Download Lesson 15: Federal Reserve System

Economics for Educators
Lesson 15 and 5E Model
Revised Edition
Robert F. Hodgin, Ph.D.
Texas Council on Economic Education
ii
Economics for Educators, Revised
Copyright © 2012
Texas Council on Economic Education
All Rights Reserved
Texas Council on Economic Education
83
Economics for Educators, Revised
Lesson 15: Federal Reserve System
What Commercial Banks Do
Commercial banks are private stock-issuing companies licensed in their state of incorporation to conduct business as a financial
institution. Many commercial banks also hold a national banking charter, making them mandatory members of the Federal Reserve
System. All banks must be chartered in the state where they conduct business. State banks that choose and meet the federal
requirements can become bank members of the Federal Reserve System.
Banks transfer funds from net savers to net borrowers in the economy. Using the funds voluntarily deposited by their customers,
uses prudent lending practices and not all customers wish to withdraw their money at the same moment (a bank “run”), the process
of allocating funds from net savers and net borrowers, at interest, works effectively. Through this institutional system of money
management, moderated by the average rate of interest, money demanded by net borrowers is matched using money supplied by
net savers in the economy.
What Central Banks Do
In the US, the Federal Reserve System is the central bank federally authorized to a) regulate the US banking system and b) to
regulate the money supply toward the broad goals of low inflation, full employment and stable interest rates. .
Federal Reserve System Structure
9 Board of Governors – 7 members appointed by the President and confirmed by the US Senate, serve
14-year terms, each staggered by two years.
9 The board chairman, appointed by the President, serves a 4-year term as chair and may be re-appointed.
9 12 Regional Federal Reserve Banks and 24 branches are located in US financial centers.
9 Federal Open Market Committee determines major policy positions for the US money supply, comprised of
o 7 members of the Board of Governors
o 5 of the 12 Fed bank presidents serve 1-year rotations
o New York Fed bank president has a permanent voting position
9 Member commercial banks (about 7,000) – includes all national banks and about 1 in 7 state banks
representing nearly 85 percent of the US money supply. Member commercial banks actually own
stock in their regional Fed bank that earns 6% interest annually.
Source: Federal Reserve System.gov
Texas Council on Economic Education
84
Economics for Educators, Revised
Money and the Federal Reserve
The Fed sits outside the US economy and interacts with the financial system using its monetary tools. To understand how the Fed
influences the money supply, we must define what money is. The domestic money supply (officially called “M1”) is the sum of coins
and currency in circulation (including vault cash on hand in commercial banks) in the US plus demand deposits (checking accounts)
in US commercial banks.
US money supply control rests on the idea of “fractional reserves.” A small fraction, currently 10 percent of each member commercial
bank’s deposits are held on reserve at the regional Fed bank, outside the economy. The remaining 90% of demand deposits are
available for loans to qualified borrowers or for investment. These reserves are not imposed to protect customer accounts. That is
the job of the Federal Deposit Insurance Corporation (FDIC). The reserve requirement is an instrument of monetary control that
limits the maximum volume of money growth in the economy.
Federal Reserve district banks monitor the commercial banks in their district, which must balance their accounts daily. On
Wednesday morning every other week, commercial member banks must comply with the reserve requirement based on deposits
resident in their own bank. So how does this process limit the money supply?
The Money Multiplier
The composition of the nation’s money supply divides evenly between cash in circulation and checkable accounts that serve as
money (M1). The reason that demand deposits are part of the money supply is that they perform much the same functions as cash.
It may seem strange, but the volume of money stock supports several times its volume in US gross domestic product flow over a
year’s time. The money supply is spent several times over to accomplish the feat.
Commercial banks, Fed policy and the non-bank public impersonally collaborate to grow or shrink the money supply. Money is
“created” in the act of borrowing from a commercial bank and “destroyed” in the act of repaying the loan. If a customer enters a bank
and comes out with a loan, the bank honors the agreement by creating a line of credit in the borrower’s name. As the newly loaned
funds are spent they become deposited into other banks as cash—new money by definition.
Perhaps equally surprising, the money supply is reduced when loans are repaid. The check that clears through the system to
extinguish the loan debt also reduces the borrower’s checking account (money by definition, or cash holdings) by the same amount.
The interesting economic aspect of these actions is that the money supply available at any one time depends on both Fed monetary
policies and the borrowing behavior of citizens and businesses.
To more fully appreciate this process, consider that the Fed literally sits outside the US financial system and works to accommodate
the economy’s money stock needs, in line with established goals like keeping inflation and unemployment low. The Fed is not
Texas Council on Economic Education
85
Economics for Educators, Revised
concerned, and neither should we be, with where it gets money—it has an open account outside the monetary system. The Fed
primarily focuses on how much money circulates inside the economy, not about making money itself.
The reserve requirement—a Fed-determined percentage of demand deposits in member banks—fixes the amount of reserves banks
must hold. The Fed, by setting this required rate defines the upper limit of money available in the economic system. Importantly,
commercial bank required reserves are not part of the money supply but form the base upon which the money supply rests.
If the Fed requires all banks to keep 10 percent of demand deposits on reserve, then $90 of every $100 in demand deposits can be
loaned to customers. As soon as borrowers acquire the $90 in loans, and spend it, most of it will find its way into other banks as new
demand deposits. These other banks also are required to keep 10 percent (now, $9) on reserve but are free to loan the remaining
$81. You can see what is happening: $100 in new demand deposits has generated new loans (money by definition) of $171 ($90 +
$81) among the borrowing public. If this process continued to its theoretical limit, the increase in the money supply would equal $900
for a total money supply volume increase of $1,000.
This “money multiplier” process works in both directions. As a customer pays off a loan, a demand deposit balance is reduced and
the money supply shrinks accordingly. How? The lending bank accepts the borrower’s check as the final loan payment, the
customer’s debt is extinguished and, once the check clears, a checking account balance is reduced, thereby shrinking the money
supply.
Some observations are in order. First, the money multiplier process does not reach its theoretical maximum because leakages
persist in the system. Not all available funds are loaned out by all banks and not all the borrowed funds are spent. Second, loans
are being extinguished, paid-off, at the same time new loans are being approved. Hence, money is being “destroyed” as new money
is “created” and the net of these two sets of acts determines, in part, whether the money supply is growing or shrinking.
If the money multiplier description above reads like financial sleight-of-hand, it is not. The money expansion and contraction process
is no more mysterious than the physics of using a lever, instead of one’s hands, to move a heavy object or using a pulley system to
lift a heavy weight.
Texas Council on Economic Education
86
Economics for Educators, Revised
Monetary Tools of the Fed
Reserve Requirements–-The percentage of demand deposits commercial banks must hold as reserves.
FED Deposit Reserve Requirement (10%)
Increase % of Demand
Deposits Held on Reserve
Bank excess reserves
decrease
Fewer loans made
Money supply decreases
Interest rate tends to fall
Decrease % of Demand
Deposits Held on Reserve
Bank excess reserves
increase
More loans possible
Money supply increases
Interest rate tends to rise
The Federal Reserve System’s charter provided for three major monetary tools, and several lesser tools. We have already
mentioned its most powerful, and least often utilized, tool—reserve requirements. It is powerful because it affects all banks in the
system and because even small changes in the reserve requirement percentage can bring about large changes in the money
supply’s upper limit.
Open Market Operations–-Buying and selling existing US government financial instruments from or to willing customers
(individuals, businesses and banks) in the economy.
FED Open Market Operations
Fed Re-sells US Govt. Bonds
to the Non-bank Public
Public gets bonds from Fed
Reduced demand deposits
Money supply reduced
Interest rate trends to rise
Fed Buys US Govt. Bonds
from the Non-bank Public
Public gets money from Fed
Increased demand deposits
Money supply increased
Interest rate tends to fall
The Fed’s most often used tool is open market operations. The Fed has the financial authority to buy and sell prior-issued US
government bonds. These bonds originated from the Treasury as debt instruments to finance congressionally-approved increases in
the federal debt. Investors willingly purchase or sell the instruments, as part of their financial portfolios, even though their interest
yields are low, because they are very safe.
Texas Council on Economic Education
87
Economics for Educators, Revised
Federal Reserve Discount Rate–-The interest rate that the Federal Reserve charges member banks for borrowing as they
work to meet the Required Reserve ratio on the one hand and satisfy the needs of business loan demand on the other.
FED Discount Rates
Discount rate increased
Higher member bank costs
Fewer funds borrowed
Reduced money supply
Interest rate tends to fall
Discount rate decreased
Lower member bank costs
More funds borrowed
Increased money supply
Interest rate tends to rise
The Fed does not control the general level of interest rates in the economy. At most, it influences the money supply to nudge interest
rates in the desired direction. The Fed sets only one interest rate—the discount rate charged member banks for borrowing from the
Fed, when a bank comes up short on the bi-weekly reserve requirement. That rate is called the discount rate because, unlike
common loans where the interest due is included in regular payments with the principal, the Fed collects the interest immediately
from the amount borrowed.
The member bank borrower repays the full amount of the loan typically within 12 to 72 hours. Member banks actually have two
sources from which they can borrow to cover a required reserve deficit. First, they can borrow the excess reserves (named “Fed
Funds”) from other member banks in the system and pay the interest rate determined in that sub-market. That interest rate is
established by the amount of excess reserves available versus the amount of deficit reserves demanded in the banking system.
Second, the deficit bank can borrow directly from the Fed. The choice is simple, the banks with the reserve shortfall borrow from
whichever source—system banks or the Fed—offers the lower interest rate.
The Fed’s responsibility is to accommodate financial needs and maintain market stability. In normal times, Fed changes in the
discount rate are interpreted as signals of the Fed’s view of the economy and its future. A decrease in the discount rate might signal
a “looser” money supply, lower interest rates or possible future inflation. An increase in the discount rate could signal a tightening of
the money supply and higher interest rates and reduce private market investment.
Texas Council on Economic Education
88
Economics for Educators, Revised
In Sum
9 Commercial banks are financial intermediaries in business to make a profit loaning and investing depositor’s funds.
9 The Fed regulates commercial banks and controls the money supply toward the goals of low inflation, full employment and
stable interest rates.
9 Money supply (M1) equals the sum of coins and currency in circulation plus commercial bank demand deposits.
9 The “money multiplier” is based on the “fractional reserve” requirement for commercial banks.
o Reserve requirements are now 10% of demand deposits, leaving as much as 90% available for loans and investments
o The money multiplier is limited by the Fed’s reserve requirement percentage and the public’s demand to borrow
9 Money is “created” in the act of borrowing and “destroyed” by loan repayment.
9 The Fed’s primary obligation is to regulate the economy’s monetary sector to achieve the goals of low inflation, stable interest
rates and full employment.
o The Fed operates from outside the monetary sector and works to maintain an adequate supply of money in the
economy
o The Fed’s objective is not to profit from any of its policy moves or operational transactions.
9 The Fed’s main tools for controlling the money supply are:
o Reserve requirements—10% of demand deposits on reserve
o Open market operations—the Fed’s buying (to increase the money supply) and selling (to decrease the money supply)
prior issued US government bonds in financial markets
o Discount rate—the interest rate the Fed charges member banks for borrowing to maintain the reserve requirement
Texas Council on Economic Education
Hold deposits in demand or checking accounts as well as savings
accounts.
Provide methods for investing money.
Loan money and charge interest
Pay interest on savings accounts
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
It has two legal requirements: to promote economic growth and to
maintain monetary stability. Its leadership consists of experts in the
field who are appointed by the president and approved by the Senate
The Federal Reserve System serves as the nation’s bank but it is not
part of the government. It received its authority from the Federal
Reserve Act in 1913 with the goal that the Fed would not be beholden
to political persuasion.
What does the Fed do?
Under what authority does it operate?
What is the Federal Reserve System?
Explore
Large banks have their own large vaults. Others store their money at
the Federal Reserve System & in other large banks.
Banks that have a national charter can borrow money from the Federal
Reserve System. Banks can borrow from other banks to meet their
daily needs.
x
x
x
x
What do they do with the extra money they hold onto?
What if banks have a cash flow problem? How do they solve it?
What are three things that banks do?
Engage
Lesson 15: The Federal Reserve System, page 83
Page | 44
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
The supply of money has decreased often due to an increasing
unemployment rate. There is less money flowing through the economy.
Prices decline.
There is too much money in circulation which increases prices. The
number of workers increases or the workers receive raises, and they
are able to spend more money.
Inflation is a quick increase in prices which means the value of money
has decreased. Money can not purchase as much as it did previously,
therefore it is less valuable.
In a time of recession, what has happened to the flow of money?
In a time of inflation, what has happened to the flow of money?
In the last two chapters we discussed inflation. What is the definition of
inflation? What happens to the value of money and why?
Explain
The Fed uses its policies to influence the money supply so that the
economy is more stable.
with 7 year staggered terms to diminish the possibility of their being
controlled by political interests.
Page | 45
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Ask the students what happened to the loan amounts? How much money is
now in circulation?
Step 3 - Customer 3 goes to USA Bank and asks for a loan to buy a new cell
phone.(etc)
“You are in luck,” says the banker. I have $40.50 to loan you. After
thanking the banker, Customer 3 takes the $40.50 loan to Honest Abe Bank.
Customer #3 now writes a check to spend his $40.50. Honest Abe Bank
keeps 10% ($4.05) in reserve at the FED.
Step 2 - Customer #2 will now ask for a $45 loan to buy textbooks (or any
example). After receiving the loan, he will deposit the $45 in the USA Bank.
Customer #2 will now write a check to spend his $45. Remind the banker
to keep 10% in reserve at the FED. Then ask how much is left “in excess
reserves” to be loaned?
Step 1- After placing everyone in their appropriate seats, instruct Customer
#1 to go to the Hometown Banker make a deposit of $50.
Ask the banker (class) what he must do with this deposit? After it is
determined that 10% must go to the “reserve”, give $5 to the FED. Ask the
banker what can be done with the remaining $45?
Put chart on board for recording deposits, RR & loans. Verbally walk the
students through each step – asking them what happens next with each
exchange of play money.
Write RESERVE RATIO = 10% on board.
Need: 5 Customer signs
Scorekeeper
Roles:
Federal Reserve Bank
Hometown Banker
USA Bank
Honest Abe Bank
Character Bank
The students are asked to volunteer for the roles in the “Money Creation”
simulation listed below. The remaining students will take notes on what
they see happening.
Extend
Page | 46
$5
$4.50
$4.05
$50
$45
$40.50
LOANSEXCESS
RESERVES
$45
$40.50
$36.45
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Customer 3 goes to USA Bank and asks for a loan.
“You are in luck,” says the banker. I have $40 to loan you. After
thanking the banker, Customer 3 takes the $40.50 loan to Honest Abe
Bank. Honest Abe Bank keeps the required reserve of 10% = $4.05 and
now has $36.45 in excess reserves.
Step 2 - Customer 2 approaches Hometown Bank and asks for a loan of
$45. Hometown Banker states that he just had a deposit that allows
him to loan out $45. Customer 2 takes his $45 loan and deposits it in
USA Bank. USA Bank takes $4.50 to the Fed and asks them to hold the
money in reserve. The excess reserves held by USA Bank are now
$40.50.
Step 1 - Customer one approaches the Hometown banker and counts
out 10 ten $5 bills. The banker puts four on the desk and takes one $5
bill to the Fed and asks the central bank to hold the reserve because
the bank is expected to hold onto 10% of its deposits. Ask the banker
how the remaining money ($45) will be used? It is called “excess
reserves” and may be loaned out to earn interest for the bank. (banks
must make loans to make a profit & stay in business)
REQUIRED
RESERVES
DEPOSITS
With each step – the Scorekeeper will record the amounts exchanged in
a chart on the board with 3 columns: deposits, required reserves and
loans (excess reserves)
The bankers are seated in front of the class and the Federal Reserve
Banker is to the side.
Use play money for this “Money Creation” activity.
You will need these signs that students can wear:
Federal Reserve Bank
Hometown Banker
USA Bank
Honest Abe Bank
Character Bank
5 Customer signs
Scorekeeper
Page | 47
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Disadvantage – will vary, but should include – hard to determine
amount of money in circulation because it is constantly changing;
banks are not required to loan out all of their excess reserves which
slows economic growth when they don’t make loans.
Advantage – allows banks to stimulate the economy encourages
spending by making loans; the reserve amounts are still in the FED and
allow the banks to have money to give to customers when they want
the money in their accounts; and the banks make interest when the
loans are repaid so they are a profitable business.
When the loans are repaid, the money will NO LONGER EXIST. The
amount of money in circulation was increased temporarily, but will be
decreased when the loans are due.
Money on Paper – it is not newly printed money – just checking
account amounts.
What is the advantage of “creating money” through the fractional banking
system? Is there a disadvantage?
What will happen when its time to repay the loans?
Is this “REAL” money or just “money on paper”?
Evaluate
Add the original deposit + the loan amount column. ($50 + $45 +
$40.50 + $36.45 = $171.95)
Customers received the loans and then spend the money for their
needs. Be sure that students understand that the money went into
circulation to purchase something and payments were made to the
stores. It does not stay in the banks.
Page | 48
The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the
Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices
Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to
provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better
economic & financial choices in a global economy.
economicstexas.org
1801 Allen Parkway Houston, Texas 77019 Telephone 713-655-1650 Fax 713-655-1655
Email: [email protected]