Download HS 322 7.1 ASSIGNMENT 7 THE FEDERAL RESERVE, CENTRAL

ASSIGNMENT 7
THE FEDERAL RESERVE, CENTRAL BANKING, AND TOOLS OF CENTRAL BANK
MONETARY POLICY
Text Reference
Rose Marquis—pages 355–380, and 385–417
OVERVIEW
The Federal Reserve System (the Fed) is responsible for carrying out monetary
policy. It has an enormous impact on the U.S. financial system, greatly influencing
the volume of available loanable funds and the prices (interest rates) attached to
them. Globally, the rise of central banking has come to be one of the most important
functions in any modern economy.
This assignment examines the organizational structure of the Fed, its major roles
in the economy, and why it is important to have independence from other
government policymakers to be effective. We will also examine the various tools it
uses to perform its most important role—controlling the supply of money and credit,
and how those actions impact on our nation’s economic goals.
OBJECTIVES
HS 322
1.
Explain why central banks are necessary in modern economies.
2.
Describe the organizational structure of the Federal Reserve System.
3.
Summarize the principal roles of the Federal Reserve System.
4.
Explain how monetary policy affects the volume of loans and deposits in the
financial system.
5.
Explain how each of the policy tools of the Federal Reserve is used to carry out
a nation’s money and credit policy.
6.
Describe how the Federal Reserve controls U.S. credit and interest rate levels.
7.
Describe how central bank policy initiatives affect a nation’s economic goals.
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OUTLINE
•
Central banking and the role of the Federal Reserve
(RM Marquis 355–379)
Role of a central bank in the economy
Control of the money supply to avoid severe inflation
Stabilizing the money and capital markets
Lender of last resort and supervisor of the banking system
Maintaining and improving the payments mechanism
Goals and channels of central banking
Major economic goals
Challenges in achieving central bank goals
Channels through which central banks work
History of the Federal Reserve
Problems in early U.S. banking
Creation of the Federal Reserve System
Early structure of the Fed
Goals and policy tools of the Fed
How the Fed is organized today
Board of Governors
Federal Open Market Committee (FOMC)
Federal Reserve Banks
Member banks of the Federal Reserve System
Roles of the Federal Reserve System
Clearing and collection of checks and other payment media
Issuing currency and coin and providing other services
Maintaining a sound banking and financial system
Serving as the federal government’s fiscal agent
Providing information to the public
Carrying out monetary policy
Focus of Federal Reserve monetary policy: interest rates, reserves, and money
Composition of reserves
Deposit multiplier
Money multiplier
•
Tools and goals of monetary policy (RM 385–408)
General versus selective credit controls
General credit controls
Open market operations
Discount rate
Reserve requirements
Selective credit controls
Moral suasion
Margin requirements
Interest rate targeting
Fed funds rate
Fed funds targeting and long-term rates
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•
The Federal Reserve and economic goals (RM 408–415)
Controlling inflation
Full employment
Sustainable economic growth
Conflicting goals and limitations of monetary policy
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KEY TERMS
Define the following:
central bank (RM 355)
money supply (RM 355–356)
lender of last resort (RM 357)
discount window (RM364)
open market operations (RM 365)
Board of Governors (RM 365)
Federal Open Market Committee—FOMC (RM 367)
fiscal agent (RM 373)
transparency (RM 371)
substitute checks (RM 372)
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monetary policy (RM 374)
legal reserves (RM 375)
deposit multiplier (RM 376)
money multiplier (RM 378)
monetary base (RM 378)
general credit control (RM 385)
selective credit control (RM 385)
transaction accounts (R 400)
nonpersonal time deposits (RM 400)
Eurocurrency liabilities (RM 400)
discount rate (RM 394)
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primary credit (RM 395)
secondary credit (RM 395)
defensive open market operations (RM 392–393)
dynamic open market operations (RM 394)
moral suasion (RM 403)
margin requirement (RM 403)
borrowed reserves (RM 406)
inflation (RM 408)
deflation (RM 411)
full employment (RM 412)
frictional unemployment (RM 412)
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QUESTIONS
(Questions followed by [A] are answered at the end of this section.)
1. Describe the principal functions performed
by central banks in market-oriented
economies.
(RM 355–357)
2. a. What are the two major economic goals
of central banking in the United States?
b. Why has simultaneous achievement of
these goals proven difficult?
(RM 357–360)
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3. Describe the principal responsibilities
assigned to
a. the Board of Governors of the Federal
Reserve System
b. the Federal Open Market Committee
(RM 365–368)
4. What is meant by monetary policy
transparency?
(RM 371)
5. What are the six prime functions performed
by the Federal Reserve Banks?
(RM 372–374)
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6. a. Who chartered the 12 Federal Reserve
District Banks?
b. What role does the Federal Reserve
Board play in selecting each District
Bank’s directors and chief officers?
(RM 368)
7. Describe the member banks of the Federal
Reserve System.
a. Who must join?
b. What percentage of banks are members?
c. What obligations are imposed on banks
that join?
d. Who technically owns the Federal
Reserve Banks?
(RM 368–371)
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8. Describe Federal Reserve notes.
a. Who issues them?
b. How are they backed?
c. Where do they appear on the issuer’s
balance sheet?
d. Who pays the cost of distributing coin
and currency to depository institutions?
(RM 373)
9. a. In what ways does the Federal Reserve
System contribute to maintaining a
sound banking and financial system?
b. What are the Fed’s duties in acting as
the government’s Fed fiscal agent?
(RM 373–374)
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10. Summarize the activities of the Federal
Reserve System in providing economic
information to the public.
(RM 374)
11. a. What is the most critical target of
Federal Reserve policy?
b. What effects do changes in reserves
have on the economy?
(RM 374–375)
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12. a. What are legal reserves, required
reserves, and excess reserves?
b. How can you calculate a bank’s excess
reserves?
(RM 375−376)
13. Why are deposit-type intermediaries able to
create money? How do leakages reduce their
money-creating capabilities?
(RM 376–379)
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14. Assume that depository institutions have just
received $1 million of excess reserves from
some source outside the banking system.
Assume further that for each new dollar of
transaction deposits received, the public will
convert $.25 into pocket money. In addition,
assume that depository institutions decide to
hold $.10 of every new dollar received as
excess reserves to protect against future
contingencies. The reserve requirement on
transaction deposits is assumed to be 5
percent. On the basis of this information,
calculate the maximum amount of new
deposits and loans that depository
institutions as a group can create. [A]
(RM 376–377)
15. In the preceding question, what is the size of
the money multiplier? [A]
(RM 378–379)
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16. a. What is the monetary base?
b. Why is it important?
(RM 378)
17. Describe each of the three principal effects
of a change in deposit reserve requirements.
(RM 399–400)
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18. Describe each of the following effects of a
change in the discount rate:
a. cost effect
b. substitution effect
c. announcement effect
(RM 397)
19. Explain the effect of a Federal Reserve open
market purchase on interest rates, total legal
reserves, and excess reserves.
(RM 385–387)
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20. a. Describe the relationship between the
SOMA manager and the FOMC.
b. What is a policy directive?
c. What is a policy statement?
(RM 388–389)
21. Describe the four basic types of Federal
Reserve open market operations.
a. straight or outright transaction
b. repurchase agreement
c. runoff
d. agency operations
(RM 389–392)
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22. How can the Federal Reserve keep the Fed
funds rate near its interest rate target?
(RM 406–407)
23. Explain why the Fed does not have direct
control over long-term interest rates.
(RM 407–408)
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24. With respect to the national economic goal
of controlling inflation, describe
a. the principal causes of inflation since
the 1960s
b. the economic effects of inflation and
deflation
(RM 408–411)
25. With respect to the national economic goals
of full employment and sustainable
economic growth, discuss
a. the current target range of frictional
unemployment when the economy is at
full employment
b. the target range for real GDP growth
(RM 412–414)
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26. Describe the principal limitations of
monetary policy.
(RM 414–415)
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ANSWERS
14.
The maximum amount of new loans and deposits that can be created is
calculated by multiplying the new excess reserves by the deposit multiplier.
The multiplier is determined by taking into account leakages into cash,* time
and savings deposits, and unused excess reserves by the following formula:
Max. new loans/deposited =
1
x $1 million
RR D + cash + exr
1
x $1 million
.05 + .25 + .10
1
= −
x $1 million = $2.5 million
.40
=
15.
Money multiplier =
1 + cash
RR D + cash + exr
1 + .25
.05 + .25 + .10
= 3.13 = money multiplier
=
*
HS 322
The text denotes cash by the term LA.
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SELF-TEST QUESTIONS
Circle your responses:
HS 322
T
F
1. If money is defined as both a medium of exchange and a store of
value, the money supply would consist solely of all currency and
coin held by the public.
(RM 355)
T
F
2. An important function of a central bank is to help stabilize money
and capital markets.
(RM 356)
T
F
3. Most of the actions taken by the Federal Reserve System to combat
inflation are carried out by government order rather than through the
marketplace.
(RM 358)
T
F
4. The Federal Reserve System’s chief policy-making and
administrative group is composed of the member banks.
(RM 365-366)
T
F
5. In principle, the Federal Reserve Board is independent of both
Congress and the executive branch of the federal government.
(RM 366)
T
F
6. One of the most important committees within the Federal Reserve
System is the Federal Open Market Committee.
(RM 367)
T
F
7. Legally, the Federal Reserve Banks are owned by the federal
government.
(RM 369)
T
F
8. Nearly all paper money in circulation in the United States today is
issued by Federal Reserve Banks.
(RM 373)
T
F
9. Most Federal Reserve services to member banks are provided free of
charge.
(RM 373)
T
F
10. The principal immediate target of Federal Reserve policy is the level
of employment in the economy.
(RM 375)
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HS 322
T
F
11. In a very simple financial system where the public makes all
payments by check and holds no thrift deposits, and where banks
hold no excess reserves, the deposit multiplier will be 8 if the reserve
requirement on transaction deposits is 12.5 percent.
(RM 376)
T
F
12. An increase in the required reserve rate for time and savings deposits
will tend to reduce the size of the transaction deposit multiplier, all
other things being equal.
(RM 376–378)
T
F
13. An increase in the volume of excess reserves maintained by banks
will tend to increase the size of the transaction deposit multiplier, all
other things being equal.
(RM 376–378)
T
F
14. The monetary base is the sum of legal reserves plus the currency and
coin held by the public
(RM 378)
T
F
15. The monetary base is one of the principal determinants of the size of
the nation’s money supply.
(RM 378)
T
F
16. A change in the size of the monetary base produces an equal change
in the size of the money supply.
(RM 378)
T
F
17. Reserve requirements only affect the size of the money multiplier.
(RM 399–400)
T
F
18. A change in the discount rate usually causes other interest rates to
change also.
(RM 397–398)
T
F
19. The tool of monetary policy on which the Federal Reserve System
most heavily relies is the discount rate.
(RM 394)
T
F
20. The sale of U.S. government securities by the Federal Reserve
System tends to push interest rates up.
(RM 386–387)
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T
F
21. The margin requirement on a regulated security is the difference
between its market value and the maximum loan value of the
security.
(RM 403–404)
T
F
22. The Federal funds rate is the same as the discount rate.
(RM 405)
T
F
23. Borrowed reserves are part of the banking system’s total reserves.
(RM 406)
T
F
24. The Fed has direct control of long-term interest rates in the economy.
(RM 407–408)
T
F
25. The goal of full employment does not require the unemployment rate
to fall to zero.
(RM 412–413)
T
F
26. The Fed’s focus is primarily on inflation targets, as deflation is no
longer a concern.
(RM 410–411)
T
F
27. In a market-oriented economy such as that of the United States, it is
probably impossible to achieve a zero unemployment rate.
(RM 412)
T
F
28. Frictional unemployment is that type of temporary unemployment
that arises when people are changing jobs to obtain higher wages or
better working conditions.
(RM 412)
Self-Test Answers
1-F, 2-T, 3-F, 4-F, 5-T, 6-T, 7-F, 8-T, 9-F, 10-F, 11-T, 12-T, 13-F, 14-T,
15-T, 16-F, 17-F, 18-T, 19-F, 20-T, 21-T, 22-F, 23-T, 24-F, 25-T, 26-F,
27-T, 28-T
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ANSWERS TO SELF-TEST QUESTIONS
HS 322
1.
False. If we define money as both a medium of exchange and a store of value, the
money supply would consist of all currency and coin held by the public plus all
publicly held checking accounts and other deposits against which drafts may be
made, plus all publicly held time and savings accounts in various types of
institutions.
2.
True. Along with control of the money supply, central banks play an important
role in stabilizing money and capital markets.
3.
False. Most actions by the Fed to combat inflation are carried out through the
marketplace, rather than by government order.
4.
False. The chief policymaking and administrative group of the Federal Reserve
System is the Board of Governors.
5.
True. The Federal Reserve Banks were established to be independent of direct
political pressures. However, the president appoints the seven members to the
Board to staggered terms ending every even year, subject to congressional
approval.
6.
True. The Open Market Committee decides the course of monetary policy and
influences the cost and availability of credit for millions of people.
7.
False. Each Federal Reserve Bank is a corporation chartered by Congress.
Legally, it is owned by the member banks in its district, which select a majority
of the bank’s Board of Directors.
8.
True. Federal Reserve notes, issued by Federal Reserve Banks, make up the
paper currency that is normally in circulation.
9.
False. The Depository Institutions Deregulation and Monetary Control Act of
1980 (DIDMCA) required the Fed to begin assessing fees sufficient to recover
their costs for many of the services it provides to member banks.
10.
False. The primary immediate target of Federal Reserve policy is the level of
market interest rates.
11.
True. In the simple system where there are no leakages, excess reserves, or thrift
deposits, the deposit multiplier would be the reciprocal of the reserve
requirement on transaction deposits.
12.
True. If the required reserve rate for time and savings deposits increased, less
funds would be available for the expansion process, and the transaction deposit
multiplier would fall.
13.
False. An increase in the volume of excess reserves maintained by banks will
tend to reduce the size of the deposit multiplier, all other things being equal.
14.
True. This is the generally accepted definition of the monetary base.
15.
True. The money supply equals the monetary base times the money multiplier.
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HS 322
16.
False. A change in the size of the monetary base, working through the money
multiplier, produces a magnified change in the size of the nation’s money supply.
17.
False. They affect the money multiplier, the mix between legal and excess
reserves, and interest rates.
18.
True. As the discount rate changes, it signals the direction of monetary policy,
and other interest rates will soon begin to move in the same direction.
19.
False. The tool relied on most heavily by the Fed is open market operations.
20.
True. Central bank sales of securities reduces the amount of demand deposits,
loans, and reserves in the commercial banking system, making money and credit
less available and increasing interest rates.
21.
True. The maximum loan value of a security is expressed as a percentage of its
current market value. The difference between its market value and loan value is
the margin requirement.
22.
False. The Federal funds rate is a market-determined interest rate on the
overnight borrowing of funds that banks pay to lend to one another.
23.
True. Some of the banking system’s total reserves are borrowed from the Fed.
24.
False. The Fed cannot directly control long-term interest rates.
25.
True. In a free economy there will always be some level of unemployment,
known as frictional unemployment, which arises as people are in the process of
changing jobs.
26.
False. When the economy slipped into recession in 2001, the Fed’s concern
switched to deflation for the first time since the Great Depression.
27.
True. There will always be some unemployment as people change jobs. Full
employment refers to a situation in which the only type of unemployment is
frictional in nature.
28.
True. Frictional unemployment is joblessness resulting from workers in the
process of changing jobs.
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