1. The Federal Reserve System
Origins & structure of the Fed.
ECO 473 – Money & Banking – Dr. D. Foster

2. The Federal Reserve Banking System
Purpose:
Develop, supervise & control the nation’s money.
Serve as a national check-clearing system.
Serve as depository for federal gov’t. funds.
Board of Governors of the FRS
7 members, equal standing but, includes
Secretary of the Treasury and
Comptroller of the Currency.
Problems:
Only using discount window,
Each District Bank sets its own policy.

3. The Federal Reserve Banking System

4. The Early Fed, 1913–1935 Accommodates the Treasury Dept. during WWI.
Buys Treasury bonds to finance G spending (aka “monetizing the debt”).
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%.

5. The Fed - version 2.0, 1935 Serves as a “lender of last resort.”
Board of Governors reconstituted:
All 7 member selected by President/Senate confirms.
Can’t include Treasury Sec. nor Comptroller of Currency.
Members serve 14 yr. terms on staggered basis.
Geographic diversity.
Office of Chairman and Vice Chairman created.
Has authority over district banks.
Federal Open Market Committee (FOMC)
12 members; primary policy-making body.

6. 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-?)

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

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

9. The Fed – Q2 2017
Treasury Securities ……… $2.56 trillion
Holdings of MBS ……… $1.8 trillion
Total Assets ….… $4.47 trillion

10. FRS – Total Assets;
Sept. 2017:
$4.46 t.
$2.46 t.
$1.77 t.

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

12. The Fed – Q2 2017
FR Notes outstanding ….. $1.49 trillion
Bank deposits …. $2.15 trillion
Total Liabilities ……… $4.47 trillion

13. FRS – Total Liabilities; 2007-2017
Sept. 2017:
$4.46 t.
$2.31 t.
$1.58 t.
$0.41 t.

14. The Federal Reserve System
Origins, structure, policies.
ECO 473 – Money & Banking – Dr. D. Foster

15. 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.

16. Federal Reserve Policy Tools
Open Market Operations
Buy/sell Treasury bonds to affect bank reserves.
The major form of monetary policy.
Since 2009, also buying MBS!
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.
Was used in 1937 and precipitates more Great Depression.
New policy? – Pay banks interest on their Excess Reserves!

17. Monetary Policy: Goals & Targets
Open Market Operations
Discount Window
Required Reserve Ratio (rrD)
Price stability
Low unemployment
Sustainable growth
Interest Rates
Monetary Aggregates

18. Choosing an Intermediate Target Variable
Characteristics:
Frequently observable
Consistency with ultimate goals
Definable and measurable
Controllable
Potential variables:
Monetary aggregates M1, M2, MZM
Interest rates (fed’l funds, prime …)
Others:
Nominal GDP
Credit aggregates
Exchange rates

19. Making Monetary Policy Transparent
FOMC Press Release
May 2, 2018
Q&A
June 22, 2016
Con. Test.
Feb. 27, 2018

20. Targeting the Federal Funds Rate of Interest
Jan. 2018
1.41%

21. Is Policy the Right Choice?
Time lags make effective policy uncertain. Recognition/Response/Transmission lags
Discretionary policy promotes uncertainty. It may promote more volatility!
Can Rules and credible eliminate bias? Milton Friedman promoted this.

22. Time Lags in Monetary (& Fiscal) Policy
Policy time lags
Recognition lag
Response lag
Transmission lag
Real GDP
Business cycle
time

23. Monetary Policy may be counterproductive
% Real GDP
time
Ideally, policy would dampen the business cycle…
But, dampening the business cycle may lower ave. growth!
Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

24. Discretion versus Rules (Milton Friedman)
Discretionary policy is the source of instability.
A policy rule can eliminate that instability.
Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion.
This is a commitment to a fixed strategy no matter what happens to other economic variables.
To be successful, the commitment must be credible.
The public believes the Fed will act this way.

25. Making Monetary Policy Rules Credible
Place constitutional limits on monetary policy.
Achieve credibility by establishing a reputation.
Maintain central bank independence.
Establish central banker contracts.
Appoint a “conservative” central banker.

26. Has the Fed maintained stable prices?

27. Has the Fed maintained the value of the $?4%

28. Quantitative Easing = Credible?
QE 1
QE 2
QE 3

29. Can the Fed undo the QEs? Inflation is a monetary phenomenon.
Austrians: the only meaningful definition of inflation is w.r.t. the money supply.
What happens if the economy starts growing?
Banks will want to lend more, raising the MS and causing inflation.
The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%?
Inflationary expectations grow and become rooted in our economy, ala 1979.
Fed starts to pull back by selling UST and MBS.
Their prices plummet; so Fed can’t buy back all the excess reserves!
Interest rates will soar; investment will falter; a recession ensues.
But, a recession accompanied by serious inflation, aka “stagflation.”
Is it an “insurance policy” against massive sell-off?

31. The Federal Reserve System
Origins & structure of the Fed.
ECO 473 – Money & Banking – Dr. D. Foster