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

2. The Origins of U.S. Central Banking
1791–1836
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.

3. 1865–1912
The Gold Standard (1875).
Brief foray into bimetalism.
Panics of 1873, 1893 and 1907
Federal Reserve Act of 1913

4. The Federal Reserve Banking System

5. The Early Fed (1913–1935) & Fed 2.0
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.
The Great Depression - Failure of the Fed (?)
Initially increased liquidity, but pulled back.
By 1933, 33% of banks fail, MS fallen 33%.
Banking Act of 1935 – a new Fed
Centralized power in Board.
Board of Governors reconstituted.
FOMC created to conduct policy.

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

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

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

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

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

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

12. The Fed – 2012
Treasury Securities ……… $1.8 trillion
Holdings of MBS …………. $.95 trillion
Total Assets ………………… $2.9 trillion

13. The Fed – 2013
Treasury Securities ……… $2.4 trillion
Holdings of MBS …………. $1.5 trillion
Total Assets ………………… $4.0 trillion

14. The Fed – 2014
Treasury Securities ……… $2.6 trillion
Holdings of MBS …………. $1.8 trillion
Total Assets ………………… $4.5 trillion

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

16. The Fed – 2013
FR Notes outstanding ….. $1.2 trillion
Bank reserve deposits …. $2.2 trillion
Total Liabilities ……….…… $4.0 trillion

17. The Fed – 2014
FR Notes outstanding ….. $1.3 trillion
Bank reserve deposits …. $2.4 trillion
Total Liabilities ……….…… $4.5 trillion

18. Federal Reserve Policy Tools
Open 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 Window
Lend to member banks to affect bank reserves.
Purpose is to target the “federal funds rate” – iff
This is the rate that banks charge each other for very short term loans.
Required Reserve Ratio (rrD)
Changing this affects bank excess reserves directly.
Used more to reflect structural changes.
Was used in 1937 and precipitates more Great Depression.
Time to let this go?
New policy – Pay banks i for ER (!!)

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

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

21. Getting from bond purchases to interest rates$ $ $ $ $ $
$$$
mm/yyyy
What is price of $1000 FV bond, matures in 2 years, $50 coupon with i=7%?
Face value (FV)
Maturity date (in n years)
Coupons & value (C)
= $50/(1.07)1 + $50/(1.07)2 + $1000/(1.07)2
Usually, we talk of annual coupons
Market price of the bond = present value of income stream discounted at interest rate i:
= $ $ $873.44
= $963.84
When the Fed buys bonds, their prices will ___ and interest rates will ___.
sells

22. 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.

23. Some simple bond pricing problems
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%.
What is the current market price of this bond?
Suppose that the current market interest rate rises to 8.7%. What will be the new market price for this bond?
Suppose that when the bond was first sold, it’s market price was $ What must have been the market rate of interest then?
Consider a bond with FV=$1000, maturity = 2022, C=$81 and i=7.25%
What is the current price of this bond?
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?

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