Download Chapter 14 - McGraw Hill Higher Education

The Federal Reserve
and Monetary Policy
Chapter 14
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
 After this chapter you should be able to:
Understand the organization of the Federal Reserve System.
2.
Explain reserve requirements.
3.
Apply the deposit expansion multiplier.
4.
Explain the creation and destruction of money.
5.
List and apply the tools of monetary policy.
6.
Discuss the Fed’s effectiveness in fighting inflation and recession.
7.
Examine the Banking Act of 1980 and 1999.
8.
List and discuss monetary policy lags.
9.
Summarize the housing bubble and the subprime mortgage crisis.
10. Explain how a normally functioning financial system was restored.
11. Discuss whether “Ben Bernanke should have been reappointed to a
second term.
1.
14-2
The Federal Reserve System

Early U.S. central banks lapsed due to political
differences over direction of U.S. economy:
•
•

Central bank protects banking system from panics:
•

Panic is “run on bank” leading to depletion of reserves.
The Federal Reserve Act of 1913 created the Federal
Reserve System:
•
•

First United States Bank [1791–1811]
Second United States Bank [1816–1836]
Legislation was response to Panic of 1907.
Federal Reserve and its District Banks created to act as
“lender of last resort” if bank’s reserves run low.
Fed is a quasi public-private enterprise.
14-3
Five Main Jobs of Federal Reserve
1.
2.
3.
4.
5.
Conduct monetary policy: control the rate of growth of
the money supply to foster macroeconomic stability
Serve as lender of last resort to commercial banks,
savings banks, savings and loan associations, and
credit unions
Issue currency (“Federal Reserve Note”)
Provide banking services to the U.S. government
Supervise and regulate our financial institutions
14-4
Structure of the Federal Reserve (“Fed”)

12 Federal Reserve District Banks, owned by the
several hundred member banks in that district (private).
•
•

Federal Reserve Board of Governors in Washington,
D.C. (public)
•

Commercial banks own stock in Fed District Banks.
Each bank issues currency. (Look at your dollar bills!)
Seven members, nominated by President and confirmed by
Senate, serve one 14-year, non-renewable term.
Chair of the Board of Governors (public)
•
•
•
Chair, nominated by President and confirmed by Senate,
serves four-year, renewable terms.
Current Chair is Ben Bernanke (former Princeton economist).
Former Chair, Alan Greenspan, served 1987-2006.
14-5
The Federal Reserve System
Concentration of districts in East and Midwest reflects US economy of 1913.
14-6
Independence of the Board of Governors

System was designed to limit political influence on Fed
policy makers.
•
•
•

Is political independence good or bad?
•
•

One vacancy occurs every other year.
There are only two appointees during each presidential term,
unless Governors retire early.
Once appointed for 14 years, Fed Governors are not
answerable to elected officials.
Pro: It allows Governors to follow unpopular policies they
believe are in the best economic interest of the nation.
Con: Critics argue they have too much power for unelected
officials.
Political independence makes it easier for the Fed to
fight inflation than it is for Congress and the President
to use fiscal policy.
14-7
Legal Reserve Requirements

To ensure stability of banking system, as well as to control the
money supply, the Fed sets legal reserve requirements.
• Every financial institution in the country is legally required to
hold a certain percentage of its deposits on reserve.
• Legal reserves can be held at the Federal Reserve District
Bank or in the bank’s own vaults.
• Time deposits have 0% reserve requirement (or reserve ratio).
Legal Reserve Requirements for Checking Accounts,
January 1, 2010*
* Numerical boundaries of these limits are revised annually.
14-8
Question for Discussion
If a bank had $100 million in checking deposits (Demand
Deposits), how much reserves would it be required to hold?
Use this table:
Answer:
First $10.7 million of deposits: 0% reserve requirement
Next 44.5 million: $44,500,000 X .03 =
$1,335,000
Next 44.8 million: $44,800,000 X .10 =
$4,480,000
Required Reserves =
$5,815,000
14-9
Definitions




Required Reserves (RR) is the minimum amount of
vault cash and deposits at the Federal Reserve District
Bank that must be held (kept on the books).
Actual Reserves (RD) is what the bank is holding–or
its Reserve Deposits.
Excess Reserves (ER) occur if bank holds more than
the required minimum on reserve.
• ER = RD – RR
Banks traditionally did not make profits on funds held
as reserves.
•
•
ER can be loaned out.
So banks have ideally wanted to hold ER as close to zero as
possible.
14-10
What Happens if the Bank is Short?

If Actual Reserves (RD) are less than Required
Reserves (RR), the Excess Reserves (ER) are
negative.
•

ER = RD – RR, so ER will be negative if RR < RD.
Negative ER means the bank is short of the legal
reserve requirement.
•
•
•
•
When this happens, banks usually borrow reserves from
another bank that does have excess reserves.
These are called federal funds and the interest rate charged
is called the federal funds rate.
A bank may also borrow reserves from its Federal Reserve
District Bank at its “discount window.” The interest rate
charged is the discount rate.
Or, the bank can sell some of its secondary reserves…
14-11
Primary and Secondary Reserves

Primary reserves: A bank’s vault cash and its deposits
at the Federal District Bank.
•

Only primary reserves count toward the legal RR.
Secondary reserves: Treasury bills, notes, certificates,
and bonds that will mature in less than a year.
•
These are easily converted into cash for reserves by selling
them to another bank.
14-12
Reserve Requirements and the Deposit
Expansion Multiplier

New money injected into the economy will have a
multiplied effect on the macroeconomy (real GDP).
•
•
•

Remember: Banks, like goldsmiths, create money when they
make loans.
If the reserve requirement is low, the bank has to keep less in
their vaults (or with the Fed) and can lend out more money.
If the reserve requirement is high, the bank has to keep more
in their vaults (or with the Fed) and can lend out less money.
The reserve requirement affects the size of the deposit
expansion multiplier.
•
Let’s look at an example of the deposit expansion process…
14-13
Example of Deposit Expansion


Assume a 10% reserve ratio.
Someone deposits $100,000 in a bank.
•
•

The company with the $90,000 loan writes a check to
spend it. This is deposited in another bank.
•
•

The bank must keep $10,000 as RR (10% x 100,000).
It can lend out $90,000.
This bank must keep $9,000 in reserves to cover the new
deposit—by borrowing cash or selling secondary reserves.
But the second bank can lend out $81,000 ($90,000 – $9,000).
This $81,000 becomes a deposit in another bank, and
the process continues.
14-14
Hypothetical Deposit Expansion with
10 Percent Reserve Requirement
If the process continued, there would be $100,000 in deposits credited to
various bank accounts, backed by $100,000 in reserves.
14-15
Calculating the Deposit Expansion Multiplier
(DEM)
1
DEM =
Reserve Ratio
Example: Assume a RR of 10%:
DEM =
1
= 10
.10
14-16
Question for Thought and Discussion


What would happen to the DEM if the reserve ratio
were increased to 24%?
Answer:
DEM =
1
= 4
.25
When RR increases, the DEM decreases.
When RR decreases, the DEM increases.
14-17
Modifications of the DEM

The real DEM is lower than if it were based solely on
the reserve ratio.

Three modifications:
1.
2.
3.
Some people will keep part of their loans in cash, rather than
depositing them in a checking account.
Banks may carry excess reserves, to avoid getting caught
short.
There are leakages of dollars to foreign countries, due to our
trade imbalance.
14-18
How Money Moves: Cash, Checks, and
Electronic Money

About 90 percent of total payments in dollars
worldwide are made electronically rather than with
cash.

In 2004 Congress passed the Check Clearing Act of
the 21st Century (“Check 21”).
•
•
Law intended to facilitate electronic check processing.
How? Let’s look at the check clearing process.
14-19
The Check Clearing Process is Changing

Slavin writes $50 check to
Bob in San Francisco.
Slavin’s bank is Citibank.
• Bob’s bank is Bank of
America.
 Follow the check 
• Fed’s District Banks
transfer the value from
one bank’s reserve
account to another’s
reserve account.
•

“Check 21” sped up this
process.
•
Digital pictures of the
check are transferred,
instead of the physical
check.
14-20
Electronic Transfers

Increasingly, money is changing hands electronically.
•
•

Example: When you use your debit card the amount is
deducted within seconds after the card is swiped.
Example: PayPal accounts facilitate paperless transfers.
About $1.4 trillion a day is transferred electronically.
•
•
About one-third of these transfers are carried out by the
Federal Reserve’s electronic network.
About two-thirds are done by the Clearing House Interbank
Payment System (CHIPS) which is owned by 10 big New
York Banks.
14-21
Tools of Monetary Policy
The most important job of the Fed is to control the
rate of growth of the money supply.
How? The Fed controls the money supply by using 3
monetary policy tools:


1.
2.
3.
Open market operations: buying and selling government
securities to financial institutions.

Open market operations have been the most
commonly used monetary policy tool.
Discount rate and federal funds rate: key interest rates that
affect other interest rates.
Reserve requirements: changing the reserve ratio.
In response to the financial crisis, the Fed has
developed new tools.

•
Paying interest on reserve deposits to control rate of bank
lending during recovery.
14-22
How Open-Market Operations Work

Remember: When the federal government runs a
budget deficit (fiscal policy), the Treasury borrows
money from the public:
•
•

Treasury issues U.S. government securities, including
Treasury bills, notes, certificates, and bonds.
The total value of all outstanding U.S. government securities
(our national debt) is about $6.0 trillion.
These securities can be resold in secondary financial
markets.
•
•
The Fed and other financial institutions buy and sell these
chunks of the national debt.
The Fed is constantly buying or selling Treasury bonds in
open (secondary) markets.
14-23
Scenario #1: Increasing the Money Supply


To increase the money supply, the Fed buys bonds
from banks and other financial institutions.
Follow the money:
•
•
•

The banks get money in exchange for some of the bonds in
their portfolios.
This money is put into circulation and increases the banks’
demand deposits.
Because of the DEM, there is a multiplied increase in the
money supply.
How does the Fed get the banks to sell?
•
•
It makes an offer they can’t refuse!
Price of bonds is pushed up.
14-24
Scenario #2: Decreasing the Money Supply


To decrease the money supply, the Fed sells bonds to
banks and other financial institutions.
Follow the money:
•
•
•

The Fed gets money in exchange for some of the bonds in
their portfolios.
This money is taken out of circulation by the Fed.
Because of the DEM, there is a multiplied decrease in the
money supply.
How does the Fed get the banks to buy?
•
•
It makes an offer they can’t refuse!
The price of bonds is pushed down.
14-25
Questions for Thought and Discussion


What happens to interest rates when the Fed buys or
sells bonds?
Use the following formula:
Interest paid
Interest rate =
Price of bond
Hint: When the Fed buys or sells bonds, they affect the market price
of the bonds.
14-26
Impact of Increasing the Money Supply



Increasing the money supply
leads to a decrease in interest
rates.
During a recession, lower
interest rates may encourage
businesses to increase
Investment and households to
increase Consumption.
If C and I increase, the fiscal
policy multiplier will lead to a
greater increase in real GDP.
14-27
Impact of Decreasing the Money Supply



Decreasing the money supply
leads to an increase in interest
rates.
During inflation, higher interest
rates may discourage business
Investment and household
Consumption.
If C and I decrease, the fiscal
policy multiplier will lead to a
greater decrease in real GDP,
but it will also bring down the
price level.
14-28
Federal Open-Market Committee

Open market operations are directed by the FOMC.
•
•

FOMC consists of 8 permanent members – the Board of
Governors and the president of the New York Federal Reserve
District Bank.
The other four positions rotate among the presidents of the
other 11 Federal Reserve District Banks.
FOMC meets about every six weeks.
•
•
To fight recessions, the FOMC buys securities, increasing the
rate of growth of the money supply.
To fight inflation, the FOMC sells securities, decreasing the
rate of growth of the money supply.
14-29
Questions for Thought and Discussion

Suppose the Fed buys $200 million of securities and
the deposit expansion multiplier (DEM) is 5. By how
much could our money supply increase?
•
•

ER x DEM = Potential increase in Money Supply
$200 million x 5 = $1,000,000,000 (or $1 billion)
Why is the answer only a “potential” increase in the
money supply? Why is the actual increase probably
less?
14-30
Monetary Policy Tool #2: Key Interest
Rates


Discount rate is the interest rate paid by member
banks when they borrow reserve deposits (RD) at their
Federal Reserve District Bank.
Federal funds rate is the interest rate banks charge
each other for borrowing reserve deposits (RD) from
each other.
•


Federal funds rate is higher than the discount rate.
Lowering interest rates is expansionary response to
recession.
Raising interest rates is contractionary response to
inflation.
14-31
Target Federal Funds Rate Since 2000


The Fed lowered the discount rate after 9/11 (2001), which brought
down the federal funds rate.
It was lowered again as the economy sank into recession in 2007.
•
Banks could increase their reserves quickly, avoiding financial panic and “runs”
on the banks.
14-32
Monetary Policy Tool #3: Changing
Reserve Requirements

The Federal Reserve Board has the power to change
reserve requirements within the legal limits of 8 and 14
percent for checkable deposits.
•

To combat recession, Fed lowers required reserve ratio
to create more excess reserves.
•

Changing reserve requirements is the ultimate weapon and is
rarely used (about once per decade).
Example: Lowered from 12% to 10% in 1992.
To combat inflation, Fed would increase required
reserve ratio.
•
Banks would have to scramble to increase reserves.
14-33
Summary: The Tools of Monetary Policy

To fight recession, the Fed will:
1.
2.
3.

Buy securities on the open market.
Lower discount rate and federal funds rate.
Lower reserve requirements.
To fight inflation, the Fed will:
1.
2.
3.
Sell securities on the open market.
Raise the discount rate and federal funds rate.
Raise reserve requirements (only as a last resort).
14-34
Contractionary Monetary Policy
Transmission Mechanism

Like pulling on a string, when the Fed fights inflation, it
get results—provided of course, it pulls hard enough.
14-35
Expansionary Monetary Policy
Transmission Mechanism




Fighting a recession is another matter.
Like pushing on a string, no matter how hard the Fed works, it might
not get anywhere.
If Aggregate Demand is low, businesses may not invest, no matter
how low interest rates are.
Keynes’ Liquidity Trap: if interest rates are too low, people will
simply hold on to their money.
14-36
New Banking Regulations
The Depository Institutions Deregulation and
Monetary Control Act of 1980:

1.
2.
3.
All depository institutions are now subject to the Fed’s legal
reserve requirements.
All depository institutions are now legally authorized to issue
checking deposits that may be interest bearing.
All depository institutions now enjoy all the advantages that
only Federal Reserve member banks formerly enjoyed –
including check clearing and borrowing from the Fed
(discounting).
The Banking Act of 1999 allows banks, securities
firms and insurances companies to merge and sell
each other’s products.

•
•
Repealed Glass-Steagall Act of 1933.
It was a major contributory factor to the financial crisis of
2008.
14-37
Monetary Policy Lags

Monetary policy has the same three lags as fiscal policy:
•
•
•
Recognition lag
Decision lag
Impact lag

The first two lags may be shorter because of
consolidated power of Fed’s Board of Governors.

But the impact lag may be longer.
14-38
Roots of The Housing Bubble

After 9/11 attack and dot-com bubble burst, Fed
dramatically lowered interest rates to combat recession.
•
•
•
Lower interest rates contributed to new bubble in housing market.
 Low interest rates made buying, flipping, and refinancing
cheap.
Banking deregulation led to creating of new financial
“instruments” for sale, including mortgage securities.
 These “collateralized debt obligations” (CDOs) bundled
mortgages into a pool that earned income as mortgages were
paid.
 Because mortgage lenders were selling mortgages to
investment banks for securities, they had less stake in
whether borrowers could actually afford their mortgage.
 Lenders assumed house values would keep rising, minimizing
the risk since houses were collateral.
Subprime mortgage market and speculative bubble boomed.
14-39
Financial Crisis of 2008

Subprime borrowers began to default on their
mortgages.
•
•

This led to an increase in the supply of houses, pushing down
housing values.
Borrowers found themselves “under water,” meaning their
homes were worth less than their mortgages.
Banks, insurance companies, hedge funds, and other
investors who owned large amounts of CDOs now
owned paper of undetermined value (“toxic assets”).
•
•
Many of the losers were “shadow banks,” financial
intermediaries that were not regulated banks.
Due to deregulation, there was little oversight as these
institutions became indebted.
14-40
Financial Meltdown and the Great Recession

Two inter-related problems in Fall 2008: financial system
meltdown and severe recession.
•
•
•
•
•
The financial crisis began to affect “Main Street. ”
Lending of all kinds froze up contributing to a credit crisis.
Consumers spending fell as home values plunged.
Unemployment rose.
Millions of homeowners, not only subprime borrowers, faced
foreclosures.
14-41
Restoring the Financial System

TARP (Toxic Asset Relief Program) Bailout:
•
•
•

Three criticisms:
•
•
•

Congress and President Bush authorized U.S. Treasury to
purchase CDOs and other securities from banks and financial
intermediaries.
TARP also authorized Treasury to purchase stock in these
companies.
Initially authorized $7 billion, in two $350 billion installments, with
little oversight.
Money not used to help homeowners avoid foreclosures.
Banks not required to use funds to increase lending.
No prohibition to pay huge executive bonuses.
Good news: Far less than $700 billion was spent and
Treasury was paid back much of the funds.
14-42
Stopping Mortgage Foreclosures

By early 2009, 1 out of 11 homes was in foreclosure.
•
•

Typically such homes become run down or even vandalized.
This lowers property values of surrounding homes, driving down
housing prices.
February 2009, President Obama passed a $275 billion
plan to help homeowners refinance their mortgages or
avert foreclosure:
1.
2.
3.
Provides incentives to lenders to change the terms of the loan to
make them more affordable.
Help homeowners who were current in their payments refinance
at lower interest rates.
Provide Fannie Mae and Freddie Mac with funds for mortgages.
14-43
Questions for Thought and Discussion

How is having foreclosed homes in your neighborhood
an example of a negative externality?

What is the difference between the TARP Bailout and
the Economic Stimulus Package described in the last
chapter?

Why is there a “credit crisis?” How does the credit crisis
affect consumers and businesses?

Should Congress have passed the TARP Bailout?
•
Why or why not?
14-44