chooses to raise interest rates, fearing inflation, for instance, the interest obligations of the government can become unsustainable.

### Can we be certain that the debt will be repaid as it comes due?

As long as the government can continue to borrow to repay debt as it matures, there is a negligible risk of default. But if Congress fails to reach an agreement on raising the debt ceiling or the Fed decides not to keep interest rates low enough to keep debt payment sustainable, the possibility of missed payments cannot be ruled out entirely.

### Final thoughts

The crisis faced by the US economy in 2020 will not be its last, and Congress, the Treasury and the Fed will doubtless be called upon to take aggressive emergency actions again. They have the experience and ammunition to do so. And just as we can learn about normal human physiology through a study of individuals suffering illness, we can learn about the normal functioning of an economy by closely observing economic institutions under crisis conditions. And as we have seen, the mechanisms of government finance revealed by this examination are less mysterious than they may first appear.

## Acknowledgements

The authors thank the Omidyar Network and the Hewlett Foundation for financial support, and the Editorial Board of CORE Economics Education, especially Wendy Carlin, for extremely valuable comments and suggestions. The authors also thank Andrew Kosenko for his valuable feedback.