slide 1 of 61 modern principles: macroeconomics tyler cowen and alex tabarrok copyright © 2010...

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Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Chapter 14

The Federal Reserve System and Open Market

Operations

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Introduction• 2008: The worldwide financial system was

in a crisis and banks and other financial institutions wanted to borrow more than $2 trillion. What could be done?

• Studying this chapter we learn… What the Federal Reserve does and how it

does it. What is meant by the money supply. How the Fed is able to influence the money

supply. How the Fed has more influence over AD than

anyone else.

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What Is the Federal Reserve System?• As the Central Bank of the United States,

the Fed… Can issue and create money. Is a bank with two customers.

• It is the government’s bank. Maintains the bank account of the U.S.

Treasury. It manages government borrowing.

• Issuing, transferring, and redeeming of U.S. Treasury bonds, bill, and notes.

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What Is the Federal Reserve System?• A Bank with two Customers…(cont.)

It is the banker’s bank.• Banks keep their own accounts at the Fed.• Banks can borrow from the Fed.

• The Fed Also… Regulates other banks. Manages the nation’s payment system. Protects financial consumers with disclosure

regulations.

• Most important function: Regulating the U.S. money supply.

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The U.S. Money Supplies• Money is anything that is widely accepted

as a means of payment. The most important assets that serve as money

in the U.S. today are:

1. Currency: Paper bills and coins.

2. Total reserves held by banks at the Fed.

3. Checkable deposits: your checking or debit account.

4. Savings deposits, money market mutual funds, and small-time deposits.

The following figure shows the magnitude and proportions of these assets…

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The U.S. Money Supplies

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The U.S. Money Supplies• Money (cont.)

Let’s look at each of these.

1. Total reserves: All major banks have accounts at the Federal Reserve System. Can be easily converted into currency.

2. Currency: Almost $800 billion or $2,500 per person. A lot is held by people in other countries.

• Panama, Ecuador, and El Salvador use the U.S. dollar as their official currency.

• Dollars are held by others in unstable countries to protect their wealth.

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3. Checkable deposits—are deposits you can write checks on or can access with a debit card.

4. Savings accounts, money market mutual funds, small-time deposits. Not as liquid as the other means of

payment.• Each can be used to pay for goods and

services, but this requires a little extra effort.

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What is meant by a “liquid asset”?

• Definition—An asset that can be used for payments, or, quickly and without loss of value, be converted into an asset that can be used for payments.

The money supply can be defined in different ways depending on exactly what kinds of liquid assets are included.

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The three most important definitions of the money supply are:

1.The monetary base (MB): currency outstanding and total reserves at the Fed.

2.M1: currency outstanding and checkable deposits.

3.M2: M1 plus saving deposits, money market mutual funds, and small-time deposits.

These definitions correspond to an inverted pyramid of ever-expanding size shown in the next figure.

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The U.S. Money Supplies• The Money Pyramid

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The U.S. Money Supplies• Difficulty of Central Banking

The Fed has direct control only over the monetary base.

Uses control over MB to influence M1 and M2. Problems:

• M1 and M2 can shrink or grow independent of what the Fed does.

• Aggregate demand can shrink or grow for other reasons than changes in M1 and M2.

• Now we turn to how the Fed influences M1 and M2.

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CHECK YOURSELF

Define the monetary base. What is the amount of currency in

circulation compared to the amount of checkable deposits?

What control does the Fed have over currency? What control does the Fed have over checkable deposits?

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Fractional Reserve Banking, Reserve Ratio, Money Multiplier

• Fractional reserve banking—A system where banks do not have to keep all of their deposits on reserve. Causes the banking system to be able create

money “out of thin air”.

• The amount of money created depends on… The reserve ratio (RR)—the fraction of

deposits held on reserve:

Deposits of Value

Reserves of ValueRR =

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• Fractional reserve banking (cont.)• The reserve requirement is determined

primarily by how liquid banks wish to be.

• The Fed sets a minimum RR.The money multiplier (MM)—the amount

the money supply expands with each dollar increase in reserves:

RR

1MM =

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• Now let’s see how fractional reserve banking, RR, and MM all work together to create money. Imagine the Fed creates $1,000 of new

money by crediting your banking account with an additional $1,000. Total ↑M = $1,000.

If your bank’s RR is 10%, they will loan out $900 (90%) of your increased deposit.

Sam borrows the $900 and deposits it in his bank.

Total ↑MS = $1,900 ($1,000 + $900)

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• Money Creation Suppose Sam’s bank has the same RR (10%).

They will loan out $810 (90%) of his increased deposit.

Total ↑M = $2,710 ($1,000 + $900 + $810) The rippling process continues until the total

change in the money supply is given by:

Ultimate change in the money supply equals the original amount the Fed injected into the economy ($1,000) times the money multiplier.

$10,00010$1,000MMReservesMS =×=×Δ=Δ

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CHECK YOURSELF

If the reserve ratio is 1/20, what percent of deposits is kept as reserves?

If the reserve ratio is 1/20, what is the money multiplier?

If the Fed increases bank reserves by $10,000 and the banking system has a reserve ratio of 1/20, what is the change in the money supply?

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How the Fed Controls the Money Supply• Three Major Tools the Fed Uses to Control

the Money Supply1. Open market operations: buying and selling

of U.S. government bonds on the open market.

2. Discount rate lending and the term auction facility: Federal Reserve lending to banks and other financial institutions.

3. Required reserves and payment of interest on reserves: Changing the minimum RR; paying interest on any reserves held by banks at the Fed.

Let’s look at each of these in turn…

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How the Fed Controls the Money Supply1. Open Market Operations

When the Fed buys anything, even apples, reserves increase.

Because government bonds can be stored and shipped electronically, and the market for government bonds is liquid and deep, the Fed can buy and sell billions of dollars worth of government bonds in a matter of minutes.

The Fed usually buys and sells short-term bonds called Treasury bills or T-bills (sometimes called Treasure securities or Treasuries).

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How the Fed Controls the Money Supply1. Open Market Operations (cont.)

If the Fed wants to increase the money supply, they will buy T-bills:

If the Fed wants to decrease the money supply, they will sell T-bills:

↓reserves of the buyer

With fewer reserves, bank↓ loans

MS↓ as themoney creationprocess ripplesin reverse throughthe economy

Fed sellsT-bills

Fed electronically↑reserves of theseller

With more reserves, bank↑ loans

MS↑ as themoney creationprocess ripplesthrough the economy

To pay forthe T-bills

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Recall: the change in the money supply is given by:

A complicating factor:

• When banks are eager to lend, they keep reserves low, and MM will be high. Changes in MB will have a larger effect on

the money supply. When banks are reluctant to lend, they hold

reserves high, and MM will be low.

• Changes in MB will have a smaller effect.

RR

1MM whereMM,ReservesMS =×Δ=Δ

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Summary

a) The Fed can increase or decrease the money supply by buying and selling government bonds.

b) The increase in reserves boosts the money supply through a multiplier process.

c) The size of the multiplier is not fixed but depends on how much of their assets banks want to hold as reserves.

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Open market operations and interest rates.• Buying and selling government bonds

rather than apples has another advantage.• Not only the monetary base changes but

interest rates change as well:

↓Demand for bonds

↓Price ofbonds

↑Interest rates

Fed sellsbonds

↑Demand for bonds

↑Price ofbonds

↓Interest rates

Fed buysbonds

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Buying bonds stimulates the economy in two ways:

• Increased money supply → increased supply of loans.

• Lower interest rates → increased demand for loans.

The Fed doesn’t “set” interest rates. Interest rates are determined by the

supply and demand for loans. The Fed works through supply and

demand.

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The Fed controls a real rate of interest only in the short run.• Why is this important?

Lending and borrowing decisions depend on the real interest rate.

The Fed has greatest influence over the short-term interest rate called the Federal Funds rate.• Federal Funds rate—is the overnight

lending rate that banks charge each other.

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Monetary policy is usually conducted in terms of the Federal Funds rate.• It is a convenient signal of monetary policy.• It responds quickly to actions by the Fed.• It can be monitored on a day-to-day basis.• M1 and M2 are more difficult to measure

and monitor. • Finally, don’t forget that the Fed controls the

Federal Funds rate through its control of the monetary base.

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How the Fed Controls the Money Supply2. Discount Rate Lending and the Term

Auction Facility Discount Rate Lending

• Because the Fed can create money at will, it is the lender of last resort.

• Discount rate: the interest rate the Fed charges banks for loans.

• These loans increase the monetary base. • When the banks repay the loans the

monetary base shrinks back.

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Auction Facility (cont.) Market traders read the discount rate as a

signal of the Fed’s willingness to allow the money supply to increase.

The discount window is intended to help banks that are in financial stress.• Banks in good health usually borrow from

other banks. • There is a stigma to borrowing from the Fed.

The very existence of the discount window makes private bank loans work more smoothly.

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Auction Facility (cont.) Two financial problems banks can get into:

1. Solvency crisis: when the value of the bank’s loans falls and the bank can no longer pay back its depositors. To avoid this, banks hold “capital”.

• “capital” in this sense—means assets in relatively safe forms (e.g., T-bills).

• Regulations impose capital requirements.

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Auction Facility (cont.) 2008—the U.S. treasury acted to

“recapitalize” parts of the U.S. banking system by investing additional money into these banks.

• While not formally “monetary policy” this action has many of the same effects as monetary policy.

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Auction Facility (cont.)2. Liquidity crisis: When enough depositors

want their money back at the same time. Banks may be solvent with lots of good

loans, but they can’t meet depositors demands at the moment.

Fear and panic can turn solvent banks into illiquid banks.

To avoid these crises, the FDIC was created during the Great Depression.

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How the Fed Controls the Money Supply2.Discount Rate Lending and the Term

Auction Facility (cont.) What if a bank is insolvent?

• Usually, depositors are paid off by the FDIC and the bank is closed.

• An exception to this occurred in 2008. Because too many banks might be

insolvent for the economy to survive widespread bank closures, the treasury decided to offer aid to banks instead.

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Auction Facility (cont.) Financial Crisis of 2007-2008: the Fed went

beyond its traditional role.

1. The Term Auction Facility Fed auctioned a fixed quantity of

reserves until the interest rate was low enough that banks would borrow the money.

2. The Fed also… Reduced collateral standards for loans. Stressed that there would be no stigma.

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How the Fed Controls the Money Supply2.Discount Rate Lending and the Term

Auction Facility (cont.) The amount of extra lending by the Fed during

the financial crisis was staggering.• December 2007 – May 2008 ≈ $475 billion.• December 2007 – December 2008 over $2

trillion (over $6,000 for every person in the U.S.)

Final note: if the loans are not paid back, U.S. taxpayers will have to bear the losses.

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How the Fed Controls the Money Supply3. Required Reserves and Payment of

Interest on Reserves Spring 2009 minimum reserve requirements

were:• 0% for liabilities under $10.3 million.• 3% for liabilities under $44.4 million.• 10% for liabilities greater than $44.4 million.

How it works:• ↑reserve requirement → ↓ lending → ↓ MS • ↓reserve requirement → ↑ lending → ↑ MS

Banks don’t have to lend → business demands are a more important determinant of RR.

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How the Fed Controls the Money Supply3. Required Reserves and Payment of

Interest on Reserves (cont.) As of 2008, it has another tool at its disposal:

In the past, reserves earned no interest. Now the Fed varies the interest rate to

help achieve goals of monetary policy.• How it works:

Banks ↓reserves↑loans

↑ MSFed ↓ interest rate on reserves

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CHECK YOURSELF

Underline the correct answers.

The Fed wants to lower interest rates: It does so by (buying/selling) bonds in an open market operation. By doing this, the Fed (adds/subtracts) reserves and through the multiplier process (increases/decreases) the money supply.

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The Federal Reserve and Systemic Risk• Systemic Risk: the risk that the failure of

one financial institution can bring down other institutions as well. March 2008: the Fed made extensive loan

guarantees to JP Morgan which was purchasing a failing company, Bear Sterns.• Bear Sterns was an “investment bank” which

is regulated by the Securities and Exchange commission, not the Fed.

• Fed’s rationale: Bear Sterns owed a lot of money to banks, and its failure would cause those banks to fail as well.

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The Federal Reserve and Systemic Risk• Preventing the spread of systemic risk is one

of the Fed’s most important tasks. There is a problem with doing this…

• Whenever the Fed acts to limit systemic risk, it creates moral hazard. Moral hazard—The tendency for banks and

other financial institutions to take on too much risk, hoping that the Fed and regulators will bail them out.

Conclusion: Limiting systemic risk while checking moral hazard is a challenge.

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CHECK YOURSELF

If a large bank makes some bad lending mistakes, will the Fed always let the bank bear the brunt of its mistakes and go under? If not, what justification will the Fed use?

Consider the moral hazard that could arise if the Fed bailed out large banks. If you work at a large bank and lose a lot of money betting that oil prices would rise when they in fact fell, what incentive would you have to double your bet the next time?

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Revisiting Aggregate Demand and Monetary Policy

• The Fed uses the tools of monetary policy to influence aggregate demand (AD). Let’s see how this works. Suppose…

• The Fed wishes to increase aggregate demand.

• It chooses to do so by buying government bonds.

• Let’s illustrate this with our AD/AS diagram.

Fed Buysbonds

↑Money supply

↓interest rates↑ Spending (AD)

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InflationRate

()

Real GDPgrowth rate

SolowGrowthcurve

New SRAS(e = 7%)

Old SRAS(e = 2%)

a

b

c

2%

4%

7%

%01)M( AD =+v

5%)M( AD =+v

6%3%

Fed ↑ Money Supply→Short-run: a → b↑ AD → ↑ real growth

rate, ↑ Long-run: b → cSRAS shifts up

↑ ↓ real growth rate to Solow rate

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• Monetary Policy is Difficult Fed actions to increase the monetary base do

not increase aggregate demand by any guaranteed amount.• We don’t know exactly how much M1 and M2

will change.• We don’t know exactly by how much lower

interest rates will stimulate investment spending. The Fed has most influence over short-

term rates and investment is most affected by long-term rates.

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• Monetary Policy is Difficult (cont.) Monetary policy takes time to work and the lags

in response are variable.• Example: if the Fed takes an action today, its

effects might not be felt for 6 to 18 months• In the meantime, economic conditions may

have changed. Analysis is difficult. The Fed must assess:

a)Whether banks will lend out all of their new reserves or simply hold higher reserves.

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• Monetary Policy is Difficult (cont.) Analysis is difficult. The Fed must assess:

(cont.)

b) How quickly increases in the monetary base will translate into new bank loans and thus larger increases in M1 and M2?

c) Whether businesses want to borrow?

d) How low do short-term interest rates have to go to stimulate more investment borrowing?

e) If businesses do borrow, will they promptly hire labor and capital?

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CHECK YOURSELF

If money is neutral in the long run, why would the Fed want to increase the money supply in the short run?

How will fear about the economy entering a recession affect the disposition of banks to lend? How will this affect the Fed’s ability to shift aggregate demand in a recession?

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Who Controls the Fed?• The Board of Governors

Seven members appointed by the President and confirmed by the Senate for 14 year terms.• The chairperson of the Fed is appointed by

the president from among the members of the board for 4 year terms.

• The U.S. is divided into 12 regions with a Federal Reserve bank in each. Each is a non-profit bank with nine directors. Presidents of the regional banks participate on

the FOMC, the most important policy making body of the Fed.

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Who Controls the Fed?• Independence of the Fed

The structure of the Fed makes it one of the most independent agencies in the U.S. government.

Two different viewpoints:

1.The Fed has too much power not to be controlled by democratically elected politicians.

2.Without this independence, politicians including the President could order the Fed to boost the money supply just before an election.

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Who Controls the Fed?• Independence of the Fed (cont.)

Even with the current structure some Fed chairpersons have exercised less independence than others.• Before the 1972 election: President Nixon

asked Arthur Burns, chair of the Fed to stimulate the economy. Burns did stimulate the economy and Nixon

won in a landslide. As expected the economic gains were

temporary and inflation was too high for the rest of the decade.

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• The Federal Reserve is the government’s bank, the banker’s bank, and has the power to… Create money. Influence aggregate demand.

• It is important to know the varied definitions of the money supply and how they differ.

• The Fed controls the money supply by buying and selling government bonds in what are called open market operations.

Takeaway

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• Buying and selling bonds changes bank reserves which changes the money supply through a multiplier process of rippling loans and deposits.

• The final result is given by:

ΔMS = ΔReserves x MM

where MM is the money multiplier

• Fed’s influence over aggregate demand is subject to uncertainty in both impact and timing.

• When the Fed buys bonds, the interest rate falls and investment and consumption are stimulated.

Takeaway

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• When the Fed sells bonds, the interest rate rises and investment and consumption contract.

• For day to day operations, the Fed focuses its attention on the Federal Funds rate.

• The Fed has influence over real rates of interest only in the short run.

• The Fed serves as a “lender of last resort” for banks and for major financial institutions.

• Preventing “systemic risk”—or the spread of financial problems from one institution to another—is one of the Fed’s most important jobs.

Takeaway

Modern Principles: Macroeconomics

Tyler Cowen and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok

Chapter 14 Appendix:

The Money Market Multiplier Process in Detail

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• Suppose the Fed buys a government bond for $1,000 from a securities dealer with an account in the First National Bank. First National’s T-account looks like this:

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• First National decides to keep $100 and loans out the rest, $900. Their T-account now looks like this:

• Note: the ratio of reserves to deposits = $100/$1000so that RR = 0.1.

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• Suppose the borrower wrote a check to Luxury Vacations Inc. which has an account in the Second National Bank. Their T-account looks like this:

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• Suppose Second National Bank also want a reserve ratio of 0.1. They will keep $90 and loan out $810. Their T-account now looks like this:

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• Suppose the person who borrowed from Second National buys a computer and writes a check to Apple who deposits the check into their account at Third National Bank Their T-account looks like this:

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• Third National Bank, which wants the same reserve ratio, keeps $81 and loans out +$729. Their T-account now looks like this:

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Appendix: The Money Market Multiplier Process in Detail

• Let’s summarize what we have so far:

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• If you look at the last table carefully, you will realize the increase in deposits of : Second National Bank = $900 = $1,000 x 0.9. Third National Bank = $810 = $1,000 x 0.92

• If you guessed that the increase in deposits of a Fourth National Bank would be: $729 = $1,000 x 0.93 you are correct! The total process of expanding deposits looks like

this:

This is a geometric series that converges to:

)9090909010001 32 n.... ...(,$ ++++×

101000$1.0

1000,1$

9.01

1000,1$ ×=×=

−×

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