1. The Federal Reserve and Monetary Policy
Chapter 14
The Federal Reserve and Monetary Policy
14-1
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives The organization of the Federal Reserve System
Reserve requirements
The deposit expansion multiplier
The tools of monetary policy
The Feds effectiveness in fighting inflation and recession
The Banking Act of 1980 and 1999
14-2
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3. The Federal Reserve System
The Federal Reserve Act of 1913 created the Federal Reserve System
To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes
First United States Bank [ ]
Second United States Bank [ ]
The charters of both were allowed to lapse
The 1907 bank crises caused the public to demand the government do something to keep this from happening again
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4. The Federal Reserve System
The Federal Reserve has five main jobs
Conduct monetary policy which is, by far, the most important job
Monetary policy is the control of the rate of growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth
Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions
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5. The Federal Reserve System
The Federal Reserve has five main jobs
Issue currency
Provide banking services to the U.S. government
Supervise and regulate our financial institutions
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6. The Federal Reserve District Banks
Each Federal Reserve District Bank is owned by the several hundred member banks in that district
A commercial bank becomes a member by buying stock in the Federal Reserve District Bank
So, the Fed is a quasi public-private enterprise, not controlled by the President or Congress
Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.
14-6
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7. The Federal Reserve System
Board of Governors
Seven members
Appointed by President
Confirmed by Senate
Sets reserve requirements
Supervises and regulates member banks
Establishes and administers regulations
Oversees Federal Reserve Banks
12 District Banks
Propose discount rates
Hold reserve balances for member institutions
Lends reserves
Furnish currency
Collects & clears checks
Handle U.S. government debt & cash balances
Federal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy
14-7
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8. The Federal Reserve System
14-8
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9. Independence of the Board of Governors
Neither the President nor Congress has any control over the Board of Governors
The President gets to appoint Board members when a vacancy occurs
Sometime this may be the Chairman
Once the Senate confirms the President’s appointment the person appointed is not answerable to the President nor the Senate
This independence allows them to follow unpopular policies if they feel it is in the best economic interest of the nation
14-9
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10. Legal Reserve Requirements
The most important job of the Federal Reserve is to control the money supply
The focal point of the Federal Reserve’s control of our money supply is legal reserve requirements
Every financial institution in the country is legally required to hold a certain percentage of its deposits on reserve, either in the form of deposits and/or cash at its Federal Reserve District Bank or its own vaults
14-10
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11. Legal Reserve Requirements
Technical Term Meanings
Required Reserves (RR) is the minimum amount of vault cash and deposits (RD) at the Federal Reserve District Bank that must be held (kept on the books) by the financial institution
Actual Reserves (RD) is what the bank is holding (on the books)
Excess Reserves = Actual Reserves - Required Reserves
ER = RD - RR
14-11
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12. 14-12
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13. First $7.8 million of deposits: 0% reserve requirement
If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?
First $7.8 million of deposits: 0% reserve requirement
Next 40.5 million: $40,500,000 X .03 = 1,215,000
Next 51.7 million: $51,700,000 X .10 = 5,170,000
Required Reserves = $6,385,000
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-13

14. What About Negative Excess Reserves?
If actual reserves (RD) are less than Required Reserves (RR), the excess Reserves (ER) are negative
If a bank does find itself short, it will usually borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charge is called the federal funds rate
A bank may also borrow reserves (RD) from its Federal Reserve District Bank at its discount window
14-14
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15. Primary and Secondary Reserves
A bank’s primary reserves are its vault cash and its deposits at the the Federal District Bank
These reserves pay no interest, therefore the banks try to hold no more than the Federal Reserve requires
14-15
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16. Primary and Secondary Reserves
Every bank holds secondary reserves, mainly in the form of very short-term U.S. government securities
Treasury bills, notes, certificates, and bonds (that will mature in less than a year) are generally considered a bank’s secondary reserves
These can be quickly converted to cash without loss if a bank suddenly needs money
14-16
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17. 14-17
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18. Deposition Expansion (Continued)
How Deposit Expansion Works
Bank A
FED
RD + 100
DD + 100
A> RD +100
Assume a 10% RR
14-18
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19. How Deposit Expansion Works
Deposition Expansion
How Deposit Expansion Works
Bank A
FED
RD + 100
DD + 100 RR
A> RD +100
When RDs at the Fed increase the money supply is increasing
B> RD + 90
ER + 90
C> RD
Bank B
Etc.
RD + 90
DD + 90 RR ER
Bank C RD DD
RD + $1,000,000 ER ER
Assume a 10% RR
14-19
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20. Deposit Expansion Multiplier (DEM)1
DEM =
Reserve Ratio
Assume a RR of 10%
Assume a RR of 25% 1 1
DEM = = 10
DEM = = 4
.10
.25
When RR decreases
DEM increases
When RR increases
DEM decreases
14-20
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21. Three Modifications of the Deposit Expansion Multiplier
Not every dollar of deposit expansion will actually be re-deposited again and lent out repeatedly
Some people may choose to hold or spend some money as currency
It is also possible that some banks will carry excess reserves
This is not likely in times of high inflation
14-21
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22. Three Modifications of the Deposit Expansion Multiplier
There are leakages of dollars to foreign countries
This is caused mainly by our foreign trade imbalance
The Deposit Expansion Multiplier is, in reality, quite a bit lower than if we based it solely on the reserve ratio
If the reserve ratio tells us it is 10, perhaps it’s only 6
14-22
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23. Cash, Checks, and Electronic Money
One of the jobs of the Federal Reserve is check clearing
In 2004 Congress passed the Check Clearing Act of the 21st Century
This was intended to hasten the adoption of electronic check processing
When you use your debit card the amount is deducted within seconds after the card is swiped
We still carry out about 80 percent of our transactions in cash
However cash covers less than one percent of monetary transactions
Electronic transfers account for five out of every six dollars that move in the economy
14-23
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24. Cash, Checks, and Electronic Money
One of the jobs of the Federal Reserve is check clearing
14-24
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25. Cash, Checks, and Electronic Money
Increasingly, money is changing hands electronically
Today, $1.5 trillion a day is transferred electronically
About one-third of these transfers are carried out by the Federal Reserve’s electronic network
About two-thirds are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 10 big New York Banks
Does all this mean that we are well on our way to a checkless, cashless society?
Yes and no
14-25
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26. Cash, Checks, and Electronic Money
Does all this mean that we are well on our way to a checkless, cashless society?
Yes and no
We still carry out nearly 85 percent of our monetary transactions in cash
When the total dollars actually spent is considered, cash covers less than 1 percent of the total value
Electronic transfers account for five out of every six dollars that move in the economy
14-26
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

27. The Tools of Monetary Policy
The most important job of the Fed is to control the rate of growth of the money supply
This effort focuses on the reserves held by financial institutions
The most important policy tool to do this is open-market operations
14-27
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28. How Open-Market Operations Work
Open-Market operations are the buying and selling of U.S. government securities
U.S. government securities are treasury bills, notes, certificates, and bonds
The Fed buys and sells securities that have already been marketed by the treasury
The total value of all outstanding U.S. government securities is more than $4.0 trillion. This is our national debt
What open market operations consist of, then, is the buying and selling of chunks of the national debt
14-28
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29. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100
DD + $100 RR ER
The multiplier would be 10
10 X 90 million = 900 million X .60 = approximate increase in the money supply of 540 million over a period of time
Assume 10% RR
14-29
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30. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
Interest Paid
IR =
RD + $100
DD + $100
Price of Bond RR ER
If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities
Assume 10% RR
14-30
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

31. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
$80
IR =
RD + $100
DD + $100
$1000 RR ER
If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities
Assume 10% RR
14-31
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

32. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
$80
IR = = 8%
RD + $100
DD + $100
$1000 RR ER
If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities
Assume 10% RR
14-32
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

33. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
$80
IR = = 8%
RD + $100
DD + $100
$1000 RR ER
$80
IR = =
6.67%
$1200
Suppose this pushed the price of the bond up to $1200?
Assume 10% RR
14-33
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

34. How the Fed Increases the Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
$80
IR = = 8%
RD + $100
DD + $100
$1000 RR ER
$80
IR = =
6.67%
$1200
When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rate
Assume 10% RR
14-34
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35. How the Fed Decreases the Money Supply
The FED sells U. S. Government Securities
The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)
Securities Firm
RD - $100
DD - $100
The money supply decreases by approximately $540 million over time
When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climb
Assume 10% RR
14-35
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36. How the Fed Decreases the Money Supply
The FED sells U. S. Government Securities
The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)
Securities Firm
$80
IR = = 8%
RD - $100
DD - $100
$1000
$80
IR = =
6.67%
$1200
The money decreases by approximately $540 million over time
When the Fed goes into the open market to sell securities, bond prices fall and interest rates climb
Assume 10% RR
14-36
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37. The Federal Open-Market Committee (FOMC)
Open-market operations are conducted by the Federal Open-Market Committee (FOMC)
This committee consist of 12 people
Eight permanent members – the board of Governors and the president of the New York Federal Reserve District Bank
The other four are presidents of the other 11 Federal Reserve District Banks
They serve on a rotating basis
14-37
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38. The Federal Open-Market Committee (FOMC)
The FOMC meets about once every six weeks to decide what policy to follow
To fight recessions, the FOMC buys securities
This increases the rate of growth of the money supply
To fight inflation, the FOMC sells securities
This decreases the rate of growth of the money supply
14-38
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39. Borrowing Reserve Deposits
The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District Bank
The federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other
This is higher than the discount rate
Banks borrow to maintain their required reserves (RR)
Banks tend to borrow reserve deposits from each other because they may not like to call attention to the fact they are having to borrow reserve deposits
14-39
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40. Increase in the Money Supply Decrease in the Money Supply
14-40
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41.
14-41
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42. Changing Reserve Requirements
The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14 percent for checkable deposits
Changing reserve requirements is the ultimate weapon and is rarely used
14-42
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43. Changing Reserve Requirements
To fight inflation, before the Board would take the drastic step of raising reserve requirements
The District Banks would raise the discount rate
The FOMC will be actively selling securities
Credit will be getting tighter
The chairman will be publicly warning that the banks are advancing too many loans
14-43
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44. Changing Reserve Requirements
If the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises
reserve requirements
This weapon is so rarely used because it is simply too powerful
If the reserve requirement on demand deposits were raised by just one half of 1 percent, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reserves
This would drastically reduce the nation’s money supply
14-44
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45. Summary: The Tools of Monetary Policy
To fight recession, the Fed will
Lower the discount rate
Buy securities on the open market
Lower reserve requirements
This would be done only as a last resort
14-45
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46. Summary: The Tools of Monetary Policy
To fight inflation, the Fed will
Raise the discount rate
Sell securities on the open market
Raise reserve requirements
This would be done only as a last resort
14-46
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47. The Fed’s Effectiveness in Fighting Inflation (Assume all the tools have been used)
Bond prices have plunged
Interest rates have soared
The growth of the money supply has been stopped dead in its tracks
Banks find it impossible to increase their loan portfolios
Buying by consumers and businesses is declining
The inflation rate has no choice but to decline
14-47
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48. The Fed’s Effectiveness in Fighting Recession (Assume all the tools have been used)
Bond prices have increased
Interest rates have gone down
Banks will have excess reserves and want to make loans
But who wants to borrow the money?
Creditworthy individuals and business have little incentive to borrow any money
Businesses and individuals who really need to borrow money can’t because the first rule of banking is: never lend money to anyone who needs it.
Easy money has little or no effect in ending a recession
14-48
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49. The Fed’s Effectiveness in Fighting Inflation and Recession
Federal Reserve policy in fighting inflation and recession has been likened to pulling and then pushing on a string
Like pulling on a string, when the Fed fights inflation, it get results – provided of course, it pulls hard enough
Fighting a recession is another matter. Like pushing on a string, no matter how hard the Fed works, it might not get anywhere
14-49
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50. The Depository Institutions Deregulation and Monetary Control Act of 1980
This Act is clearly the most important piece of banking legislation passed since the 1930s
Under this Act:
All depository institutions are now subject to the Fed’s legal reserve requirements
All depository institutions are now legally authorized to issue checking deposits that may be interest bearing
All depository institutions now enjoy all the advantages that only Federal Reserve member banks formerly enjoyed –including check clearing and borrowing from the Fed (discounting)
14-50
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51. The Depository Institutions Deregulation and Monetary Control Act of 1980
Another important consequence of this law is that by the end of the 1990s, intense competition reduced the 40,000-plus financial institutions that existed at the beginning of the 1980s to a little 20,000 today
The lifting of the prohibition against interstate banking combined with further advances in electronic banking will create greater consolidation, perhaps with just 30 to 40 giant financial institutions doing most of the business
14-51
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52. The Banking Act of 1999
In 1980 the jurisdiction of the Federal Reserve had been extended to all commercial banks and thrift institutions
In 1999 it was further extended to insurance companies, pension funds, investment companies, securities brokers, and finance companies
This new law allows banks, securities firms and insurances companies to merge and sell each other’s products
14-52
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53. Fiscal and Monetary Policies Should Mesh
In 1990s there was little coordination in the making of fiscal and monetary policies
Fiscal policies are made by the federal government
Monetary policy is determined by the Fed
Fiscal policy at best is described as a series of compromises between Congress and the President
Fiscal and monetary policy should mesh, but obviously different people with different objectives cause these to work at cross-purposes all too often
A step in the right direction could be to allow every President to appoint the Chairman of the Board at the Fed when he begins his term
What about doing away with the Fed and allow the elected leaders of the federal government to determine both fiscal and monetary policy?
14-53
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54. Current Issue: Who Controls Our Interest Rates?
What can we expect over the next decade?
The Federal Budget annual deficit will probably exceed $500 billion every year
Americans will continue to spend not only all their incomes but continue to spend more than they earn with credit cards
The U.S. Treasury will become still more dependent on the kindness of foreigners to finance our debt
Who does control our interest rates?
While the Fed is still the biggest kid on the block, it no longer calls all of the shots
If our financial dependency on foreigners continue to grow
Our monetary policy will originate more and more in Shanghai, Tokyo, , London, , Frankfort, and other financial capitals
14-58
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