Lecture 8 Chapter 10: Federal Reserve. Copyright c 2007 by The McGraw-Hill Companies, Inc. All...

Lecture 8

Chapter 10: Federal Reserve

Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

Money and Its Uses

Medium of ExchangeAn asset used in purchasing goods and

services Unit of Account

A basic measure of economic value Store of Value

An asset that serves as a means of holding wealth


Money and Its Uses

M1Sum of currency outstanding and balances

held in checking accounts M2

All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks


The Composition of Money in the U.S.

Money Supply, M1 (in billions)

Currency (in circulation)Demand depositsOther checkable depositsTraveler’s checks

Total M1

$664312309

8

$1,293

Money Supply, M2 (in billions)

M1Savings deposits a

Small time depositsMoney market mutual funds

Total M2

$1,2933,158

810796

$6,057

$1,293

$6,057

a Including money market deposit accounts. Source: http://www.federalreserve.gov.

The M1 and M2 Money Supply of the U.S –––––––––– (as of December 2003) ––––––––––


Components of M1 and M2,April 2005 (billions of dollars)

M1

Currency

Demand deposits

Other checkable deposits

Travelers’ checks

M2

M1

Savings deposits

Small-denomination time deposits

Money market mutual funds

1,354.6

704.6

318.5

324.0

7.5

6,469.7

1,354.6

3,544.3

866.2

704.6


Components of M1 and M2,Feb 2009 (billions of dollars)

M1

Currency

Demand deposits

Other checkable deposits

Travelers’ checks

M2

M1

Savings deposits

Small-denomination time deposits

Money market mutual funds

1,558.3

834.6

397.2

641.8

5.5

8,275.4

1,558.3

4,286.3

1,360.4

1,070.4


• The banking industry includes:• commercial banks, • savings and loans, and,• credit unions.

The Business of Banking

• Banks are profit-seeking institutions

• Banks play a central role in the capital market (loanable funds market):• They help to bring together people who

want to save for the future with those who want to borrow for current investment projects.


The Functions of Commercial Banking Institutions

Assets

Vault cash Reserves at the Fed Loans outstanding U.S. govt securities

Other securities Other assets

Total

Checking deposits Savings and time deposits Borrowings Other liabilities Net worth

Consolidated Balance Sheet of Commercial Banking InstitutionsYear-end 2003 (billions of $)

Liabilities

$ 25 9

4,399 1,105

752 1,001

$ 7,291

$ 485 4,117 1,480

679 530

$ 7,291

• Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities).

• Most of these deposits are invested and loaned out, providing interest income for the bank.

• Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.


The Functions of Commercial Banking Institutions

Assets

Non Interest Earning Other Securities Loans outstanding U.S. govt securities Trading AccountOther assets

Total

Checking deposits Savings and time deposits Borrowings Other liabilities Net worth (Capital Acct)

Consolidated Balance Sheet of Commercial Banking InstitutionsYear-end 2007 (billions of $)

Liabilities

$ 1,509 639 6,473

922633 901

$ 11,077

$ 695 4,026 4,755

465 1,136

$ 11,077

• Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities).

• Most of these deposits are invested and loaned out, providing interest income for the bank.

• Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.


• The U.S. banking system is a fractional reserve system; banks are required to maintain only a fraction of their assets as reserves against the deposits of their customers (required reserves).

• Vault cash and the deposits the bank holds with the Federal Reserve count as reserves.

• Excess reserves (actual reserves in excess of the legal requirement) can be used to extend new loans and make new investments.

• Under a fractional reserve system, an increase in deposits will provide the bank with excess reserves and place it in a position to extend additional loans, and thereby expand the money supply.

Fractional Reserve Banking


Bank

New cash deposits:

Actual Reserves New

Required Reserves

Potential demand deposits created byextending new loans

Initial deposit (bank A) Second stage (bank B) Third stage (bank C) Fourth stage (bank D) Fifth stage (bank E) Sixth stage (bank F) Seventh stage (bank G)

$1,000.00 $200.00 160.00

102.40 81.92 65.54 52.43

800.00 $800.00

512.00 128.00 640.00

640.00 512.00

409.60 409.60

327.68 327.68

262.14 262.14 209.71

Total $5,000.00 $1,000.00 $4,000.00

All others (other banks) 1,048.58 209.71 838.87

Creating Money from New Reserves

• When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.


How Banks Create Moneyby Extending Loans

• The lower the reserve requirement, the greater potential expansion in the money supply resulting from the creation of new reserves.

• The fractional reserve requirement places a ceiling on potential money creation from new reserves.

• Deposit or Money Multiplier = 1/Θ• Θ is ‘reserve requirement’ in decimal form• 1/.2 = 5 for a 20% reserve requirement

• The actual deposit multiplier will be less than the potential because: • Some persons will hold currency rather

than bank deposits. • Some banks may not use all their excess

reserves to extend loans.


Commercial Banks and the Creation of Money

Bank ReservesCash or similar assets held by commercial

banks for the purpose of meeting depositor withdrawals and payments

100 Percent Reserve BankingA situation in which banks’ reserves equal

100 percent of their deposits



AssumeRepublic of Gorgonzola

No banking system Government issues 1 million guilders People want to place their 1 million guilders in a

bank


Consolidated Balance Sheet of Gorgonzolan Commercial Banks (Initial)

AssetsCurrency 1,000,000 guilders

LiabilitiesDeposits 1,000,000 guilders

Citizens open accounts and deposit 1 million guilders• Deposits are liabilities for the bank• The guilders are an asset for the bank• Guilders are the bank’s reserves• Reserves = deposits: 100 percent reserve bankingReserves are not part of the money supplyDeposits are part of the money supply


Consolidated Balance Sheet of Gorgonzolan Commercial Banks After One Round of Loans

AssetsCurrency (= reserves) 1,000,000 guilders

Loans to farmers 900,000 guilders


Fractional Reserve Banking System• Bankers agree they only need a reserve to deposit ratio of 10%• Required reserves = 100,000 guilders, 10% of deposits• Loan out the excess reserves of 900,000 guilders


Consolidated Balance Sheet ofGorgonzolan Commercial Banks after Guilders Are Redeposited

AssetsCurrency (= reserves)

1,000,000 guilders

Loans to farmers

900,000 guilders


Loan proceeds are deposited• Reserves = 1,000,000 guilders• Deposits = 1,900,000 guilders• Money supply = 1,900,000 guilders• Reserve to deposit ratio = 52.6% or excess reserves = 810,000• Banks can loan the 810,000 guilders


Consolidated Balance Sheet of Gorgonizolan Commercial Banks After Two Rounds of Loans and Redeposits


1,000,000 guilders

Loans to farmers

1,710,000 guilders


Loan proceeds are deposited• Reserves = 1,000,000 guilders• Deposits = 2,710,000 guilders• Money supply = 2,710,000 guilders• Reserve to deposit ratio = 36.9%• Excess reserves = 729,000 guilders


Final Consolidated Balance Sheet of Gorgonzolan Commercial Banks


1,000,000 guilders

Loans to farmers

9,000,000 guilders


Observations• Lending will continue until the reserve to deposit ratio = 10%• When loans = 9,000,000 guilders

•Deposits = 10,000,000 guilders•Reserves = 1,000,000 guilders•Reserve to deposit ratio = 10%•No excess reserves

• The money supply = 10,000,000 guilders



ObservationsThe use of a fractional-reserve banking

system allows the money supply to grow as a multiple of the reserves

In Gorgonzola, with a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposit.



The Money Supply with Both Currency and DepositsGorgonzola residents choose to hold 500,000

guilders as currencyDeposit 500,000 in the banksReserve-deposit ratio = 10%Bank deposits = 500,000/.10 = 5,000,000



The Money Supply with Both Currency and DepositsMoney supply = currency + bank deposits

5,500,000 = 500,000 + 5,000,000

The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency



The Money Supply at ChristmasCurrency = 500Bank reserves = 500Reserve-deposit ratio = 0.20Money supply = 500 + 500/.20 =

500 + 2,500 = 3,000



The Money Supply at Christmas If Xmas shoppers withdraw 100Money supply = 600 + 400/.20

600 + 2,000 = 2,600



The Money Supply at ChristmasObservation

When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5.

In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.


The Federal Reserve System

Two Main ResponsibilitiesMonetary policyOversight and regulation of financial markets



The History and Structure of the Federal Reserve SystemFounded by the Federal Reserve Act of 1913The primary mission of the Fed is to promote

economic growth, low inflation, and stable financial markets.



The Structure12 regional Federal Reserve banks

Assess economic conditions in their regions to assist in national policymaking

Provide service to the commercial banks in their districts


Philadelphia3SanFrancisco

12

1 Boston

4

Cleveland9

Minneapolis

11

Dallas

Washington, D.C. (Board of Governors)10

Kansas City

7

Chicago

5 Richmond

2 New York

Atlanta6

St. Louis

8

The Federal Reserve Districts

• The map indicates the 12 Federal Reserve districts and the cities in which the district banks are located.

• Each district bank monitors the commercial banks in their region and assists them with the clearing of checks.

• The Board of Governors of the Federal Reserve System is located in Washington D.C.



The StructureBoard of Governors

Seven governors Appointed by the president and confirmed by the Senate

to 14 year staggered terms

Chairman of the Board of Governors Selected by the president from the governors Serves a four year term



The StructureFederal Open Market Committee (FOMC)

Members include: The seven Fed governors President of the New York Fed Four presidents, chosen on a rotating basis, from the

remaining Federal Reserve Banks

Determines monetary policy


2008 Members of the FOMC

There are only 10 people listed… as there are only currently 5 Board members due to resignations.

Ben S. Bernanke, Board of Governors, ChairmanDonald L. Kohn, Board of GovernorsRandall S. Kroszner, Board of GovernorsFrederic S. Mishkin, Board of GovernorsKevin M. Warsh, Board of Governors

Timothy F. Geithner, New York, Vice ChairmanRichard W. Fisher, DallasSandra Pianalto, ClevelandCharles I. Plosser, PhiladelphiaGary H. Stern, Minneapolis


2009 Members of the FOMC

There are only 10 people listed… as there are only currently 5 Board members due to resignations.

Ben S. Bernanke, Board of Governors, Chairman Elizabeth A. Duke, Board of Governors Donald L. Kohn, Board of Governors Daniel K. Tarullo, Board of Governors Kevin M. Warsh, Board of Governors William C. Dudley, New York, Vice Chairman Charles L. Evans, Chicago Jeffrey M. Lacker, Richmond Dennis P. Lockhart, Atlanta Janet L. Yellen, San Francisco


Press Release

Release Date: March 18, 2009 For immediate release

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

2009 Monetary Policy Releases


The Public: Households & businesses

Commercial BanksSavings & Loans

Credit UnionsMutual Savings Banks


• The Board of Governors is at the center of Federal Reserve operations.

• The board sets all the rates and regulations for the depository institutions.

• The seven members of the Board of Governors also serve on the Federal Open Market Committee (FOMC).

• The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities.

Federal ReserveBoard of Governors

7 members appointed by the president,with the consent of the U.S. Senate

12 Federal ReserveDistrict Banks

(25 branches)

Open MarketCommittee

Board of Governors &5 Federal Reserve Bank Presidents (alternating terms, New York Bankalways represented).



Controlling the Money Supply: Open-Market OperationsThe primary function of the Fed is monetary

policy.The Fed controls the money supply by

changing the supply of bank reserves.



Controlling the Money Supply: Open-Market OperationsOpen-market operations are the most

important method of changing the supply of bank reserves.



Increasing The Money SupplyThe Fed purchases government bonds from

the public.The people deposit the funds they get from

their sale of bonds to the Fed.The increase in deposits increase bank

reserves.



Increasing The Money SupplyThe increase in reserves will lead to an

expansion of the money supply as banks make more loans.

Recall The change in the money supply is a multiple of

the change in reserves.



Reducing The Money SupplyThe Fed sells government bonds to the

public.The Fed presents the checks from the sale of

the bonds to the banks for payment.



Reducing The Money SupplyThe bank’s reserves will fall when they clear

the checks.The money supply will fall by a multiple of the

decrease in reserves.



Open-Market PurchaseThe purchase of government bonds from the

public by the Fed for the purpose of increasing the supply of bank reserves and the money supply



Open-Market SaleThe sale by the Fed of government bonds to

the public for the purpose of reducing bank reserves and the money supply



Open-Market OperationsOpen-market purchases and open-market

sales


The Federal Reserve System Example

Increasing the money supply by open-market operations

Currency = 1,000 shekels Reserves = 200 Reserve-deposit ratio = 0.2




Money supply = 1,000 + 200/0.2 = 2,000 shekels Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekels


The Federal Reserve System The Fed’s Role in Stabilizing Financial

Markets: Banking PanicsSuppose:

Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional)

to meet the depositors demand. The bank fails and further erodes depositor

confidence which triggers additional failures.


The Federal Reserve System The Fed’s Role in Stabilizing Financial

Markets: Banking PanicsThe Fed to the rescue:

Instill confidence Discount lending Open Market Operations


The Federal Reserve System Economic Naturalist

The banking panics of 1930 - 1933 and the money supply

One-third of U.S. banks closed Depositors withdrew their funds Banks raised the reserve-deposit ratio


Key U.S. MonetaryStatistics, 1929-1933

Currency Reserve-deposit Bank Moneyheld by public ratio reserves supply

December 1929 3.85 0.075 3.15 45.9

December 1930 3.79 0.082 3.31 44.1

December 1931 4.59 0.095 3.11 37.3

December 1932 4.82 0.109 3.18 34.0

December 1933 4.85 0.133 3.45 30.8


Fed Independence

Long tenure for members of the Board of Governors.Staggered appointments

Bank Presidents appointed to 5-year term by Bank’s Board of DirectorsBoard of Directors selected by bank members


Funding of the Federal Reserve

The Fed is structured to be self-sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities. Therefore, it is independent of Congressional decisions about appropriations.

Fed refunds Treasury most of interest each year the money that is collected in the form of interest.

Federal reserve banks owned by domestic banks.


How the Fed Controls the Money Supply


The Three Tools the Fed Uses to Control the Money Supply

• The Fed has three major tools that it can use to control the money supply:• Reserve requirements

– setting the fraction of assets that banks must hold as reserves (vault cash or deposits with the Fed), against their checking deposits,

• Open market operations – the buying and selling of U.S. government securities in the open market, and,

• Discount rate – setting the interest rate at which it loans funds to commercial banks and other depository institutions.


Controlling the Money Supply:Setting Reserve Requirements

• Reserve requirements:a percent of a specified liability category (for example checking deposits) that banking institutions are required to hold as reserves against that type of liability. • When the Fed lowers the required

reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply.

• Raising the reserve requirements has the opposite effect.

• The Chinese central bank has used this instrument recently.


Controlling the Money Supply:Open Market Operations

• Open Market Operations:the buying and selling of U.S. Treasury bonds by the Fed.• This is the primary tool used by the

Federal Reserve to control the money supply.

• Note: the U.S. Treasury bonds held by the Fed are part of the national debt.


Controlling the Money Supply:Open Market Operations

• Open Market Operations:the buying and selling of U.S. Treasury bonds by the Fed.

• When the Fed buys bonds … the money supply expands because:

• bond buyers acquire money• bank reserves increase, placing banks

in a position to expand the money supply through the extension of additional loans

• When the Fed sells bonds …the money supply contracts because:

• bond buyers give up money for securities• bank reserves decline, causing them to

extend fewer loans



Increasing The Money SupplyThe Fed purchases government bonds from

the public.The people deposit the funds they get from

their sale of bonds to the Fed.The increase in deposits increase bank

reserves.



Increasing The Money SupplyThe increase in reserves will lead to an

expansion of the money supply as banks make more loans.

Recall The change in the money supply is a multiple of

the change in reserves.



Reducing The Money SupplyThe Fed sells government bonds to the

public.The Fed presents the checks from the sale of

the bonds to the banks for payment.



Reducing The Money SupplyThe bank’s reserves will fall when they clear

the checks.The money supply will fall by a multiple of the

decrease in reserves.




Currency = 1,000 shekels Reserves = 200 Reserve-deposit ratio = 0.2




Money supply = 1,000 + 200/0.2 = 2,000 shekels Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekels


Controlling the Money Supply:The Discount Rate

• Discount Rate:the interest rate the Fed charges banking institutions for borrowed funds

• The discount rate is closely related to the interest rate in the federal funds market, a private loanable funds market where banks with excess reserves extend short-term loans to other banks trying to meet their reserve requirements.• The interest rate in this market is called

the federal funds rate.


Controlling the Money Supply:The Discount Rate

• Under the operating procedures adopted in 2003, the Fed now charges most banks a discount rate that is slightly higher than the federal funds rate.

• If the Fed wanted to reduce the supply of money it would increase the differential between the discount and federal funds interest rates.

• A decrease in the differential would have the opposite affect.

• Recently the Fed reduced the differential between the discount and federal funds rate


How the Fed Controls the Federal Funds Rate

• Announcements after the regular meetings of the Federal Open Market Committee often focus on the Fed’s target for the fed funds rate.

• The Fed controls the federal funds rate through open market operations.• The Fed can reduce the fed funds rate by

buying bonds, which will inject additional reserves into the banking system.

• The Fed can increase the fed funds rate by selling bonds, which drains reserves from the banking system.

• Thus, though the media often focuses on the Fed’s target fed funds rate, the Fed is still using open market operations to influence this rate and control the money supply.


• The Federal Reserve:• is concerned with the monetary climate for

the economy • does not issue bonds• determines the money supply — primarily

through its buying and selling of bonds issued by the U.S. Treasury

The Functions of the Fed and Treasury

• The U.S. Treasury:• is concerned with the finance of the federal

government• issues bonds to the general public to finance

the budget deficits of the federal government• does not determine the money supply


Aggregate Reserves or the Monetary Base Recent Fed actions of quantitative easing

have led to a spike in the monetary base that has not been seen before


Monetary Base By Month

0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

1800000 1

959-

Jan.

196

0-A

ug.

196

2-M

ar.

196

3-O

ct.

196

5-M

ay

196

6-D

ec.

196

8-Ju

ly

197

0-F

eb.

197

1-S

ep.

197

3-A

pr.

197

4-N

ov.

1

976-

June

197

8-Ja

n.

197

9-A

ug.

198

1-M

ar.

198

2-O

ct.

198

4-M

ay

198

5-D

ec.

198

7-Ju

ly

198

9-F

eb.

199

0-S

ep.

199

2-A

pr.

199

3-N

ov.

1

995-

June

199

7-Ja

n.

199

8-A

ug.

200

0-M

ar.

200

1-O

ct.

200

3-M

ay

200

4-D

ec.

200

6-Ju

ly

200

8-F

eb.

Month

Mill

ion

s

Series1


Federal Reserve Note

Money gets into the economy through member banks drawing down their Reserve account, in exchange for an equal amount of currency.

Printed by the Bureau of Engraving and Printing


Money and Prices

VelocityA measure of the speed at which money

changes hands in transaction involving final goods and services

stockMoney

GDP Nominal

stockMoney

nstransactio of Value Velocity


Money and Prices

VelocityA measure of the speed at which money

changes hands in transaction involving final goods and services

M

x YP

supply)(money M

GDP) (real x Y level) (price P (V)Velocity


Money and Prices

Velocity in 2004M1 = $1,367.3 billionM2 = $6,428.4 billionNominal GDP = $11,734.3 billion

8.58 billion $1,367.3

billion $11,734.3 V M1,

1.83 billion $6,428.4

billion $11,734.3 V M2,


Money and Prices

Velocity in 2008 (averaged monthly data)M1 = $1,424 billionM2 = $7,726.9 billionNominal GDP = $14,264.6 billion

10.01 billion $1,424

billion $14,264.6 V M1,

1.85 billion $7,726.9

billion $14,264.6 V M2,


Money and Prices

Money and Inflation in the Long RunRecall

M

Y x P V


Money and Prices

Money and Inflation in the Long RunQuantity equation

M x V = P x Y

Assume V & Y are constant over the time period

Y x P V x M


Money and Prices

Money and Inflation in the Long Run If the Fed increases M by 10%, then prices

must increase by 10%.High rates of money growth are associated

with high rates of inflation (too much money chasing too few goods).

Y x P V x M

Lecture 8 Chapter 10: Federal Reserve. Copyright c 2007 by The McGraw-Hill Companies, Inc. All...

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Transcript of Lecture 8 Chapter 10: Federal Reserve. Copyright c 2007 by The McGraw-Hill Companies, Inc. All...