The Federal Reserve System

FEDERAL RESERVE SYSTEMFEDERAL RESERVE SYSTEM

The Federal Reserve System is charged The Federal Reserve System is charged with using monetary policy to control the with using monetary policy to control the money supplymoney supply

Regulating the lending activity (deposit Regulating the lending activity (deposit creation) of the banking systemcreation) of the banking system

FED INDEPENDENCEFED INDEPENDENCE

Members of the Board of Governors are Members of the Board of Governors are appointed by the President and approved by appointed by the President and approved by the Senate. Their terms are 14 years.the Senate. Their terms are 14 years.

Presidents of the regional Reserve Banks Presidents of the regional Reserve Banks are appointed by each banks Board of are appointed by each banks Board of Directors.Directors.

FED INDEPENDENCE cont.FED INDEPENDENCE cont.

Fed expenses are paid from its own Fed expenses are paid from its own earnings rather than Congressional earnings rather than Congressional appropriations.appropriations.

Fed policy actions do not have to be ratified Fed policy actions do not have to be ratified by the President or Congress.by the President or Congress.

FEDERAL OPEN MARKET FEDERAL OPEN MARKET COMMITTEE (FOMC)COMMITTEE (FOMC)

The seven member Board of Governors The seven member Board of Governors plus the President of the Federal Reserve plus the President of the Federal Reserve Bank of NY and four other Federal Reserve Bank of NY and four other Federal Reserve Bank Presidents (serving on a rotating Bank Presidents (serving on a rotating basis)basis)

Meets every six weeks to determine short-Meets every six weeks to determine short-run monetary policyrun monetary policy

Federal Reserve Districts and Federal Reserve Districts and Federal Reserve Bank Locations Federal Reserve Bank Locations

Exhibit 1Exhibit 1

Functions of the Federal Reserve Functions of the Federal Reserve SystemSystem

Control the money supplyControl the money supply Supply the economy with paper money (Federal Supply the economy with paper money (Federal

Reserve Notes)Reserve Notes) Provide check-clearing servicesProvide check-clearing services Hold depository institutions' reservesHold depository institutions' reserves Supervise member banksSupervise member banks Serve as the lender of last resortServe as the lender of last resort Serve as a fiscal agent for the TreasuryServe as a fiscal agent for the Treasury

Check-Clearing Process Check-Clearing Process Exhibit 2Exhibit 2

MONETARY POLICY TOOLSMONETARY POLICY TOOLS

Open market operations - the buying and Open market operations - the buying and selling of gov’t. securities by the Fed.selling of gov’t. securities by the Fed.

discount ratediscount rate reserve requirementreserve requirement

Open Market Operations Open Market Operations Exhibit 3Exhibit 3

T-AccountT-Accountr = .10r = .10

AssetsAssets LiabilitiesLiabilities

Reserves $35,000 Demand Deposits $200,000

Loans $165,000

ExamplesExamples

If the required-reserve ratio is r=10%, then If the required-reserve ratio is r=10%, then required reserves are equal to ________. required reserves are equal to ________.

Excess reserves are equal to ________. Excess reserves are equal to ________. This bank can lend a maximum of This bank can lend a maximum of

_________. _________.

T-AccountT-Accountr = .10r = .10

AssetsAssets LiabilitiesLiabilities

Reserves $20,000 Demand Deposits $200,000

Loans $165,000

Securities $15,000

ExamplesExamples If the required-reserve ratio is r=10%, then required If the required-reserve ratio is r=10%, then required

reserves are equal to ________. reserves are equal to ________. Excess reserves are equal to ________. Excess reserves are equal to ________. If the Fed buys $15,000 worth of government bonds If the Fed buys $15,000 worth of government bonds

from banks, total reserves will rise to _________ from banks, total reserves will rise to _________ and excess reserves will equal to _________.and excess reserves will equal to _________.

After the purchase of securities by the Fed, if all After the purchase of securities by the Fed, if all banks makes loans until excess reserves equal 0 and banks makes loans until excess reserves equal 0 and there are no cash leakage, checkable deposits can there are no cash leakage, checkable deposits can expand by a maximum of _________.expand by a maximum of _________.

WHY THE FED USES OPEN WHY THE FED USES OPEN MARKET OPERATIONS MARKET OPERATIONS

MOST OFTENMOST OFTEN more flexiblemore flexible easily reversedeasily reversed quick implementationquick implementation

MONETARY POLICY TOOLSMONETARY POLICY TOOLS

Open market operations Open market operations discount rate - bank borrowing and lending discount rate - bank borrowing and lending

can be influenced by changes in this interest can be influenced by changes in this interest raterate

reserve requirementreserve requirement

DISCOUNT RATEDISCOUNT RATE

The interest rate that the Fed charges The interest rate that the Fed charges depository institutions that borrow depository institutions that borrow

reserves from it.reserves from it.

FEDERAL FUNDS MARKETFEDERAL FUNDS MARKET

A market where banks lend reserves A market where banks lend reserves to one another, usually for short to one another, usually for short

periods of timeperiods of time

FEDERAL FUNDS RATEFEDERAL FUNDS RATE

The interest rate banks charge one The interest rate banks charge one another to borrow reserves in the another to borrow reserves in the

federal funds market.federal funds market.

POLICY IN ACTIONPOLICY IN ACTION

Banks are more likely to borrow from other Banks are more likely to borrow from other banks than the Fedbanks than the Fed

the spread between the disc. rate and the the spread between the disc. rate and the fed. funds rate is the key.fed. funds rate is the key.

the signal effect of a change in the discount the signal effect of a change in the discount rate is often most important.rate is often most important.

FEDERAL FUNDS RATE FEDERAL FUNDS RATE TARGETTARGET

Reports by media frequently stress the Reports by media frequently stress the Fed’s announcement about changes in the Fed’s announcement about changes in the federal funds rate targetfederal funds rate target

The Fed can influence the federal funds rate The Fed can influence the federal funds rate by altering the amount of reserves in the by altering the amount of reserves in the systemsystem

Financial markets normally react to an Financial markets normally react to an announcement by the Fedannouncement by the Fed

MONETARY POLICY TOOLSMONETARY POLICY TOOLS

Open market operations Open market operations discount ratediscount rate reserve requirement - the size of the simple reserve requirement - the size of the simple

deposit multiplier can be altered by deposit multiplier can be altered by changing r .changing r .

RESERVE REQUIREMENTRESERVE REQUIREMENT

The rule that specifies the amount of The rule that specifies the amount of reserves a bank must hold to back up reserves a bank must hold to back up

depositsdeposits

POLICY IN ACTIONPOLICY IN ACTION

changes in the reserve requirement are changes in the reserve requirement are probably the least used policy toolprobably the least used policy tool

the impact is too large, difficult to control, the impact is too large, difficult to control, and hard to reverse in a relatively short time and hard to reverse in a relatively short time period.period.

Fed Monetary Tools and TheirFed Monetary Tools and TheirEffects on the Money Supply Effects on the Money Supply

Exhibit 5Exhibit 5

FED MONETARY TOOL MONEY SUPPLY

OPEN MARKET OPERATION

Buys government securities Increases

Sells government securities Decreases

REQUIRED-RESERVE RATIO (r)

Raises r Decreases

Lowers r Increases

DISCOUNT RATE

Raises rate (relative to the federal funds rate) Decreases

Lowers rate (relative to the federal funds rate) Increases

EQUATION OF EXCHANGEEQUATION OF EXCHANGE

M V = P QM V = P Q M is the money supplyM is the money supply V is the velocity of moneyV is the velocity of money P is the price levelP is the price level Q is the real GDPQ is the real GDP

MONETARIST POLICIESMONETARIST POLICIES

Changes in the money supply have a direct Changes in the money supply have a direct impact on AD and thereby change nominal impact on AD and thereby change nominal GDP.GDP.

Equation of Exchange MV = PQEquation of Exchange MV = PQ V is stableV is stable

MONETARIST POLICIESMONETARIST POLICIES

If Real GDP rises by 3% a year, any If Real GDP rises by 3% a year, any increase in M greater than 3% will cause increase in M greater than 3% will cause increases in the price level.increases in the price level.

Increases of less than 3% will inhibit Increases of less than 3% will inhibit economic growth or cause deflationeconomic growth or cause deflation

the FED should use a money growth rule the FED should use a money growth rule instead of discretionary policy.instead of discretionary policy.

The Monetarist Position The Monetarist Position Exhibit 6BExhibit 6B

Ms < Md(Disequilibrium)

Too little money Decreases Falls

Ms > Md(Disequilibrium)

Too much money Increases Rises

Ms = Md(Equilibrium)

The right amount of money Does notchange

Does notchange

CONDITION INDIVIDUALS ARE HOLDING… SPENDING… GDP…

MONETARIST POLICY MONETARIST POLICY OUTCOMESOUTCOMES

If the economy is initially in long-run If the economy is initially in long-run equilibriumequilibrium

an increase in the money supply will an increase in the money supply will increase Price and Real GDP in the short increase Price and Real GDP in the short runrun

in the long-run, only prices will risein the long-run, only prices will rise

Monetarism in an AD-AS Monetarism in an AD-AS Framework Framework

Exhibit 5 (1 of 4)Exhibit 5 (1 of 4)

MONETARIST POLICY MONETARIST POLICY OUTCOMESOUTCOMES

If the economy is initially in long-run If the economy is initially in long-run equilibriumequilibrium

a decrease in money supply will lower the a decrease in money supply will lower the Price level and Real GDP in the short runPrice level and Real GDP in the short run

only Price level will be lower in the long-only Price level will be lower in the long-run.run.

Monetarism in an AD-AS Monetarism in an AD-AS Framework Framework

Exhibit 5 (2 of 4)Exhibit 5 (2 of 4)

APPROPRIATE POLICIESAPPROPRIATE POLICIES

What are the appropriate monetary policies What are the appropriate monetary policies to close a recessionary gap?to close a recessionary gap?– buy bondsbuy bonds– decrease discount ratedecrease discount rate– decrease reserve requirementdecrease reserve requirement

APPROPRIATE POLICIESAPPROPRIATE POLICIES

What are appropriate monetary policies to What are appropriate monetary policies to close an inflationary gap?close an inflationary gap?– sell bondssell bonds– increase the discount rateincrease the discount rate– increase reserve requirementsincrease reserve requirements

KEYNESIAN VIEW vs. KEYNESIAN VIEW vs. MONETARIST VIEWMONETARIST VIEW

Monetarist ViewMonetarist View

- Changes in money supply can directly - Changes in money supply can directly affect output in the short runaffect output in the short run

- Changes only price level in the long run- Changes only price level in the long run

KEYNESIAN VIEW vs. KEYNESIAN VIEW vs. MONETARIST VIEWMONETARIST VIEW

Keynesian ViewKeynesian View

- Uses money market model to predict the - Uses money market model to predict the effect of monetary policy on the interest effect of monetary policy on the interest raterate

- I and C are tied to the interest rate- I and C are tied to the interest rate

- Changing the interest rate alter the level of - Changing the interest rate alter the level of aggregate spendingaggregate spending

INTEREST RATESINTEREST RATES

REAL RATE - the rate of return banks REAL RATE - the rate of return banks must have to cover costs and provide a must have to cover costs and provide a return to investorsreturn to investors

NOMINAL RATE - real rate plus the NOMINAL RATE - real rate plus the expected rate of inflationexpected rate of inflation

DEMAND FOR MONEYDEMAND FOR MONEY

The inverse relationship between the The inverse relationship between the quantity of money balances and the interest quantity of money balances and the interest raterate

the interest rate is the opportunity cost of the interest rate is the opportunity cost of holding moneyholding money

Demand for, and Supply of Money Demand for, and Supply of Money Exhibit 1Exhibit 1

Interest Rate

Quantity of Money

M20

Interest Rate

Quantity of Money

0M1

i2

i1

Demand for Money

Supply of Money

(a) (b)

Equilibrium in the Money Market Equilibrium in the Money Market Interest Rate

Quantity of Money

D1

0 M1

i2

i1

Excess Demandfor Money

S1Excess Supplyof Money

i3

Equilibrium in themoney market

BONDS AND INTEREST BONDS AND INTEREST RATESRATES

bonds have a face valuebonds have a face value bonds pay a fixed interest payment each bonds pay a fixed interest payment each

year (coupon pmt)year (coupon pmt) bond prices are determined by the bond prices are determined by the

relationship between current interest rates relationship between current interest rates and the bond’s rateand the bond’s rate

BONDS AND INTEREST BONDS AND INTEREST RATESRATES

Bond Prices are inversely related to the Bond Prices are inversely related to the current interest rate.current interest rate.

If current interest rates are higher than the If current interest rates are higher than the bond’s rate then the bond will sell below bond’s rate then the bond will sell below face valueface value

If interest rates fall, bond prices riseIf interest rates fall, bond prices rise

KEYNESIAN VIEWKEYNESIAN VIEW

An expansionary Monetary Policy could fail to An expansionary Monetary Policy could fail to stimulate ADstimulate AD

Fiscal Policy is more effectiveFiscal Policy is more effective Liquidity TrapLiquidity Trap - Investment spending may not be increased even - Investment spending may not be increased even

at very low interestat very low interest - All participants prefer hold money- All participants prefer hold money - Increase in M- Increase in MSS will not reduce int. rate will not reduce int. rate - No increase in AD- No increase in AD

KEYNESIAN VIEWKEYNESIAN VIEW

Pessimistic Business ExpectationsPessimistic Business Expectations

- Investment demand decreases - Investment demand decreases

- Lower interest rates may NOT be - Lower interest rates may NOT be associated with higher investment spendingassociated with higher investment spending

- Monetary policy will again prove - Monetary policy will again prove ineffectiveineffective