The Federal Reserve System and Its Tools Unit 4 Lesson 4 Activity 38 Graboyes, Rover. University of Richmond. Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y

Objectives Describe the structure of the Federal Reserve System Identify each of the tolls of the Fed and explain Explain basic balance sheets

Introduction The focus of this lesson is the Federal Reserve System; how its actions relate to the money creation process introduced in the last lesson and how its tools affect the money supply. The Federal Reserve System is the central bank for the United States created in 1913. It has regulatory authority for many financial institutions that hold checkable deposits. It has the responsibility to control the money supply to promote the economic goals of full employment, price stability and stable economic growth.

Federal Reserve System: (Fed) Provides Resilient National Currency Nation’s Financial Agent Regulating Private Banking System National Check-Clearing Mechanism Banking Institution for the Nation’s Banks (Carter, 147)

Operate the nation’s payments system: The 12 Federal Reserve Banks provide: “banking services to depository institutions; they maintain reserve and clearing accounts to provide various payment services, including collecting checks, electronically transferring funds, and storing, distributing, receiving, and processing currency and coin. For the federal government: the Reserve Banks maintain the Treasury Department’s transaction account, pay Treasury checks, process electronic payments, issue, transfer, and redeem U.S. government securities.” (Hill)

Income Federal Reserve Bank Interest earned on government. securities Priced services to depository institutions NOT OPERATED FOR PROFIT! End of fiscal year money is turned over to the U.S. Treasury Department. (“Federal Reserve Board”)

The Federal Open Market Committee [FOMC] “The Fed’s chief body for monetary policymaking. The FOMC’s decisions ultimately affect interest rates. The FOMC meets in Washington, usually eight times a year.” (Emery)

“The Federal Reserve controls the three tools of monetary policy— open market operations, the discount rate, reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.” (“Federal Reserve Board”)

“Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.” (“Federal Reserve Board”)

Primary Responsibility: “Among the Fed's duties are managing the growth of the money supply, providing liquidity in times of crisis, and ensuring the integrity of the financial system. The FOMC's decisions to change the growth of the nation's money supply affect the availability of credit and the level of interest rates that businesses and consumers pay. Those changes in money supply and interest rates, in turn, influence the nation's economic growth and employment in the short run and the general level of prices in the long run.” (“Federal Reserve Board”)

The Mechanics of Monetary Policy To manage the money supply, the Federal Reserve uses the tools of monetary policy to influence the quantity of reserves in the banking system. Increasing (decreasing) reserves tend to expand (contract) a bank’s ability to make loans. Thus, reserve management gives the Fed powerful influences over the money supply and, in turn, over the general price level. The primary tool for reserve management today is open market operations (OMO). Discount rate changes serve primarily as signals; reserve requirements are rarely changed. Using T-accounts show how the Fed could use open market operations to increase money supply.

Balance Sheets “The Federal Reserve operates with a sizable balance sheet that includes a large number of distinct assets and liabilities. Left side of a balance sheet shows the assets, and the right side shows the liabilities.” Net worth = assets - liabilities Liabilities: Treasury Securities Federal Reserve notes (U.S. paper currency) and the deposits that thousands of depository institutions, the U.S. Treasury, and others hold in accounts at the Federal Reserve Banks. Assets: holdings of Treasury, agency, mortgage-backed securities; discount window lending; lending to other institutions;  foreign currency (“Federal Reserve Board”)

Example: Baseline case Figure 38.1 shows a baseline T-account. The required reserve ratio is 10% of checking deposits. With $26 in reserve accounts and $4 to Federal Reserve notes (vault cash), total bank reserves = $30, exactly 10% of checkable deposits (in other words, no excess reserves). Net worth = assets - liabilities

Figure 38.1 Baseline Case Assets Liabilities The Fed Treasury securities $83 $26 Reserve accounts of banks $57 Federal Reserve notes Banks Reserve accounts $26 $300 Checkable deposits Federal Reserve notes $4 $405 $135 Net worth (to stockholders) Bank Customers Checkable deposits $300 $405 Loans Federal Reserve notes $53 Treasury securities $52 Money supply = $353 (300 +53)

Example: Expansionary policy via open market purchases Suppose the Fed believes the economy is heading into a recession and wishes to increase the money supply by $100. Using open market operations, the Fed purchases $10 worth of Treasury securities from the public. Fig. 38.2 shows the consolidated accounts after the changes of this Fed action works it way through the economy. Changes are shown in boldface. Be sure to compare Fig 38.1 with Fig. 38.2 to see the changes. The Fed’s $10 increase in reserve accounts yields a $100 increase in the money supply.

Figure 38.2 After $10 Open Market Purchase Assets Liabilities The Fed Treasury securities (+10) $93 $36 Reserve accounts of banks (+10) $57 Federal Reserve notes Banks Reserve accounts (+10) $36 $400 Checkable deposits (+100) Federal Reserve notes $4 Loans (+90) $495 $135 Net worth (to stockholders) Bank Customers Checkable deposits (+100) $400 $495 Loans (+90) Federal Reserve notes $53 Treasury securities (-10) $42 Money supply = $453 (400 +53)

Activity 38 For Questions 1 thru 4 start with the baseline case in Fig. 38.1. The Fed wishes to decrease the money supply from $353 to $303 by market operations. The reserve requirement is 10%. Will the Fed want to by or sell existing Treasury securities? _____________ What is the money multiplier? ______ What is the value of Treasury securities that need to be bought or sold? _____________ Sell 10 (1/0.10 = 10) (50/10 = 5)

Figure 38.3 Assets Liabilities The Fed Treasury securities Reserve accounts of banks $57 Federal Reserve notes Banks Reserve accounts Checkable deposits Federal Reserve notes Loans $135 Net worth (to stockholders) Bank Customers Checkable deposits Loans Federal Reserve notes $53 Treasury securities Money supply = (-$5) (-$5) $78 $21 (-$50) (-$5) $21 $250 $4 $360 (-$5) (-$45) $250 $360 (+$5) $57 $303 ($250 + $53)

What is the deposit expansion multiplier? _____________ For Q 5 thru 7, suppose banks keep zero excess reserve and the reserve requirement is 15%. What is the deposit expansion multiplier? _____________ A customer deposits $100,000 in his checking account. How much of this can the bank lend to new customers? ___________________ How much must the bank add to its reserves? ___________________ In what two forms can a bank hold the new required reserves? (1/0.15 = 6.67) 85% of 100,000 = $85,000 15% of 100,000 = $15,000 Vault cash or in the reserve account (Fed Res.)

Suppose that the $100,000 had previously been held in Federal Reserve notes under the customer’s mattress and that banks continue to hold no excess reserves. By how much will the customer’s deposit cause the money supply to grow? ______________________ A very low discount rate may (encourage / discourage banks from borrowing) from the federal Reserve. Underline the correct answer and explain why. $85,000 x 6.67 = $566,950 If banks are able to borrow from the federal Reserve at a low interest rate and make loans at a high rate, this will earn a profit and, hence, have an incentive to use the discount window.

The federal funds rate is the interest rate at which financial institutions can borrow from other financial institutions. Suppose the federal funds rate is 5% and the discount rate is 4.5 percent. Why is it that a bank might choose to borrow in the federal funds market, rather than getting the lower interest rate available through the discount window? Borrowing from another financial institution will have fewer transaction costs, plus the bank will not have the added scrutiny of its business practices that borrowing from the Federal Reserve will generate.

In a foreign country, the reserve requirement is 100% In a foreign country, the reserve requirement is 100%. What will be the deposit expansion multiplier? ___________ If the fed decided to implement a policy action designed to increase the money supply in which direction would bank reserves and the federal funds rate change and why? (1/1 = 1) If the Fed wants to increase the money supply it will institute a policy to increase reserves (giving banks an increased ability to make loans). Banks have more money to loan to other banks, businesses and consumers, so the federal funds rate is likely to decrease.

Circle the correct symbol (↑ for increase, ↓ for decrease) Fed Actions and Their Effects Federal Reserve action Bank Reserves Money Supply Fed Funds Rate A. Sold Treasury securities on the open market   B. Bought Treasury securities on the open market C. Raised the discount rate D Lowered the discount rate E. Raised the reserve requirement F. Lowered the reserve requirement

Contractionary Policy Indicate in the table in Fig. 38.5 how the Federal Reserve could use each of the three monetary policy tolls to pursue an expansionary policy and a contractionary policy. Fig. 38.5 Tools of Monetary Policy Monetary Policy Expansionary Policy Contractionary Policy A. Open market operations   B. Discount rate C. Reserve requirements Buy Treasury securities Sell Treasury securities Lower discount rate Raise discount rate Lower required reserve ratio Raiser required reserve ratio

Why do banks hold excess reserves, which pay no interest? Why does the Fed rarely use the reserve requirement as an instrument of monetary policy? required by law to hold required reserves (2) as a precaution in case of sudden withdrawals or changes in economic conditions. Changes in the required reserve ratio cause radical or strong changes in the monetary system. It is difficult for financial institutions to adjust to changes in the required reserve ratio. In general, the Fed uses the tools of monetary policy to adjust the economy in smaller increments.

What does it mean to say that the Fed changes the discount rate mostly as a signal to markets? Why does the fed currently target the federal funds rate rather than the money supply? It signals to the banks and others how the Fed would like the money supply to change. (The discount rate has no impact if banks do not borrow from the Federal Reserve; banks do not have to borrow because if they need funds, they can always go to the federal funds market.) It targets the federal funds rate because the Fed believes that this rate is closely tied to economic activity. (The Fed uses changes in reserves to affect the federal funds rate.)

Works Cited Emery, Barbara. “Monetary Policy”. Federal Reserve Bank of Philadelphia. 18 Feb 2009 http://www.philadelphiafed.org/ education/teachers/lesson-plans/index.cfm?tab= 3&CFID=1604898&CFTOKEN=97766325&jsess ionid=383079bdcb242df693e17a7e4b313a554b 54> “Federal Reserve Board”. Federalreserve.gov. 1 March 2006. 14 March 2006. http://www.federal reserve.gov/general.htm Hill, Andrew T. “What Does the Fred Do? Federal Reserve Bank of Philadelphia. 18 Feb 2009. <http://www.philadelphiafed.org/education/teach ers/lesson-plans/index.cfm?tab=3&CFID= 1604898&CFTOKEN=97766325&jsessionid=38 3079bdcb242df693e17a7e4b313a554b54>