Chapter 10: Federal Reserve Lecture 8 Chapter 10: Federal Reserve

Money and Its Uses Medium of Exchange Unit of Account Store of Value An asset used in purchasing goods and services Unit of Account A basic measure of economic value Store of Value An asset that serves as a means of holding wealth

Money and Its Uses M1 Sum of currency outstanding and balances held in checking accounts M2 All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks

The M1 and M2 Money Supply of the U.S The Composition of Money in the U.S. The M1 and M2 Money Supply of the U.S –––––––––– (as of December 2003) –––––––––– Money Supply, M1 (in billions) $1,293 Currency (in circulation) $664 Demand deposits 312 Other checkable deposits 309 Traveler’s checks 8 Total M1 $1,293 Money Supply, M2 (in billions) $6,057 M1 $1,293 Savings deposits a 3,158 Small time deposits 810 Money market mutual funds 796 Total M2 $6,057 a Including money market deposit accounts. Source: http://www.federalreserve.gov.

Components of M1 and M2, April 2005 (billions of dollars) Currency Demand deposits Other checkable deposits Travelers’ checks M2 Savings deposits Small-denomination time deposits Money market mutual funds 1,354.6 704.6 318.5 324.0 7.5 6,469.7 3,544.3 866.2

Components of M1 and M2, Feb 2009 (billions of dollars) Currency Demand deposits Other checkable deposits Travelers’ checks M2 Savings deposits Small-denomination time deposits Money market mutual funds 1,558.3 834.6 397.2 641.8 5.5 8,275.4 4,286.3 1,360.4 1,070.4

The Business of Banking The banking industry includes: commercial banks, savings and loans, and, credit unions. Banks are profit-seeking institutions Banks play a central role in the capital market (loanable funds market): They help to bring together people who want to save for the future with those who want to borrow for current investment projects.

Commercial Banking Institutions The Functions of Commercial Banking Institutions Assets Vault cash Reserves at the Fed Loans outstanding U.S. govt securities Other securities Other assets Total Checking deposits Savings and time deposits Borrowings Other liabilities Net worth Consolidated Balance Sheet of Commercial Banking Institutions Year-end 2003 (billions of $) Liabilities $ 25 9 4,399 1,105 752 1,001 $ 7,291 $ 485 4,117 1,480 679 530 Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities). Most of these deposits are invested and loaned out, providing interest income for the bank. Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.

Commercial Banking Institutions The Functions of Commercial Banking Institutions Consolidated Balance Sheet of Commercial Banking Institutions Year-end 2007 (billions of $) Assets Liabilities Non Interest Earning $ 1,509 Checking deposits $ 695 Other Securities 639 Savings and time deposits 4,026 Loans outstanding 6,473 Borrowings 4,755 U.S. govt securities 922 Other liabilities 465 Trading Account 633 Net worth (Capital Acct) 1,136 Other assets 901 Total $ 11,077 $ 11,077 Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities). Most of these deposits are invested and loaned out, providing interest income for the bank. Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.

Fractional Reserve Banking The U.S. banking system is a fractional reserve system; banks are required to maintain only a fraction of their assets as reserves against the deposits of their customers (required reserves). Vault cash and the deposits the bank holds with the Federal Reserve count as reserves. Excess reserves (actual reserves in excess of the legal requirement) can be used to extend new loans and make new investments. Under a fractional reserve system, an increase in deposits will provide the bank with excess reserves and place it in a position to extend additional loans, and thereby expand the money supply.

Creating Money from New Reserves New cash deposits: Actual Reserves Potential demand deposits created by extending new loans New Required Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $5,000.00 $1,000.00 $4,000.00 When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

How Banks Create Money by Extending Loans The lower the reserve requirement, the greater potential expansion in the money supply resulting from the creation of new reserves. The fractional reserve requirement places a ceiling on potential money creation from new reserves. Deposit or Money Multiplier = 1/Θ Θ is ‘reserve requirement’ in decimal form 1/.2 = 5 for a 20% reserve requirement The actual deposit multiplier will be less than the potential because: Some persons will hold currency rather than bank deposits. Some banks may not use all their excess reserves to extend loans.

Commercial Banks and the Creation of Money Bank Reserves Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments 100 Percent Reserve Banking A situation in which banks’ reserves equal 100 percent of their deposits

Commercial Banks and the Creation of Money Assume Republic of Gorgonzola No banking system Government issues 1 million guilders People want to place their 1 million guilders in a bank

Consolidated Balance Sheet of Gorgonzolan Commercial Banks (Initial) Assets Currency 1,000,000 guilders Liabilities Deposits 1,000,000 guilders Citizens open accounts and deposit 1 million guilders Deposits are liabilities for the bank The guilders are an asset for the bank Guilders are the bank’s reserves Reserves = deposits: 100 percent reserve banking Reserves are not part of the money supply Deposits are part of the money supply

Consolidated Balance Sheet of Gorgonzolan Commercial Banks After One Round of Loans Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 900,000 guilders Liabilities Deposits 1,000,000 guilders Fractional Reserve Banking System Bankers agree they only need a reserve to deposit ratio of 10% Required reserves = 100,000 guilders, 10% of deposits Loan out the excess reserves of 900,000 guilders

Consolidated Balance Sheet of Gorgonzolan Commercial Banks after Guilders Are Redeposited Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 900,000 guilders Liabilities Deposits 1,900,000 guilders Loan proceeds are deposited Reserves = 1,000,000 guilders Deposits = 1,900,000 guilders Money supply = 1,900,000 guilders Reserve to deposit ratio = 52.6% or excess reserves = 810,000 Banks can loan the 810,000 guilders

Consolidated Balance Sheet of Gorgonizolan Commercial Banks After Two Rounds of Loans and Redeposits Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 1,710,000 guilders Liabilities Deposits 2,710,000 guilders Loan proceeds are deposited Reserves = 1,000,000 guilders Deposits = 2,710,000 guilders Money supply = 2,710,000 guilders Reserve to deposit ratio = 36.9% Excess reserves = 729,000 guilders

Final Consolidated Balance Sheet of Gorgonzolan Commercial Banks Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 9,000,000 guilders Liabilities Deposits 10,000,000 guilders Observations Lending will continue until the reserve to deposit ratio = 10% When loans = 9,000,000 guilders Deposits = 10,000,000 guilders Reserves = 1,000,000 guilders Reserve to deposit ratio = 10% No excess reserves The money supply = 10,000,000 guilders

Commercial Banks and the Creation of Money Observations The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves In Gorgonzola, with a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposit.

Commercial Banks and the Creation of Money The Money Supply with Both Currency and Deposits Gorgonzola residents choose to hold 500,000 guilders as currency Deposit 500,000 in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000/.10 = 5,000,000

Commercial Banks and the Creation of Money The Money Supply with Both Currency and Deposits Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency

Commercial Banks and the Creation of Money The Money Supply at Christmas Currency = 500 Bank reserves = 500 Reserve-deposit ratio = 0.20 Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000

Commercial Banks and the Creation of Money The Money Supply at Christmas If Xmas shoppers withdraw 100 Money supply = 600 + 400/.20 600 + 2,000 = 2,600

Commercial Banks and the Creation of Money The Money Supply at Christmas Observation When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.

The Federal Reserve System Two Main Responsibilities Monetary policy Oversight and regulation of financial markets

The Federal Reserve System The History and Structure of the Federal Reserve System Founded by the Federal Reserve Act of 1913 The primary mission of the Fed is to promote economic growth, low inflation, and stable financial markets.

The Federal Reserve System The Structure 12 regional Federal Reserve banks Assess economic conditions in their regions to assist in national policymaking Provide service to the commercial banks in their districts

The Federal Reserve Districts 10 Kansas City 9 Minneapolis San Francisco 12 7 Chicago 1 Boston 4 Cleveland 2 New York Philadelphia 3 5 Richmond Washington, D.C. (Board of Governors) St. Louis 8 Atlanta 6 11 Dallas The map indicates the 12 Federal Reserve districts and the cities in which the district banks are located. Each district bank monitors the commercial banks in their region and assists them with the clearing of checks. The Board of Governors of the Federal Reserve System is located in Washington D.C.

The Federal Reserve System The Structure Board of Governors Seven governors Appointed by the president and confirmed by the Senate to 14 year staggered terms Chairman of the Board of Governors Selected by the president from the governors Serves a four year term

The Federal Reserve System The Structure Federal Open Market Committee (FOMC) Members include: The seven Fed governors President of the New York Fed Four presidents, chosen on a rotating basis, from the remaining Federal Reserve Banks Determines monetary policy

2008 Members of the FOMC There are only 10 people listed… as there are only currently 5 Board members due to resignations. Ben S. Bernanke, Board of Governors, Chairman Donald L. Kohn, Board of Governors Randall S. Kroszner, Board of Governors Frederic S. Mishkin, Board of Governors Kevin M. Warsh, Board of Governors Timothy F. Geithner, New York, Vice Chairman Richard W. Fisher, Dallas Sandra Pianalto, Cleveland Charles I. Plosser, Philadelphia Gary H. Stern, Minneapolis

2009 Members of the FOMC There are only 10 people listed… as there are only currently 5 Board members due to resignations. Ben S. Bernanke, Board of Governors, Chairman Elizabeth A. Duke, Board of Governors Donald L. Kohn, Board of Governors Daniel K. Tarullo, Board of Governors Kevin M. Warsh, Board of Governors William C. Dudley, New York, Vice Chairman Charles L. Evans, Chicago Jeffrey M. Lacker, Richmond Dennis P. Lockhart, Atlanta Janet L. Yellen, San Francisco

2009 Monetary Policy Releases Press Release Release Date: March 18, 2009 For immediate release Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.  Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.  Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.  U.S. exports have slumped as a number of major trading partners have also fallen into recession.  Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth. In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.  Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.  To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.  The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.  The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.  2009 Monetary Policy Releases  

Federal Reserve Board of Governors 12 Federal Reserve District Banks The Federal Reserve System Federal Reserve Board of Governors 7 members appointed by the president, with the consent of the U.S. Senate The Board of Governors is at the center of Federal Reserve operations. The board sets all the rates and regulations for the depository institutions. 12 Federal Reserve District Banks (25 branches) Open Market Committee Board of Governors & 5 Federal Reserve Bank Presidents (alternating terms, New York Bank always represented). The seven members of the Board of Governors also serve on the Federal Open Market Committee (FOMC). Commercial Banks Savings & Loans Credit Unions Mutual Savings Banks The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities. The Public: Households & businesses

The Federal Reserve System Controlling the Money Supply: Open-Market Operations The primary function of the Fed is monetary policy. The Fed controls the money supply by changing the supply of bank reserves.

The Federal Reserve System Controlling the Money Supply: Open-Market Operations Open-market operations are the most important method of changing the supply of bank reserves.

The Federal Reserve System Increasing The Money Supply The Fed purchases government bonds from the public. The people deposit the funds they get from their sale of bonds to the Fed. The increase in deposits increase bank reserves.

The Federal Reserve System Increasing The Money Supply The increase in reserves will lead to an expansion of the money supply as banks make more loans. Recall The change in the money supply is a multiple of the change in reserves.

The Federal Reserve System Reducing The Money Supply The Fed sells government bonds to the public. The Fed presents the checks from the sale of the bonds to the banks for payment.

The Federal Reserve System Reducing The Money Supply The bank’s reserves will fall when they clear the checks. The money supply will fall by a multiple of the decrease in reserves.

The Federal Reserve System Open-Market Purchase The purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply

The Federal Reserve System Open-Market Sale The sale by the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply

The Federal Reserve System Open-Market Operations Open-market purchases and open-market sales

The Federal Reserve System Example Increasing the money supply by open-market operations Currency = 1,000 shekels Reserves = 200 Reserve-deposit ratio = 0.2

The Federal Reserve System Example Increasing the money supply by open-market operations Money supply = 1,000 + 200/0.2 = 2,000 shekels Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekels

The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures.

The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: Instill confidence Discount lending Open Market Operations

The Federal Reserve System Economic Naturalist The banking panics of 1930 - 1933 and the money supply One-third of U.S. banks closed Depositors withdrew their funds Banks raised the reserve-deposit ratio

Key U.S. Monetary Statistics, 1929-1933 Currency Reserve-deposit Bank Money held by public ratio reserves supply December 1929 3.85 0.075 3.15 45.9 December 1930 3.79 0.082 3.31 44.1 December 1931 4.59 0.095 3.11 37.3 December 1932 4.82 0.109 3.18 34.0 December 1933 4.85 0.133 3.45 30.8

Fed Independence Long tenure for members of the Board of Governors. Staggered appointments Bank Presidents appointed to 5-year term by Bank’s Board of Directors Board of Directors selected by bank members

Funding of the Federal Reserve The Fed is structured to be self-sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities. Therefore, it is independent of Congressional decisions about appropriations. Fed refunds Treasury most of interest each year the money that is collected in the form of interest. Federal reserve banks owned by domestic banks.

How the Fed Controls the Money Supply

The Three Tools the Fed Uses to Control the Money Supply The Fed has three major tools that it can use to control the money supply: Reserve requirements – setting the fraction of assets that banks must hold as reserves (vault cash or deposits with the Fed), against their checking deposits, Open market operations – the buying and selling of U.S. government securities in the open market, and, Discount rate – setting the interest rate at which it loans funds to commercial banks and other depository institutions.

Controlling the Money Supply: Setting Reserve Requirements Reserve requirements: a percent of a specified liability category (for example checking deposits) that banking institutions are required to hold as reserves against that type of liability. When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply. Raising the reserve requirements has the opposite effect. The Chinese central bank has used this instrument recently.

Controlling the Money Supply: Open Market Operations Open Market Operations: the buying and selling of U.S. Treasury bonds by the Fed. This is the primary tool used by the Federal Reserve to control the money supply. Note: the U.S. Treasury bonds held by the Fed are part of the national debt.

Controlling the Money Supply: Open Market Operations Open Market Operations: the buying and selling of U.S. Treasury bonds by the Fed. When the Fed buys bonds … the money supply expands because: bond buyers acquire money bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans When the Fed sells bonds … the money supply contracts because: bond buyers give up money for securities bank reserves decline, causing them to extend fewer loans

The Federal Reserve System Increasing The Money Supply The Fed purchases government bonds from the public. The people deposit the funds they get from their sale of bonds to the Fed. The increase in deposits increase bank reserves.

The Federal Reserve System Increasing The Money Supply The increase in reserves will lead to an expansion of the money supply as banks make more loans. Recall The change in the money supply is a multiple of the change in reserves.

The Federal Reserve System Reducing The Money Supply The Fed sells government bonds to the public. The Fed presents the checks from the sale of the bonds to the banks for payment.

The Federal Reserve System Reducing The Money Supply The bank’s reserves will fall when they clear the checks. The money supply will fall by a multiple of the decrease in reserves.

The Federal Reserve System Example Increasing the money supply by open-market operations Currency = 1,000 shekels Reserves = 200 Reserve-deposit ratio = 0.2

The Federal Reserve System Example Increasing the money supply by open-market operations Money supply = 1,000 + 200/0.2 = 2,000 shekels Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekels

Controlling the Money Supply: The Discount Rate Discount Rate: the interest rate the Fed charges banking institutions for borrowed funds The discount rate is closely related to the interest rate in the federal funds market, a private loanable funds market where banks with excess reserves extend short-term loans to other banks trying to meet their reserve requirements. The interest rate in this market is called the federal funds rate.

Controlling the Money Supply: The Discount Rate Under the operating procedures adopted in 2003, the Fed now charges most banks a discount rate that is slightly higher than the federal funds rate. If the Fed wanted to reduce the supply of money it would increase the differential between the discount and federal funds interest rates. A decrease in the differential would have the opposite affect. Recently the Fed reduced the differential between the discount and federal funds rate

How the Fed Controls the Federal Funds Rate Announcements after the regular meetings of the Federal Open Market Committee often focus on the Fed’s target for the fed funds rate. The Fed controls the federal funds rate through open market operations. The Fed can reduce the fed funds rate by buying bonds, which will inject additional reserves into the banking system. The Fed can increase the fed funds rate by selling bonds, which drains reserves from the banking system. Thus, though the media often focuses on the Fed’s target fed funds rate, the Fed is still using open market operations to influence this rate and control the money supply.

The Functions of the Fed and Treasury The U.S. Treasury: is concerned with the finance of the federal government issues bonds to the general public to finance the budget deficits of the federal government does not determine the money supply The Federal Reserve: is concerned with the monetary climate for the economy does not issue bonds determines the money supply — primarily through its buying and selling of bonds issued by the U.S. Treasury

Aggregate Reserves or the Monetary Base Recent Fed actions of quantitative easing have led to a spike in the monetary base that has not been seen before

Federal Reserve Note Money gets into the economy through member banks drawing down their Reserve account, in exchange for an equal amount of currency. Printed by the Bureau of Engraving and Printing

Money and Prices Velocity A measure of the speed at which money changes hands in transaction involving final goods and services

Money and Prices Velocity A measure of the speed at which money changes hands in transaction involving final goods and services

Money and Prices Velocity in 2004 M1 = $1,367.3 billion Nominal GDP = $11,734.3 billion

Money and Prices Velocity in 2008 (averaged monthly data) M1 = $1,424 billion M2 = $7,726.9 billion Nominal GDP = $14,264.6 billion

Money and Prices Money and Inflation in the Long Run Recall

Money and Prices Money and Inflation in the Long Run Quantity equation M x V = P x Y Assume V & Y are constant over the time period

Money and Prices Money and Inflation in the Long Run If the Fed increases M by 10%, then prices must increase by 10%. High rates of money growth are associated with high rates of inflation (too much money chasing too few goods).