Chapter 27 THE FEDERAL RESERVE SYSTEM AND MONETARY POLICY Gottheil — Principles of Economics, 7e...

Chapter 27Chapter 27

THE FEDERAL RESERVE THE FEDERAL RESERVE SYSTEM AND MONETARY SYSTEM AND MONETARY POLICYPOLICY

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e2

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

Economic PrinciplesEconomic Principles


Money supply versus interest rate targets

Countercyclical monetary policy

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.



In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies.



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.



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.


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.

Exhibit 1: Growth of State Exhibit 1: Growth of State Banks: 1784-1860 ($ millions)Banks: 1784-1860 ($ 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.



Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government.



• 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.



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.



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.



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.



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.



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.



In 1907 the highly respected Knicker-bocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913.

The Federal Reserve SystemThe Federal Reserve System


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.



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.


EXHIBIT 2 THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM

Exhibit 2: The Geography of the Exhibit 2: The Geography of the Federal Reserve SystemFederal Reserve System


• In what Federal Reserve Bank district do you live?

• What is the reserve bank city for your district?


EXHIBIT 3 NATIONAL BANKS AND STATE BANKS 2011

Source: Federal Deposit Insurance Corporation, Institution Directory, 2011 (Washington, D.C.: FDIC, 2011).

Exhibit 3: National Banks and State Exhibit 3: National Banks and State Banks 2011Banks 2011


How many banks are chartered nationally?

Of the 7,519 banks in the country, fewer than 1,400 are chartered nationally.

Exhibit 3: National Banks and Exhibit 3: National Banks and State Banks 2011State Banks 2011


How many state-chartered banks are members of the Fed?Of the 4214 state-chartered banks in the country, 816 banks are members of the Federal Reserve System.


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.

Exhibit 4: Organizational StructureExhibit 4: Organizational Structureof the Federal Reserve Systemof the Federal Reserve System


What is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)?

• The Board of Governors



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).



Federal Open Market Committee

• The Fed’s principal decision-making body, charged with executing the Fed’s open market operations.


EXHIBIT 5 IDENTIFYING LETTERS AND DISTRICT BANKS

Exhibit 5: Identifying Letters Exhibit 5: Identifying Letters and District Banksand District Banks


If 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



Discount rate

• The interest rate the Fed charges banks that borrow reserves from it.


EXHIBIT 6 BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE

Exhibit 6: Bank Transactions Exhibit 6: Bank Transactions Triggered by Brian’s PurchaseTriggered by Brian’s Purchase


Why 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.


EXHIBIT 7A FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP


EXHIBIT 7B FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP


EXHIBIT 7C FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

Exhibit 7: From Changes in the Exhibit 7: From Changes in the Money Supply to Changes in Money Supply to Changes in

Real GDPReal 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.

Controlling the Money SupplyControlling the Money Supply


Countercyclical monetary policy

• Policy directives used by the Fed to moderate swings in the business cycle.



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.


EXHIBIT 8 RESERVE REQUIREMENTS (JULY 2006)

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., July 2000).

Exhibit 8: Reserve Requirements Exhibit 8: Reserve Requirements (July 2006)(July 2006)


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.


EXHIBIT 9 CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN

Exhibit 9: Change in the Dallas Exhibit 9: Change in the Dallas Fed’s Accounts after Providing Fed’s Accounts after Providing

a $5,000 Loan to PFNa $5,000 Loan to PFN


If 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.

Exhibit 9: Change in the Dallas Exhibit 9: Change in the Dallas Fed’s Accounts after Providing Fed’s Accounts after Providing

a $5,000 Loan to PFNa $5,000 Loan 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?



Federal funds market

• The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight.



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.


EXHIBIT 10 CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED

Exhibit 10: Change in PFN’s Exhibit 10: Change in PFN’s Accounts after Receiving a $5,000 Accounts after Receiving a $5,000

Loan from the Dallas FedLoan from 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.


EXHIBIT 11 FEDERAL RESERVE BANK OF NEW YORK DISCOUNT RATES: 1990–2008 (selected dates)

Source: Federal Reserve Bank, New York, July 2008.

Exhibit 11: Federal Reserve Exhibit 11: Federal Reserve Bank of New York Discount Bank of New York Discount

Rates, 1990–2008Rates, 1990–2008


What was the lowest discount rates charged by the New York Fed, and when did that take place?• The New York Fed charged .75 percent on

November 6, 2002.



Federal funds rate

• The interest rate on loans made by banks in the federal funds market.



Open market operations

• The buying and selling of government bonds by the Federal Open Market Committee.



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.


EXHIBIT 12 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM PFN ($ millions)

Exhibit 12: Change in the Fed’s Exhibit 12: Change in the Fed’s Accounts after Buying $10 Accounts after Buying $10

Million of Securities from PFNMillion of Securities from PFN


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.


EXHIBIT 13 CHANGE IN PFN’S ACCOUNTS AFTER SELLING $10 MILLION OF SECURITIES TO THE FED ($ millions)

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 FedMillion of Securities to the Fed


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.


EXHIBIT 14 CHANGE IN PFN’S ACCOUNTS AFTER MARIA SELLS $10 MILLION OF SECURITIES ($ millions)

Exhibit 14: Change in PFN’s Exhibit 14: Change in PFN’s Accounts after Maria Sells $10 Accounts after Maria Sells $10

Million of SecuritiesMillion of Securities


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.


EXHIBIT 15 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM MARIA ($ MILLIONS)

Exhibit 15: Change in the Fed’s Exhibit 15: Change in the Fed’s Accounts after Buying $10 Accounts after Buying $10

Million of Securities from MariaMillion of Securities from Maria


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.

Exhibit 15: Change in the Fed’s Exhibit 15: Change in the Fed’s Accounts After Buying $10 Accounts After Buying $10

Million of Securities from MariaMillion of Securities from Maria


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.


EXHIBIT 16 CHANGE IN PFN’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES ($ MILLIONS)

Exhibit 16: Change in PFN’s Exhibit 16: Change in PFN’s Accounts after Buying $10 Accounts after Buying $10

Million of SecuritiesMillion of Securities


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.


EXHIBIT 17 THE FED’S TARGET OPTIONS

Exhibit 17: The Fed’s Target OptionsExhibit 17: The Fed’s Target 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.

Controlling the Interest Rate: The Controlling the Interest Rate: The Fed’s Alternative Target OptionFed’s Alternative Target Option


• 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.



The Fed’s countercyclical monetary policy works either way, by changing interest rates or by changing the money supply.

Past Fed Governor Martha Past Fed Governor Martha Seger Describes How the Seger Describes How the

FOMC WorksFOMC 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.



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.


EXHIBIT 18 THE FED’S COUNTERCYCLICAL OPERATIONS

The Fed’s Countercyclical The Fed’s Countercyclical Monetary PolicyMonetary Policy


What was the Fed’s role in the addressing the Bank Crash of 2007?

Both the Fed and government rushed to rescue the at-risk commercial and investment banks, buying up substantial quantities of their over-valued – and in some cases, worthless – assets.

Chapter 27 THE FEDERAL RESERVE SYSTEM AND MONETARY POLICY Gottheil — Principles of Economics, 7e...

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