The Federal Reserve System and Monetary Policy

Name: The Federal Reserve System and Monetary Policy
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Description: The Federal Reserve System and Monetary Policy

The Federal Reserve System and Monetary Policy
Chapter 27 The Federal Reserve System and Monetary Policy Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Gottheil — Principles of Economics, 7e
Economic Principles The Federal Reserve System as a central bank The discount rate as a tool of monetary policy Open market operations as a tool of monetary policy Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History Bank note A promissory note, issued by a bank, pledging to redeem the note for a specific amount of gold or silver. The terms of redemption are specified on the note. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History The first real U.S. money was the Continental Note. Since Congress had no taxing authority, it printed Continental Notes to finance the Revolution. Excessive printing rendered the Continental Note nearly useless. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History State-chartered bank A commercial bank that receives its charter or license to function from a state government and is subject to the laws of that state. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

EXHIBIT 1 GROWTH OF STATE BANKS: 1784– ($ MILLIONS) Source: U.S. Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, D.C.: U.S. Government Printing Office, 1949,) pp. 261–263. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 1: Growth of State Banks: 1784-1860 ($ millions)
What are some reasons for the rapid growth of state banks? The money supply was inadequate to finance the growing number of farms, factories, and businesses. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History Congress accepted Hamilton’s plan and created the First Bank of the United States in 1791. This central bank dampened the inclination of state-chartered banks to overissue notes by demanding that the notes be redeemed in silver and gold. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History Nationally chartered bank A commercial bank that receives its charter from the comptroller of the currency and is subject to federal law as well as the laws of the state in which it operates. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History When the 20-year charter of the First Bank of the U.S. expired in 1811, advocates of states’ rights in Congress prevailed, and the charter was not renewed. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History In 1816 Congress created the Second Bank of the U.S., which again stabilized state banking practices. As with the First Bank, however, political pressure led to the failure of Second Bank of the U.S. in the 1830s. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History During the Civil War, Congress passed the National Bank Act, which created a national banking system and the office of the comptroller of the currency, which chartered national banks. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History National banks had to buy Treasury Bonds equal to one-third of their capital, and could issue notes only in proportion to their Treasury bond holdings. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

A Glimpse at History In 1907 the highly respected Knicker-bocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

The Federal Reserve System
The Federal Reserve Act of 1913 created the Federal Reserve System (the “Fed”). The Fed has 12 regional district banks that serve as the region’s central bank. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Does the president of the U.S. control the Fed? No. Although the Fed was created by and responsible to Congress, the Fed pursues an independent monetary policy that at times may conflict with policies pursued by the president or Congress. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 2: The Geography of the Federal Reserve System
In what Federal Reserve Bank district do you live? What is the reserve bank city for your district? Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

EXHIBIT 3 NATIONAL BANKS AND STATE BANKS 2011 Source: Federal Deposit Insurance Corporation, Institution Directory, 2011 (Washington, D.C.: FDIC, 2011). Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 3: National Banks and State Banks 2011
How many banks are chartered nationally? Of the 7,519 banks in the country, fewer than 1,400 are chartered nationally. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 3: National Banks and State Banks 2011
How many state-chartered banks are members of the Fed? Of the 4214 state-chartered banks in the country, 816 banks are members of the Federal Reserve System. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

EXHIBIT 4 ORGANIZATIONAL STRUCTURE OF THE FEDERAL RESERVE SYSTEM Source: Board of Governors of the Federal Reserve System, Division of Support Services, Purposes & Functions, 1984. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 4: Organizational Structure of the Federal Reserve System
What is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)? The Board of Governors Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

The Fed’s main charge is to safeguard the proper functioning of our monetary system (money supply, interest rates, and the economy’s price level). Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 5: Identifying Letters and District Banks
If you look at the seal to the left of George Washington’s picture on a $1 bill and see the letter “L,” in what district bank was that $1 bill issued? San Francisco Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 6: Bank Transactions Triggered by Brian’s Purchase
Why does Brian’s check go to the Atlanta Fed and the Cleveland Fed? One of the functions of a district Fed is to clear checks. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 7: From Changes in the Money Supply to Changes in Real GDP
How does an increase in the money supply lead to an increase in real GDP? Increasing the money supply leads to lower interest rates, which promotes increased investment spending, which increases aggregate demand. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Controlling the Money Supply
Countercyclical monetary policy Policy directives used by the Fed to moderate swings in the business cycle. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Reserve requirement The minimum amount of reserves the Fed requires a bank to hold, based on a percentage of the bank’s total deposit liabilities. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

EXHIBIT 8 RESERVE REQUIREMENTS (JULY 2006) Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., July 2000). Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 8: Reserve Requirements (July 2006)
Do reserve requirements imposed by the Fed depend on the bank’s total deposits? Yes. Banks with more than $42.8 million in checking account balances must hold 10 percent of those deposits on reserve. Smaller banks only need to hold 3 percent of checking account balances on reserve. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply? Money held by the Fed is not counted in the money supply. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply? Money held by the Fed is not counted in the money supply. PFN can loan out much of the money it borrowed from the Fed. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Federal funds market The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

1. If a private bank has $5,000 in new reserves and the reserve requirement is 20 percent, then what is the maximum amount of new money supply that can be created from this $5,000? $5,000 × (1/0.2) = $25,000. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 10: Change in PFN’s Accounts after Receiving a $5,000 Loan from the Dallas Fed If the Dallas Fed loans money to a private bank such as PFN, does this generate a liability for PFN? Yes. The liability is the borrowed money that PFN owes to the Fed. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 11: Federal Reserve Bank of New York Discount Rates, 1990–2008
What was the lowest discount rates charged by the New York Fed, and when did that take place? The New York Fed charged .75 percent on November 6, 2002. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

2. If the Fed wanted to reduce the money supply, would it purchase or sell government securities? It would sell government securities. Money used to buy the securities from the Fed would leave the money supply. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 12: Change in the Fed’s Accounts after Buying $10 Million of Securities from PFN What was the change in the Fed’s liabilities after buying $10 million of securities from PFN? The Fed’s liabilities increased by $10 million due to a $10 million increase in PFN’s reserve. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 13: Change in PFN’s Accounts after Selling $10 Million of Securities to the Fed If the Fed buys $10 million of securities from PFN, how much of the proceeds from this sale can PFN loan out? PFN can loan out all $10 million because these represent excess reserves. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 14: Change in PFN’s Accounts after Maria Sells $10 Million of Securities Suppose that the Fed bought $10 million of securities from a private individual (Maria) rather than from PFN. Would this still increase the money supply? Yes, but not by as much. If she deposits the check at the bank, the bank can loan out only $8 million of the new demand deposit. The other $2 million are required reserves. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 15: Change in the Fed’s Accounts after Buying $10 Million of Securities from Maria If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts? The Fed’s assets increase by $10 million because it owns more securities. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 15: Change in the Fed’s Accounts After Buying $10 Million of Securities from Maria If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts? The Fed’s assets increase by $10 million because it owns more securities. The Fed’s liabilities increase by $10 million from clearing the check for PFN. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 16: Change in PFN’s Accounts after Buying $10 Million of Securities What happens to the money supply as a consequence of the transaction shown in Exhibit 16? By selling securities to PFN, the Fed reduces PFN’s reserves by $10 million. PFN is no longer in a position to loan that $10 million, which reduces the money supply. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 17: The Fed’s Target Options
If Fed targets the money supply, as in Panel a, what countercyclical policy is no longer available to the Fed? The Fed can no longer control the interest rate, since the interest rate depends on the positioning of the demand for money. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Controlling the Interest Rate: The Fed’s Alternative Target Option
If the Fed targets the money supply, it cannot at the same time control the interest rate. Likewise by choosing to target the interest rate, the Fed loses control over the money supply. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Past Fed Governor Martha Seger Describes How the FOMC Works
According the Honorable Martha Seeger, what is the biggest difference between the Fed as textbook writers describe it, and how it really is? It is much more difficult for the Fed to make decisions than the process described by textbook writers. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Margin requirements The maximum percentage of the cost of a stock that can be borrowed from a bank or any other financial institution, with the stock offered as collateral. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

The Fed’s Countercyclical Monetary Policy
What was the Fed’s role in the addressing the Bank Crash of 2007? Both the Fed and government rushed to rescue the at-risk commercial and investment banks, buying up substantial quantities of their over-valued – and in some cases, worthless – assets. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

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