1. Chapter 15 Parks Econ104 The Federal Reserve and Monetary Policy

2. The Federal Reserve The Federal Reserve is the United States Central Bank. Founded in 1913 after four severe banking panics. Chartered by the federal government but is largely independent of the authority of the Congress and President. Primary role is to conduct monetary policy and to act as a lender of the last resort to banks to stabilize the financial system. The Federal Reserve is the United States Central Bank. Founded in 1913 after four severe banking panics. Chartered by the federal government but is largely independent of the authority of the Congress and President. Primary role is to conduct monetary policy and to act as a lender of the last resort to banks to stabilize the financial system.

3. Structure of the Fed The unique structure of the Federal Reserve is a consequence of history and politics.

4. Structure of the Fed The Board of Governors – is the highest governing body of the Federal Reserve. –It consists of seven members including the chairperson--currently Ben S Bernanke. The Twelve District Banks provide regional check clearing, bank supervision, payments processing, and economic analysis. The Board of Governors – is the highest governing body of the Federal Reserve. –It consists of seven members including the chairperson--currently Ben S Bernanke. The Twelve District Banks provide regional check clearing, bank supervision, payments processing, and economic analysis.

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13. Structure of the Fed The F.O.M.C. (Federal Open Market Committee) –is responsible for directing monetary policy. –consists of 12 members, the seven from the Board of Governors plus five Presidents of the District Banks who serve on a rotating basis, one of which is always from the New York Fed. –meets about every six weeks to discuss monetary policy and decide what course of action to take. The F.O.M.C. (Federal Open Market Committee) –is responsible for directing monetary policy. –consists of 12 members, the seven from the Board of Governors plus five Presidents of the District Banks who serve on a rotating basis, one of which is always from the New York Fed. –meets about every six weeks to discuss monetary policy and decide what course of action to take.

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17. Tools of Monetary Policy The Federal Reserve's attempt at stabilization policy is referred to as monetary policy. Tool include: 1.Open Market Operations (OMO), 2.Change in the discount rate, and 3.Change in the reserve requirement ratio. 4.other stuff The Federal Reserve's attempt at stabilization policy is referred to as monetary policy. Tool include: 1.Open Market Operations (OMO), 2.Change in the discount rate, and 3.Change in the reserve requirement ratio. 4.other stuff

18. Tool #1: Open Market Operations An Open Market Operation is –the Fed's purchase (open market purchase) or sale (open market sale) of government securities via transactions in the open market. –by far the most important tool of the Fed and it is used daily to target the federal funds rate. –An open market operation impacts the banking system by changing bank reserves initially and, ultimately, the money supply. An Open Market Operation is –the Fed's purchase (open market purchase) or sale (open market sale) of government securities via transactions in the open market. –by far the most important tool of the Fed and it is used daily to target the federal funds rate. –An open market operation impacts the banking system by changing bank reserves initially and, ultimately, the money supply.

19. Tool #1: Open Market Operations Example: the Fed purchases $100 million of government securities from commercial banks.

20. © OnlineTexts.com p. 20 Expansionary monetary policy Buy BONDS With RESERVES – increasing reserves which increases excess reserves which allows increased loans. BUY BONDS – Bid price of bond up, lowers interest rate BUY BONDS – increases money supply lowering interest rate Expansionary monetary policy Buy BONDS With RESERVES – increasing reserves which increases excess reserves which allows increased loans. BUY BONDS – Bid price of bond up, lowers interest rate BUY BONDS – increases money supply lowering interest rate

21. © OnlineTexts.com p. 21 Contractionary monetary policy Sell BONDS – decreases reserves because in the end reserves must be used to pay for the bonds that the FED sells Sell BONDS – lowers price of bonds, increasing interest rates Sell BONDS – decreases the money supply raising interest rates

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24. © OnlineTexts.com p. 24 Where did the Fed get $$ to buy bonds The central bank can CREATE reserves. NOTE – the FED was limited to buying US Treasuries but now it can ‘buy’ other stuff such as the junk at Bear-Stearns, AIG, CITI- GROUP. It could buy anything to increase the money supply/lower interest rates but it can only sell what it has. The central bank can CREATE reserves. NOTE – the FED was limited to buying US Treasuries but now it can ‘buy’ other stuff such as the junk at Bear-Stearns, AIG, CITI- GROUP. It could buy anything to increase the money supply/lower interest rates but it can only sell what it has.

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29. Tool #2: Change in the Discount Rate The discount window is where depository institutions go to borrow funds from the Fed. –The discount rate is the interest rate at which the Federal Reserve lends funds to banks. –Borrowings from the discount window are short- term, usually lasting only a week or two. –Changes to the system were implemented recently, establishing primary credit and secondary credit programs. The discount window is where depository institutions go to borrow funds from the Fed. –The discount rate is the interest rate at which the Federal Reserve lends funds to banks. –Borrowings from the discount window are short- term, usually lasting only a week or two. –Changes to the system were implemented recently, establishing primary credit and secondary credit programs.

30. Tool #2: Change in the Discount Rate Suppose the Fed decreases the discount rate by one percentage point, say, from six percent to five percent. This change induces banks to borrow $5 million more in reserves from the Fed to fund additional loan opportunities.

31. © OnlineTexts.com p. 31 The discount rate is changed when the Fed Funds Rate target is changed and the discount rate is generally lower.

32. Tool #3: Change in the Required Reserve Ratio The required reserve ratio is the minimum amount of reserves that a bank must hold relative to its deposit base. –Reserves include vault cash and reserves held at the Federal Reserve. –Currently in the U.S. banking system, the required reserve ratio is 10 percent. –Lowering the ratio frees up reserves, while raising the ratio reduces reserves. The required reserve ratio is the minimum amount of reserves that a bank must hold relative to its deposit base. –Reserves include vault cash and reserves held at the Federal Reserve. –Currently in the U.S. banking system, the required reserve ratio is 10 percent. –Lowering the ratio frees up reserves, while raising the ratio reduces reserves.

33. Tool #3: Change in the Required Reserve Ratio Example: the Fed lowers the required reserve ratio from 12.5 percent to 10 percent, freeing up $2,500 in excess reserves.

34. © OnlineTexts.com p. 34 2006 0% of first 8.5 mill 3% up to 48.5 mill 10% over 48.5 mill At times the 48.5 is changed a bit. 1990-1991 was 12% r.t. 10% - lowered req. res. by 8.9 billion. Fed also reduced to 0% reserves for CDs reducing req res by 13 billion 2006 0% of first 8.5 mill 3% up to 48.5 mill 10% over 48.5 mill At times the 48.5 is changed a bit. 1990-1991 was 12% r.t. 10% - lowered req. res. by 8.9 billion. Fed also reduced to 0% reserves for CDs reducing req res by 13 billion

35. Summary of Monetary Policy Tools

36. © OnlineTexts.com p. 36 Links http://wfhummel.cnchost.com/linkshistoricaldata. html http://wfhummel.cnchost.com/linkshistoricaldata. html http://www.federalreserve.gov/releases/Z1/Curre nt/z1r-4.pdfhttp://www.federalreserve.gov/releases/Z1/Curre nt/z1r-4.pdf has the balance sheets for many sectors including the Fed Res at page 68. Page 88 is cool to see more debt that is not reported (agency debt). Page 94 home mortgages. http://www.federalreserve.gov/releases/h41/Curren t/h41.pdf Links http://wfhummel.cnchost.com/linkshistoricaldata. html http://wfhummel.cnchost.com/linkshistoricaldata. html http://www.federalreserve.gov/releases/Z1/Curre nt/z1r-4.pdfhttp://www.federalreserve.gov/releases/Z1/Curre nt/z1r-4.pdf has the balance sheets for many sectors including the Fed Res at page 68. Page 88 is cool to see more debt that is not reported (agency debt). Page 94 home mortgages. http://www.federalreserve.gov/releases/h41/Curren t/h41.pdf

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39. Impacts of Monetary Policy on the Economy How do Federal Reserve actions impact the behavior of output, inflation, and unemployment? Monetary policy ultimately works by changing interest rates in the loanable funds market, which change the level of demand for goods and services in the economy OR changing the amount of credit ‘easily available’. How do Federal Reserve actions impact the behavior of output, inflation, and unemployment? Monetary policy ultimately works by changing interest rates in the loanable funds market, which change the level of demand for goods and services in the economy OR changing the amount of credit ‘easily available’.

40. The Loanable Funds Market Demand for loanable funds comes borrowers. The supply of loanable funds comes from savers.

41. The Loanable Funds Market Expansionary monetary policy, by increasing bank the quantity of bank reserves, increases the supply of loanable funds, which lowers interest rates.

42. The Impact of Monetary Policy on the Economy The final piece of the puzzle is that the lower interest rates increase investment, which shifts the Aggregate Demand curve to the right. –Both the level of output and the price level increase. –Contractionary policy reduces the price level and the level of output. –Remember that monetary policy affects Aggregate Demand, not Aggregate Supply. The final piece of the puzzle is that the lower interest rates increase investment, which shifts the Aggregate Demand curve to the right. –Both the level of output and the price level increase. –Contractionary policy reduces the price level and the level of output. –Remember that monetary policy affects Aggregate Demand, not Aggregate Supply.

43. Expansionary Monetary Policy

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