1. The Federal Reserve System
I. Origins of the FRS
II. Its Functions & Structure
ECO 473 – Money & Banking – Dr. D. Foster

2. The Federal Reserve System
I. Origins of the FRS
ECO 473 – Money & Banking – Dr. D. Foster

3. Central Banking – The Bank of England
Created in 1694
Bought gov’t bonds and issued notes.
Held all government debt.
Notes were not “legal tender,” but widely accepted.
Insolvent in 2 years.
Parliament allowed them to suspend specie payment.
Brief competition (Nat’l Land Bank; South Seas)
1708: monopoly on bank notes & short term loans.
Late 1700s, massive suspension lasted 24 years.
1833: notes made legal tender.
Peel Act – limit fractional reserve notes
Failed to recognize deposits as money.

4. Central Banking - The 1st and 2nd BUS
Mercantilist movement behind banks.
Fed owns 20%, deposits funds here.
Banks buy government debt; issue notes.
wholesale prices up 72%.
Periodic specie suspension and bank panics.
BUS will hold bank notes.
2nd BUS inflates, then deflates in 1819.
“The bank was saved, but the people ruined.”
Jackson kills the 2nd BUS.

5. The “Free Banking” Era: 1836-1863
Van Buren sets up Independent Treasury System
Came and went and lasted only until Civil War.
Fed’l government held only specie, not paper.
Decentralized banking
Still heavily regulated.
State banks required to hold state gov’t. debt to back their note/dd issue.
Notes accepted for taxes.
Restricted branching making redemption harder.
Private note clearing – Suffolk System
Held specie reserve of members.
Different bank notes accepted.
Insulated banks from panics.

6. The National Banking System
Specie suspension & greenbacks 12/1861.
1861 to 1863, MS doubled.
Wholesale prices up 22% per year during war.
The National Banking Act of 1863
Created national currency.
Taxed non-national bank notes.
Bought gov’t debt & issued notes.
The rise & fall of Jay Cooke.
State banks benefit by holding reserves in nat’l notes.
Didn’t stop periodic panics.

7. The Federal Reserve System
“An engine of inflation.” [See Appendix]
An addition layer means more money creation.
1914 to 1920, MS doubles
member banks DD 250%.
non-member banks DD 33%.
Reserve deposits on savings falls.
Shift from DD to TD.
Generally accepted that savings are “payable upon demand.”
Ben Strong & the Morgans.

8. 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.

9. The Federal Reserve Banking System

10. 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%.

11. The Federal Reserve System
II. Its Functions & Structure
ECO 473 – Money & Banking – Dr. D. Foster

12. 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.

13. 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-?)

14. The Fed’s Balance Sheet
THE FED’S ASSETS
Treasury securities
U.S. agency securities
Discount window loans
Gold certificates.
Special Drawing Right (SDR) certificates
Foreign currency reserves
Cash items in the process of collection
LIABILITIES AND EQUITY CAPITAL
Federal Reserve notes
Bank reserve deposits
U.S. Treasury deposits
Foreign official deposits
Deferred availability cash items
Equity capital

15. The Fed’s Balance Sheet - 2005
The Consolidated Balance Sheet of the Federal Reserve System ($ Millions, as of January 31, 2005)
782,003

18. 2012

20. 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 (!!)

21. 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.

22. The Federal Reserve System
I. Origins of the FRS
II. Its Functions & Structure
ECO 473 – Money & Banking – Dr. D. Foster

23. Pyramiding the Money Supply
Appendix:
Pyramiding the Money Supply
Banks have $1 mill. of gold and rr = 25%.
They can issue $4 mill. of loans = notes + demand deposits.
Add national banks. They can hold $1 mill. of gold and expand money to $4 million.
Other banks can treat $4 mill. as their reserves and expand the MS (by increasing DD) to $16 million.
Add the Federal Reserve. They can hold $1 mill. of gold and expand money to $4 million.
National banks can treat $4 mill. as their reserves and expand the MS (by increasing DD) to $16 million.
Other banks can treat $16 mill. as their reserves and expand the MS to $64 million.