Download The Federal Reserve

The Federal Reserve System
Structure and Policy Tools
ECO 285 – Macroeconomics – Dr. D. Foster
The Origins of U.S. Central Banking
1791–1836
 Bank of England
 The Bank of North America (1781)
 The First Bank of the United States (1791)
 The Second Bank of the United States (1816)
1837–1865
 The Free-Banking period.
 The Civil War & Greenbacks - a fiat money.
1865–1912
 The Gold Standard (1875).
 Brief foray into bimetalism.
 Panics of 1873, 1893 and 1907
 Federal Reserve Act of 1913
The Federal Reserve
Banking System
The Early Fed (1913–1935) & Fed 2.0
 Accommodates the Treasury Dept. during WWI.
 Buys Treasury bonds to finance G spending.
 From 1916 to 1918, this increases MS by 70%.
 Huge risk of inflation.

The Great Depression - Failure of the Fed (?)
 Initially increased liquidity, but pulled back.
 By 1933, 33% of banks fail, MS fallen 33%.

Banking Act of 1935 – a new Fed
 Centralized power in Board.
 Board of Governors reconstituted.
 FOMC created to conduct policy.
The Federal Reserve Banking System
 Purposes:
1. Develop, supervise & control the nation’s money.
2. Serve as a “lender of last resort.”
3. Serve as a national check-clearing system.
4. Serve as depository for federal gov’t. funds.
 Structure:
1. Board of Governors.
2. Twelve District Banks.
3. Federal Open Market Committee.
4. Regulatory bureaucracy.
The Federal Reserve Banking System
 Board of Governors:
1. Selected for one 14 year term. [Except…]
2. Staggered selection; geographic diversity.
3. Chairman & Vice Chairman selected for 4 years.
4. Can’t be members of the executive branch.
 Policy Tools:
1. Open Market Operations.
• Buy and sell U.S. Treasury bonds.
2. Set bank required reserve ratio.
3. Set “discount” rate of interest.
The Banking System
Assets
Liabilities & Equity
Reserves
+$10,000
+$2,000
(Cash in vault)
Demand Deposits
(Checking; Transaction)
T-Bills
+$10,000
(Liquidity & income)
Loans
+$8,000
Equity
(Banks’ earnings)
Accounting Identity: A  L + E
M1
+$8,000
The Fed & the Banking System
Assets
Reserves
(Cash in vault)
Liabilities & Equity
Demand Deposits
(Checking; Transaction)
T-Bills
(Liquidity & income)
Loans
Equity
(Banks’ earnings)
M1
The Evolution of the Modern Fed
 WWII - working “for” the U.S. Treasury
 Federal Reserve–Treasury Accord (1951)
 “Leaning Against The Wind”
– Martin (1953-1970)
 The technocratic Fed
– Burns (1970-1978) . . .
the “political business cycle”
 Coping with inflation
– Volcker (1979-1987)
 Keeping the economy stable?
– Greenspan (1987-2006)
 Coping with recession
– Bernanke (2006-2014)
– Yellen (2014-?)
The Fed’s Balance Sheet – 12/2007
In millions of dollars.
$ Amount
% of Total
Liability &
Equity
Fed'l Reserve
Notes
$791,691
86.5%
1.2%
Bank reserve
deposits
$20,767
2.3%
$48,636
5.3%
U.S. Treasury
deposits
$16,120
1.8%
Foreign
currencies
$22,914
2.5%
Other
$49,298
5.4%
Other
$86,560
9.5%
Equity
$36,900
4.0%
Asset
$ Amount
% of Total
Assets
U.S. Treasuries
$745,629
81.5%
Gold
certificates
$11,037
Loans to banks
Total Assets
$914,776
Liability
Total Liability +
Equity
$914,776
Treasury Securities ……… $1.8 trillion
Holdings of MBS …………. $.95 trillion
Total Assets ………………… $2.9 trillion
Treasury Securities ……… $2.4 trillion
Holdings of MBS …………. $1.5 trillion
Total Assets ………………… $4.0 trillion
Treasury Securities ……… $2.6 trillion
Holdings of MBS …………. $1.8 trillion
Total Assets ………………… $4.5 trillion
2012
FR Notes outstanding ….. $1.1 trillion
Bank reserve deposits …. $1.5 trillion
Total Liabilities ……….…… $2.9 trillion
FR Notes outstanding ….. $1.2 trillion
Bank reserve deposits …. $2.2 trillion
Total Liabilities ……….…… $4.0 trillion
FR Notes outstanding ….. $1.3 trillion
Bank reserve deposits …. $2.4 trillion
Total Liabilities ……….…… $4.5 trillion
Federal Reserve Policy Tools
• Open Market Operations
– Buy/sell Treasury bonds to affect bank reserves.
– The major form of monetary policy.
– What will the Fed do if we run out of Treasury bonds?
• Discount Window
– Lend to member banks to affect bank reserves.
– Purpose is to target the “federal funds rate” – iff
• This is the rate that banks charge each other for very short term loans.
• Required Reserve Ratio (rrD)
–
–
–
–
Changing this affects bank excess reserves directly.
Used more to reflect structural changes.
Was used in 1937 and precipitates more Great Depression.
Time to let this go?
New policy – Pay banks i for ER (!!)
Goals of Monetary Policy
• Inflation goals:
– Low/no inflation with limited year-to-year
variability.
• Output goals:
– High and stable economic (GDP) growth.
• Employment goals:
– Stable employment growth with low
unemployment.
Yellen’s Press
Conference
Sept. 21, 2016
Intermediate Targets of Monetary Policy
Limited long-term
information about the
economy available to
policymakers means that
they pick an intermediate
target.
Characteristics:
--Frequently observable
--Consistency with ultimate
goals
--Definable and measurable
--Controllable
• Usual target variables:
– Monetary aggregates
M1, M2, MZM
– Interest rates
(fed’l funds, prime …)
– Others …
Getting from bond purchases to interest rates
Bond
$$$
$ $ $ $ $
$
mm/yyyy
Face
value
(FV)
Maturity Coupons &
date
value (C)
(in n years)
What is price of $1000 FV
bond, matures in 2 years,
$50 coupon with i=7%?
= $50/(1.07)1 + $50/(1.07)2 + $1000/(1.07)2
• Usually, we talk of annual coupons
= $46.73 + $43.67 + $873.44
• Market price of the bond = present value of income stream
= $963.84
discounted at interest rate i:
When the Fed buys
sells bonds, their prices will ___ and interest rates will ___.
What is interest?
• Payment made to savers to compensate
them for foregoing consumption.
• “The most powerful force in the
universe is compound interest.”
• Interest rates embody our
expectations of the future.
Some simple bond pricing problems
1. A bond has a face value (FV) of $1000, will mature in seven years,
has an annual coupon of $74. The market rate of interest is 8.1%.
a) What is the current market price of this bond?
b) Suppose that the current market interest rate rises to 8.7%. What will be the new
market price for this bond?
c) Suppose that when the bond was first sold, it’s market price was $1000. What must
have been the market rate of interest then?
2. Consider a bond with FV=$1000, maturity = 2020, C=$81 and
i=7.25%
a) What is the current price of this bond?
b) If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it
will affect all interest rates to some extent. If they buy lots of bonds and interest
rates fall to 6.88%, what will happen to the price of your bond? What do you think
about the Fed’s actions?
The Federal Reserve System
Structure and Policy Tools
ECO 285 – Macroeconomics – Dr. D. Foster
Key: Some simple bond pricing problems
1. A bond has a face value (FV) of $1000, will mature in seven years,
has an annual coupon of $74. The market rate of interest is 8.1%.
a) What is the current market price of this bond?
$963.68
b) Suppose that the current market interest rate rises to 8.7%. What will be the new
market price for this bond?
$933.91
c) Suppose that when the bond was first sold, it’s market price was $1000. What must
have been the market rate of interest then?
$1000
2. Consider a bond with FV=$1000, maturity = 2020, C=$81 and
i=7.25%
$1028.63
a) What is the current price of this bond?
b) If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it
will affect all interest rates to some extent. If they buy lots of bonds and interest
rates fall to 6.88%, what will happen to the price of your bond? What do you think
about the Fed’s actions?
$1041.44 Woo hoo!!