CHAPTER 2 THE FEDERAL RESERVE

The Role of the Central Bank Issue currency (notes) and control the money supply in the country. Serve as a lender-of-last resort for banks facing liquidity crisis, thereby preventing bank runs and financial panics. Responsible for the regulatory oversight of the banking system. Provide banking services to banks such as check clearing services.

The Role of the Central Bank Responsible for the conduct of monetary policy to keep inflation low (the bank’s ultimate objective). Price stability is closely related to the goal of steady economic growth, because firms are more likely to invest in capital to increase productivity and economic growth when inflation is low.

The Federal Reserve’s Balance Sheet Assets Liabilities Securities S Discount Loans DL Currency (Notes) in circulation C Reserves (Bank Deposits) R Monetary Base (High-Powered Money) MB = C + R

Monetary Policy Tools 1. Open Market Operations Buying government securities from the private sector (dealers, banks, or individuals) increases banks’ reserves and banks' ability to make loans and expands the money supply. Selling government securities to the private sector (dealers, banks, or individuals) reduces banks’ reserves and banks' ability to make loans and contracts the money supply.

Monetary Policy Tools Advantages of Open Market Operations 1. Controlled by the Federal Reserve 2. Flexible 3. Easily reversed 4. Quickly implemented

Monetary Policy Tools 2. Discount Operations Banks pay the discount rate on discount loans from the Federal Reserve. Raising/Lowering the discount rate increases/ lowers the cost of borrowing from the Federal Reserve.

Monetary Policy Tools Advantages of Discount Operations 1. Lender-of-Last Resort Role 1. To prevent banking panics 2. To prevent non-bank financial panics Examples: 1987 ‘Black Monday’ stock market crash Disadvantages of Discount Operations 1. Announcement Effect: Confusion interpreting discount rate changes. 2. Fluctuations in discount loans cause unintended fluctuations in the money supply. Not fully controlled by the Federal Reserve. 4. Moral Hazard Problem: Too-Big-To-FAIL (TBTF) Problem.

Monetary Policy Tools 3. Reserve Requirements Reserves are vault cash kept in banks and bank deposits with the Federal Reserve. Required reserves are the proportion (percentage) of deposits with bank that must be kept as reserves. Excess reserves equals actual reserves minus required reserves. Excess reserves may be loaned to individuals or sold to other banks in the Federal funds market.

Monetary Policy Tools Increasing reserve requirements increases the percentage of bank deposits kept in the Federal Reserve and limits bank lending. Decreasing reserve requirements reduces the percentage of bank deposits kept in the Federal Reserve and expands bank lending.