Transcript Lecture8a

CHAPTER 7 & 8
THE FEDERAL RESERVE,
MONETARY POLICY, AND
INTEREST RATES
Origins of the Federal Reserve System
• Prior to 1863, banks issued bank notes that
functioned like our present day currency but
were the obligations of individual banks.
– Because of the risk of failure, some banks’ notes
traded at a discount.
– The quantity of money in circulation fluctuated
causing the business cycle
– Banks that followed unsound practices (inflation)
saw their money (bank notes) diminish in value.
Origins of the Federal Reserve System
(continued)
• From 1863 to 1914 banknotes were backed by
holdings of U.S. government bonds.
– In 1863, the National Banking Act placed a tax on
banknotes issued by state-chartered banks (thereby
leading to their demise) and required national banks
to back their banknotes with holdings of U.S.
government bonds.
– State banks continued operating by issuing demand
deposits.
Origins of the Federal Reserve System
(concluded)
– Demand deposits were not insured, so they
were often discounted when the bank was
distant, suspect, or unknown.
– Further, banks were subject to liquidity
problems and the economy suffered several
recessions and crises, culminating in the
crash of 1907.
– These problems lead to the passage of the
Federal Reserve Act in 1913.
The Initial Purposes of the Fed
Were to:
• Provide an elastic currency supply (money
supply control).
• Serve as a lender of last resort (discount
window).
• Provide for a sounder banking system
(regulatory powers).
• Improve the payments system (check clearing
and promoting payments system technology).
Non-monetary Powers of the Fed
• Regulation Q -- established the maximum rate
that depository institutions could pay on
deposit accounts until it was phased out over
the 1980-1986 period.
• Securities Credit Regulation -- establishes
borrowing (margin) limits for buyers of
securities on margin.
• Supervision and Examination of State Member
Banks.
Non-monetary Powers of the Fed
(concluded)
• Regulation of Bank Holding Companies.
• Regulation of Payment System.
• Control of International Banking
Activities.
• Consumer Credit Regulation.
Organization of the Federal
Reserve System
Advisory Councils
Federal Reserve banks
(12 districts)
Advise
Board of Governors
(7 appointed members)
• Sets reserve requirements and approves
discount rates as part of monetary policy.
• Supervises and regulates member banks and
bank holding companies.
• Establishes and administers protective
regulations in consumer finance.
• Oversees Federal Reserve Banks.
Exercises
General
Supervision
• Propose discount rates.
• Hold reserve balances for depository
institutions and lend to them at the
discount window.
• Furnish Currency.
• Collect and clear checks and transfer
funds for depository institutions.
• Handle U.S. government debt and cash
balances
Compose
Federal Open Market Committee
(Board of Governors and 5 Federal Reserve bank presidents)
• Directs open market operations, which is the primary instrument of monetary policy.
The Fed's Balance Sheet (1998)
Assets
Loans
Government and Agency
Securities and Repos
Coins
Cash Items in Process of
Collection (CIPC)
Other Assets
Gold certificates and SDRs
Foreign-Denom. Assets
Other Assets and premises
Total ($510.1 billion)
Source: Board of Governors, Federal Reserve System.
Percent Liabilities
0.05% Federal Reserve Notes
Deposits:
89.02%
Depository Inst. Reserves
0.08%
U.S. Treasury Deposits
Foreign and Other
0.48% Deferred Availability Cash
Items (DACI)
3.97% Other Liabilities and Accrued
3.45% Dividends
2.93% Capital and Surplus
100.0% Total ($510.1 billion)
Percent
90.80%
3.99%
1.31%
0.10%
0.39%
0.93%
2.48%
100.0%
Banks Hold Deposits in Other Banks and Federal
Reserve Banks in Order to Clear Checks
• While the physical paper check moves
from bank to bank, the deposit accounts
of banks are merely debited or credited.
• Many checks are cleared locally through
clearing house associations. Checks
drawn on association member banks are
netted out.
The Federal Reserve Banks Are Heavily Involved
in the Check Clearing of Out of Town Checks
• Most depository institutions either directly or
indirectly (through other banks) hold reserve
deposits in the Fed.
• Checks written on other banks are sent to the
Fed and, depending on the distance and time
needed to present the check to the paying bank,
the reserve account of the check depositing
bank may receive immediate or delayed
(DACI) credit.
The Federal Reserve Banks Are Heavily Involved in the
Check Clearing of Out of Town Checks (concluded)
• When a check is cleared and a deposit
transfer is made at the Fed, the total
bank reserves remain the same; only the
ownership (one bank to another) changes.
Three Tools of Federal Reserve
Monetary Policy
1. Establishing reserve requirements, the
minimum proportion (percentage) of bank
deposits they must keep on deposit at the Fed.
– Increasing reserve requirements (%) increases the
percentage of bank deposits kept in noninterest
bearing deposits at the Fed and limits bank lending.
– Decreasing reserve requirements (%) reduces the
percentage of bank deposits kept in the Fed and
provides the banking system with excess reserves.
Three Tools of Federal Reserve
Monetary Policy (continued)
– Bank deposits (reserves) in the Fed are
needed to clear checks and to satisfy reserve
requirements.
– Actual reserves (AR) are balances needed to
meet check clearing and legal reserve
requirements including
• vault cash.
• noninterest bearing bank deposits in Federal
Reserve banks.
Three Tools of Federal Reserve
Monetary Policy (continued)
– Required reserves (RR) is the dollar level of
reserves needed to meet legal reserve
requirements.
• Reserve requirements (%) and the level and type
of deposits determine the level of required
reserves in a period.
• Actual reserves (have) needed for check clearing
may exceed required reserves (have to have) and
vice versa.
Three Tools of Federal Reserve
Monetary Policy (continued)
– Excess reserves (ER) equals actual minus required
reserves.
• Excess reserves may be loaned to customers or sold to other
banks (federal funds market) by an individual bank.
• If the level of the banking system's Federal Reserve
borrowed reserves (BR) (Fed loan credited to reserve
accounts) exceeds the level of excess reserves in a period,
the banking system is in a net borrowed reserve position, is
less likely to promote lending activities, and interest rates
are most likely to be increasing.
Three Tools of Federal Reserve
Monetary Policy (continued)
• If the level of level of excess reserves
exceeds Fed borrowing, the banking
system is in a net-free reserve position,
credit is easier and interest rates are
generally lower.
Three Tools of Federal Reserve
Monetary Policy (continued)
2. Open market operations affect the level of
member bank reserves and the monetary base.
– Buying government securities from the private
sector, the Fed eventually credits member bank
deposits, thus increasing the level of bank reserves
and the banks' ability to make loans and expand the
money supply.
– Selling securities (could be any asset) to private
security dealers or banks, the Fed is paid with a
bank check which reduces the level of member bank
actual reserves.
Three Tools of Federal Reserve
Monetary Policy (concluded)
3.Discount Rate Policy -- The rate of
interest depository institutions pay for
borrowing from the Fed.
– Raising the discount rate increases the cost
of borrowing for needed reserve balances.
– Lowering the discount rate lowers the cost of
bank liquidity and encourages lending and
money supply expansion.
Impacts of Federal
Reserve Policy
• Expansionary monetary policy
– Open market operations -- purchase securities -increase bank excess reserves and the monetary
base.
– Reserve requirements -- reduce reserve
requirements -- increase excess reserves and
increase the deposit expansion multiplier.
– Discount rate -- reduce the rate -- reduce the cost of
borrowing reserves.
– Expands the money supply; reduces interest rates.
Impacts of Federal
Reserve Policy (concluded)
• Restrictive monetary policy
– Open market operations -- sell securities, reduce
bank reserves and the monetary base.
– Reserve requirements -- increase reserve
requirements, reduces excess reserves and the
deposit expansion multiplier.
– Discount rate -- increase the discount rate and the
cost of borrowing reserve deficiencies.
– Reduce the money supply or its growth rate;
increase interest rates.
Effects of Federal Reserve
Policy in the Financial System
• Changes in the Money Supply
– When the Fed either increases the monetary
base or reduces reserve requirements, banks’
excess reserves increase.
– Excess reserves are loaned out or invested.
– Transaction deposits increase as loaned or
invested funds are deposited.
– The money supply increases.
Effects of Federal Reserve
Policy in the Financial System
• Changes in Interest Rates
(continued)
– Expansion of the monetary base or reductions in
reserve requirements increase bank liquidity.
– Federal Funds rate declines.
– Price of other money market securities increase
(rates decline) as banks invest their liquidity.
– Loan rates and other security rates decline with
continued increases in bank liquidity.
– Monetary policy starts in the bank money market
and spreads to other financial institutions and
markets and to the real economy.
Effects of Federal Reserve
Policy in the Financial System
(concluded)
• Credit availability is increased with the
expansion of bank liquidity and reduced
interest rates.
• Wealth Effects -- reduced interest rates
(increased security prices) increases the wealth
of individuals.
– Increased wealth prompts increased spending.
– Increased spending has a current income, Y, impact
and a multiplier effect in future income periods.
Short-Run Effects of
Monetary Policy
• Monetary policy affects spending
– Investment.
– Consumption.
– State and local government.
• Effects of Monetary Policy on Changes in
Investment
– Investment demand, traditionally, has been
sensitive to changes in interest rates.
Short-Run Effects of
Monetary Policy (continued)
– Housing investment -- both credit
availability and mortgage rates have been
impacted severely by monetary policy.
– Plant and equipment investment is related to
expected rates of return relative to the cost
of financing.
– Planned inventory investment is sensitive to
the cost and availability of credit.
Short-Run Effects of
Monetary Policy (continued)
• Consumption expenditures are affected
several ways:
– Increased or decreased holdings of money
affect spending.
– Credit availability and interest rate levels
affect the purchase of durable goods.
– Changes in wealth affect spending in the
current period.
Short-Run Effects of
Monetary Policy (concluded)
• Foreign trade is affected by monetary policy.
– Increased interest rates increase the value of the
dollar relative to the other currencies.
– Increased dollar exchange rates encourage imports;
discourage exports.
• State and Local Government Expenditures
– Monetary policy affects capital project expenditures.
– Higher interest rates limit expenditures.
Changes in the Discount Rate
Long-Run Effects of
Monetary Policy
• Expectations are affected by current,
short-run monetary policy actions.
• High money growth to stimulate the
economy may increase interest rates
(interest rate effects).
– Market expects inflation from near-term
policy action.
– Investors sell long-term bonds, prices fall,
and interest rates increase.
Long-Run Effects of
Monetary Policy (concluded)
• Expected inflation may cause increased
spending and borrowing and increased interest
rates.
– Pay back lower value debts.
– Buy before the price goes up psychology.
– May move the economy to inflationary income
levels.
– Cost increases (interest and labor) faster than price
increases will cause reductions in investment
spending.
Practical Considerations
in Monetary Policy
• Expectations may nullify intent of policy.
• Time lags in implementing monetary
policy reduce its effectiveness.
• Political pressures influence Federal
Reserve policy.