Download The Federal Reserve and Its Power

The Federal Reserve and Its
Power
Chapter 2
FIN 221
1
Dr. Hisham Abdelbaki FIN 221
Functions of The CB (The Fed)
• Issuing Notes
• Bank of Government
1. Holds its accounts / holds its reserves from foreign
currencies.
2. Lends it
3. Buys and sells its securities
4. Offers monetary advices
• Bank of Banks
• Lender of last resort
• Conducting and monitoring the Monetary Policy
2
Dr. Hisham Abdelbaki FIN 221
Purposes and powers of a Central
Bank (The Fed)
• Supervise nation’s money supply and payments system.
• Regulate other financial institutions, especially
depository institutions (Supervise banks more vigorously).
• Serve as “Lender of last resort” when financial system
has liquidity problems.
• National government’s “fiscal agent” (i.e. depository
bank)
• Provide an “elastic” currency (currency notes - ability to
adjust money supply to changes in economy)
• Improve payments system (check clearing).
3
Dr. Hisham Abdelbaki FIN 221
The FED Balance Sheet
• Monetary actions lead to changes in the Fed’s balance
sheet and changes in its balance sheet result in
changes to the nation’s money supply.
• Liabilities and Capital:
• The Fed conducts monetary policy by changing the
nation’s monetary base.
• Monetary base = currency in circulation + the deposits
of financial institutions at the Fed.
• Increase monetary base leads to increase money
Dr. Hisham Abdelbaki FIN 221
4 supply
1. Federal Reserve Notes
The Fed notes are lawful money because they are legal tender
for all debts public and private.
2. Depository Institutions Reserve
• All depository institutions must keep reserves with the FED.
•
These reserves bear NO interest.
•
Total reserves equal required and excess reserves.
•
A.
B.
C.
• 5
These reserves are used to:
Clear checks, wire transfers and other payment items.
Control the rate of growth of money supply.
Provide liquidity in the event of financial crisis.
RR and RRR (Example)
Dr. Hisham Abdelbaki FIN 221
3. Treasury Deposits
The Fed acts as “fiscal Agent” for the US treasury dep. Which
means the Fed acts as a bank for the treasury.
4. Deferred Availability Cash Items (DACI)
The value of checks deposited at the Fed by depository
institutions that have not yet been credited to the institutions’
accounts.
5. Capital
• Capital paid in by banks that are members of the Federal
Reserve System to purchase stock.
•
•
The Fed pays a 6 % dividend on that stock regardless of its
earnings.
6
The Fed returns the reminder (surplus) to the US treasury
Dr. Hisham Abdelbaki FIN 221
each year.
Assets of the FED
1.Loans
• The Fed can make loans ONLY to banks and
other depository institutions.
• For short term at discount rate.
• Change in the loan account lead to changes in
the reserve account then changes in money
supply.
7
Dr. Hisham Abdelbaki FIN 221
2. Government Securities
• The Fed buys and sells securities in the market
through its Open Market Operations.
• Consist of:
A. US Treasury securities
B. US government agency securities
3. Cash Items in Process of Collection (CIPC)
The cleared reserves BUT have not yet obtained
funds. i.e. checks in the process of clearing and
settlement.
8
Dr. Hisham Abdelbaki FIN 221
4. Float
The difference between DACI and CIPC
Float = CIPC – DACI
5. Other Assets:
• Foreign-denominated assets
• Gold certificates and Special Drawing Rights
(SDRs)
•Buildings, computers vehicles, and other assets
needed to house its operations and conducts its
business.
9
Dr. Hisham Abdelbaki FIN 221
The Fed’s Role in Check Clearing
• The Fed plays a major role in check clearing,
particularly in clearing checks drawn on
depository institutions which hold reserves
or clearing deposit balances with the Fed.
• Bank deposits at the Fed can be easily
transferred between the accounts of the
depository institutions by making
appropriate entries on the Fed books.
10
Dr. Hisham Abdelbaki FIN 221
Fed Reserve Tools of Monetary Policy
1. Open Market Operations
•
The Fed is the only institution that can expand or contract
its liabilities. To expand them, it needs only issue Fed notes
or write a check on itself.
•
The purchase of government bonds by the Fed will
expand the money supply while the sale of bonds
will result in contraction of the money supply.
11
Dr. Hisham Abdelbaki FIN 221
How can selling / buying Gov. securities by the Fed effect
on money supply?
Example 1: The Fed decides to buy $2000 in Gov. bonds from
Citibank. The T-accounts for the Citibank and the Fed after
the transaction will be :
Citibank
- 2000 Gov. bonds
Fed
+ 2000 Gov. bonds
+ 2000 R. at Fed
12
Dr. Hisham Abdelbaki FIN 221
+ 2000 R. of Citibank
Example 2:The Fed decides to sell $2000 bonds to the
Citibank. The T-accounts will show:
Citibank
+ 2000 Gov. bonds
- 2000 R. at Fed
13
Fed
- 2000 Gov. bonds - 2000 R. at Citibank
Dr. Hisham Abdelbaki FIN 221
2. Discount Rate (Discount Window Borrowing)
• The discount rate is the rate of interest that financial
institutions must pay to borrow reserve deposits from the
Fed.
• When the discount rate is high, the institutions are more
reluctant to borrow reserves and become more careful
about expanding asset and deposit holdings. And Vice
Versa.
• Example: when banks borrow from the discount window,
the funds they borrow are paid in reserves by the Fed.
Suppose Citibank borrows $1000 at the window. The Taccounts will look as follows:
14
Dr. Hisham Abdelbaki FIN 221
Citibank
Fed
+ 1000 R. at Fed + 1000 Discount Loan + 1000 loan to citib
15
Dr. Hisham Abdelbaki FIN 221
+ 1000 R. of Citi
3. Reserve Requirements
• The CB can establish reserve requirements within
certain limits. Such requirements determine the amounts
of funds financial institutions must hold at the CB to
back their deposits.
• Only the CB can change the reserve requirements for
depository institutions.
• Changing reserve requirements change the money
supply.
16
Dr. Hisham Abdelbaki FIN 221
Example: Assume BNB has:
Demand deposits = $ 5000, Reserve requirement = 20%.
The bank is fully loaned up and therefore has no excess
reserves i.e. ER=0. Citibank’s T-account looks as follows:
Reserves
Loans
1000
4000
Demand Deposits
5000
Now: The Fed decides to reduce reserve requirement on
demand deposits from 20% to 10%.What happens then?
First step: The new requirement lowers the amount of
reserves to $500 and increase the ER by $500.
That is: RR = 10% X $5000 = $500
ER = $1000-$500 = $500
17
Dr. Hisham Abdelbaki FIN 221
Reserves
RR
ER
Loans
1000 Demand Deposits
5000
500
500
4000
Second step:
What Citibank will do with the $500 ER?
• Hold it at the Fed (No Profits)
• Make loans and expand deposits to the point where all
of the excess reserves are again absorbed as RR.
• The T-account of Citibank will look as follows:
18
Dr. Hisham Abdelbaki FIN 221
Reserves
RR
ER
Loans
1000
Demand Deposits
10000
1000
0
9000
• At RRR (k) = 10% , the bank can support 10,000 of
deposits (DEP = RR / k = 1000 / 10% = 10,000).
•The CB expands the amount of bank deposits by
lowering reserve requirements on deposits.
• Similarly, when the Fed increases the reserve
requirements ,the banking system will contract the
amount of bank deposits and hence decrease the money
supply.
19
Dr. Hisham Abdelbaki FIN 221
Comparing the Monetary Tools
• The CB does not use all three tools to conduct
monetary policy on a regular basis
• Each tool plays a different and important role In the CB
monetary arsenal.
Advantages of OMO :
- Can be done easily almost instantaneously with no
announcement effect.
- Any changes in the money supply can be easily
reversed without an announcement effect.
20
Dr. Hisham Abdelbaki FIN 221
Shortcomings of discount rate adjustment:
• Changes in the Discount rate will affect the money
supply only if banks are willing to respond.
• Because the Fed scrutinizes borrowing at the discount
window, banks may be reluctant to overuse this privilege.
• Borrowing under the discount window is short-term and
it is difficult to gauge the impact on the money supply for
a given change in the discount rate.
• As a practical matter, changing the discount rate is not a
viable tool for conducting monetary policy.
21
Dr. Hisham Abdelbaki FIN 221
Changes to reserve requirements :
• Changes in reserve requirements are not used
as a tool of monetary policy .This is because it is
difficult to make a number of small adjustments to
reserve requirements and frequent changes are
disruptive to the banking system.
• Changing reserve requirements is typically done
to deal with structural problems in the banking
system.
22
Dr. Hisham Abdelbaki FIN 221
Summary : How tools of monetary policy affect the
money supply
Monetary policy tool
Increase in money
supply
Decrease in money
supply
OMO
Purchasing Tsecurities in the
market
Selling T-securities in
the market
Adjusting the
discount rate
Fed lowers the
interest rate
Fed raises the
interest rate
Adjusting bank
reserve requirement
Fed lowers the
reserve ratio to cause
a higher money
multiplier
Fed raises the
reserve ratio to cause
a lower money
multiplier
23
Dr. Hisham Abdelbaki FIN 221
23