1 The Federal Reserve System 1. Functions of the Fed 2. Fed Policy Levers 3. Interest Rates 4. Inflation Implications 5. Money Definitions 6. Banking 7. Money Creation 8. Fed Policy

2 1. Functions of the Fed : about the Federal Reserve System Conducting the nation's monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices Supervising and regulating banking institutions Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets Providing certain financial services

3 2. Fed Policy Levers Influence Bank Reserves to change Money Supply and Federal Funds Rate Discuss later in which ways bank reserves may be changed. Short-run and Long-run implications of changing Bank Reserves:

4 Market for Bank Reserves Bank Reserves Federal Funds Rate Demand for Reserves Supply of Reserves a b c

5 Implications Bank Reserves up -> Money Supply up, Fed Funds Rate down -> Market Rates down -> 1. stock prices increase, 2. dollar (exchange rate) depreciates, 3. investment and consumer durables demand increase. 4. first production increases, then the price level.

6 Market for Bank Reserves Bank Reserves Federal Funds Rate Demand for Reserves Supply of Reserves a b c

7 Interest Rates over Time Time Market Rates Time of temporary increase in growth rate of bank reserves

8 Interest Rates over Time Time Market Rates Time of permanent increase in growth rate of bank reserves Rate end up permanently higher due to higher inflation

9 3. Nominal and Real Interest Rates (or returns) Observed market rates are Nominal Taxes are based on market rates. Real returns take inflation into account. Due to x% inflation, a loan is worth x% less in real terms after one year. For the lender the return per $ of the loan is the nominal interest % - x%. Same for the cost of the borrower.

10 Nominal and Real rates (continued) Thus: real Interest % = nominal interest % - inflation %. After-tax real interest % = (1 - tax rate) x (nominal interest %) - inflation %. “Fischer Effect”: fully anticipated 1% higher inflation should raise nominal interest rates by 1% (by more if taxes are considered; less in reality).

11 4. Inflation Implications Eliminate our current 2% inflation rate? Inflation = % change in level of all prices (includes wages in principle). Anticipated versus Unanticipated. Anticipated inflation: Misconceptions

12 Misconceptions Costs of Anticipated Inflation Real wages decrease systematically. Costs increase. Galloping inflation imminent. Taxes increase [bracket creep]. Loss to society. Redistribution of wealth (lenders lose, borrowers gain).

13 True costs of anticip a ted inflation Menu costs, Shoe leather costs People on fixed incomes suffer. Even if income tax brackets adjust: capital gains tax due to inflation, depreciation at original cost. High inflation implies variable inflation, larger Unanticipated inflation changes.

14 Costs of Unanticipated Inflation Arbitrary redistribution: –Real wages affected if labor contracts Firms affected in opposite direction. –Borrowers and lenders affected in opposite ways. Confused Market signals: –Firms do not know if their price went up due to inflation or increased popularity. –Relative prices change

15 Price Stability Should we strive for 0% inflation? –Unknown risks of deflation. –Temporarily higher unemployment. –People on fixed incomes benefit. –Underground economy and our foreign creditors benefits. –Harder to cut salaries.

16 5. What Counts as Money? M1 = Currency in hands of the public (coins + paper money), Checkable Deposits, Traveler’s Checks. M2 = M1 + Savings Deposits, MMDA’s, MMMF’s (retail), Small Time Deposits. M3 = M2 + Large Time Deposits, MMMF’s (institutional), Repurchase Agreements, Eurodollars. Credit Cards??

17 6. The Banking System Fractional Reserve Banking: only part of the checking deposits is backed by Bank Reserves. Bank Reserves = Currency in Vault + Accounts at the Fed. = Required Reserves + Excess Reserves Profitability, Solvability, Liquidity

18 Bank Balance Sheet Assets Typical BankLiabilities Currency Checking Deposits Accounts at Fed Savings and Time Loans andDeposits Securities Capital $x

19 7. Money Creation Money Multiplier: relation between money created by Fed and total Money Supply Monetary Base: money created by Fed = All Currency + Bank Accounts at Fed = Bank Reserves + Currency in Circulation. Why is Money Multiplier greater than 1?: $1 in new bank reserves -> banks lend out -> part comes back to banks in form of checking accounts -> hold 10% to back up checking acounts (fractional reserve banking) -> lend out the rest.

20  Money Supply = (Money Multiplier) x (  Monetary Base) Money multiplier gives the increase in money per unit of base money created by Fed. In practice about 2.2 for M1. Realistic? --banks always get rid of excess reserves fast --people hold cash about 50c per $ --banks hold excess reserves voluntarily.

21 8. Federal Reserve Policy Origin of Fed: Bank Panics (last in 1907) -> need for “Lender of Last Resort.” (1913) Board of Governors 12 Fed Reserve District Banks (24 branch banks) Federal Open Market Committee (FOMC) Member Banks (mostly National Banks) Bank Runs during depression led to Federal Depository Insurance Corporation (FDIC)

22 Tools for affecting Money 1. Open Market Operations (NY Fed) 2. Discount Loans to Banks 3. Changes in Reserve Requirements OMO’s most common, First two affect Bank Reserves, Third affects money multiplier.

23 Policy Question Should Greenspan further lower FFR? Yes: Economy slowing down, World needs a boost, Exchange rate too high, Liquidity needs (LTCM), Good for Banks, Avoids Deflation. No: “Irrational exuberance”, Inflationary (due to both lower exchange rate and lower interest), Don’t let inflation genie out.