Download Powerpoint Chapter 14 - The Federal Reserve and Monetary Policy

Chapter 14
The Federal Reserve and Monetary
Policy
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-1
Chapter 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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
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 [ 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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-3
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-4
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-5
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.
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-6
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-7
The Federal Reserve System
Federal Reserve Districts are shaded.
Board of Governors of the Federal Reserve System
Federal Reserve Bank cities
Federal Reserve Branch cities
Boundaries of Federal Reserve Branch territories
12
Alaska
Seattle
1
9
Helena
Portland
Buffalo
2
Boston
Minneapolis
7
12
Chicago
Detroit
Cleveland
Omaha
Salt
Lake
City
San
Francisco
Kansas
El
Paso
Little
Rock
Richmond
5
Charlotte
Atlanta
Birmingham
Dallas
San
Houston
Antonio
Baltimore
Washington
Nashville
Oklahoma
City
11
Philadelphia
St.
Louis
8
Los
Angeles
New York
4
Denver
10
3
Pittsburgh
6
Jacksonville
New Orleans
12
Hawaii
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Miami
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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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-9
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-10
Legal Reserve Requirements
[March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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14-11
Legal Reserve Requirements
[March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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.
14-12
Legal Reserve Requirements
[March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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.
14-13
Legal Reserve Requirements [March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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
RD 100.000
DD 100.000
RD 100.000
100.000
.03 X 42.8 = 1.284
.10 X 57.2 = 5.720
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
-
42.800
57.200
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Legal Reserve Requirements [March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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
RD 100.000
RR
7.004
DD 100.000
RD 100.000
.03 X 42.8 = 1.284
.10 X 57.2 = 5.720
RR = 7.004
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-15
Legal Reserve Requirements [March 1997]
Checking Accounts
$0 - 42.8 million
Over 42.8 million
Time Deposits
3%
10%
0%
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
RD 100.000
- RR 7.004
ER 92.996
DD 100.000
RD 100.000
.03 X 42.8 = 1.284
.10 X 57.2 = 5.720
RR = 7.004
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-16
Legal Reserve Requirements [March 1997]
Checking Accounts
$0 - 42.8 million
3%
Over 42.8 million
10%
Time Deposits
0%
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
RD 120.000
- RR 97.004
ER 22.996
DD 1000.000
RD 120.000
1,000.0
.03 X 42.8 =
1.284
.10 X 957.2 = 95.720
RR = 97.004
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
-
42.8
- 957.2
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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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-18
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-19
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-20
Deposition Expansion
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
100.00
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Deposition Expansion
(Continued)
How Deposit Expansion Works
Bank A
RD + 100
DD + 100
FED
A> RD +100
Assume a 10% RR
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14-22
Deposition Expansion
How Deposit Expansion Works
Bank A
RD + 100
RR
10
ER + 90
DD + 100
Bank B
RD + 90
DD + 90
RR
9
ER + 81
FED
A> RD +100
When RDs
B> RD + 90
C> RD + 81.0
at the Fed
increase the
Etc.
money
Etc.
supply is
increasing
Etc.
Bank C
RD + 81
DD + 81.0
ER
8.1
ER + 72.9
Assume a 10% RR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
RD + $1,000,000
14-23
Deposit Expansion Multiplier
(DEM)
1
DEM =
Reserve Ratio
Assume a RR of 10 %
1
DEM =
.10
= 10
Assume a RR of 25 %
DEM =
1
.25
When RR decreases
When RR increases
DEM increases
DEM decreases
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
=4
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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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-25
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-26
Cash, Checks, and Electronic Money
One of the jobs of the Federal Reserve is check clearing
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-27
Cash, Checks, and Electronic
Money
• 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
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14-28
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% 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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-29
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-30
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-31
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
RD + $100 DD + $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
Assume 10% RR
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14-32
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
RD + $100 DD + $100
RR - 10
ER + 90
IR =
Interest Paid
Price of Bond
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-33
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
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-34
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
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
= 8%
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-35
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 - 10
ER + 90
IR =
IR =
$80
$1000
$80
$1200
= 8%
= 6.67%
Suppose this pushed the price of the bond up to $1200?
Assume 10% RR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-36
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 - 10
ER + 90
IR =
IR =
$80
$1000
$80
$1200
= 8%
= 6.67%
When the Fed goes into the open market to buy securities, it bids
up their price and lowers their interest rate
Assume 10% RR
14-37
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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14-38
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
IR =
IR =
$80
$1000
$80
$1200
= 8%
= 6.67%
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
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14-39
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
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14-40
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-41
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
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14-42
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-43
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-44
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%, 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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-45
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-46
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
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14-47
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-48
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-49
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-50
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)
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14-51
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 more than half that number
The lifting of the prohibition against interstate
banking combined with further advances in
electronic banking will create greater
consolidation
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14-52
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
• All financial firms, including banks, can now
sell all sorts of investments
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-53