Transcript Chapter 10 Federal Reserve System

The Federal Reserve System
FEDERAL RESERVE SYSTEM
The Federal Reserve System is charged with
using monetary policy to control the money
supply
 Regulating the lending activity (deposit
creation) of the banking system

FED INDEPENDENCE
Members of the Board of Governors are
appointed by the President and approved by
the Senate. Their terms are 14 years.
 Presidents of the regional Reserve Banks
are appointed by each banks Board of
Directors.

FED INDEPENDENCE cont.
Fed expenses are paid from its own earnings
rather than Congressional appropriations.
 Fed policy actions do not have to be ratified
by the President or Congress.

FEDERAL OPEN MARKET
COMMITTEE (FOMC)
The seven member Board of Governors plus
the President of the Federal Reserve Bank
of NY and four other Federal Reserve Bank
Presidents (serving on a rotating basis)
 Meets every six weeks to determine shortrun monetary policy

Federal Reserve Districts and
Federal Reserve Bank Locations
Exhibit 1
Functions of the Federal Reserve
System
Control the money supply
 Supply the economy with paper money (Federal
Reserve Notes)
 Provide check-clearing services
 Hold depository institutions' reserves
 Supervise member banks
 Serve as the lender of last resort
 Serve as a fiscal agent for the Treasury

Check-Clearing Process
Exhibit 2
MONETARY POLICY TOOLS
Open market operations - the buying and
selling of gov’t. securities by the Fed.
 discount rate
 reserve requirement

Open Market Operations
Exhibit 3
T-Account
r = .10
Assets
Reserves
Loans
Liabilities
$35,000
$165,000
Demand Deposits $200,000
Examples
If the required-reserve ratio is r=10%, then
required reserves are equal to ________.
 Excess reserves are equal to ________.
 This bank can lend a maximum of
_________.

T-Account
r = .10
Assets
Liabilities
Reserves
$20,000
Securities
$15,000
Loans
$165,000
Demand Deposits $200,000
Examples




If the required-reserve ratio is r=10%, then
required reserves are equal to ________.
Excess reserves are equal to ________.
If the Fed buys $15,000 worth of government
bonds from banks, total reserves will rise to
_________ and excess reserves will equal to
_________.
After the purchase of securities by the Fed, if all
banks makes loans until excess reserves equal 0
and there are no cash leakage, checkable deposits
can expand by a maximum of _________.
WHY THE FED USES OPEN
MARKET OPERATIONS MOST
OFTEN
more flexible
 easily reversed
 quick implementation

MONETARY POLICY TOOLS
Open market operations
 discount rate - bank borrowing and lending
can be influenced by changes in this interest
rate
 reserve requirement

DISCOUNT RATE
The interest rate that the Fed charges
depository institutions that borrow
reserves from it.
FEDERAL FUNDS MARKET
A market where banks lend reserves
to one another, usually for short
periods of time
FEDERAL FUNDS RATE
The interest rate banks charge one
another to borrow reserves in the
federal funds market.
POLICY IN ACTION
Banks are more likely to borrow from other
banks than the Fed
 the spread between the disc. rate and the
fed. funds rate is the key.
 the signal effect of a change in the discount
rate is often most important.

FEDERAL FUNDS RATE
TARGET
Reports by media frequently stress the Fed’s
announcement about changes in the federal
funds rate target
 The Fed can influence the federal funds rate
by altering the amount of reserves in the
system
 Financial markets normally react to an
announcement by the Fed

MONETARY POLICY TOOLS
Open market operations
 discount rate
 reserve requirement - the size of the simple
deposit multiplier can be altered by
changing r .

RESERVE REQUIREMENT
The rule that specifies the amount of
reserves a bank must hold to back up
deposits
POLICY IN ACTION
changes in the reserve requirement are
probably the least used policy tool
 the impact is too large, difficult to control,
and hard to reverse in a relatively short time
period.

Fed Monetary Tools and Their
Effects on the Money Supply
Exhibit 5
FED MONETARY TOOL
MONEY SUPPLY
OPEN MARKET OPERATION
Buys government securities
Sells government securities
Increases
Decreases
REQUIRED-RESERVE RATIO (r)
Raises r
Lowers r
Decreases
Increases
DISCOUNT RATE
Raises rate (relative to the federal funds rate)
Lowers rate (relative to the federal funds rate)
Decreases
Increases
EQUATION OF EXCHANGE
MV=P Q
 M is the money supply
 V is the velocity of money
 P is the price level
 Q is the real GDP

MONETARIST POLICIES
Changes in the money supply have a direct
impact on AD and thereby change nominal
GDP.
 Equation of Exchange MV = PQ
 V is stable

MONETARIST POLICIES
If Real GDP rises by 3% a year, any
increase in M greater than 3% will cause
increases in the price level.
 Increases of less than 3% will inhibit
economic growth or cause deflation
 the FED should use a money growth rule
instead of discretionary policy.

The Monetarist Position
Exhibit 6B
CONDITION
INDIVIDUALS ARE HOLDING…
SPENDING…
GDP…
Ms > Md
Too much money
(Disequilibrium)
Increases
Rises
Ms < Md
Too little money
(Disequilibrium)
Decreases
Falls
Ms = Md
(Equilibrium)
Does not
change
Does not
change
The right amount of money
MONETARIST POLICY
OUTCOMES
If the economy is initially in long-run
equilibrium
 an increase in the money supply will
increase Price and Real GDP in the short
run
 in the long-run, only prices will rise

Monetarism in an AD-AS
Framework
Exhibit 5 (1 of 4)
MONETARIST POLICY
OUTCOMES
If the economy is initially in long-run
equilibrium
 a decrease in money supply will lower the
Price level and Real GDP in the short run
 only Price level will be lower in the longrun.

Monetarism in an AD-AS
Framework
Exhibit 5 (2 of 4)
APPROPRIATE POLICIES

What are the appropriate monetary policies
to close a recessionary gap?
– buy bonds
– decrease discount rate
– decrease reserve requirement
APPROPRIATE POLICIES

What are appropriate monetary policies to
close an inflationary gap?
– sell bonds
– increase the discount rate
– increase reserve requirements
KEYNESIAN VIEW vs.
MONETARIST VIEW

Monetarist View
- Changes in money supply can directly
affect output in the short run
- Changes only price level in the long run
KEYNESIAN VIEW vs.
MONETARIST VIEW

Keynesian View
- Uses money market model to predict the
effect of monetary policy on the interest rate
- I and C are tied to the interest rate
- Changing the interest rate alter the level of
aggregate spending
INTEREST RATES
REAL RATE - the rate of return banks
must have to cover costs and provide a
return to investors
 NOMINAL RATE - real rate plus the
expected rate of inflation

DEMAND FOR MONEY
The inverse relationship between the
quantity of money balances and the interest
rate
 the interest rate is the opportunity cost of
holding money

Demand for, and Supply of Money
Exhibit 1
Interest Rate
Interest Rate
Supply of Money
i2
i1
Demand for Money
0
M2
M1
Quantity of Money
(a)
0
Quantity of Money
(b)
Equilibrium
in
the
Money
Market
Interest Rate
S1
i2
Excess Supply
of Money
Equilibrium in the
money market
i1
i3
D1
Excess Demand
for Money
0
M1
Quantity of Money
BONDS AND INTEREST
RATES
bonds have a face value
 bonds pay a fixed interest payment each
year (coupon pmt)
 bond prices are determined by the
relationship between current interest rates
and the bond’s rate

BONDS AND INTEREST
RATES
Bond Prices are inversely related to the
current interest rate.
 If current interest rates are higher than the
bond’s rate then the bond will sell below
face value
 If interest rates fall, bond prices rise

KEYNESIAN VIEW
An expansionary Monetary Policy could fail to
stimulate AD
 Fiscal Policy is more effective
 Liquidity Trap
- Investment spending may not be increased even
at very low interest
- All participants prefer hold money
- Increase in MS will not reduce int. rate
- No increase in AD

KEYNESIAN VIEW

Pessimistic Business Expectations
- Investment demand decreases
- Lower interest rates may NOT be
associated with higher investment spending
- Monetary policy will again prove
ineffective