Llad Phillips1 Introduction to Economics Macroeconomics The US Economy

Llad Phillips2 Welcome Product Sales and Auctions Savings Bonds, T-Bills, and Securities link: bonds, notes, and T-Bills FAQ; Treasury Direct

Llad Phillips3 Outline: Lecture Eight The Banking System The Banking System The Federal Reserve The Federal Reserve

Llad Phillips4 Full Reserve Banking Dates to the Middle Ages Dates to the Middle Ages  goldsmiths  accept customer deposits of gold  issue certificates of deposit to customer customer can use certificates as a medium of exchangecustomer can use certificates as a medium of exchange paper money substitutes for gold moneypaper money substitutes for gold money no money creationno money creation

Llad Phillips5 Assets-Liabilities Statement

Llad Phillips6 Full Reserve Banking AssetsLiabilities Goldsmith customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins Note: The goldsmith is perfectly liquid. If a customer comes in with a certificate of deposit, the goldsmith has the reserves of gold to exchange for the certificate. Note: The goldsmith is perfectly solvent. The value of the gold reserves held as assets equals the value of the certificates issued, i.e assets equal liabilities.

Llad Phillips7 Banking as a Business Goldsmiths note that only about 25% of customers want to exchange certificates for gold on a given day Goldsmiths note that only about 25% of customers want to exchange certificates for gold on a given day This creates an incentive for the goldsmiths to use some of the remaining gold reserves to make loans and earn interest This creates an incentive for the goldsmiths to use some of the remaining gold reserves to make loans and earn interest

Llad Phillips8 Fractional Reserve Banking AssetsLiabilities Goldsmith customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins Note: The goldsmith is no longer perfectly liquid. If all the customers come in with certificates of deposit and demand 1,500 Florins, the goldsmith only has reserves of 1,000 Florins in gold to exchange for the certificates. The customers panic! Note: The goldsmith may not remain solvent. If the goldsmith makes unwise loans, and the customer in debt defaults, then the value of assets, 1,000 Florins, is less than the value of liabilities, 1,500 Florins. loans of 500 Florinscertificates of deposit, 500 Florins (money creation)

Llad Phillips9 History of US Capitalism Punctuated by a series of banking crises Punctuated by a series of banking crises  for example: panic of 1907  motivates the formation of the Federal Reserve, 1913

Llad Phillips10 Banking Crises (continued)  widespread bank failures in 1932  depositors lose money  Roosevelt declares a bank holiday upon assuming office  Federal Deposit Insurance Corporation, FDIC, created in 1934 insures accounts up to $100,000insures accounts up to $100,000

Llad Phillips11 Banking Crises (continued)  Savings and Loans failures in the 1980’s  in 1989 & 1990, 100’s of insolvent thrifts taken over bail out of depositors costs US taxpayers about $500 Bbail out of depositors costs US taxpayers about $500 B

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Llad Phillips13 Fractional Reserve Banking is subject to two threats Liquidity Crisis Liquidity Crisis  rumors  depositors lose confidence  run on the banks to withdraw deposits  not enough reserves to meet demands of depositors  panic Bank Failures Bank Failures  banks make unsound loans  for example, make real estate loans and then the real estate market crashes  debtors default on loans  banks become insolvent  depositors lose money

Llad Phillips14 Economic Concept: Moral Hazard The creation of the Federal Deposit Insurance Corporation, FDIC, and the Federal Savings and Loan Insurance Corporation, FSLIC, did not prevent the failure of S&L’s in the 80’s The creation of the Federal Deposit Insurance Corporation, FDIC, and the Federal Savings and Loan Insurance Corporation, FSLIC, did not prevent the failure of S&L’s in the 80’s  with an account insured up to $100,000, a depositor then takes less care to check out the policies and practices of an S&L before depositing cash  this effect of insurance making one feel “safe” and hence taking less care to avoid loss is called moral hazard

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Llad Phillips16 Source:

Llad Phillips17 The Federal Reserve Objectives Objectives Tools Tools Organization and Structure Organization and Structure

Llad Phillips18 The Federal Reserve Objectives Objectives  prevent liquidity crises  prevent solvency crises  control inflation and money stock growth  stabilize short term interest rates

Federal Reserve as Central Bank Tools Tools  lender of last resort to private banks  sets required ratio of reserves to deposits  establishes sound banking practices  manipulates bank reserves  affects federal funds rate and sets the discount rate

Llad Phillips20 Fed: Lender of Last Resort to Banks at Discount Rate Source: Federal Reserve Bank of Minneapolis

Llad Phillips22 Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits Helps Prevent Liquidity Crises Helps Prevent Liquidity Crises For Example: Dec 1992 For Example: Dec 1992  deposits of 0-$42.2M (small banks)  required minimum reserve ratio: 3%  deposits of $42.2+M- (large banks)  required minimum reserve ratio: 10%

Llad Phillips23 Reserve Ratios (Continued) For Example 1994 For Example 1994  deposits of 0-$4M: 0% reserve ratio  deposits of $4+M-$51.9M: 3% reserve ratio  deposits of $51.9M- :10% Infrequent Changes in Reserve Ratios Infrequent Changes in Reserve Ratios

Llad Phillips24 Source: Fed: Establish Sound Banking Practices

Llad Phillips25 Federal Reserve: Organization and Structure

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Llad Phillips27 Federal Open Market Committee Meetings Federal Open Market Committee: 12 Members 7 Board Governors, President of New York Fed, 4 other Presidents

Llad Phillips28 Federal Reserve Open Market Operations Tight Money Policy Tight Money Policy  Fed sells securities in secondary market  decreases bank reserves  decreases excess reserves  decreases banking system capacity to make loans Easy Money Policy Easy Money Policy  Fed buys securities in secondary market  increases bank reserves  increases excess reserves  increases banking system capacity to make loans

Llad Phillips29 FOMC Tries to Tighten Credit Sells Treasuries in Secondary Market FEDCommercial Banks Net Result: changes asset mix of banks & decreases total bank reserves

Llad Phillips30 FOMC Tries to Loosen Credit Buys Treasuries in Secondary Market FEDCommercial Banks Net Result: changes asset mix of banks & increases total bank reserves

Llad Phillips31 Limitations to FOMC Efforts FOMC can increase reserves by buying securities: this enables banks to make loans FOMC can increase reserves by buying securities: this enables banks to make loans  Fed can not force banks to make loans  Fed can not force consumers or businesses to ask banks for loans Metaphor: “you can lead a horse to water, but you can not make him drink” Metaphor: “you can lead a horse to water, but you can not make him drink” Contractionary monetary policy is more direct than expansionary monetary policy Contractionary monetary policy is more direct than expansionary monetary policy  if Fed sells securities, this reduces reserves, and hence for a given level of bank deposits and required reserves, decreases excess reserves

Llad Phillips32 Understanding Open Market Operations Familiarity with the Fed’s balance sheet Familiarity with the Fed’s balance sheet Definitions of Banking Reserve Aggregates Definitions of Banking Reserve Aggregates Fed is a corporation Fed is a corporation  national banks are chartered by the US Comptroller of Currency  national banks must be members and buy stock; this provides Fed with working capital  state banks can be members if they choose  Fed’s profits, above a given level, are given to US Treasury

Llad Phillips33 Federal Reserve System Balance Sheet, August 13, 1997 Source: TheWall Street Journal, Friday , p.C 18

Llad Phillips34 Bank Reserve Aggregates, * Excess Reserves = Total Reserves - Required Reserves ** Free Reserves = Excess Reserves - Borrowed Reserves Source: TheWall Street Journal, Friday , p.C 18

Llad Phillips35 How Effective Has the Fed Been? Fed Goals Fed Goals  maximum employment  stable prices  moderate long-term interest rates Fed Objectives or Targets Fed Objectives or Targets  quantity of reserves  price of reserves  federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks

HooverRooseveltTrumanIke JFK LBJNixon/ Ford Carter ReaganBush Clinton Misery Index = Unemployment Rate + Inflation Rate

Llad Phillips37 Summary-Vocabulary-Concepts full reserve banking full reserve banking fractional reserve banking fractional reserve banking banking system crisis banking system crisis  illiquid bank  insolvent bank FDIC, FSLIC FDIC, FSLIC lender of last resort lender of last resort discount rate discount rate ratio of required reserves to deposits ratio of required reserves to deposits Federal Funds Rate Federal Funds Rate Federal Reserve (FR) Federal Reserve (FR)  District  Board of Governors  Open Market Committee  open market operations  policy goals  policy targets Reserve Aggregates Reserve Aggregates  total reserves  nonborrowed reserves  required reserves  excess reserves  free reserves secondary Treasuries market secondary Treasuries market

Llad Phillips38 The Federal Reserve System: Purposes & Functions format: Adobe Acrobat

Llad Phillips39 The Federal Reserve System: Purposes & Functions format: Adobe Acrobat