Banking and Monetary Policy

7/29/2019 Banking and Monetary Policy

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Banking and Monetary Policy

During the Middle Ages, trade routes from the Farand Middle East brought new business to Europe.

During the early Renaissance, banks as we know

them developed from jewelers and goldsmiths, who

first served as depositories, and then eventuallybegan loaning those deposits.

Through this development, these early banks

began providing three necessary functions for

market economies.


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Banks as we know them developed from jewelersand goldsmiths, who first served as depositories,

and then eventually began loaning those deposits.


began providing three necessary functions formarket economies.

1. Providing a Place for Safekeeping.


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Banks as we know them developed from jewelersand goldsmiths, who first served as depositories,

and then eventually began loaning those deposits.


began providing three necessary functions formarket economies.


2. Making Loans.


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Originally, loans were made in cash, using a small

portion of deposits. This is known as Direct ReserveBanking. It is necessary to calculate the normal

amount of cash withdrawn during a business day,

and the banker must make sure to not lend out so

much of his reserves that there is not enough cashon hand to meet the demand.

Deposits are broken into two categories:

1. Required reserves The amount that must beheld in reserve and cannot be lent.

2. Excess reserves The amount that can beloaned.



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Three functions of banks.


2. Making Loans.

3. Creating Money


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Three functions of banks.


2. Making Loans.

3. Creating Money

The creation of money is dependent upon a system

known as Fractional Reserve Banking. Thisconcept developed during the renaissance. As

people became used to the idea of trading thereceipts representing deposits as money, banks

began making loans using receipts instead of cash

(specie).


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It is necessary for the banker to again determine the

amount of money that is normally withdrawn during abusiness day, and that percentage of deposits will

establish the required reserves.

Using that value, we can calculate how much money canbe created using the deposit multiplier formula.

M=100

% reserve requirement


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Deposit RR% Required Excess


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Three Conflicting Goals of Commercial Banks

1. Safety


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1. Safety

2. Profitability


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1. Safety

2. Profitability

3. Liquidity


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Banking in the United States

In the colonial period, banks in the American

colonies operated under English law, and were

chartered by the King. The Bank of England

maintained offices in Philadelphia and Boston.

After the revolution, under the Articles of

Confederation, banks were chartered by the

States.


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The Constitution granted

the Federal Governmentthe power to charter

banks, resulting in the

Dual Chartering system.The First Bank of the

United States was

chartered by Congress in

1791. Its charter wouldexpire in 1811, and was

succeeded by the Second

Bank of the US in 1816.



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The Second Bank of the US was chartered in 1816.

Its charter would expire in 1836, after the BankWar, a dispute between President Andrew Jackson

and Second Bank President Nicholas Biddle.


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During the dispute, Jackson transferredFederal funds into private banks, known as

pet banks. The US would operate without a

central bank until the creation of the Federal

Reserve System in 1913.


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The Federal Reserve Bank of the United States

The Federal Reserve System was created by an act

of Congress. It took effect in December of 1913.

The need for a central bank had been exacerbated

by financial panics in 1873, 1893 and 1907, largely

tied to political concerns overspecie circular, the

issuance of money based on gold and silver, andthe uncertainty caused by increasing Federal debt.


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The Panic of 1907 had resulted in an unprecedented

wave of bank failures, partly because of the increasingurbanization of the population, and because of

technological change. The harm caused by these bank

failures resulted in renewed calls for a central bank.

Wealthy bankers favored a central bank based on the

Bank of England. Senator Nelson Aldrich led a group

who created a plan for a new central bank based upontheir wishes. With some modifications, this plan was

adopted by the Democrat controlled Congress under

President Woodrow Wilson.


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Concerns about instituting a Central Bank led

Congress to spend two years debating the creationof this new entity.

Many were opposed to putting Federal funds into a

quasi-public bank, and there was a fear of renewing

the corruption and inefficiency of the pet banks.

There were also still geographic rivalries left over

from the Civil War, and the expansion into the West.

There were continuing economic issues betweenurban & rural interests, and agriculture &

manufacturing interests.

Finally, it was agreed that the bank needed to be

beyond political influence or control.



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In order to resolve these issues, the Fed was

designed with a unique structure. It is a system ofprivate banks owned by the Federal Government, so

no individual may hold an account there.

Member banks, agencies of the FederalGovernment, and foreign governments may hold

accounts with the Fed.



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Structure of the Fed

To overcome the geographic concerns, a system

was created that does not have one bank. Rather, it

consists of 12 Regional Banks. Districts were set up

according to common business interests and similar

volume of banking business in 1913.

Each district is responsible for banking policy withinits borders.



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There are 12 Federal Reserve District Banks.



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Political Autonomy

The management of the Fed is not rested in one person;three bodies oversee its management. These are among the

most powerful people in the world, because their decisions

are exempt from checks and balances.

1. Federal Reserve Board of GovernorsSeven Members, each serves a 14 year term.

Appointed by the President, approved by Senate.

One members term expires in every odd numbered year.Overseen by a chairman who serves a 4 year term.



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Political Autonomy

The management of the Fed is not rested in one person;

three bodies oversee its management. These are among

the most powerful people in the world, because their

decisions are exempt from checks and balances.

1. Federal Reserve Board of Governors2. Federal Reserve Open Market Committee

12 members, including

7 members of the Board of Governors plus

5 of the district bank Presidents, who serve one yearterms in rotation, except the 2nd bank President is always

a member.



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Political Autonomy

The management of the Fed is not rested in one person;

three bodies oversee its management. These are among

the most powerful people in the world, because their

decisions are exempt from checks and balances.


3. Federal Reserve Advisory Council

12 prominent commercial bankers, one from each district,appointed by the President.



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Political Autonomy

The management of the Fed is not rested in one person; three

bodies oversee its management. These are among the most

powerful people in the world, because their decisions are

exempt from checks and balances.


3. Federal Reserve Advisory Council

Congress also acted to protect the autonomy of the

Fed by making them the only Federal Agency allowedto fund its own operations, rather than asking

Congress for a budget appropriation.



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The Fed serves six main functions for the Federal government.

Functions of the Fed1. Serves as the bank for the Federal Government and

holds the reserves of member banks.



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Member Banks

All banks chartered by the federal government must be members.

State-chartered banks who meet standards set by the Board of

Governors may be members.

Member banks must hold stock in the Federal Reserve.

Member banks must hold FDIC insurance.

Member banks receive preferential access and rates for the use of Fedservices and FDIC insurance.

Non-Member Banks

State chartered Banks who do not meet the Fed standards or choose

not to apply for Fed membership are known as non-member banks.

Non-Members operate under State banking regulations.

Non member banks may elect to not carry FDIC insurance.



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29% of banks are Federally chartered - 71% are State chartered

38% of banks are Member banks - 62% are Non-Members

Member Banks hold 77% of all deposits



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2. Oversees and Regulates the Commercial Banking

System and protects the credit rights of consumers.


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System and protects the credit rights of consumers.3. Insures deposits and promotes stability of commercial

banks (through the FDIC).



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banks (through the FDIC)

4. Regulates the supply of currency in circulation.



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5. Serves as a clearinghouse for checks and performsother functions for banks.



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5. Serves as a clearinghouse for checks and performsother functions for banks.

6. Enacts Monetary Policy through its control of the money

supply.



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Monetary Policy is the intentional use of the

governments power to regulate the moneysupply in an attempt to influence the level of

economic activity.

Unlike Fiscal Policy, whose main weakness is

political considerations, Monetary Policy, like the

Fed, is largely unaffected by politics.



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Milton Friedman (1912-2006)

Born in New York City

BA in Math from Rutgers

MA in Economics from U. of Chicago

PhD in Econ and Stats - Columbia

Taught at U of Chicago 1946-1976

Nobel Prize in Economics-1976

Wrote:

Capitalism and Freedom(1962)

A Monetary History of the UnitedStates, 18671960(1963)

Free to Choose(1980)


Milton FriedmanFather of Monetary

Policy


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There are three main tools used by the Fed to

influence the money supply:

1. Open Market Operations



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influence the money supply:1. Open Market Operations

The Fed conducts weekly securities auctions. To

increase the money supply, they offer fewer

securities for sale, or offer a lower interest

rate. This directs money that would have gone

into the treasury into private investments

where it stays in the money supply. Todecrease the money supply, they offer better

rates or terms, attracting more investment,

thus removing it from the money supply.



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influence the money supply:1. Open Market Operations

2. Changes in the Discount Rate



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influence the money supply:

1. Open Market Operations

2. Changes in the Discount Rate

The discount rate is the interest rate charged to

member banks for short term loans. Raising therate discourages borrowing and reduces the

money supply. Lowering the rate encourages

borrowing and increases the money supply.



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influence the money supply:1. Open Market Operations.

2. Changes in the Discount Rate.

3. Changes in the Reserve Requirement.



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influence the money supply:1. Open Market Operations.

2. Changes in the Discount Rate.

3. Changes in the Reserve Requirement.

The Fed sets the reserve requirement for all banks.Using the deposit multiplier formula, we can see

that increasing the rate directly lowers the amount

of loanable funds, lowering the rate would increase

the amount of loanable funds.



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Monetary Policy

Recently, the Fed has used a policy tool known

as Quantitative Easing.

This involves the issuance of Federal Securities

that are then bought by the Treasury. The money

supply is directly increased by the amount of the

issue.


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Non-Bank Financial Institutions

These are commercial entities that look and

act like banks, and perform many of the

functions of commercial banks, but they are

technically and legally not banks.


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Credit Unions


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Credit Unions

Savings and Loans Associations


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Credit Unions

Savings and Loans Associations

Mutual Savings Banks


Banking and Monetary Policy

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