The Federal Reserve

What is the “Fed”? Created on December 23, 1913 – Largely in response to previous financial “panics” Serves as the nation’s central banking system – Meaning that the Fed: “Oversees” commercial banks in their districts Makes sure these banks follow sound financial procedures and are void of fraudulent behavior Prevent “bank runs” (i.e. Great Depression) Manage supply of money available in country through various practices (to be continued…)

The Fed’s Organization Board of Governors (or Federal Reserve Board) – Chair and vice-chair, along with other members, appointed by President and approved by Congress Federal Open Market Committee (FOMC) – next slide Twelve regional Federal Reserve banks located in major cities throughout the nation Privately owned U.S. member banks

Some Notable Chairs Janet Yellen (Feb Present) Ben Bernanke (February 1, 2006 – February 3, 2014) Alan Greenspan (August 11, 1987 – January 31, 2006)

Federal Open Market Committee Responsible for setting monetary policy Consists of: All seven members of the Board of Governors Twelve regional bank presidents- Five active votes Created in 1935 to give power to central authority (Note: B of G has 7 votes; Regional banks have 5)

What is Monetary Policy? Original monetary goals of the Federal Reserve Act of 1913 (originally set by regional Fed banks): – Achieve maximum employment – Achieve stable prices of products – Achieve moderate long-term interest rates **These powers were expanded and given to central Board of Governors. We will return to this post- Great Depression!

Profit of the Federal Reserve goes to the U.S. Treasury after the bank pays 6% dividends to member banks’ capital investment

How are the goals of Monetary Policy achieved? 1.Setting Reserve Minimums a)Amount of $$ banks need to hold in cash 2.Discount Rate a)Rate at which banks can borrow from Fed 3.Open Market Operations a)Buying/selling securities through banks to increase or decrease cash available (money stock)

The Federal Reserve and the Great Depression According to your reading*, the Great Depression was a result of the Fed allowing the money stock to collapse as panics engulfed the banking system. (It fell 30%) Here’s a breakdown of the three key monetary policies of the Fed, as well as how their misguided execution may have caused the Great Depression... But first, the Money Stock: *Source: The Great Depression: An Overview by David Wheelock

Reminder: Money Stock, aka Money Supply Bank deposits (balances held in checking in savings) + Coins and Currency = Total amount of money available in a particular economy at a particular point in time.

Controlling the Money Supply Important for Fed to control money supply: – Too much could mean inflation Lots to spend, prices go up People eventually spend less- We know what that does! – Too little could mean deflation Too little to spend, prices go down Could increase loan defaults and bankruptcies Could lead to decline in income, output, and employment Recall from reading*: Price stability is the paramount goal because fluctuations cause financial instability. Prime goal of monetary policy : monitor ordinary fluctuations so they don’t grow into economic catastrophes *Source: The Great Depression: An Overview by David Wheelock

Monetary Policy: Reserve Minimums Recall: 1.When you deposit money in a bank, some goes into a vault. 2.Banks earn low returns on cash that they keep in their vaults or with the Federal Reserve, so there is incentive to make loans 3.If a depositor requests money from their “transactional account”, that must be paid back!

Monetary Policy: Reserve Minimums The amount a bank loans out depends largely on amount of reserves they must hold – For example: You can’t loan out $10 if you only have $15 in deposits! To ensure withdrawals can be paid, the Fed sets reserve minimums that banks must hold: – Minimum percentage of total $$ deposited – Can be held in vault (cash) or with local Federal Reserve

Monetary Policy: Reserve Minimums The Great Depression How did the Federal Reserve’s “reserve minimums policy” in 1930s falter? 1.Low reserve minimums Banks did not hold much in reserves When people lost trust in banks and financial system due to: – Stock market crash; and – Banks losing their investments in stock market…. Depositors (account holders) rushed to the bank to withdraw money Banks did not have enough reserves to match deposits

Monetary Policy: Reserve Minimums The Great Depression How did the Federal Reserve’s “reserve minimums policy” in 1930s falter? HOWEVER, it’s normal to hold low reserves – (i.e. in 2014, rates as low as 0% of deposits!!!!) So, how do you pay off depositors? – You BORROW from other banks or the Fed.. Which brings us to the next reason:

Monetary Policy: Reserve Minimums The Great Depression 2. No safety net Not all banks were “member banks”, nor were they backed by the Fed Many did not have other branches to borrow from Was a widespread problem = few banks had $$ to lend.. Which means borrowing rates were EXPENSIVE

Monetary Policy: Borrowing Rates, aka Effect Federal Funds Rate and Discount Rate What happens when a bank ends the day below reserve minimum? a)Borrow from another bank who has excess federal funds rate) a)The FOMC sets a target for the federal funds rate b)Low rate means it’s cheap for banks to borrow c)If it’s cheap to borrow, then it’s cheap to loan to consumers (borrow at 2%, loan at 4% = profit!!) d)This also means more spending for consumers b)Borrow from the Fed discount rate)

Monetary Policy: Federal Effective Funds Rate The federal effective funds rate increased in 1928, making borrowing expensive. Banks could not borrow from other banks – Would cause bankruptcy and failure If banks couldn’t borrow from other banks, at least they could borrow from the Fed, right? – WRONG!

Federal Funds Rate The rate at which banks can borrow from other banks FOMC sets a target federal funds rate, but the actual rate is considered the effective federal funds rate By changing reserve minimums and conducting open market relations, the Fed can expand and shrink money stock (by setting high reserve rates and selling treasury notes). Less money means more pressure on loaning, which increases the federal funds rate (competition for loans). This makes market interest rates higher.

Monetary Policy: Discount Rate Discount Rate (Fed to bank): Interest rate charged to banks on loans they receive from their regional Federal Reserve Bank AKA the “discount window” During the Great Depression, the Fed would only lend to: – Member banks with sufficient collateral Did not lend to non-Members until 1980 Result: Many banks failed!!!- We know what this means!

Monetary Policy: Discount Rate the Fed raised the discount rate from 3.5% to 5% Raised to 6% Why?: Prevent spending, and therefore prices on assets, from soaring – Remember: They don’t know a Great Depression is coming!!!! Problem: Further reduction in spending means great deflation and greater depression

Monetary Policy: Open Market Operations Federal Reserve can purchase bonds/ “securities” from banks If they purchase, cash goes to banks and Fed gets bond If they sell, cash goes to Fed and bond goes to bank (their “cash” decreases = lower money stock)

Monetary Policy: Open Market Operations During the Great Depression: – Federal Reserve COULD’VE purchased securities to flood banks with $$ – Did NOT

In summary… Banking panics served to: – Decrease money stock (total money available to consumers) Meant lower spending  deflation  bankruptcies – Made borrowing expensive Less banks had $$ to loan to others  domino effect The Federal Reserve: – set reserve minimums low before GD; – allowed borrowing to remain expensive during GD; and – did not increase $ available to banks through open market operations. The misguided federal actions (monetary policy) allowed money stock to fall too low. Thus, the Fed evolved greatly as a result of the GD to prevent a similar thing from happening again.

Federal Reserve Analysis: Small Groups In small groups: – Illustrate how your assigned monetary policy works – Explain how the Federal Reserve’s approach to this policy contributed to the Great Depression – Explain WHAT THEY COULD’VE DONE to prevent further economic recession