The Federal Reserve System

Ch 13 - Pg 254-258Ch 15 - All

Chap 13, 15 Vocabulary Monetary policy Open-market operations (OMO) Reserve ratio Discount rate Easy money policy Tight money policy

Velocity of money Federal Funds Rate Prime interest rate Federal Reserve System Board of Governors FOMC Federal Reserve Banks

Monetary Policy Central banks (The Fed, Bank of

Japan, ECB, Bank of England…) manage monetary policies. Their task is to promote full employment, maintain price stability, and encourage long-run economic through control of Monetary Policy, or by managing the money supply and interest rates.

Independence of the Central Banks

Studies have shown that the more independent (less government intervention) a Central Bank is, then the better the bank is able to control inflation.

The Federal Reserve is an independent government agency.

The Federal Reserve System The Federal Reserve System was created in 1913 following a series of financial panics in the United States. Congress created the Federal Reserve to be a central bank, serving as a banker’s bank.

The Federal Reserve Act of 1913 created the “Fed”

One of the Fed’s primary jobs was to serve as a lender of last resort—lending funds to banks that suffered from panic runs.

The Structure of the Federal Reserve The United States was divided into 12 Federal

Reserve districts, each of which has a Federal Reserve Bank.

The Structure of the Federal Reserve (Continued)

The structure of the Federal Reserve today consists of three distinct subgroups:• Federal Reserve District Banks (12)

El Paso is in the 11th Federal Reserve District (the Dallas Fed). El Paso has one of the three branch banks managed by the Dallas Federal Reserve Bank.

• The Board of Governors (7 members)• The Federal Open Market Committee (the

most important policy making component of the Federal Reserve)

The Structure of the Federal Reserve (Continued)

The Structure of the Federal Reserve The matter of central bank independence from

political authorities is a lively debate among economists.

Monetary discipline (policy) is important for the performance of the economy. Countries with greater central independence tend to have lower inflation rates.

The Federal Reserve is a “quasi public” banking system

• The district banks are privately owned but “publicly controlled”

Owned by member banks (banks within the district who have elected to join the Fed)

Controlled by Board of Governors

The Structure of the Federal Reserve The Board of Governors of the Federal

Reserve is the true seat of power over the monetary system.

Headquartered in Washington, DC, the 7 members of the board are appointed for staggered 14-year terms by the President and must be confirmed by the Senate.

The chairperson serves a four-year term and is the principal spokesperson for monetary policy in the U.S. What he says is carefully observed, or anticipated, by financial markets. A tool of monetary policy is that of “moral suasion”.

The current Chairman is Ben Bernanke

The Structure of the Federal Reserve

The Federal Open Market Committee (FOMC) is a 12-person board consisting of the 7 members of the Board of Governors, the president of the New York Federal Reserve Bank, plus the presidents of four other regional Federal Reserve Banks. These four presidents serve on a rotating basis.

The FOMC meets 8 times a year to determine appropriate monetary policy.

The FOMC is the major policy-making group within the Federal Reserve system.

Functions of the Federal Reserve System

Control the Money Supply through open market operations (buying and selling government securities)

Supply the economy with paper money. Provide check-clearing services. Hold depository institutions’ reserves

• It is the banker’s bank. All banking institutions MUST maintain an account at the Federal Reserve District Bank.

• A crucial function to managing the money supply

Functions of The Federal Reserve System

Supervise Member Banks. Serve as the government’s

banker. Serve as the lender of last resort. Serve as a fiscal agent for the

Treasury. Holds the Government’s “checking account”.

Monetary Policy Chap. 15

Tools For Controlling the Money Supply 1. Open Market Operations: Buying and Selling U.S.

Government Securities in the Financial Markets. This is the # 1 tool the Fed relies upon to manage the money supply.

2. Sets the Reserve Requirement: The reserves which banks must maintain either in their vaults or on deposit at their district’s Federal Reserve Bank

3. Sets the Discount Rate: The rate at which member banks can borrow from the Fed.

4. ? Moral Suasion: Speeches and comments by Fed officials that attempt to influence the economy.

5. During the last financial crisis, the Fed used Quantative Easing (QE) to increase the money supply. They bought outstanding government bonds.

Which Tool Does the Fed Prefer to Use?

The Fed prefers Open Market Operations because:

• Open market operations are flexible• Open market operations can be reversed• Open market operations can be

implemented quickly• Open market operations are used daily by

the New York Fed bank.

How Open Market Purchases Affect the Money Supply

Assume Fed purchases securities from a bank. The Fed receives the securities from a bank,

and the bank’s excess reserves increase by the amount of the purchase (Reserves = Bank deposits at the Fed + Vault Cash).

When the banks have a reserve increase and no other bank has a similar decline, the money supply expands through a process of increased loans and checkable deposits.

“Buying Bonds = Bigger Bucks”

How Open Market Sales Affect the Money Supply

Assume the Fed sells securities to a bank.

To pay for the securities, the Fed takes excess reserves from the bank.

Because of the decrease in the bank’s reserves, the bank reduces potential loans, which reduces the potential volume of checkable deposits and the money supply.

“Selling Bonds = Smaller Bucks”

Open Market Operations

The Required-Reserve Ratio

The Fed can also influence the money supply by changing the required-reserve ratio.

An increase in the required-reserve ratio leads to a decrease in the money supply

A decrease in the required-reserve ratio leads to an increase in the money supply.

This tool is infrequently used by the Fed as it cause a disruption to daily banking operations. For example, if the Fed raised the reserve requirement, banks may need to call in loans to meet their reserve requirement.

The Discount Rate A bank can borrow from the Fed at

the Discount Rate. It is a “collateralized” loan (i.e. bank must provide collateral – bonds)

Discount Rate: The interest rate a bank pays for a loan from the Fed. When a bank borrows money from the Fed, the

potential money supply increases because its reserves increase while the reserves of no other

bank decrease.

The Federal Funds Rate The interest rate refers to the

Federal Funds Rate set by the FOMC

The Fed Funds rate is the most important interest rate as it influences many other interest rates such as the Prime Rate.

The prime rate is what commercial banks use to lend to their best customers; also it affects other lending rates.

Fed Funds Rate (contd) The Fed Funds rate defined: It is the rate at

which banks borrow overnight from other banks to meet their reserve requirements should their reserves fall short.

The Fed Funds Rate serves as a “target rate” to regulate the money supply. On a daily basis the Fed Funds Rate may increase or decrease slightly as demands for money increase or decrease in our economy. For example, a natural disaster may increase the demand for money.

Fed Funds Rate• http://www.dallasfed.org/data/data/rmfe

dfun.htm Prime Rate

• http://www.dallasfed.org/data/data/rmbkprim.htm

Why do banks need overnight loans?

Banks are like any other business in that they seek to maximize profits. Banks make a profit by loaning out as much of their excess reserves as possible and charging interest to the borrower. If, in the course of business, they have loaned out all excess reserves and do not have enough money to satisfy the required reserve ratio, then they must either borrow from the Fed’s discount window, or most likely borrow from each other in the Fed Funds market at the Federal Funds Rate.

Fed Actions to Counter Inflation

Tight (or Contractionary) Money Policy• To counter inflation (inflationary Gap on

the SRAS/AD graph)• Fed attempts to reduce Aggregate

Demand Contract money supply

•Sell bonds, raise reserve requirement, raise discount rate

Inflationary Gap An inflationary gap exists when equilibrium

occurs beyond full employment output.

GDPR

PL

AD

SRASLRAS

YF

P

Y

Fed Actions to Counter a Recession

Easy (or Expansionary) Money Policy• To counter recession (Recessionary Gap)

or downturn of the economy. Expands money supply

• Fed attempts to increase Aggregate Demand

• Buy bonds, lower reserve requirement, lower discount rate

Recessionary Gap A recessionary gap exists when equilibrium

occurs below full employment output.

GDPR

PL

AD

SRASLRAS

YF

P

Y

Fed Monetary Tools & Their Effects on the Money Supply

Federal Reserve and Interest Rates

• An open market sale shifts the supply of money to the left and leads to higher interest rates.

An open market purchase shifts the supply of money to the right and leads to lower interest rates.

Interest Rates, Investment, and Output

Increase in GDP

Open market

purchase

Money supply

increases

Interest rates fall

Investment spending

rises

i%

i

QM

MS

MD

Q

i1

MS1

Q1

i%

IG

ID

I I1

i

i1

GDPR

PL

AD

SRASLRAS

YF

P

Y

AD1

P1

Graphing Expansionary

Monetary Policy

1. Money Supply Increases;2. Interest Rate Decreases,3. Investment Increases, AD & GDP Increases and Unemployment (Y) decreases.

How Monetary Policy Affects International Trade

International trade and movements of financial funds across countries are affected by interest rates and exchange rates.

The exchange rate is the rate at which one currency trades for another country’s currency.

A decrease in the value of a currency is called depreciation. An increase in the value of a currency is called appreciation.

We will see this topic again in Chapter 37. But remember the value is determined by the laws of supply and demand.

THE MARKET FOR CURRENCY

P

Q

D

SEXCHANGE

RATE: .97 CD = $1 USDC

anad

ian

$ p

rice

of U

.S. d

olla

r

Quantity of U.S. $

1.25

.97

.80

Can. $$depreciates

Can. $appreciates

S1

Q Q1

p1

pAs Interest rate decreases, money supply increases (S1) and the $ depreciates and C$ appreciates.

How Monetary Policy Affects International Trade

Lower interest rates brought on by the Fed will cause the dollar to depreciate. This will ultimately change the demand and supply of goods and services around the globe because it will make U.S. goods cheaper than foreign goods.

increase in net

exports

open market bond

purchase

increase in money

supply

fall in interest

rates

fall in exchang

e rate

increase in GDP

Monetary Policy Challenges for the Fed Stabilization policies are intended

to move the economy closer to full employment or potential output. In practice, however, it is very difficult to accomplish this goal.

Lags in monetary policy: Normally it takes approximately 18 months for interest rate changes to fully work their way through the economy.

Strengths/Weaknesses of Monetary Policy

Strengths• Speed and flexibility• “No” political pressures• Managing the money supply is the key to

managing the economy Weaknesses

• Fed cannot “force” loans. It is easier to slow inflation than correct a recession

• Velocity,or often we spend money may change• Change in interest rates may not affect

investment

Monetary PolicyRecession Inflation

Open Market Ops. Fed buys bonds Fed sells bondsReserve Requirement Lower increaseDiscount Rate Lower raise

Remember, monetary policy does not affect Fiscal Policy; i.e. government spending and taxing. They should complement each other but the Fed is independent of the President and Congress and there have been instances when fiscal and monetary policies have moved in different directions.

The Financial Crisis of 2008 Subprime (remember the Prime Rate)

lending during the U.S. housing bubble of the mid-2000s spread through the financial system.

When the bubble burst, massive losses by banks and non-bank financial institutions led to widespread collapse in the financial system.

To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt.

The Financial Crisis of 2008 Because much of the crisis originated

in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector.

The 2008 Crisis and the Fed Fed officials believed that this change in standard

operating procedure was necessary to stave off an even more severe financial crisis.

Usually, the Fed invests only in U.S. government debt, which is considered a very safe asset; the same could not be said of many of the loans made during 2008.

Normally, the Federal Reserve holds almost no assets other than U.S. Treasury bills.

In response to the 2008 financial crisis, however, the Fed created an alphabet soup of special “facilities” to lend money to troubled financial institutions, leading to a dramatic shift in its balance sheet. For example, the Fed bought stock in General Motors to keep this company out of bankruptcy.