1. Chapter 14 The Federal Reserve and Monetary Policy 14-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives 14-2 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

3. 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 [ 1791 - 1811] –Second United States Bank [ 1816 - 1836] 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 The Federal Reserve System 14-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 14-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 14-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

7. The Federal Reserve System Board of Governors –7 appointed members –Appointed by President –Confirmed by Senate Sets reserve requirements Supervises & 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

8. 14-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve System

9. Legal Reserve Requirements 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 at its Federal Reserve District Bank or in its own vaults 14-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

10. 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 14-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-12 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

13. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-13 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? The model below excludes vault cash Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

14. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-14 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? The model below excludes vault cash Fed Bank DD 100.000RD 100.000.03 X 42.8 = 1.284 100.000 - 42.800 57.200.10 X 57.2 = 5.720 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

15. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-15 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? The model below excludes vault cash Fed Bank DD 100.000RD 100.000.03 X 42.8 = 1.284.10 X 57.2 = 5.720 RR = 7.004 RR 7.004 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

16. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-16 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? The model below excludes vault cash Fed Bank DD 100.000RD 100.000.03 X 42.8 = 1.284.10 X 57.2 = 5.720 RR = 7.004 RR 7.004 - ER 92.996 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

17. Legal Reserve Requirements [March 1997] Checking Accounts $0 - 42.8 million 3% Over 42.8 million 10% Time Deposits 0% 14-17 If a bank had demand deposits (DD) of 1,000 million ($1 billion) and held 120 million in actual reserves (RD) in the form of deposits at the Federal Reserve District Bank, calculate its required reserves (RR) and its excess reserves (ER) Fed Bank DD 1000.000RD 120.000.03 X 42.8 = 1.284.10 X 957.2 = 95.720 RR = 97.004 RR 97.004 - ER 22.996 1,000.0 - 42.8 - 957.2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18. 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 14-18 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19. 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 Primary and Secondary Reserves 14-19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

20. 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 Primary and Secondary Reserves 14-20 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21. Deposition Expansion 14-21 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Deposit Expansion with 10 Percent Reserve Requirement Deposits (thousands) Reserves $100.0 $10.0 $ 90.0 9.0 $ 81.0 8.1 $ 72.9 7.29 $ 65.61 6.661 $ 59.05 5.904 $ 53.541 5.354 $ 48.186 4.819 $ 43.368 4.337 $ 39.031 3.903 * To save space the rest of the calculations are omitted $1,000.00 100.00

22. Deposition Expansion (Continued) 14-22 How Deposit Expansion Works Bank AFED DD + 100RD + 100A> RD +100 Assume a 10% RR Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23. Deposition Expansion 14-23 How Deposit Expansion Works Bank A FED DD + 100RD + 100 A> RD +100 Assume a 10% RR RR 10 ER + 90 Bank B DD + 90RD + 90 B> RD + 90 RR 9 ER + 81 Bank C DD + 81.0RD + 81 C> RD + 81.0 ER 8.1 ER + 72.9 Etc. RD + $1,000,000 When RDs at the Fed increase the money supply is increasing Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

24. Deposit Expansion Multiplier (DEM) 14-24 DEM = 1 Reserve Ratio Assume a RR of 10 % DEM = 1.10 = 10 Assume a RR of 25 % DEM = 1.25 = 4 When RR increases DEM decreases When RR decreases DEM increases Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

25. 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 14-25 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

26. 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 ration tells us it is 10, perhaps it’s only 6 14-26 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

27. Cash, Checks, and Electronic Money One of the jobs of the Federal Reserve is check clearing 14-27 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

28. Increasingly, money is changing hands electronically –Today, more than $1.7 trillion a day is transferred electronically –About $600 billion of these transfers are carried out by the Federal Reserve’s electronic network –About $1.1 trillion are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 11 big New York Banks Cash, Checks, and Electronic Money 14-28 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

29. 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% of our monetary transactions in cash –When the total dollars actually spent is considered, cash covers less than 1% of the total value –Electronic transfers account for five out of every six dollars that move in the economy Cash, Checks, and Electronic Money 14-29 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

30. 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 14-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

31. 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 14-31 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

32. How the Fed Increases the Money Supply 14-32 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

33. How the Fed Increases the Money Supply 14-33 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = Interest Paid Price of Bond Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

34. How the Fed Increases the Money Supply 14-34 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = $80 $1000 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

35. How the Fed Increases the Money Supply 14-35 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = $80 $1000 = 8% Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

36. How the Fed Increases the Money Supply 14-36 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 Suppose this pushed the price of the bond up to $1200? IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

37. How the Fed Increases the Money Supply 14-37 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 DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rate IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

38. How the Fed Decreases the Money Supply 14-38 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 DD - $100 Assume 10% RR RD - $100 When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climb The money supply decreases by approximately $540 million over time Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

39. How the Fed Decreases the Money Supply 14-39 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 DD - $100 Assume 10% RR RD - $100 When the Fed goes into the open market to sell securities, bond prices fall and interest rates climb IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% The money decreases by approximately $540 million over time Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

40. 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 14-40 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

41. The Federal Open-Market Committee (FOMC) 14-41 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

42. 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 14-42 Borrowing Reserve Deposits Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

43. Changing Reserve Requirements The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14% for checkable deposits –Changing reserve requirements is the ultimate weapon and is rarely used 14-43 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

44. 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 14-44 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

45. 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%, 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 14-45 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

46. 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 14-46 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

47. 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 14-47 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

48. 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 14-48 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

49. 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 14-49 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

50. 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 14-50 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

51. 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) 14-51 Th e De pos itor y Ins titu tio ns Der egu lati on an d Mo net ary Co ntr ol Act of 198 0 (Co nti nue d) The Depository Institutions Deregulation and Monetary Control Act of 1980 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

52. 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 more than half that number The lifting of the prohibition against interstate banking combined with further advances in electronic banking will create greater consolidation The Depository Institutions Deregulation and Monetary Control Act of 1980 14-52 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

53. 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 All financial firms, including banks, can now sell all sorts of investments 14-53 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.