The Federal Reserve and Its Power Chapter 2 FIN 221 1Dr. Hisham Abdelbaki FIN 221

Functions of The CB (The Fed) Issuing Notes Bank of Government 1.Holds its accounts / holds its reserves from foreign currencies. 2.Lends it 3.Buys and sells its securities 4.Offers monetary advices Bank of Banks Lender of last resort Conducting and monitoring the Monetary Policy Dr. Hisham Abdelbaki FIN 2212

Purposes and powers of a Central Bank (The Fed) Dr. Hisham Abdelbaki FIN 2213 Supervise nation’s money supply and payments system. Regulate other financial institutions, especially depository institutions (Supervise banks more vigorously). Serve as “Lender of last resort” when financial system has liquidity problems. National government’s “fiscal agent” (i.e. depository bank) Provide an “elastic” currency (currency notes - ability to adjust money supply to changes in economy) Improve payments system (check clearing).

The FED Balance Sheet Monetary actions lead to changes in the Fed’s balance sheet and changes in its balance sheet result in changes to the nation’s money supply. Liabilities and Capital: The Fed conducts monetary policy by changing the nation’s monetary base. Monetary base = currency in circulation + the deposits of financial institutions at the Fed. Increase monetary base leads to increase money supply 4Dr. Hisham Abdelbaki FIN 221

1.Federal Reserve Notes The Fed notes are lawful money because they are legal tender for all debts public and private. 2. Depository Institutions Reserve All depository institutions must keep reserves with the FED. These reserves bear NO interest. Total reserves equal required and excess reserves. These reserves are used to: A.Clear checks, wire transfers and other payment items. B.Control the rate of growth of money supply. C.Provide liquidity in the event of financial crisis. RR and RRR (Example) 5Dr. Hisham Abdelbaki FIN 221

3. Treasury Deposits The Fed acts as “fiscal Agent” for the US treasury dep. Which means the Fed acts as a bank for the treasury. 4. Deferred Availability Cash Items (DACI) The value of checks deposited at the Fed by depository institutions that have not yet been credited to the institutions’ accounts. 5.Capital Capital paid in by banks that are members of the Federal Reserve System to purchase stock. The Fed pays a 6 % dividend on that stock regardless of its earnings. The Fed returns the reminder (surplus) to the US treasury each year. 6Dr. Hisham Abdelbaki FIN 221

Assets of the FED 1.Loans The Fed can make loans ONLY to banks and other depository institutions. For short term at discount rate. Change in the loan account lead to changes in the reserve account then changes in money supply. 7Dr. Hisham Abdelbaki FIN 221

8 2. Government Securities The Fed buys and sells securities in the market through its Open Market Operations. Consist of: A. US Treasury securities B. US government agency securities 3. Cash Items in Process of Collection (CIPC) The cleared reserves BUT have not yet obtained funds. i.e. checks in the process of clearing and settlement.

Dr. Hisham Abdelbaki FIN Float The difference between DACI and CIPC Float = CIPC – DACI 5. Other Assets: Foreign-denominated assets Gold certificates and Special Drawing Rights (SDRs) Buildings, computers vehicles, and other assets needed to house its operations and conducts its business.

The Fed’s Role in Check Clearing The Fed plays a major role in check clearing, particularly in clearing checks drawn on depository institutions which hold reserves or clearing deposit balances with the Fed. Bank deposits at the Fed can be easily transferred between the accounts of the depository institutions by making appropriate entries on the Fed books. 10Dr. Hisham Abdelbaki FIN 221

Fed Reserve Tools of Monetary Policy 1.Open Market Operations The Fed is the only institution that can expand or contract its liabilities. To expand them, it needs only issue Fed notes or write a check on itself. The purchase of government bonds by the Fed will expand the money supply while the sale of bonds will result in contraction of the money supply. 11Dr. Hisham Abdelbaki FIN 221

12 How can selling / buying Gov. securities by the Fed effect on money supply? Example 1: The Fed decides to buy $2000 in Gov. bonds from Citibank. The T-accounts for the Citibank and the Fed after the transaction will be : Citibank Fed Gov. bonds Gov. bonds R. of Citibank R. at Fed

Dr. Hisham Abdelbaki FIN Example 2:The Fed decides to sell $2000 bonds to the Citibank. The T-accounts will show: Citibank Fed Gov. bonds Gov. bonds R. at Citibank R. at Fed

Dr. Hisham Abdelbaki FIN Discount Rate (Discount Window Borrowing) The discount rate is the rate of interest that financial institutions must pay to borrow reserve deposits from the Fed. When the discount rate is high, the institutions are more reluctant to borrow reserves and become more careful about expanding asset and deposit holdings. And Vice Versa. Example: when banks borrow from the discount window, the funds they borrow are paid in reserves by the Fed. Suppose Citibank borrows $1000 at the window. The T- accounts will look as follows:

Dr. Hisham Abdelbaki FIN Citibank Fed R. at Fed Discount Loan loan to citib R. of Citi

Dr. Hisham Abdelbaki FIN Reserve Requirements The CB can establish reserve requirements within certain limits. Such requirements determine the amounts of funds financial institutions must hold at the CB to back their deposits. Only the CB can change the reserve requirements for depository institutions. Changing reserve requirements change the money supply.

Dr. Hisham Abdelbaki FIN Example: Assume BNB has: Demand deposits = $ 5000, Reserve requirement = 20%. The bank is fully loaned up and therefore has no excess reserves i.e. ER=0. Citibank’s T-account looks as follows: Reserves 1000 Demand Deposits 5000 Loans 4000 Now: The Fed decides to reduce reserve requirement on demand deposits from 20% to 10%.What happens then? First step: The new requirement lowers the amount of reserves to $500 and increase the ER by $500. That is: RR = 10% X $5000 = $500 ER = $1000-$500 = $500

Dr. Hisham Abdelbaki FIN Reserves 1000 Demand Deposits 5000 RR 500 ER 500 Loans 4000 Second step: What Citibank will do with the $500 ER? Hold it at the Fed (No Profits) Make loans and expand deposits to the point where all of the excess reserves are again absorbed as RR. The T-account of Citibank will look as follows:

Dr. Hisham Abdelbaki FIN Reserves 1000 Demand Deposits RR 1000 ER 0 Loans 9000 At RRR (k) = 10%, the bank can support 10,000 of deposits (DEP = RR / k = 1000 / 10% = 10,000). The CB expands the amount of bank deposits by lowering reserve requirements on deposits. Similarly, when the Fed increases the reserve requirements,the banking system will contract the amount of bank deposits and hence decrease the money supply.

Comparing the Monetary Tools The CB does not use all three tools to conduct monetary policy on a regular basis Each tool plays a different and important role In the CB monetary arsenal. Advantages of OMO : -Can be done easily almost instantaneously with no announcement effect. -Any changes in the money supply can be easily reversed without an announcement effect. Dr. Hisham Abdelbaki FIN 22120

Dr. Hisham Abdelbaki FIN Shortcomings of discount rate adjustment: Changes in the Discount rate will affect the money supply only if banks are willing to respond. Because the Fed scrutinizes borrowing at the discount window, banks may be reluctant to overuse this privilege. Borrowing under the discount window is short-term and it is difficult to gauge the impact on the money supply for a given change in the discount rate. As a practical matter, changing the discount rate is not a viable tool for conducting monetary policy.

Dr. Hisham Abdelbaki FIN Changes to reserve requirements : Changes in reserve requirements are not used as a tool of monetary policy.This is because it is difficult to make a number of small adjustments to reserve requirements and frequent changes are disruptive to the banking system. Changing reserve requirements is typically done to deal with structural problems in the banking system.

Dr. Hisham Abdelbaki FIN Summary : How tools of monetary policy affect the money supply Monetary policy toolIncrease in money supply Decrease in money supply OMOPurchasing T- securities in the market Selling T-securities in the market Adjusting the discount rate Fed lowers the interest rate Fed raises the interest rate Adjusting bank reserve requirement Fed lowers the reserve ratio to cause a higher money multiplier Fed raises the reserve ratio to cause a lower money multiplier