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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?
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Money
3
Money
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Money
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Money
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Money
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Money
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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
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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.
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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.
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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.
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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.
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Definition
Money:
A widely accepted means of payment.
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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.
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The U.S. Money Supplies
Major Means of Payment in the United States (February 2014)
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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.
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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.
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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.
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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.”
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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.
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Self-Check
The largest means of payment in the US. is:
a. Currency.
b. Checkable deposits.
c. Savings deposits.
Answer: c – savings deposits.
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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.
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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.
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The U.S. Money Supplies
The Money Pyramid, 2014
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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.
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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.
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Definition
Fractional Reserve Banking:
A system where banks hold only a
fraction of deposits in reserve, lending
the rest.
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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.
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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.
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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.
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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.
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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.
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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.
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Printing Money
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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.
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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.
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Definition
Open market operations:
Occur when the Fed buys or sells
government bonds.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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Definition
Federal funds rate:
The overnight lending rate from one
major bank to another.
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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.
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Definition
Lender of last resort:
Loans money to banks and other
financial institutions when no one else
will.
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Definition
Discount rate:
The interest rate banks pay when they
borrow directly from the Fed.
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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.
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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.
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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.
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Definition
Solvency crisis:
Occurs when banks become insolvent.
Insolvent bank:
A bank that has liabilities that are
greater than its assets.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Aggregate Demand and Monetary
Policy
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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?
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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.
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Takeaway
 At least five factors amplify economic shocks:
•
•
•
•
•
Labor supply and intertemporal substitution
Uncertainty and irreversible investment
Labor adjustment costs
Time bunching
Collateral shocks
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