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The Banking System, The Federal Reserve, and Monetary Policy

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1 The Banking System, The Federal Reserve, and Monetary Policy
Chapter 16 The Banking System, The Federal Reserve, and Monetary Policy

2 The Banking System, the Federal Reserve, and Monetary Policy
Where does money actually come from? The government just prints it, right? Much of our money supply is paper currency printed by our national monetary authority Most of our money supply is not paper currency and is not printed by anyone The monetary authority in the United States—the Federal Reserve System—is not technically a part of the government But a quasi-independent agency that operates along side of the government Lieberman & Hall; Introduction to Economics, 2005

3 What Is Counted as Money
Money is the means of payment in the economy The standard definition of money is cash, checking account balances, and traveler’s checks First, only assets—things of value that people own—are regarded as money Second, only things that are widely acceptable as a means of payment are regarded as money The Federal Reserve keeps track of the total money supply and reports it each week Lieberman & Hall; Introduction to Economics, 2005

4 The Components of The Money Supply
We count as money cash in the hands of the public In July, 2003 the Fed reported that cash in the hands of the public totaled $646 billion Almost half of this cash is circulating in foreign countries In July, 2003 the public held about $8 billion in traveler’s checks The remaining component of the money supply is checking account balances The U.S. public held $314 billion in demand deposits in July, 2003 Lieberman & Hall; Introduction to Economics, 2005

5 The Components of The Money Supply
Other checkable deposits is the catchall category for several types of checking accounts that work like demand deposits In July, 2003 the U.S. public held $298 billion of these types of checkable deposits Money Supply = cash in the hands of the public + Traveler’s checks + demand deposits + other checkable deposits In July, 2003 this amounted to Money Supply = $646 billion + $8 billion + $314 billion + $298 billion = $1,266 billion It is important to understand that our measure of the money supply excludes many things that people use regularly as a means of payment Lieberman & Hall; Introduction to Economics, 2005

6 Financial Intermediaries
Banks are important examples of Financial Intermediaries A business firm that specializes in brokering between savers and borrowers An intermediary helps to solve problems by combining a large number of small savers’ funds into custom designed packages Then lends them to larger borrowers The intermediary can reduce the risk to savers by spreading its loans among a number of different borrowers Four types of depository institutions Savings and loan associations (S&Ls) Mutual savings banks Credit unions Commercial banks Lieberman & Hall; Introduction to Economics, 2005

7 Commercial Banks A commercial bank is a private corporation, owned by its stockholders, that provides services to the public Most important service is to provide checking accounts Banks provide checking account services in order to earn a profit Bank profits come from lending Banks do not lend out every dollar of deposits they receive They hold some back as reserves Lieberman & Hall; Introduction to Economics, 2005

8 Bank Reserves and The Required Reserve Ratio
Commercial bank’s reserves are funds that it has not lent out But instead keeps in a form that is readily available to its depositors Bank holds its reserves in two places In its vault In a special reserve account managed by the Federal Reserve Why does the bank hold reserves? First, on any given day, some of the bank’s customers might want to withdraw more cash than other customers are depositing Second, banks are required by law to hold reserves Required reserve ratio, set by the Federal Reserve Tells banks the fraction of their checking accounts that they must hold as required reserves The relationship between a bank’s required reserves (RR), demand deposits (DD), and the required reserve ratio (RRR) is RR = RRR × DD Lieberman & Hall; Introduction to Economics, 2005

9 The Federal Reserve System
Every large nation controls its banking system with a central bank The Bank of England was created in 1694 France waited until 1800 to establish the Banque de France Congress established the Federal Reserve System in 1913 Why did it take the United States so long to take control of its monetary system? Suspicion of central authority Large size and extreme diversity of our country These characteristics explain why our central bank is different in form from its European counterparts One major difference is that it does not have the word “central” or “bank” anywhere in its title Lieberman & Hall; Introduction to Economics, 2005

10 The Federal Reserve System
Instead of a single central bank, the United States is divided into 12 different Federal Reserve districts Each one served by its own Federal Reserve Bank Another interesting feature of the Federal Reserve System is its peculiar status within the government It is not even a part of the government, but rather a corporation whose stockholders are the private banks that it regulates But it is unlike other corporations in several ways Fed was created by Congress and could be eliminated by Congress if it so desired Both the president and Congress exert some influence on the Fed through their appointments of key officals in the system Fed’s mission is not to make a profit for its stockholders like an ordinary corporation, but rather to serve the general public Lieberman & Hall; Introduction to Economics, 2005

11 Figure 1: The Geography of the Federal Reserve System
District boundaries State boundaries Reserve Bank cities Board of Governors of the Federal Reserve System Dallas Boston New York Washington San Francisco Kansas City Atlanta 12 9 10 11 8 6 5 7 4 3 2 1 St. Louis Chicago Richmond Cleveland Minneapolis Philadelphia Note: Both Alaska and Hawaii are in the Twelfth District Lieberman & Hall; Introduction to Economics, 2005

12 The Structure of The Fed
Near the top is the Board of Governors, consisting of seven members Who are appointed by the president and confirmed by the Senate for a 14 year term The most powerful person at the Fed is the chairman of the Board of Governors To keep any president or Congress from having too much influence over the Fed, the 4-year term of the chair is not coterminous with the 4-year term of the president Each of the 12 Federal Reserve Banks is supervised by nine directors, three of whom are appointed by the Board of Governors The other six are elected by private commercial banks The directors of each Federal Reserve Bank choose a president of that bank Who manages its day-to-day operations 3,000 of the 9,000 commercial banks in the United States are members of the Federal Reserve System They include all national banks and some state banks All of the largest banks in the United States are nationally chartered banks and therefore member banks as well Lieberman & Hall; Introduction to Economics, 2005

13 Figure 2: The Structure of the Federal Reserve System
Senate confirms Chair of Board of Governors 12 Federal Reserve District Banks Lend reserves Clear checks Provide currency 3,500 Member Banks Elect 6 directors of each Federal Reserve Bank Appoints 3 directors of each Federal Reserve Bank President appoints Federal Open Market Committee (7 Governors + 5 Reserve Bank Presidents) Conducts open market operations to control the money supply Board of Governors (7 members, including chair) Supervises and regulates member banks Supervises 12 Federal Reserve District Banks Sets reserve requirements and approves discount rate Lieberman & Hall; Introduction to Economics, 2005

14 The Federal Open Market Committee
Most economists regard FOMC as most important part of Fed Federal Open Market Committee (FOMC) A committee of Federal Reserve officials that establishes U.S. monetary policy After determining the current state of the economy, the FOMC sets the general course for the nation’s money supply Summaries of its meetings are published only after a delay of a month or more FOMC controls the nation’s money supply by buying and selling bonds in the public (“open”) bond market Lieberman & Hall; Introduction to Economics, 2005

15 The Functions of the Federal Reserve
Federal Reserve, as overseer of the nation’s monetary system, has a variety of important responsibilities Supervising and regulating banks Acting as a “bank for banks” Issuing paper currency Check clearing Controlling the money supply Lieberman & Hall; Introduction to Economics, 2005

16 How the Fed Increases the Money Supply
To increase money supply, Fed will buy government bonds Called an open market purchase Open Market Operations Purchases or sales of bonds by the Federal Reserve System The demand deposit multiplier is the number by which we must multiply the injection of reserves to get the total change in demand deposits For any value of the required reserve ratio (RRR), the formula for the demand deposit multiplier is 1/RRR Using our general formula for the demand deposit multiplier, we can restate what happens when the Fed injects reserves into the banking system as follows ΔDD = (1/RRR) × ΔReserves Lieberman & Hall; Introduction to Economics, 2005

17 How the Fed Decreases the Money Supply
Fed can also decrease money supply by selling government bonds An open market sale The Fed has trillions of dollars worth of government bonds from open market purchases it has conducted in the past A withdrawal of reserves is a negative change in reserves Can still use our demand deposit multiplier—1/(RRR)—and our general formula ΔDD = (1/RRR) x ΔReserves Lieberman & Hall; Introduction to Economics, 2005

18 Some Important Provisos About the Demand Deposit Multiplier
Our formula for demand deposit multiplier—1/RRR—is oversimplified The multiplier is likely to be smaller than formula suggests As the money supply increases, the public typically will want to hold part of the increase as demand deposits, and part of the increase as cash Banks may want to hold excess reserves—reserves beyond those legally required Lieberman & Hall; Introduction to Economics, 2005

19 Other Tools for Controlling the Money Supply
There are other tools that the Fed can use to increase or decrease the money supply Changes in the Required Reserve Ratio Changes in the Discount Ratio Changes in either the required reserve ratio or the discount rate could change the money supply by causing banks to expand or contract their lending Neither of these policy tools is used very often Why are these other tools used so seldom? They can have unpredictable effects While other tools can affect the money supply, open market operations have two advantages over them Precision and secrecy This is why open market operations remain the Fed’s primary means of changing the money supply Lieberman & Hall; Introduction to Economics, 2005

20 The Demand For Money Don’t people always want as much money as possible? Isn’t their demand for money infinite? Actually, no The “demand for money” Means how much money people would like to hold, given the constraints that they face Lieberman & Hall; Introduction to Economics, 2005

21 An Individual’s Demand for Money
Money is one of the ways that each of us, as individuals, can hold our wealth An individual’s demand for money is the amount of wealth that the individual chooses to hold as money, rather than as other assets When you hold money, you bear an opportunity cost Interest or other financial return you could have earned if you held your wealth in some other form Lieberman & Hall; Introduction to Economics, 2005

22 An Individual’s Demand for Money
Bond IOU issued by a corporation or a government agency when it borrows money Individuals choose how to divide wealth between two assets Money, which can be used as a means of payment but earns no interest Bonds, which earn interest, but cannot be used as a means of payment Since interest is the opportunity cost of holding money The greater the interest rate, the less money an Individual will want to hold Lieberman & Hall; Introduction to Economics, 2005

23 The Demand for Money by Businesses
Businesses face the same types of constraints as individuals They have only so much wealth, and they must decide how much of it to hold in money rather than in other assets The quantity of money demanded by businesses follows the same principles we have developed for individuals They want to hold more money when the opportunity cost is lower and less money when the interest rate is higher Lieberman & Hall; Introduction to Economics, 2005

24 The Economy-Wide Demand for Money
When we use the term “demand for money” without the word “individual,” we mean the total demand for money by all wealth holders in the economy The demand for money is the amount of total wealth in the economy that all households and businesses, together, choose to hold as money Rather than as bonds A rise in the interest rate will decrease the quantity of money demanded A drop in the interest rate will increase the quantity of money demanded Lieberman & Hall; Introduction to Economics, 2005

25 The Money Demand Curve This tells us the total quantity of money demanded in the economy at each interest rate The curve is downward sloping As long as the other influences on money demanded don’t change, a drop in the interest rate will increase the quantity of money demanded Lowers the opportunity cost of holding money Lieberman & Hall; Introduction to Economics, 2005

26 Figure 3: The Money Demand Curve
The money demand curve is drawn for a given real GDP and a given price level. Money ($ Billions) Interest Rate At an interest rate of 6 percent, $500 billion of money is demanded. E 6% If the interest rate drops to 3 percent, the quantity of money demanded increases to $800 billion. F 3% Md 500 800 Lieberman & Hall; Introduction to Economics, 2005

27 The Supply of Money Just as we did for money demand, we would like to draw a curve showing the quantity of money supplied at each interest rate The interest rate can rise or fall, but the money supply will remain constant unless and until the Fed decides to change it Open market purchases of bonds inject reserves into the banking system Shift the money supply curve rightward by a multiple of the reserve injection Open market sales have the opposite effect They withdraw reserves from the system and shift the money supply curve leftward by a multiple of the reserve withdrawal Lieberman & Hall; Introduction to Economics, 2005

28 Figure 4: The Supply of Money
Money ($ Billions) Interest Rate E 6% J 3% 500 700 Lieberman & Hall; Introduction to Economics, 2005

29 Equilibrium in the Money Market
We want to find the equilibrium interest rate The rate at which the quantity of money demanded and the quantity of money supplied are equal Equilibrium in the money market occurs When the quantity of money people are actually holding is equal to the quantity of money they want to hold Lieberman & Hall; Introduction to Economics, 2005

30 How the Money Market Achieves Equilibrium
When there is an excess supply of money in the economy, there is also an excess demand for bonds Excess Supply of Money The amount of money supplied exceeds the amount demanded at a particular interest rate Excess Demand for Bonds The amount of bonds demanded exceeds the amount supplied at a particular interest rate When the interest rate is higher than its equilibrium value The price of bonds will rise Lieberman & Hall; Introduction to Economics, 2005

31 Figure 5: Money Market Equilibrium
Money ($ Billions) Interest Rate 6% 9% 3% Ms At a higher interest rate, an excess supply of money causes the interest rate to fall. At the equilibrium interest rate of 6%, the public is content to hold the quantity of money it is actually holding. At a lower interest rate, an excess demand for money causes the interest rate to rise. E Md 300 500 800 Lieberman & Hall; Introduction to Economics, 2005

32 An Important Detour: Bond Prices and Interest Rates
A bond A promise to pay back borrowed funds at a certain date or dates in the future The interest rate that you will earn on your bond depends entirely on the price of the bond The higher the price, the lower the interest rate When the price of bonds rises, the interest rate falls When the price of bonds falls, the interest rate rises The relationship between bond prices and interest rate helps explain why the government, the press, and the public are so concerned about the bond market Where bonds issued in previous periods are bought and sold Lieberman & Hall; Introduction to Economics, 2005

33 Back to the Money Market
A rise in the price of bonds means a decrease in the interest rate The complete sequence of events is In the case of an excess demand for money and an excess supply of bonds The following would happen Lieberman & Hall; Introduction to Economics, 2005

34 How the Fed Changes the Interest Rate
To change the interest rate, the Fed must change the equilibrium interest rate in the money market, and it does this by changing the money supply The process works like this Or this If the Fed increases the money supply by buying government bonds, the interest rate falls If the Fed decreases the money supply by selling government bonds, the interest rate rises By controlling the money supply through purchases and sales of bonds, the Fed can also control the interest rate Lieberman & Hall; Introduction to Economics, 2005

35 Figure 6: An Increase in the Money Supply
At point E, the money market is in equilibrium at an interest rate of 6 percent. To lower the interest rate, the Fed could increase the money supply to $800 billion. Money ($ Billions) Interest Rate 6% 3% The excess supply of money (and excess demand for bonds) would cause bond prices to rise, and the interest rate to fall until a new equilibrium is established at point F with an interest rate of 3 percent. E F Md 500 800 Lieberman & Hall; Introduction to Economics, 2005

36 How the Interest Rate Affects Spending
We can summarize the impact of monetary policy as follows When the Fed increases the money supply, the interest rate falls and spending on three categories of goods increases Plant and equipment New housing Consumer durables When the Fed decreases the money supply, the interest rate rises and these categories of spending fall Lieberman & Hall; Introduction to Economics, 2005

37 Monetary Policy and the Economy
When the Fed controls or manipulates the money supply in order to achieve any macroeconomic goal it is engaging in monetary policy This is what happens when the Fed conducts open market purchases of bonds Open market sales by the Fed have exactly the opposite effects Lieberman & Hall; Introduction to Economics, 2005

38 Figure 7: Monetary Policy and the Economy
Interest Rate E 6% F 3% 500 800 Money ($ Billions) Spending on plant and equipment, housing, and durables r Total Spending GDP Lieberman & Hall; Introduction to Economics, 2005

39 Expectations and Money Demand
Why should expectations about the future interest rate affect money demand today? If you expect the interest rate to rise in the future, then you also expect the price of bonds to fall in the future A general expectation that interest rates will rise in the future will cause the money demand curve to shift rightward in the present When the public as a whole expects the interest rate to rise in the future They will drive up the interest rate in the present When the public expects the interest rate to drop in the future They will drive down the interest rate in the present Lieberman & Hall; Introduction to Economics, 2005

40 Figure 9: Interest Rate Expectations
Money ($ Billions) Interest Rate 5% 10% Ms E 500 Lieberman & Hall; Introduction to Economics, 2005

41 Expectations and the Fed
Changes in interest rates due to changes in expectations can have important consequences Fortunes can be won and lost depending on how people have bet on the future Another consequence of changes in expectations is the effect on the overall economy When a change in expectations becomes a self-fulfilling prophecy, it causes current interest rates to change The public’s ever-changing expectations about future interest rates make the Fed’s job more difficult Lieberman & Hall; Introduction to Economics, 2005

42 The Fed’s Response to Changes in Money Demand
Changes in the expected future interest rate can shift the money demand curve Changes in tastes for holding money and other assets, or changes in technology, can also shift the money demand curve Money demand shifts—if ignored—would create problems for the economy If the Fed’s goal is to stabilize real GDP, it cannot sit by while these events occur Lieberman & Hall; Introduction to Economics, 2005

43 The Fed’s Response to Changes in Money Demand
To stabilize real GDP when money demand changes on its own (not in response to a spending shock), the Fed must change the money supply Specifically, it must increase the money supply in response to an increase in money demand And decrease the money supply in response to a decrease in money demand To prevent changes in money demand from affecting real GDP, the Fed should set a target for the interest rate And adjust the money supply as necessary to maintain that target Since the Fed conducts open market operations each day It is able to use continuous feedback to keep the interest rate relatively constant Lieberman & Hall; Introduction to Economics, 2005

44 Figure 9: The Fed’s Response to Changes in Money Demand
Interest Rate 10% E E' 5% Money ($ Billions) 500 1,000 Lieberman & Hall; Introduction to Economics, 2005

45 The Fed’s Response to Spending Shocks
Shifts in total spending—due to changes in autonomous consumption, investment spending, taxes, or government purchases—cause changes in real GDP How can the Fed keep real GDP close to potential output when there are direct spending shocks like these? To stabilize real GDP, the Fed must change its interest rate target in response to a spending shock And change the money supply to hit its new target It must raise its interest rate target (decrease the money supply) in response to a positive spending shock and lower the interest rate target (increase the money supply) in response to a negative spending shock Fed’s policy of stabilizing real GDP comes at a price Fluctuations in the interest rate Fluctuations in the interest rate are costly Fluctuations in real GDP are costly too, and the Fed has concluded that it is a good idea to adjust its interest rate targets aggressively when necessary to stabilize real GDP Lieberman & Hall; Introduction to Economics, 2005

46 Figure 10: The Fed’s Response to Spending Shocks
Interest Rate 7.5% H E 5% Md Money ($ Billions) 300 500 Lieberman & Hall; Introduction to Economics, 2005

47 Using the Theory: The Fed and the Recession of 2001
Our most recent recession lasted from March to November of 2001 What did policy makers do to try to prevent the recession, and to deal with it once it started? Why did consumption spending behave abnormally, rising as income fell and preventing the recession from becoming a more serious downturn? Starting in January 2001 the Fed began to worry The Fed feared that if it did nothing, the investment slowdown would lead through the multiplier to a significant drop in real GDP The Fed decided to take action Beginning in January, the Fed began increasing the money supply rapidly The federal funds rate is the interest rate that banks with excess reserves charge for lending reserves to other banks In September of 2001, during which real GDP probably hit bottom, the federal funds rate averaged about 3.1 percent Lieberman & Hall; Introduction to Economics, 2005

48 Using the Theory: The Fed and the Recession of 2001
Although the Fed’s policy did not completely prevent the recession It no doubt saved the economy from a more severe and longer-lasting one Lower interest rates stimulate consumption spending on consumer durables Moreover, when interest rates drop dramatically and rapidly—as they did in 2001—a frenzy of home mortgage refinancing can occur Home refinancing and additional borrowing on homes seemed to play a major role in boosting consumption spending during the recession of 2001 Lieberman & Hall; Introduction to Economics, 2005

49 Figure 11(a): The Fed in Action: 2001
Money ($ Billions) Interest Rate A 6.4% During 2001, the Fed repeatedly increased the money supply . . . 3.1% C $1,093 1,170 Lieberman & Hall; Introduction to Economics, 2005

50 Figure 11(b): The Fed in Action: 2001
Money (M1) ($ Billions) 1,000 1,050 1,100 1,150 1,200 Aug. 2000 Dec. Apr. 2001 During 2001, the Fed repeatedly increased the money supply . . . Lieberman & Hall; Introduction to Economics, 2005

51 Figure 11(c): The Fed in Action: 2001
5.0 4.0 6.0 Federal Funds Rate Percent 2.0 3.0 Aug. 2000 Dec. Apr. 2001 which caused the interest rate to drop. Lieberman & Hall; Introduction to Economics, 2005


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