The Federal Reserve System The Federal Reserve System (“the Fed”) is the central bank of the United States. Central bank functions: Banks’ bank: accepts deposits from banks makes loans to banks. Banker for the government. It controls the money supply. Regulates banks Clears checks

Structure of the Federal Reserve System The Board of Governors Alan Greenspan, Chair 6 other governors 12 Regional Federal Reserve District Banks (FRBs) Federal Open Market Committee (FOMC) The Board of Governors (7) 5 of 12 District Presidents (in Rotation) 9

The Federal Reserve System Instructor Notes: 1) The nation is divided into 12 Federal Reserve districts, each having a Federal Reserve bank. (Some of the larger districts also have branch banks.) 2) The Board of Governors of the Federal Reserve System is located in Washington, D.C. 14

The Board of Governors Seven members appointed by the President and confirmed by the Senate 14-year term Terms are staggered: one comes vacant every two years President appoints Chairman to serve a four-year term 10

Functions of the Fed Banking Services and Supervision Supplies currency to banks through its 12 district federal reserve banks. Holds reserves of banks in the district bank of each bank. These are commercial bank deposits at the Fed Processes and routes checks to banks through its district banks and processing centers. Makes loans to banks—it is the “lender of last resort”, the “banker’s bank”. It supervises and regulate banks, ensuring that they operate in a sound and prudent manner. Banker for the U.S. government. Manages sales of government securities for the U.S. Treasury.

Change money supply to meet policy goals of the FOMC. Functions of the Fed Controlling the Money Supply Vary money supply to meet seasonal fluctuations in the demand for money. Helps keep interest rates steady. Example: 4th quarter holiday season creates an increased demand for money to buy gifts. Change money supply to meet policy goals of the FOMC.

Policy Goals of the Fed Ultimate Goal: Economic growth with stable prices. Intermediate Targets: The Fed establishes target growth rate for the money supply, consistent with its ultimate goals. The money supply growth rate is an intermediate target

Fed Policy Linkages

Velocity = Turns per year Velocity of Money Velocity of money: the average number of times a dollar is spent on final goods and services in a year. Velocity = Turns per year

Velocity of Money = $GDP/M

Equation of Exchange: relates quantity of money to nominal GDP M = money supply (some aggregate) V = velocity of money (of the aggregate) P = price level Q = real GDP PQ = nominal GDP MV = PQ (Note: V = PQ/M)

MV = PQ 5% + 3% = P% + 2% P% = 6% Equation of Exchange and Inflation: Or in terms of growth rates: M% + V% = P% + Q% If velocity is growing at 3% per year, the money supply is growing at 5% per year, and real GDP is growing at 2% per year, what must the inflation rate (P%) be? 5% + 3% = P% + 2% P% = 6% 67

Operating Procedures FOMC Directive: Instructions to the Federal Reserve Bank of NY Buy or sell government bonds to keep the federal funds rate at a specific level. The federal funds rate (“fed funds rate”): the interest rate banks charge when they lend excess reserves to each other. The buying and selling of government bonds by the fed to achieve policy objectives are open market operations

“primary lending rate” 3) Open market operations The Fed’s Policy Tools 1) Reserve Requirements 2) Discount rate “primary lending rate” 3) Open market operations Manage the public’s expectations Inflation Targeting? 23

Reserve Requirement Legal reserves: the cash a bank holds in its vault plus its deposits at the Fed. When Fed lowers reserve requirements, banks have excess reserves which they can then lend. Such lending triggers the deposit expansion multiplier, increasing the money supply. Similarly, the Fed may decrease the money supply by raising reserve requirements.

Discount Rate (Primary Credit Rate) The discount rate is the rate of interest a Fed District Bank charges when a bank borrows from it. When the Fed raises the discount rate, it raises the cost of borrowing reserves, reducing the amount of reserves borrowed. Lower levels of reserves result in reduced lending, and reduced money supply.

Open Market Operations Open Market Operations (OMOs): buying and selling of government bonds by the Fed to control bank reserves, the fed funds rate, and the money supply. Buy Ease Sell Tighten An increase in reserves results in an increase in the money supply and a reduction in the fed funds rate.

Now to combine money supply with money demand: Transactions demand: hold money to buy goods and services. Precautionary demand: cover unplanned transactions or emergencies. Speculative demand: deal with uncertainty about the value of other assets … fear decline in the value of other assets, so hold money as a safeguard.

Money Demand Interest rate is opportunity cost of holding money. The higher the interest rate the lower the quantity of money demanded.

Effect of a change in income on money demand Transactions demand increases with income. As nominal income increases, the volume of transactions increase, requiring more money.

Money Supply Money supply is controlled by the Fed, and therefore is not a function of interest rates. As a result the money supply function is vertical.

Money Market Equilibrium

How Money Supply Changes affect GDP

Money Supply and Interest Rates Fed Increases Money Supply r1 Interest Rates Fall r2 Md Money