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Banking, Federal Reserve, Monetary Policy Other tidbits.

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1 Banking, Federal Reserve, Monetary Policy Other tidbits

2 BANKING, MONEY AND THE FED What is money? Why do we need it? How can we get it? Is there ever enough? Is there ever too much???? What backs the dollar?

3 Early Banking continued GOLD STANDARD Congress passed the Gold Standard Act- tied to the basic unit of currency and equal to it. Currency could be traded in for gold- people felt secure. – Advantage: confidence of people- prevented government from printing too much currency. – Disadvantage- economic growth is tied to the money supply – no flexibility for productive growth. – Most countries between 1871 and 1914 were on Gold Standard. U.S was last to get on.

4 Early Banking U.S. government went off the gold standard Britain went of two years earlier Gold Reserve Act passed- required citizens to turn in their gold and gold certificates- people were given Federal Reserve Notes in exchange- those who refused to turn in gold had their gold confiscated President Nixon declared no gold backing whatever for dollar- placed the exchange equivalent with other currencies (dollar v pound v yen v mark) (now in 2008… dollar v pound v Euro) Gold window was closed! And as we know, the dollar will fluctuate with currency market..Referred to as Exchange rate.

5 What Gives Money Its Value?  Our money today has value because of its general acceptability.

6 Money vs. Barter  Money - Any good that is widely accepted for purposes of exchange and in the repayment of debt.  Barter - Exchanging goods and services for other goods and services without the use of money.

7 Barter is inefficient and expensive Deteriorates after few trades Requires a double co-incidence of wants. Too costly to travel long distances (trading a cow for a fuzzy fleece from L.L. Bean in Maine.)

8 MONEY SUPPLY Key to money is…………do people have faith in it? If not, they rush out and spend it….. No savings! SO… what do we have today in our economy- high/low savings rate What has the federal government done lately to increase our spending? Money supply means- all the money available for spending at any one time. Fed used to use M1 as barometer. Today, they use M2.

9 History of Why American Banks were created

10 The warm(Revolutionary) left us in debt. Some states were bankrupt. We needed one unified currency... Hamilton suggested a central bank. The First Bank's charter was drafted in 1791 by the Congress and signed by George Washington. In 1811, Congress voted to abandon

11 Progression to FED 1812 War with Britain- no money to finance- almost lost- scraped enough at last moment to win – British distracted with Napoleonic Wars Second Bank of U.S – Andrew Jackson took it down- only wanted State Banks Free-for-all began….

12 EARLY PROBLEMS OF U.S. BANKING SYSTEM. Before the Fed was established U.S. could not adjust supplies of money to business activity Banks were often short of cash- if people deposited their money- wanted it on the spot, had legal right to withdraw it. Banks often kept some $ in their reserve accts, and deposited money in other banks. Sometimes demand for currency was >than the amount of money on hand. Banks would draw on deposits from other banks and sell other assets such as government securities.

13 banking system problems Pressure from depositors often caused a chain reaction of money shortage in a number of banks. People panicked. If bank could not meet its demand for currency- it “failed” Bank closings brought on periods of economic depression called “money panics” (people lost confidence in their bank and wanted their money out) Panic of Congress decided the U.S. needed a central banking system where money supply could expand and contract.- Federal Reserve System- 1913

14 Previous cyclical depressions prior to Federal Reserve being created 1819 – Several years of inflation engineered by the 2 nd Bank of the U.S – 2 nd Bank of U.S. went down after Andrew Jackson did away with central banking. He felt central banking was inherently inflationary – depression in northern states and not southern states.. Reflected by state chartered banks requiring state banks to buy state bonds by state govts.  1893 – happened as a result of silver legislation- caused inflated currency- lasted 4 years – Panic… set the stage for Federal Reserve System.

15 EARLY BANKING Under what authority can the U.S. Treasury print dollars? (Article I, Section 8, clause 5) In early days: most banks were state banks – issued their own currency backed by their own supply of either gold or silver Bank of the U.S. – only national bank- acted much like the U.S. Treasury by collecting and paying debts owed to the federal government No regulation of state banks-no limit on amount of currency they could print. Early years- many banks went bankrupt.

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17 So… what’s the bottom line? Beginning government – attempt at national banking… that failed States wanted to control banking and that failed. Chaos evident with no confidence and market crashes/ depression- banks failed… attempt to re- build national stability For a period of years, banking stability seemed assured. Today,(2010) we have seen that banking took a turn of strong instability.

18 Additional info on Banking….legalities Has Congress the power to incorporate a bank? (Yes, “necessary and proper clause” “to make all laws which shall be necessary and proper for carrying into execution” the expressed powers in the Constitution.” May a state tax a U.S. Bank? (No, the power to tax involves the power to destroy. Such a tax could be used to destroy an institution vitally necessary to carry out the operations of the federal government, and therefore is unconstitutional and void. McCulloch vs. Maryland (1819)

19 Banks Today!  Community Reinvestment Act (Carter Administration)- required banks to provide loans to low-income families.  Continued with no-income families.  Banks bundled the risky loans- sold paper- good investment for other banks, financials, global players entered here also.  Continued for about 10 years, with banks continuing the risky loans.  Hedge fund investors played their cards, and entered the scene.  Off to the races!

20 Bailout U.S. Federal Reserve/Treasury Department have orchestrated the biggest bailout of banks, financials, Fannie and Freddie, AIG, etc. etc. The automobile industry is also in on the act. Fed has pumped billions into system Treasury has trillions extra and 200 billion for Fannie and Freddie

21 Crisis of Banking Part 1 and 2 Part I K:\videos for class\HornK8 sent you a video The Crisis of Credit Visualized - Part 1.htm Part 2 Ew&feature=relmfu Ew&feature=relmfu

22 COMPONENTS OF MONEY M1= Currency coins, demand deposits, travelers checks M2=M1+Savings deposits, small time deposits (under $100,000), money market mutual funds. M3=M1+M2+large denomination time deposits (over $100,000) LM3 + liquid assets (T-bills, U.S.Savings bonds, commercial paper) Near Monies: Credit cards Stocks and Bonds IRA’s Keogh Accounts

23 Four functions of money Medium of exchange Basis for quoting prices Store of value (can accumulate wealth by saving) Standard of deferred payment (buy now, pay later… no payments until 2020) Money will be good to pay in 2020 as is today.

24 Are Credit and Debit Cards Money? Yes!  Credit card use represents loans which must be repaid. They represent the use of someone else's money.  Debit cards give access to checkable deposits which are already part of the money supply.

25 Value of Money How much money do you have: in your pocket in your checking account in your savings account MMoney has value- too much in circulation, decreases its value……. inflation is BAD WWhat backs our currency? OOur money is called what? WWhat will a dollar buy today?

26 MONEY SUPPLY Key to money is…………do people have faith in it? If not, they rush out and spend it….. No savings! SO… what do we have today in our economy- high/low savings rate What has the federal government done lately to increase our spending? Money supply means- all the money available for spending at any one time. Fed used to use M1 as barometer. Today, they use M2.

27 Supply and Demand for Credit Banks and other lending institutions lend money- expect to be paid for its use. Amount they lend (subject to some legal restrictions) is determined by how much they have to lend and how much the borrower is willing to pay. This charge or price for use of money = interest

28 Demand for Money  Represents the inverse relationship between the quantity demanded of money balances and the price of holding money balances.  Interest rate is the price (opportunity cost) of holding money balances.

29 Equilibrium in the Money Market At an interest rate of i 1, the money market is in equilibrium: There is neither an excess supply of money nor an excess demand for money

30 Interest rates fluctuate with changes in demand for money in relationship to changes in supply of money available. Money becomes valuable just like other value created for other commodities (demand relative to supply) So when the FED began lowering the FF Rate, and money was almost “free,” did this affect our financial crisis today????

31 HOW DID WE GET FRACTIONAL BANKING SYSTEM? Goldsmiths: Knights brought back gold when making conquests…what to do with it? – measured it for purity of value Gold treasure more than King could use Receipt was given for deposits- based on purity value People who had gold began to deposit with Goldsmiths- receipts given - receipts exchanged rather than gold and used for purchase. Church entered and said it was fraudulent for Goldsmiths to do this.

32 Easier to exchange receipts than pick up actual gold and exchange for g/s Goldsmiths began to make loans on deposits not claimed… kept a fraction on reserve…loaned out rest

33 Federal Reserve

34 FEDERAL RESERVE STRUCTURE Board of Governors 7 Members 12 District Banks Member Banks One of 7 is Chairman

35 FED Can Issue Federal Reserve Notes………………. Have you ever seen a Federal Reserve Note? Do any of you have any Federal Reserve Notes? A=Boston B= New York C= Philadelphia D= Cleveland E= Richmond, VA F= Atlanta G= Chicago H= St. Louis I= Minneapolis J= Kansas City K= Dallas L= San Francisco

36 1. A.Boston 2. B. NY 3.C. Philadelphia 4.D. Cleveland 5.E. Richmond,VA 6.F. Atlanta 7. G. Chicago 8.H. St. Louis 9. I. Minneapolis 10. J. Kansas City 11. K. Dallas* 12.L. San Francisco 12 Regional Banks

37 12 District Banks. Dallas is the 11 th District… K 25 Regional Banks. Dallas has region banks in El Paso, San Antonio, Houston.

38 Is the Fed effective??? What is the Discount Rate today 6/27/ /8/ /2/ /22/ /20/ /17/ % 4/15/ /16/ % 6/29/ % 4/17/ % 11/21/ % Spring, % Dec. 2004, 3.00%

39 What is the Federal Funds Rate –Today 6/24/ /8/ /2/ / /20/ /17/ % 4/15/ % 4/16/ % 6/29/ % 4/17/06, 5.00% 11/21/05, 4.15% Was 2.875%(spring, 2005) (was 2% 12/2004) (2003, FFR was 1.0%)

40 Prime Rate? – Today – 6/24/ /8/ /2/ /22/ % 4/20/ % 11/17/ % 5/15/ % 4/16/ % 6/29/06, 8.00% 4/17/06, 7.75%, 11/21, 7.00% (was 5.75% in spring 2005) (was /2004)? Where does fiscal policy enter in here? What would constitute a counter cyclical move by either the Federal government or the Federal Reserve?

41 3 Monetary Tools for the FED 1.Reserve Requirement 2.Discount Rate 3.FOMC

42 One Tool to Control Money Supply Reserve Requirement The Fed requires banking institutions, including S&Ls, Credit Unions, Loan Assns, to maintain reserves against the demand deposits of their customers. Required and excess are important concepts Required Reserves are: vault cash and deposits held for them at the Fed. This RR can alter the loans that members can make by: a)Lowering RR = creating more money to loan b)Raising the RR= decreasing money creation. RR’s do not change very often. Changes in RR can be disruptive of banking operations. RR change could force banks to sell securities quickly or call in loans to meet the Fed requirement. Current: 3% 0-$46.5 Mil 10% $46.5 +

43 How Fractional Banking Works Fed RR is 20%(bank required to hold a percentage of its deposits on RR Deposit made = $100, ,000 (bank holds in reserve $ 80,000 (bank can loan this amount) This $80,000 is considered new money Whoever receives the $80,000 as a loan then deposits it into an account and can write checks immediately, but the bank views it as “never seen before.”

44 CONTINUED RR/FRACTIONAL BANKING EXAMPLE $80, ,000 (20% reserve required) -16,000 (20% reserve required) $64,000 (potential new loan which can be created and loaned out to another customer $64,000 (potential new loan which can be created and loaned out to another customer $64,000 new deposit in mind of bank - 12,800 (20 % must be kept in reserve) - 12,800 (20 % must be kept in reserve) $51,200 considered new money available for loan $51,200 considered new money available for loan

45 CONTINUED RR/FRACTIONAL EXAMPLE This cycle keeps going on and on- The money multiplier factor for 20% RR is 5 to 1 Using the above example- banks could create 5 times the $100,000 at 20% reserve required or in other words, it can create $500,00 “NEW MONEY” At 25% required as opposed to say 10%- higher requirement would lower the multiplier effect from 10 to 4 which in turn would not allow banks to have as much money to loan- or would be taking money out of circulation.

46 Summary/RR/Fractional Banking/Multiplier The higher the required reserve- the lower the multiplier. The potential deposit expansion multiplier is merely the reciprocal of the required reserve ratio (r ) In case of 20% example or l/5 of total deposits to be held- deposit expansion multiplier is 5 If 10% was to be held- deposit expansion multiplier is 10.

47 Money Multiplier Potential and Actual: Potential = 1 required reserve Actual (will be much smaller than potential) a. currency drain (in pockets) b. Excess reserves (held in banks)

48 DOES MULTIPLIER ALWAYS WORK? no Creating New Money with the deposit expansion multiplier effect will not work if:  All excess reserves are tied up. (purchase securities, loans, etc.)  If person receiving the loan decides to hold currency rather than deposit it into the bank  If banks decide not to extend loans even though they have excess reserves available (referred in the early 90’s as “credit crunch.” And… is happening today!

49 Banking Change 1993 Sweet Accounts Banks are in business to make money!!! When they get greedy- they often fail as we have seen To get around the RR requirement- Banks got creative Transfer from savings to deposit accounts if accounts were negative Transfer out of deposit to savings if too much not “earning interest” Reducing the amount in deposit accounts can lower % required for RR.

50 SECOND TOOL TO CONTROL MONEY SUPPLY- DISCOUNT RATE There are two types of interest: Simple and discount. – Simple- paid each time a payment is made on the loan. – Discount- entire amount of interest owed is deducted from loan before it is issued

51 Discount Rate Continued -Member banks “lent out” (have no money to loan and a good corporate customer wants a loan) - Or, perhaps they can’t cover their required reserve requirement. - Need to pay out customer request for deposited funds and poor management of prior loans left bank short of cash

52 DISCOUNT RATE CONTINUED District Bank is not a charity bank… charges interest on money loaned to member banks. – If Member Bank borrows $100,000 at 10% – The interest is discounted up-front- Member has $90,000 to take back to loan. – Member bank is not going to loan at 10% – Adds 2 to 3 points to constitute prime rate. In this example is 13%

53 Discount Rate continued – If ordinary citizen wants to borrow, points added to prime depending on type of loan, collateral, history, etc. – Prime rate is always higher than discount- each bank sets own prime, but large banks tend to all have the same. – Prime is rate given to best corporate customers.

54 DISCOUNT RATE CONTINUED  If Fed wants to cut down on bank loans, they can raise the discount rate.  Recently the Fed lowered the discount rate to encourage loans  **Banks will borrow from Federal Funds Rate before going to the Fed to borrow. Too many trips to the Fed to borrow signals poor fiscal management of the bank  What is the Federal Funds Rate? The rate banks can charge (as set by the BOG) for short-term loans between each other – often overnight.  Federal Funds rate will be lower than discount rate. Why?  1.25 vs 1.00 (11/24/08) Today:.50% vs.25%

55 ON May 17, Fed revised Discount program Type of discount would be called Primary Credit. Available for very short term back-up source of liquidity to depository institutions in sound financial condition. Would be extended at a rate above the “usual” level of short- term federal funds rate. Interest rate on primary credit would be 100 basis points above targeted federal funds rate. If FF rate is.5 the primary credit would be 1.5 This encourages banks to borrow from each other rather than going to Fed. Allows Fed to eliminate a lot of bank investigations and paperwork. Also establishing a secondary credit = another 50 basis points to financial depositories not quite as sound. NOT!!!!!!!!!!

56 THIRD TOOL TO CONTROL OPEN MARKET COMMITTEE (FOMC) This is the most common tool used by Fed to alter the money supply. Buying and Selling of U.S. securities on the open market FOMC meets about every six weeks. FOMC = all 7 BOG, 12 District Presidents N.Y. President permanent member, other 11 Presidents rotate on the voting 12 on yearly basis. FOMC constitutes 12 persons. Can directly influence the money supply in a non- disruptive way.

57 FOMC Continued  FED can write a check without funds in an account so to speak.  FED holds large portfolio of U.S. government securities  FED engages in open market trading with approximately 3 dozen major securities dealers.  These transactions take place at NY Fed Trading Desk A SELL OPERATION  When Fed wishes to restrain money supply growth, the Fed sells U.S. government securities on the open market.

58 FOMC Continued  Call goes out from NY Desk to pre-selected security dealers. Go out to the banks with the offer.  Securities dealers then pay the Fed from deposits held at their banks, and the Fed simply deducts an equivalent amount from the banks’ reserve account.  As result- banks have less credit in reserve-(taken from excess reserves) and cannot make as many loans  Banks might even have to sell some of their investments… reduced supply of credit throughout the banking system.

59 FED controls this operation by enticing banks to buy government securities by offering “good deals.” Example: Treasury Bond issued to FED. $10,000. FED offers this Bond interest to pay a fixed rate of 10% yearly until bond expires.- Fed (through Security dealer) goes to bank and says (sell this $10,000 bond for $8,000 – still pay the 10%- (this is selling below par) This pulls lump sum out of circulation (actual rate bank will make over bond life is 12l/2 %. Money supply has shrunk. If the banks elect to buy- less money to loan. Banks prefer buy government securities because of the risk factor being lowered.

60 FOMC CONTINUED BUY OPERATION:  When FED wants to increase the money supply, it reverses the procedure and purchases U.S. government securities on the open market. It then credits the reserve accounts of the banks in which securities dealers keep their deposits. End result is that banks have more funds to lend.  Example: Fed offers to buy the $10,000 bond sold on open market for $12,000. Bank sells- this puts money in circulation or creates potential for banks to loan more to member banks.

61 FOMC CONTINUED Open Market is not in the business to make money- they actually lose money on most transactions Main function is to control loans the banks can make. Securities desk in N.Y. puts the bonds for buy or sell out to Security dealers for best bid. Every security purchased lowers the money supply. FED can use this tool as major way to offset cyclical economic swings. Can also supply money for seasonal adjustment demands made by business and consumers. Or, as we saw, provide money when disaster strikes.

62 FOMC assesses growth operations directed to 4 objectives: full employment, economic growth, stable prices and balance of payments.

63 No bank will ever loan out ALL of its excess reserves- This would leave them with no flexibility in buying Govt Securities. Banks are in business to make a profit!


65 FED AS THE NATION’S CENTRAL BANK MONETARY POLICY AS REQUIRED BY Congress Provide a flow of credit and money that will foster economic stability and growth Establish a high level of employment Provide stability in purchasing power of the dollar. Reminder- Fed is autonomous Three principal tools to implement monetary policy: 1.Reserve requirements 2.Discount rate 3.Open market operations

66 Money and Production Money is the means of helping to facilitate our economic purposes of production, distribution, and consumption of goods and services Relationship between money supply, price levels and business is important aspect of macro theory. Equation of Exchange: MV=PT or MV=PQ Money x Velocity = Prices x Business Transactions (real levels of output) MV= total spending for the year (velocity is # times $ turns over in a year ) PQ= total business for that year. If any of these get out of balance- economy out of sync.

67 Equation of Exchange M x V ≡ P x Q where: M represents Money Supply V represents Velocity* ≡ means must be equal to P represents Price Q represents Real GDP *The average number of times a dollar is spent to buy final goods and services in a year

68 Demand for Money What is so magical about the $$$$ Store of Value 1.Need for transactions 2.Emergencies/ safeguards 3.Rather hold $ than other assets- equity plus 4.Assume stability of the dollar or all bets off.

69 HOW MONETARY POLICY CAN AFFECT INTERNATIONAL TRADE Contractionary Monetary Policy (decrease the growth in money supply Increase in interest rates Encourages foreign financial investors in U.S. Strengthens the international value of dollar Increases imports Decrease exports Employment may decrease Inflation may decrease Expansionary Monetary Policy (increases rate of growth in money supply) Decreases interest rates Discourages foreign financial investment in the U.S. Weakens the international value of the dollar Decreases imports Increases exports Employment may increase..Inflation may increase

70 U.S. has a Stop/Go Monetary Policy ExpansionContraction Interest rate Quantity of money SS1 D Interest rate Quantity of money D S1 S

71 FED IN ACTION Fed wants to affect Consumption and Investment by adjusting the monetary policy. Invese relationship between price of existing bonds and rate of interest Interest rate Bond value Today…. Interest rate ? Bond value ?

72 Figure 16-4 Determining the Price of Bonds, Panel (a) Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall

73 Figure 16-4 Determining the Price of Bonds, Panel (b) Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise

74 BIG PICTURE FOR FED To forestall depressions in period of prosperity To stimulate the economy in period of declining economic activity. I.E. To smooth out the swings of the business cycle… uses counter-cyclical moves


76 So, are you better off? Or is the federal government the Grinch?

77 Kiley puts all her excess bones in the bank!

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