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Chapter 15 The Federal Reserve System and Open Market Operations MODERN PRINCIPLES OF ECONOMICS Third Edition Outline What Is the Federal Reserve System? The U.S. Money Supplies Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier How the Fed Controls the Money Supply The Federal Reserve and Systemic Risk Revisiting Aggregate Demand and Monetary Policy Who Controls the Fed? 2 Money 3 Money 4 Money 5 Money 6 Money 7 Money 8 Quotes & Videos “Paper money will always return to its intrinsic value. Nothing.” – Voltaire The Fed Turned the Stock Market Into a 'Hall of Mirrors‘ (7:00) https://www.youtube.com/watch?v=DMyFlsf-tWs Why Not Print More Money? https://www.youtube.com/watch?v=ZkyBnaYCUhw 9 Introduction Through its influence over the money supply, the Federal Reserve has more influence over aggregate demand than any other institution. Shifts in aggregate demand can greatly influence the economy in the short run. This chapter looks at the Federal Reserve System and the tools it uses to influence money supply, aggregate demand, and the economy. 10 Federal Reserve System The Federal Reserve has the power to create money. It doesn’t have to literally print money, it can add reserves to bank accounts held at the Fed. This new money can be given away or lent out in a way that increases aggregate demand. The Fed’s most important job is to regulate the money supply. 11 Federal Reserve System As the government’s bank, the Fed: • Maintains the bank account of the U.S. Treasury. • Manages government borrowing through U.S. Treasury bonds, bills, and notes. It regulates other banks and lends them money. It manages the nation’s payment system. It protects financial consumers with disclosure regulations. 12 Self-Check Which of the following is NOT a function of the Federal Reserve? a. Maintaining the US Treasury bank account. b. Lending money to other banks. c. Lending money to consumers. Answer: c – lending money to consumers. 13 Definition Money: A widely accepted means of payment. 14 The U.S. Money Supplies Most important assets that serve as means of payment in the U.S. today: • Currency—paper bills and coins. • Total reserves held by banks at the Fed. • Checkable deposits—your checking or debit account. • Savings deposits, money market mutual funds, and small-time deposits. 15 The U.S. Money Supplies Major Means of Payment in the United States (February 2014) 16 Definition Liquid asset: an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments. 17 The U.S. Money Supplies Currency is coins and paper bills held by people and nonbank firms. Total currency amounts to about $4,000 per person. Quite a bit of U.S. cash is used in other countries. Panama, Ecuador, El Salvador and others use the U.S. dollar as their official currency. Dollars are also used unofficially in unstable countries as a means of preserving wealth. 18 The U.S. Money Supplies Total reserves play an important role in the financial system. All major banks have accounts at the Federal Reserve that they use for trading with other banks and the Fed itself. It’s not currency but electronic claims that can be converted into currency if the bank wishes. 19 The U.S. Money Supplies Checkable deposits are deposits that you can write checks on or access with a debit card. These are deposits used most often in making daily transactions. They are also called demand deposits because you can access this money “on demand.” 20 The U.S. Money Supplies The largest means of payment are savings accounts, money market mutual funds, and small-time deposits (also called certificates of deposit or CDs). Extra work is required to use them as a means of payment. Typically you must transfer the money to a checking account before you can use it. 21 Self-Check The largest means of payment in the US. is: a. Currency. b. Checkable deposits. c. Savings deposits. Answer: c – savings deposits. 22 Definition Liquid asset: an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments. 23 The U.S. Money Supplies The money supply can be defined in different ways depending on which liquid assets are included in the definition. The three most important definitions of the money supply are: The monetary base (MB): Currency and total reserves held at the Fed. M1: Currency plus checkable deposits. M2: M1 plus savings deposits, money market mutual funds, and small time deposits. 24 The U.S. Money Supplies The Money Pyramid, 2014 25 The U.S. Money Supplies Difficulty of Central Banking The Fed has direct control only over the monetary base. Uses control over MB to influence M1 and M2. Problems: M1 and M2 can shrink or grow independent of what the Fed does. Aggregate demand can shrink or grow for other reasons than changes in M1 and M2. 26 Self-Check The monetary base includes: a. Currency and reserves held by banks at the Federal Reserve. b. Currency and checkable deposits. c. Currency and savings deposits. Answer: a – currency and reserves held by banks at the Federal Reserve. 27 Definition Fractional Reserve Banking: A system where banks hold only a fraction of deposits in reserve, lending the rest. 28 Fractional Reserve Banking When money is deposited in an account, the bank holds a fraction of the account balance in reserve and uses the rest to make loans. Banks earn profit on these loans. Banks share some of the profit with you by paying interest on the money you provide. They also provide services like check writing and check clearing. 29 Fractional Reserve Banking The law and the Federal Reserve require banks to keep some reserves. Banks need those reserves to meet depositor demands for currency and payment services. Reserves involve opportunity costs: money held in reserve isn’t being lent, and lending is where banks earn most of their profits. Banks balance these benefits and costs when deciding on the ratio between reserves and deposits. 30 Definition Reserve Ratio (RR): The ratio of reserves to deposits. Money Multiplier (MM): The amount the money supply expands with each dollar increase in reserves. MM = 1/RR. 31 Reserve Ratio If $1 in cash is held in reserve for every $10 of deposits, the reserve ratio is: 1 10 = .10 The reserve ratio is determined primarily by how liquid banks wish to be. 32 Money Multiplier The inverse of the reserve ratio (1/RR) is called the money multiplier, MM. The money multiplier is the ratio of deposits to reserves; in our case, 10 1 = 10 The money multiplier tells us how much deposits expand with each dollar increase in reserves. 33 Money Multiplier CUSTOMER BANKS $1000 $900 $810 DEPOSITS $810 $900 $1000 $1000 is deposited Bank keeps 10% reserve, loans $900 Bank keeps 10% reserve, loans $810 So far, banks created 810 + 900 = $1710 in additional money. Money Multiplier The process continues until there are no excess reserves to lend. With a reserve ratio of 10%, the money multiplier = 1/0.10 = 10. The initial $1000 increase in reserves can expand total deposits (money supply) by: Change in reserves x MM = Change in money supply $1000 x 10 = $10,000. 35 Printing Money 36 Self-Check If the reserve ratio is 5%, the money multiplier is equal to: a. 20. b. 10. c. 2. Answer: a – the money multiplier is the inverse of the reserve ratio, 1/.05 = 20. 37 Controlling the Money Supply The Fed has three major tools to control the money supply: 1. Open market operations. 2. Discount rate lending and the term auction facility. 3. Paying interest on reserves held by banks at the Fed. 38 Definition Open market operations: Occur when the Fed buys or sells government bonds. 39 Open Market Operations The Fed changes the money supply by buying or selling government bonds (T-bills). To pay for the T-bills, the Fed electronically increases the reserves of the seller, usually a bank or large dealer. With more reserves, the bank makes additional loans, which are used to buy goods and pay wages. The new deposits increase the reserves of other banks, which will also make more loans. 40 Open Market Operations The Fed controls the monetary base, but it does not control how much or how quickly the base will change loans and the money supply. The money multiplier is determined by the reserve ratio, which is determined by banks. When banks are confident, they will keep their reserves low so the MM will be large. When banks are reluctant to lend the MM will be low and a change in the monetary base will not change the money supply by much. 41 Open Market Operations When the Fed buys or sells bonds, it changes the monetary base and influences interest rates at the same time. When the Fed buys bonds, the demand for bonds increases, pushing up the price of bonds and lowering the interest rate. Buying bonds stimulates the economy through higher money supplies and lower interest rates. When the Fed sells bonds, the process works in reverse. 42 Open Market Operations Buying and selling government bonds changes interest rates: Fed buys bonds ↑Demand for bonds ↑Price of bonds ↓Interest rates Fed sells bonds ↓Demand for bonds ↓Price of bonds ↑Interest rates 43 Open Market Operations Usually, the Fed conducts open market operations by buying and selling short-term debt. When the economy requires an extra boost, the Fed may influence long-term rates through quantitative easing. This involves buying longer-term government bonds, or other longer-term securities, in the 10- to 30-year range. 44 Definition Quantitative easing: When the Fed buys longer-term government bonds or other securities. Quantitative tightening: When the Fed sells longer-term government bonds or other securities. 45 Self-Check The Fed influences short-term rates through: a. Quantitative easing. b. Open market operations. c. The reserve ratio. Answer: b – the Fed influences short-term rates through open market operations, or buying and selling government bonds. 46 Definition Federal funds rate: The overnight lending rate from one major bank to another. 47 Open Market Operations The Fed usually focuses on the Federal Funds rate, or the overnight rate. • It is a convenient signal of monetary policy. • It responds quickly to actions by the Fed. • It can be monitored on a day-to-day basis. Instead of increasing the money supply, the Fed can buy bonds until the Federal Funds rate drops by the desired amount. The Fed can also increase the Federal Funds rate by selling bonds. 48 Definition Lender of last resort: Loans money to banks and other financial institutions when no one else will. 49 Definition Discount rate: The interest rate banks pay when they borrow directly from the Fed. 50 Discount Rate Lending In normal times, the Fed lends to banks at the discount rate. A bank that borrows from the Fed is said to be borrowing from the discount window. When banks pay back these loans, the monetary base shrinks once again. Most of the time, banks are not borrowing from the discount window but it is available if they get into financial trouble. 51 Discount Rate Lending Market traders read the discount rate as a signal of the Fed’s willingness to allow the money supply to increase. • The “discount window” is intended to • help banks that are in financial stress. Banks in good health usually borrow from other banks. There is a stigma to borrowing from the Fed. • The very existence of the discount window makes private bank loans work more smoothly. 52 Self-Check The discount rate is the rate at which: a. Banks lend to each other. b. The Fed lends to the banks. c. The banks lend to their discount customers. Answer: b – the discount rate is the rate at which the Fed lends to the banks. 53 Definition Solvency crisis: Occurs when banks become insolvent. Insolvent bank: A bank that has liabilities that are greater than its assets. 54 Discount Rate Lending In 2008, many U.S. banks were potentially insolvent due to bad real estate loans and other investment mistakes. The value of loans fell so far that some banks were no longer able to pay back their depositors. The U.S. Treasury acted to “recapitalize” parts of the U.S. banking system. This helped to maintain lending and avoid a large decrease in the money supply. 55 Definition Liquidity crisis: Occurs when banks are illiquid. Illiquid bank: A bank that has short-term liabilities that are greater than its short-term assets but overall has assets that are greater than its liabilities. 56 Discount Rate Lending If all the depositors want their money back at the same time, there is a potential problem. Fear can turn solvent banks into illiquid banks very quickly. To avoid bank runs, the Federal Deposit Insurance Corporation (FDIC) guarantees bank deposits up to $250,000 for each depositor. If there is still a liquidity crisis, the Fed can act as a lender of last resort to help banks meet their obligations. 57 Discount Rate Lending During the financial crisis of 2007–2008, the Fed went considerably beyond its traditional role in helping out financial institutions: • The Term Auction Facility was set up to inject reserves into the system. • Over the course of the year, the Fed lent over $2 trillion to the banking system. • The Troubled Asset Relief Program (TARP), gave up to $700 billion to banks. 58 Self-Check The Fed wants to lower interest rates: a) It does so by buying bonds in an open market operation. b) It does so by selling bonds in an open market operation. c) It does so by printing more money Answer: a – It does so by buying bonds in an open market operation. 59 Interest on Reserves As of 2008, the Fed can vary the rate of interest that it pays banks on reserves. Previously, banks received no interest payments on reserves and therefore tried to minimize them. This meant banks sometimes worked at cross purposes with the Fed. 60 Definition Systemic risk: The risk that the failure of one financial institution can bring down other institutions as well. Moral Hazard: Occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out. 61 Systemic Risk During the financial crisis of 2007–2008, the Fed bailed out the companies Bear Stearns and American International Group (AIG), under the rationale that they both owed a lot of money to banks. Failure of the two companies was an issue of systemic risk. Whenever the Fed acts to limit systemic risk, it insulates at least some banks from the financial consequences of their bad decisions which leads to moral hazard. 62 Aggregate Demand and Monetary Policy 63 Aggregate Demand and Monetary Policy To estimate the effect of its actions on aggregate demand, the variables Fed must try to predict and monitor are: • Will banks lend out all the new reserves or will they lend out only a portion, holding the rest as excess reserves? • How quickly will increases in the monetary base translate into new bank loans and thus larger increases in M1 and M2? • Do businesses want to borrow? How low do short-term interest rates have to go to stimulate more investment borrowing? • If businesses do borrow, will they promptly hire labor and capital, or will they just hold the money as a precaution against bad times? 64 Who Controls the Fed? The Fed has a seven-member Board of Governors, who are appointed by the president for 14-year terms and confirmed by the Senate. The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years. The Fed is not just one bank but 12 Federal Reserve Banks, each headquartered in a different region of the country. 65 Takeaway At least five factors amplify economic shocks: • • • • • Labor supply and intertemporal substitution Uncertainty and irreversible investment Labor adjustment costs Time bunching Collateral shocks 66