The Federal Reserve System ECO 285 – Macroeconomics – Dr. D. Foster Structure and Policy Tools

The Origins of U.S. Central Banking  Bank of England  The Bank of North America (1781)  The First Bank of the United States (1791)  The Second Bank of the United States (1816) 1837–1865  The Free-Banking period.  The Civil War & Greenbacks - a fiat money. 1791–1836

1865–1912  The Gold Standard (1875).  Brief foray into bimetalism.  Panics of 1873, 1893 and 1907  Federal Reserve Act of 1913

The Federal Reserve Banking System

The Early Fed (1913–1935) & Fed 2.0 The Great Depression - Failure of the Fed (?)  The Great Depression - Failure of the Fed (?) Initially increased liquidity, but pulled back. By 1933, 33% of banks fail, MS fallen 33%. Accommodates the Treasury Dept. during WWI.  Accommodates the Treasury Dept. during WWI. Buys Treasury bonds to finance G spending. From 1916 to 1918, this increases MS by 70%. Huge risk of inflation. Banking Act of 1935 – a new Fed  Banking Act of 1935 – a new Fed Centralized power in Board. Board of Governors reconstituted. FOMC created to conduct policy.

The Federal Reserve Banking System  Purposes  Purposes: 1.Develop, supervise & control the nation’s money. 2.Serve as a “lender of last resort.” 3.Serve as a national check-clearing system. 4.Serve as depository for federal gov’t. funds.  Structure  Structure: 1.Board of Governors. 2.Twelve District Banks. 3.Federal Open Market Committee. 4.Regulatory bureaucracy.

The Federal Reserve Banking System  Board of Governors  Board of Governors: 1.Selected for one 14 year term. [Except…] 2.Staggered selection; geographic diversity. 3.Chairman & Vice Chairman selected for 4 years. 4.Can’t be members of the executive branch.  Policy Tools  Policy Tools: 1.Open Market Operations. Buy and sell U.S. Treasury bonds. 2.Set bank required reserve ratio. 3.Set “discount” rate of interest.

The Banking System Reserves (Cash in vault) T-Bills (Liquidity & income) Loans (Banks’ earnings) Demand Deposits (Checking; Transaction) Equity AssetsLiabilities & Equity Accounting Identity: A  L + E M1 +$10,000 +$10,000 +$8,000 +$8,000 +$2,000

The Fed & the Banking System Reserves (Cash in vault) T-Bills (Liquidity & income) Loans (Banks’ earnings) Demand Deposits (Checking; Transaction) Equity AssetsLiabilities & Equity M1

The Evolution of the Modern Fed WWII - working “for” the U.S. Treasury  WWII - working “for” the U.S. Treasury Federal Reserve–Treasury Accord (1951)  Federal Reserve–Treasury Accord (1951) “Leaning Against The Wind”  “Leaning Against The Wind” –Martin ( ) The technocratic Fed  The technocratic Fed –Burns ( )... the “political business cycle” Coping with inflation  Coping with inflation –Volcker ( ) Keeping the economy stable?  Keeping the economy stable? –Greenspan ( ) Coping with recession  Coping with recession –Bernanke ( ) –Yellen (2014-?)

The Fed’s Balance Sheet – 12/2007 In millions of dollars.

Treasury Securities ……… $1.8 trillion Holdings of MBS …………. $.95 trillion Total Assets ………………… $2.9 trillion

Treasury Securities ……… $2.4 trillion Holdings of MBS …………. $1.5 trillion Total Assets ………………… $4.0 trillion

Treasury Securities ……… $2.6 trillion Holdings of MBS …………. $1.8 trillion Total Assets ………………… $4.5 trillion

2012 FR Notes outstanding ….. $1.1 trillion Bank reserve deposits …. $1.5 trillion Total Liabilities ……….…… $2.9 trillion

FR Notes outstanding ….. $1.2 trillion Bank reserve deposits …. $2.2 trillion Total Liabilities ……….…… $4.0 trillion

FR Notes outstanding ….. $1.3 trillion Bank reserve deposits …. $2.4 trillion Total Liabilities ……….…… $4.5 trillion

Federal Reserve Policy Tools Open Market OperationsOpen Market Operations –Buy/sell Treasury bonds to affect bank reserves. –The major form of monetary policy. –What will the Fed do if we run out of Treasury bonds? Discount WindowDiscount Window –Lend to member banks to affect bank reserves. –Purpose is to target the “federal funds rate” – i ff This is the rate that banks charge each other for very short term loans.This is the rate that banks charge each other for very short term loans. Required Reserve Ratio (rr D )Required Reserve Ratio (rr D ) –Changing this affects bank excess reserves directly. –Used more to reflect structural changes.structural changes –Was used in 1937 and precipitates more Great Depression. –Time to let this go?let this go New policy – Pay banks i for ER (!!)

Goals of Monetary Policy Inflation goals:Inflation goals: –Low/no inflation with limited year-to-year variability. Output goals:Output goals: –High and stable economic (GDP) growth. Employment goals:Employment goals: –Stable employment growth with low unemployment. Yellen’s Press Conference March 16, 2016

Intermediate Targets of Monetary Policy information Limited long-term information about the economy available to policymakers means that they pick an intermediate target. Characteristics Characteristics: observable --Frequently observable --Consistency --Consistency with ultimate goals measurable --Controllable --Definable and measurable --Controllable Usual target variablesUsual target variables: –Monetary aggregates M1, M2, MZM –Interest rates (fed’l funds, prime …)Interest rates –Others …

Getting from bond purchases to interest rates Face value (FV) $$$ mm/yyyy $ $ $ $ $ $ Bond Maturity date (in n years) Coupons & value (C) When the Fed buys bonds, their prices will ___ and interest rates will ___. sells Usually, we talk of annual coupons Market price of the bond = present value of income stream discounted at interest rate i: What is price of $1000 FV bond, matures in 2 years, $50 coupon with i=7%? = $50/(1.07) 1 + $50/(1.07) 2 + $1000/(1.07) 2 = $ $ $ = $963.84

What is interest? Payment made to savers to compensate them for foregoing consumption. “The most powerful force in the universe is compound interest.” Interest rates embody our expectations of the future.

Some simple bond pricing problems 1.A bond has a face value (FV) of $1000, will mature in seven years, has an annual coupon of $74. The market rate of interest is 8.1%. a)What is the current market price of this bond? b)Suppose that the current market interest rate rises to 8.7%. What will be the new market price for this bond? c)Suppose that when the bond was first sold, it’s market price was $1000. What must have been the market rate of interest then? 2.Consider a bond with FV=$1000, maturity = 2020, C=$81 and i=7.25% a)What is the current price of this bond? b)If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it will affect all interest rates to some extent. If they buy lots of bonds and interest rates fall to 6.88%, what will happen to the price of your bond? What do you think about the Fed’s actions?

The Federal Reserve System ECO 285 – Macroeconomics – Dr. D. Foster Structure and Policy Tools

Key: Some simple bond pricing problems 1.A bond has a face value (FV) of $1000, will mature in seven years, has an annual coupon of $74. The market rate of interest is 8.1%. a)What is the current market price of this bond? b)Suppose that the current market interest rate rises to 8.7%. What will be the new market price for this bond? c)Suppose that when the bond was first sold, it’s market price was $1000. What must have been the market rate of interest then? 2.Consider a bond with FV=$1000, maturity = 2020, C=$81 and i=7.25% a)What is the current price of this bond? b)If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it will affect all interest rates to some extent. If they buy lots of bonds and interest rates fall to 6.88%, what will happen to the price of your bond? What do you think about the Fed’s actions? $ $ $1000 $ $ Woo hoo!!