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Transcript of © 2005 Thomson C hapter 27 The Federal Reserve System and Monetary Policy.
© 2005 Thomson
CChapter 27hapter 27
The Federal Reserve The Federal Reserve System and System and
Monetary PolicyMonetary Policy
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
The Federal Reserve System as a central bank
The discount rate as a tool of monetary policy
Open market operations as a tool of monetary policy
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
Money supply versus interest rate targets
Countercyclical monetary policy
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
Bank note
• A promissory note, issued by a bank, pledging to redeem the note for a specific amount of gold or silver. The terms of redemption are specified on the note.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
The first real U.S. money was the Continental Note.• Since Congress had no taxing authority, it printed Continental Notes to finance the Revolution.
• Excessive printing rendered the Continental Note nearly useless.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
State-chartered bank
• A commercial bank that receives its charter or license to function from a state government and is subject to the laws of that state.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 1 GROWTH OF STATE BANKS: 1784–1860 ($ MILLIONS)
Source: U.S. Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, D.C.: U.S. Government Printing Office, 1949,) pp. 261–263.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 1: Growth of Exhibit 1: Growth of State Banks: 1784-1860 State Banks: 1784-1860
($ millions)($ millions)What are some reasons for the rapid growth of state banks?• The money supply was inadequate to finance the growing number of farms, factories, and businesses.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History• Congress accepted Hamilton’s plan and created the First Bank of the United States in 1791.
• This central bank dampened the inclination of state-chartered banks to overissue notes by demanding that the notes be redeemed in silver and gold.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
Nationally chartered bank
• A commercial bank that receives its charter from the comptroller of the currency and is subject to federal law as well as the laws of the state in which it operates.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
When the 20-year charter of the First Bank of the U.S. expired in 1811, advocates of states’ rights in Congress prevailed, and the charter was not renewed.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
In 1816 Congress created the Second Bank of the U.S., which again stabilized state banking practices. As with the First Bank, however, political pressure led to the failure of Second Bank of the U.S. in the 1830s.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
During the Civil War, Congress passed the National Bank Act, which created a national banking system and the office of the comptroller of the currency, which chartered national banks.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
National banks had to buy Treasury Bonds equal to one-third of their capital, and could issue notes only in proportion to their Treasury bond holdings.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
A Glimpse at HistoryA Glimpse at History
In 1907 the highly respected Knickerbocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Federal Reserve The Federal Reserve SystemSystem
The Federal Reserve Act of 1913 created the Federal Reserve System (the “Fed”). The Fed has 12 regional district banks that serve as the region’s central bank.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Federal Reserve The Federal Reserve SystemSystem
Does the president of the U.S. control the Fed?• No. Although the Fed was created by and responsible to Congress, the Fed pursues an independent monetary policy that at times may conflict with policies pursued by the president or Congress.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 2 THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 2: The Exhibit 2: The Geography of the Geography of the Federal Reserve Federal Reserve
SystemSystem• In what Federal Reserve Bank district do you live?
• What is the reserve bank city for your district?
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 3 NATIONAL BANKS, STATE BANKS, AND TOTAL DEPOSITS: 2000 ($ BILLIONS)
Source: Federal Deposit Insurance Corporation, Statistics on Banking, 2000 (Washington, D.C.: FDIC, 2000).
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 3: National Banks, Exhibit 3: National Banks, State Banks, and Total State Banks, and Total
Deposits: 2000 ($ billions)Deposits: 2000 ($ billions)
Of the following, which had the largest number of banks in 2000?a. National banks
b. State banks (Fed member)
c. Savings institutions
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 3: National Banks, Exhibit 3: National Banks, State Banks, and Total State Banks, and Total
Deposits: 2000 ($ billions)Deposits: 2000 ($ billions)
Of the following, which had the largest number of banks in 2000?a. National banks
b. State banks (Fed member)
c. Savings institutions
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 4 ORGANIZATIONAL STRUCTURE OF THE FEDERAL RESERVE SYSTEM
Source: Board of Governors of the Federal Reserve System, Division of Support Services, Purposes & Functions, 1984.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 4: Organizational Exhibit 4: Organizational Structure of the Federal Structure of the Federal
Reserve SystemReserve SystemWhat is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)?
• The Board of Governors
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Federal Reserve The Federal Reserve SystemSystem
The Fed’s main charge is to safeguard the proper functioning of our monetary system (money supply, interest rates, and the economy’s price level).
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Federal Reserve The Federal Reserve SystemSystem
Federal Open Market Committee
• The Fed’s principal decision-making body, charged with executing the Fed’s open market operations.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 5 IDENTIFYING LETTERS AND DISTRICT BANKS
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 5: Identifying Exhibit 5: Identifying Letters and District Letters and District
BanksBanksIf you look at the seal to the left of George Washington’s picture on a $1 bill and see the letter “L”, in what district bank was that $1 bill issued?• San Francisco
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Federal Reserve The Federal Reserve SystemSystem
Discount rate
• The interest rate the Fed charges banks that borrow reserves from it.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 6 BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 6: Bank Exhibit 6: Bank Transactions Triggered Transactions Triggered
by Brian’s Purchaseby Brian’s PurchaseWhy does Brian’s check go to the Atlanta Fed and the Cleveland Fed?
• One of the functions of a district Fed is to clear checks.
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© 2005 Thomson
EXHIBIT 7A FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP
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© 2005 Thomson
EXHIBIT 7B FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP
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© 2005 Thomson
EXHIBIT 7C FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 7: From Changes in Exhibit 7: From Changes in the Money Supply to the Money Supply to Changes in Real GDPChanges in Real GDP
How does an increase in the money supply lead to an increase in real GDP?• Increasing the money supply leads to lower interest rates, which promotes increased investment spending, which increases aggregate demand.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
Countercyclical monetary policy
• Policy directives used by the Fed to moderate swings in the business cycle.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
Reserve requirement
• The minimum amount of reserves the Fed requires a bank to hold, based on a percentage of the bank’s total deposit liabilities.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 8 RESERVE REQUIREMENTS (SEPTEMBER 2000)
Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., December 2000), p. A9.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 8: Reserve Exhibit 8: Reserve Requirements Requirements
(September 2000)(September 2000)Do reserve requirements imposed by the Fed depend on the bank’s total deposits?• Yes. Banks with more than $42.8 million in checking account balances must hold 10 percent of those deposits on reserve. Smaller banks only need to hold 3 percent of checking account balances on reserve.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 9 CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 9: Change in the Exhibit 9: Change in the Dallas Fed’s Accounts Dallas Fed’s Accounts
After Providing a $5,000 After Providing a $5,000 Loan to PFNLoan to PFNIf the Dallas Fed loans money to a
private bank such as PFN, why does this increase the money supply?• Money held by the Fed is not counted in the money supply.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 9: Change in the Exhibit 9: Change in the Dallas Fed’s Accounts Dallas Fed’s Accounts
After Providing a $5,000 After Providing a $5,000 Loan to PFNLoan to PFN
• Money held by the Fed is not counted in the money supply.
• PFN can loan out much of the money it borrowed from the Fed.
If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply?
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
Federal funds market
• The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
1. If a private bank has $5,000 in new reserves and the reserve requirement is 20 percent, then what is the maximum amount of new money supply that can be created from this $5,000?• $5,000 × (1/0.2) = $25,000.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 10 CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 10: Change in Exhibit 10: Change in PFN’s Accounts After PFN’s Accounts After
Receiving a $5,000 Loan Receiving a $5,000 Loan from the Dallas Fedfrom the Dallas Fed
If the Dallas Fed loans money to a private bank such as PFN, does this generate a liability for PFN?• Yes. The liability is the borrowed money that PFN owes to the Fed.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 11 FEDERAL RESERVE BANK OF NEW YORK DISCOUNT RATES: 1985–2003 (% PER YEAR)
Source: Federal Reserve Bank, St. Louis.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 11: Federal Reserve Exhibit 11: Federal Reserve Bank of New York Discount Bank of New York Discount Rates: 1985-2003 (% per Rates: 1985-2003 (% per
year)year)What were the lowest discount rates charged by the New York Fed, and in what year(s)?
• The New York Fed charged 3 percent discount rates in 1992 and in 1994.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
Federal funds rate
• The interest rate on loans made by banks in the federal funds market.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
Open market operations
• The buying and selling of government bonds by the Federal Open Market Committee.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Controlling the Money SupplyMoney Supply
2. If the Fed wanted to reduce the money supply, would it purchase or sell government securities?• It would sell government securities. Money used to buy the securities from the Fed would leave the money supply.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 12 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM PFN ($ MILLIONS)
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 12: Change in the Exhibit 12: Change in the Fed’s Accounts After Fed’s Accounts After Buying $10 Million of Buying $10 Million of
Securities from PFN ($ Securities from PFN ($ millions)millions)What was the change in the Fed’s
liabilities after buying $10 million of securities from PFN?• The Fed’s liabilities increased by $10 million due to a $10 million increase in PFN’s reserve.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 13 CHANGE IN PFN’S ACCOUNTS AFTER SELLING $10 MILLION OF SECURITIES TO THE FED ($ MILLIONS)
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 13: Change in PFN’s Exhibit 13: Change in PFN’s Accounts After Selling $10 Accounts After Selling $10 Million of Securities to the Million of Securities to the
Fed ($ millions)Fed ($ millions)If the Fed buys $10 million of securities from PFN, how much of the proceeds from this sale can PFN loan out?• PFN can loan out all $10 million because these represent excess reserves.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 14 CHANGE IN PFN’S ACCOUNTS AFTER MARIA SELLS $10 MILLION OF SECURITIES ($ MILLIONS)
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 14: Change in PFN’s Exhibit 14: Change in PFN’s Accounts After Maria Sells $10 Accounts After Maria Sells $10
Million of Securities ($ Million of Securities ($ millions)millions)
Suppose that the Fed bought $10 million of securities from a private individual (Maria) rather than from PFN. Would this still increase the money supply?• Yes, but not by as much. If she deposits the check at the bank, the bank can loan out only $8 million of the new demand deposit. The other $2 million are required reserves.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 15 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM MARIA ($ MILLIONS)
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 15: Change in the Exhibit 15: Change in the Fed’s Accounts After Fed’s Accounts After Buying $10 Million of Buying $10 Million of
Securities from Maria ($ Securities from Maria ($ millions)millions)If the Fed bought $10 million of securities
from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?• The Fed’s assets increase by $10 million because it owns more securities.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 15: Change in the Exhibit 15: Change in the Fed’s Accounts After Fed’s Accounts After Buying $10 Million of Buying $10 Million of
Securities from Maria ($ Securities from Maria ($ millions)millions)If the Fed bought $10 million of securities
from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?• The Fed’s assets increase by $10 million because it owns more securities.
• The Fed’s liabilities increase by $10 million from clearing the check for PFN.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 16 CHANGE IN PFN’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES ($ MILLIONS)
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 16: Change in PFN’s Exhibit 16: Change in PFN’s Accounts After Buying $10 Accounts After Buying $10
Million of Securities ($ Million of Securities ($ millions)millions)
What happens to the money supply as a consequence of the transaction shown in Exhibit 16?• By selling securities to PFN, the Fed reduces PFN’s reserves by $10 million. PFN is no longer in a position to loan that $10 million, which reduces the money supply.
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© 2005 Thomson
EXHIBIT 17 THE FED’S TARGET OPTIONS
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 17: The Fed’s Exhibit 17: The Fed’s Target OptionsTarget Options
If Fed targets the money supply, as in Panel a, what countercyclical policy is no longer available to the Fed?• The Fed can no longer control the interest rate, since the interest rate depends on the positioning of the demand for money.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Interest Controlling the Interest Rate: The Fed’s Rate: The Fed’s
Alternative Target Alternative Target OptionOption
• If the Fed targets the money supply, it cannot at the same time control the interest rate.
• Likewise by choosing to target the interest rate, the Fed loses control over the money supply.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Interest Controlling the Interest Rate: The Fed’s Rate: The Fed’s
Alternative Target Alternative Target OptionOption
The Fed’s countercyclical monetary policy works either way, by changing interest rates or by changing the money supply.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Past Fed Governor Past Fed Governor Martha Seger Describes Martha Seger Describes How the FOMC WorksHow the FOMC Works
According the Honorable Martha Seeger, what is the biggest difference between the Fed as textbook writers describe it, and how it really is?• It is much more difficult for the Fed to make decisions than the process described by textbook writers.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Controlling the Interest Controlling the Interest Rate: The Fed’s Rate: The Fed’s
Alternative Target Alternative Target OptionOption
Margin requirements
• The maximum percentage of the cost of a stock that can be borrowed from a bank or any other financial institution, with the stock offered as collateral.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 18 FEDERAL RESERVE’S MARGIN REQUIREMENTS: 1940–94 (PERCENTAGE)
Source: Banking and Monetary Statistics, 1940–1970 (Washington, D.C.: Board of Governors of the Federal Reserve System, 1975), p. 799; and Federal Reserve Bulletin, July 1994, p. A27.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 18: Federal Exhibit 18: Federal Reserve’s Margin Reserve’s Margin
Requirements: 1940-94 Requirements: 1940-94 (Percentage)(Percentage)
Why were margin requirements so high during World War II?
• The fiscal stimulus from huge wartime government expenditures generated inflationary pressure, and the Fed raised margin requirements to discourage speculative bank loans.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 19 THE FED’S COUNTERCYCLICAL OPERATIONS
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Gottheil - Principles of Economics, 4e
Exhibit 19: The Fed’s Exhibit 19: The Fed’s Countercyclical Countercyclical
OperationsOperationsWhat countercyclical Fed policies are used during the recovery and prosperity phase of the business cycle?
• Containment of the money supply by raising reserve requirements, raising the discount rate, or selling bonds on the open market.