Chapter 14 The Federal Reserve and Monetary Policy 14-1 Copyright 2008 by The McGraw-Hill...

Chapter 14

The Federal Reserve and Monetary Policy

14-1Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives

14-2

• The organization of the Federal Reserve System

• Reserve requirements• The deposit expansion multiplier• The tools of monetary policy• The Feds effectiveness in fighting

inflation and recession• The Banking Act of 1980 and 1999

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

• The Federal Reserve Act of 1913 created the Federal Reserve System– To provide for the establishment of Federal reserve

banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes

– First United States Bank [ 1791 - 1811]– Second United States Bank [ 1816 - 1836]

• The charters of both were allowed to lapse

– The 1907 bank crises caused the public to demand the government do something to keep this from happening again

The Federal Reserve System



• The Federal Reserve has five main jobs– Conduct monetary policy which is, by far,

the most important job• Monetary policy is the control of the rate of

growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth

– Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions



• The Federal Reserve has five main jobs– Issue currency– Provide banking services to the U.S.

government– Supervise and regulate our financial

institutions


The Federal Reserve District Banks

• Each Federal Reserve District Bank is owned by the several hundred member banks in that district– A commercial bank becomes a member by buying

stock in the Federal Reserve District Bank

– So, the Fed is a quasi public-private enterprise, not controlled by the President or Congress

• Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.


The Federal Reserve System• Board of Governors

– Seven members

– Appointed by President

– Confirmed by Senate

• Sets reserve requirements

• Supervises and regulates member banks

• Establishes and administers regulations

• Oversees Federal Reserve Banks

• 12 District Banks

• Propose discount rates

• Hold reserve balances for member institutions

• Lends reserves

• Furnish currency

• Collects & clears checks

• Handle U.S. government debt & cash balances

Federal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy


Independence of the Board of GovernorsIndependence of the Board of Governors

• Neither the President nor Congress has any control over the Board of Governors – The President gets to appoint Board

members when a vacancy occurs• Sometime this may be the Chairman

– Once the Senate confirms the President’s appointment the person appointed is not answerable to the President nor the Senate

– This independence allows them to follow unpopular policies if they feel it is in the best economic interest of the nation


Legal Reserve Requirements

• The most important job of the Federal Reserve is to control the money supply

• The focal point of the Federal Reserve’s control of our money supply is legal reserve requirements– Every financial institution in the country is legally

required to hold a certain percentage of its depositsdeposits on reserve, either in the form of deposits and/or cash at its Federal Reserve District Bank or its own vaults


Legal Reserve Requirements• Technical Term Meanings

– Required Reserves (RR) is the minimum amount of vault cash and deposits (RD) at the Federal Reserve District Bank that must be held (kept on the books) by the financial institution

– Actual Reserves (RD) is what the bank is holding (on the books)

– Excess Reserves = Actual Reserves - Required Reserves

• ER = RD - RR


14-13

If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?


First $7.8 million of deposits: 0% reserve requirement

Next 40.5 million: $40,500,000 X .03 = 1,215,000

Next 51.7 million: $51,700,000 X .10 = 5,170,000

Required Reserves = $6,385,000

What About Negative Excess Reserves?

• If actual reserves (RD) are less than Required Reserves (RR), the excess Reserves (ER) are negative– If a bank does find itself short, it will usually

borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charge is called the federal funds rate

– A bank may also borrow reserves (RD) from its Federal Reserve District Bank at its discount window


• A bank’s primary reserves are its vault cash and its deposits at the the Federal District Bank– These reserves pay no interest, therefore the

banks try to hold no more than the Federal Reserve requires

Primary and Secondary Reserves


• Every bank holds secondary reserves, mainly in the form of very short-term U.S. government securities– Treasury bills, notes, certificates, and bonds

(that will mature in less than a year) are generally considered a bank’s secondary reserves

– These can be quickly converted to cash without loss if a bank suddenly needs money

Primary and Secondary Reserves


Deposition Expansion(Continued)

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How Deposit Expansion WorksBank A FED

DD + 100RD + 100 A> RD +100

Assume a 10% RRCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Deposition Expansion

14-19

How Deposit Expansion Works

Bank AFEDDD + 100RD + 100

A> RD +100

Assume a 10% RR

RR 10ER + 90

Bank BDD + 90RD + 90

B> RD + 90

RR 9ER + 81

Bank CDD + 81.0RD + 81

C> RD + 81.0

ER 8.1ER + 72.9

Etc.

Etc.

Etc.

RD + $1,000,000

When RDs at the Fed increase the money supply is increasing


Deposit Expansion Multiplier(DEM)

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DEM = 1

Reserve Ratio

Assume a RR of 10%

DEM =1

.10= 10

Assume a RR of 25%

DEM = 1

.25= 4

When RR increases

DEM decreases

When RR decreases

DEM increases Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Three Modifications of the Deposit Expansion Multiplier

• Not every dollar of deposit expansion will actually be re-deposited again and lent out repeatedly– Some people may choose to hold or spend

some money as currency

• It is also possible that some banks will carry excess reserves– This is not likely in times of high inflation


Three Modifications of the Deposit Expansion Multiplier

• There are leakages of dollars to foreign countries– This is caused mainly by our foreign trade

imbalance

• The Deposit Expansion Multiplier is, in reality, quite a bit lower than if we based it solely on the reserve ratio– If the reserve ratio tells us it is 10, perhaps

it’s only 6


Cash, Checks, and Electronic Money

• One of the jobs of the Federal Reserve is check clearing• In 2004 Congress passed the Check Clearing Act of the

21st Century– This was intended to hasten the adoption of electronic check

processing• When you use your debit card the amount is deducted

within seconds after the card is swiped• We still carry out about 80 percent of our transactions

in cash– However cash covers less than one percent of monetary

transactions– Electronic transfers account for five out of every six dollars

that move in the economy


Cash, Checks, and Electronic MoneyOne of the jobs of the Federal Reserve is check clearing

14-24

$50 00

Me Bob

$50 00

Bob

Bank ofAmerica

Branch office

BobÕs checkingaccount risesby $50

$50 00

$50 00$50 00

NewYorkFederal Reserve

District Bank

San FranciscoFederal Reserve

District Bank

Bank ofAmerica

Main office

Deducts $50 fromCitibankÕsreserves

Bank ofAmericaÕsreserves rise by $50

$50 00Citibank

Main office$50 00

Citibank

Branch office

Deducts $50 frommy checking account


• Increasingly, money is changing hands electronically– Today, $1.5 trillion a day is transferred electronically– About one-third of these transfers are carried out by the

Federal Reserve’s electronic network– About two-thirds are done by the Clearing House Interbank

Payment System (CHIPS) which is owned by 10 big New York Banks

• Does all this mean that we are well on our way to a checkless, cashless society?– Yes and no



• Does all this mean that we are well on our way to a checkless, cashless society?– Yes and no

– We still carry out nearly 85 percent of our monetary transactions in cash

– When the total dollars actually spent is considered, cash covers less than 1 percent of the total value

– Electronic transfers account for five out of every six dollars that move in the economy



The Tools of Monetary Policy

• The most important job of the Fed is to control the rate of growth of the money supply

• This effort focuses on the reserves held by financial institutions– The most important policy tool to do this is

open-market operations


How Open-Market Operations Work

• Open-Market operations are the buying and selling of U.S. government securities– U.S. government securities are treasury bills, notes,

certificates, and bonds

– The Fed buys and sells securities that have already been marketed by the treasury

• The total value of all outstanding U.S. government securities is more than $4.0 trillion. This is our national debt

– What open market operations consist of, then, is the buying and selling of chunks of the national debt


How the Fed Increases the Money Supply

14-29

The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)

Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90

The multiplier would be 1010 X 90 million = 900 million X .60 = approximate increase in the money supply of 540 million over a period of time



14-30


Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90

If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities

IR = Interest Paid

Price of Bond



14-31


Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90


IR = $80

$1000



14-32


Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90


IR = $80

$1000= 8%



14-33


Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90

Suppose this pushed the price of the bond up to $1200?

IR = $80

$1000= 8%

IR = $80

$1200= 6.67%



14-34


Securities Firm

DD + $100

Assume 10% RR

RD + $100RR - 10 ER + 90

When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rate

IR = $80

$1000= 8%

IR = $80

$1200= 6.67%


How the Fed Decreases the Money Supply

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The FED sells U. S. Government SecuritiesThe Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)

Securities Firm

DD - $100

Assume 10% RR

RD - $100

When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climb

The money supply decreases by approximately $540 million over time


How the Fed Decreases the Money Supply

14-36

The FED sells U. S. Government SecuritiesThe Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)

Securities Firm

DD - $100

Assume 10% RR

RD - $100

When the Fed goes into the open market to sell securities, bond prices fall and interest rates climb

IR = $80

$1000= 8%

IR = $80

$1200= 6.67%

The money decreases by approximately $540 million over time


The Federal Open-Market Committee (FOMC)

• Open-market operations are conducted by the Federal Open-Market Committee (FOMC)– This committee consist of 12 people

• Eight permanent members – the board of Governors and the president of the New York Federal Reserve District Bank

• The other four are presidents of the other 11 Federal Reserve District Banks

– They serve on a rotating basis


The Federal Open-Market Committee (FOMC)

14-38

• The FOMC meets about once every six weeks to decide what policy to follow– To fight recessions, the FOMC buys

securities• This increases the rate of growth of the money

supply

– To fight inflation, the FOMC sells securities• This decreases the rate of growth of the money

supply


• The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District Bank

• The federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other– This is higher than the discount rate

• Banks borrow to maintain their required reserves (RR)– Banks tend to borrow reserve deposits from each

other because they may not like to call attention to the fact they are having to borrow reserve deposits

14-39

Borrowing Reserve Deposits



Increase in the Money Supply Decrease in the Money Supply


1954-2006

Changing Reserve Requirements

• The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14 percent for checkable deposits– Changing reserve requirements is the

ultimate weapon and is rarely used



• To fight inflation, before the Board would take the drastic step of raising reserve requirements– The District Banks would raise the discount

rate– The FOMC will be actively selling securities– Credit will be getting tighter– The chairman will be publicly warning that

the banks are advancing too many loans



• If the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises

reserve requirements– This weapon is so rarely used because it is simply

too powerful– If the reserve requirement on demand deposits were

raised by just one half of 1 percent, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reserves

• This would drastically reduce the nation’s money supply


Summary: The Tools of Monetary Policy

• To fight recession, the Fed will– Lower the discount rate– Buy securities on the open market– Lower reserve requirements

• This would be done only as a last resort


Summary: The Tools of Monetary Policy

• To fight inflation, the Fed will– Raise the discount rate– Sell securities on the open market– Raise reserve requirements

• This would be done only as a last resort


The Fed’s Effectiveness in Fighting Inflation

(Assume all the tools have been used)• Bond prices have plunged• Interest rates have soared• The growth of the money supply has been

stopped dead in its tracks• Banks find it impossible to increase their loan

portfolios• Buying by consumers and businesses is

declining• The inflation rate has no choice but to decline


The Fed’s Effectiveness in Fighting Recession

(Assume all the tools have been used)• Bond prices have increased• Interest rates have gone down• Banks will have excess reserves and want to

make loans– But who wants to borrow the money?

• Creditworthy individuals and business have little incentive to borrow any money

• Businesses and individuals who really need to borrow money can’t because the first rule of banking is: never lend money to anyone who needs it.

• Easy money has little or no effect in ending a recession


The Fed’s Effectiveness in Fighting Inflation and Recession

• Federal Reserve policy in fighting inflation and recession has been likened to pulling and then pushing on a string– Like pulling on a string, when the Fed fights

inflation, it get results – provided of course, it pulls hard enough

– Fighting a recession is another matter. Like pushing on a string, no matter how hard the Fed works, it might not get anywhere


Chapter 14 The Federal Reserve and Monetary Policy 14-1 Copyright 2008 by The McGraw-Hill...

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