Chapter 14. The Federal Reserve and Monetary Policy

Chapter 14The Federal Reserve and Monetary Policy14-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter Objectives14-2The organization of the Federal Reserve SystemReserve requirementsThe deposit expansion multiplierThe tools of monetary policyThe Feds effectiveness in fighting inflation and recessionThe Banking Act of 1980 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve Act of 1913 created the Federal Reserve SystemTo provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes First United States Bank [ 1791 - 1811]Second United States Bank [ 1816 - 1836]The charters of both were allowed to lapseThe 1907 bank crises caused the public to demand the government do something to keep this from happening againThe Federal Reserve System14-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve SystemThe Federal Reserve has five main jobsConduct monetary policy which is, by far, the most important jobMonetary policy is the control of the rate of growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growthServe as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions14-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve SystemThe Federal Reserve has five main jobsIssue currencyProvide banking services to the U.S. governmentSupervise and regulate our financial institutions14-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve District BanksEach Federal Reserve District Bank is owned by the several hundred member banks in that districtA commercial bank becomes a member by buying stock in the Federal Reserve District BankSo, the Fed is a quasi public-private enterprise, not controlled by the president or CongressEffective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.14-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve SystemBoard of Governors7 appointed membersAppointed by PresidentConfirmed by SenateSets reserve requirementsSupervises & regulates member banksEstablishes and administers regulationsOversees Federal Reserve Banks12 District BanksPropose discount ratesHold reserve balances for member institutionsLends reservesFurnish currencyCollects & clears checksHandle U.S. government debt & cash balancesFederal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy14-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.14-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Reserve SystemLegal Reserve RequirementsThe focal point of the Federal Reserve’s control of our money supply is legal reserve requirementsEvery financial institution in the country is legally required to hold a certain percentage of its deposits on reserve, either in the form of deposits at its Federal Reserve District Bank or in its own vaults 14-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve RequirementsTechnical Term MeaningsRequired Reserves (RR) is the minimum amount of vault cash and deposits (RD) at the Federal Reserve District Bank that must be held (kept on the books) by the financial institutionActual Reserves (RD) is what the bank is holding (on the books)Excess Reserves = Actual Reserves -Required Reserves ER = RD - RR 14-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-12If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-13If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?The model below excludes vault cashCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-14If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?The model below excludes vault cashFedBankDD 100.000RD 100.000RD 100.000.03 X 42.8 = 1.284 100.000- 42.800 57.200 .10 X 57.2 = 5.720Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-15If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?The model below excludes vault cashFedBankDD 100.000RD 100.000RD 100.000.03 X 42.8 = 1.284.10 X 57.2 = 5.720RR = 7.004RR 7.004Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-16If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold?The model below excludes vault cashFedBankDD 100.000RD 100.000RD 100.000.03 X 42.8 = 1.284.10 X 57.2 = 5.720RR = 7.004RR 7.004-ER 92.996 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal Reserve Requirements [March 1997]Checking Accounts $0 - 42.8 million 3%Over 42.8 million 10%Time Deposits 0%14-17If a bank had demand deposits (DD) of 1,000 million ($1 billion) and held 120 million in actual reserves (RD) in the form of deposits at the Federal Reserve District Bank, calculate its required reserves (RR) and its excess reserves (ER) FedBankDD 1000.000RD 120.000RD 120.000 .03 X 42.8 = 1.284.10 X 957.2 = 95.720 RR = 97.004RR 97.004-ER 22.996 1,000.0 42.8 957.2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What About Negative Excess Reserves?If actual reserves (RD) are less than Required Reserves (RR), the excess Reserves (ER) are negativeIf a bank does find itself short, it will usually borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charge is called the federal funds rateA bank may also borrow reserves (RD) from its Federal Reserve District Bank at its discount window14-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A bank’s primary reserves are its vault cash and its deposits at the the Federal District BankThese reserves pay no interest, therefore the banks try to hold no more than the Federal Reserve requiresPrimary and Secondary Reserves14-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Every bank holds secondary reserves, mainly in the form of very short-term U.S. government securitiesTreasury bills, notes, certificates, and bonds (that will mature in less than a year) are generally considered a bank’s secondary reservesThese can be quickly converted to cash without loss if a bank suddenly needs money Primary and Secondary Reserves14-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Deposition Expansion14-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Deposit Expansion with 10 Percent Reserve RequirementDeposits (thousands) Reserves $100.0 $10.0 $ 90.0 9.0 $ 81.0 8.1 $ 72.9 7.29 $ 65.61 6.661 $ 59.05 5.904 $ 53.541 5.354 $ 48.186 4.819 $ 43.368 4.337 $ 39.031 3.903 * To save space the rest of the calculations are omitted $1,000.00 100.00 Deposition Expansion(Continued)14-22How Deposit Expansion WorksBank AFEDDD + 100RD + 100A> RD +100Assume a 10% RRCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Deposition Expansion14-23How Deposit Expansion WorksBank AFEDDD + 100RD + 100A> RD +100Assume a 10% RRRR 10ER + 90Bank BDD + 90RD + 90B> RD + 90RR 9ER + 81Bank CDD + 81.0RD + 81C> RD + 81.0ER 8.1ER + 72.9 Etc.Etc.Etc.RD + $1,000,000 When RDs at the Fed increase the money supply is increasingCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Deposit Expansion Multiplier(DEM)14-24DEM = 1Reserve RatioAssume a RR of 10 %DEM =1.10=10Assume a RR of 25 % DEM = 1.25=4When RR increasesDEM decreasesWhen RR decreasesDEM increases Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Three Modifications of the Deposit Expansion MultiplierNot every dollar of deposit expansion will actually be re-deposited again and lent out repeatedlySome people may choose to hold or spend some money as currencyIt is also possible that some banks will carry excess reservesThis is not likely in times of high inflation14-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Three Modifications of the Deposit Expansion MultiplierThere are leakages of dollars to foreign countriesThis is caused mainly by our foreign trade imbalanceThe Deposit Expansion Multiplier is, in reality, quite a bit lower than if we based it solely on the reserve ratioIf the reserve ration tells us it is 10, perhaps it’s only 614-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Cash, Checks, and Electronic MoneyOne of the jobs of the Federal Reserve is check clearing14-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Increasingly, money is changing hands electronicallyToday, more than $1.7 trillion a day is transferred electronicallyAbout $600 billion of these transfers are carried out by the Federal Reserve’s electronic networkAbout $1.1 trillion are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 11 big New York Banks Cash, Checks, and Electronic Money14-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Does all this mean that we are well on our way to a checkless, cashless society?Yes and noWe still carry out nearly 85% of our monetary transactions in cashWhen the total dollars actually spent is considered, cash covers less than 1% of the total valueElectronic transfers account for five out of every six dollars that move in the economy Cash, Checks, and Electronic Money14-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Tools of Monetary PolicyThe most important job of the Fed is to control the rate of growth of the money supplyThis effort focuses on the reserves held by financial institutionsThe most important policy tool to do this is open-market operations14-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How Open-Market Operations WorkOpen-Market operations are the buying and selling of U.S. government securitiesU.S. government securities are Treasury bills, notes, certificates, and bondsThe Fed buys and sells securities that have already been marketed by the TreasuryThe total value of all outstanding U.S. government securities is more than $4.0 trillion. This is our national debtWhat open market operations consist of, then, is the buying and selling of chunks of the national debt 14-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-32The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90The multiplier would be 1010 X 90 million = 900 million X .60 = approximate increase in the money supply of 540 million over a period of timeCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-33The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securitiesIR = Interest PaidPrice of BondCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-34The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securitiesIR = $80$1000Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-35The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securitiesIR = $80$1000=8%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-36The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90Suppose this pushed the price of the bond up to $1200?IR = $80$1000=8%IR = $80$1200=6.67%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Increases the Money Supply14-37The FED buys U. S. Government SecuritiesThe Fed writes a check for, say, $100 million (this is money created out of nothing)Securities FirmDD + $100Assume 10% RRRD + $100RR - 10 ER + 90When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rateIR = $80$1000=8%IR = $80$1200=6.67%Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Decreases the Money Supply14-38The FED sells U. S. Government SecuritiesThe Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)Securities FirmDD - $100Assume 10% RRRD - $100When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climbThe money supply decreases by approximately $540 million over timeCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How the Fed Decreases the Money Supply14-39The FED sells U. S. Government SecuritiesThe Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed)Securities FirmDD - $100Assume 10% RRRD - $100When the Fed goes into the open market to sell securities, bond prices fall and interest rates climbIR = $80$1000=8%IR = $80$1200=6.67%The money decreases by approximately $540 million over timeCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Open-Market Committee (FOMC)Open-market operations are conducted by the Federal Open-Market Committee (FOMC)This committee consist of 12 peopleEight permanent members – the board of Governors and the president of the New York Federal Reserve District BankThe other four are presidents of the other 11 Federal Reserve District BanksThey serve on a rotating basis14-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Open-Market Committee (FOMC)14-41The FOMC meets about once every six weeks to decide what policy to followTo fight recessions, the FOMC buys securitiesThis increases the rate of growth of the money supplyTo fight inflation, the FOMC sells securitiesThis decreases the rate of growth of the money supplyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District BankThe federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each otherThis is higher than the discount rate Banks borrow to maintain their required reserves (RR)Banks tend to borrow reserve deposits from each other because they may not like to call attention to the fact they are having to borrow reserve deposits14-42Borrowing Reserve DepositsCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Changing Reserve RequirementsThe Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14% for checkable depositsChanging reserve requirements is the ultimate weapon and is rarely used14-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Changing Reserve RequirementsTo fight inflation, before the Board would take the drastic step of raising reserve requirementsThe District Banks would raise the discount rateThe FOMC will be actively selling securitiesCredit will be getting tighterThe chairman will be publicly warning that the banks are advancing too many loans14-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Changing Reserve RequirementsIf the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises reserve requirementsThis weapon is so rarely used because it is simply too powerfulIf the reserve requirement on demand deposits were raised by just one-half of 1%, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reservesThis would drastically reduce the nation’s money supply 14-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Summary: The Tools of Monetary PolicyTo fight recession, the Fed willLower the discount rateBuy securities on the open marketLower reserve requirementsThis would be done only as a last resort14-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Summary: The Tools of Monetary PolicyTo fight inflation, the Fed willRaise the discount rateSell securities on the open marketRaise reserve requirementsThis would be done only as a last resort14-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Fed’s Effectiveness in Fighting Inflation(Assume all the tools have been used)Bond prices have plungedInterest rates have soaredThe growth of the money supply has been stopped dead in its tracksBanks find it impossible to increase their loan portfoliosBuying by consumers and businesses is decliningThe inflation rate has no choice but to decline 14-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Fed’s Effectiveness in Fighting Recession(Assume all the tools have been used)Bond prices have increasedInterest rates have gone downBanks will have excess reserves and want to make loansBut who wants to borrow the money?Creditworthy individuals and business have little incentive to borrow any moneyBusinesses and individuals who really need to borrow money can’t because the first rule of banking is: never lend money to anyone who needs it. Easy money has little or no effect in ending a recession14-49Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Fed’s Effectiveness in Fighting Inflation and RecessionFederal Reserve policy in fighting inflation and recession has been likened to pulling and then pushing on a stringLike pulling on a string, when the Fed fights inflation, it get results – provided of course, it pulls hard enoughFighting a recession is another matter. Like pushing on a string, no matter how hard the Fed works, it might not get anywhere14-50Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.This Act is clearly the most important piece of banking legislation passed since the 1930sUnder this ActAll depository institutions are now subject to the Fed’s legal reserve requirementsAll depository institutions are now legally authorized to issue checking deposits that may be interest bearingAll depository institutions now enjoy all the advantages that only Federal Reserve member banks formerly enjoyed –including check clearing and borrowing from the Fed (discounting)14-51 The Depository Institutions Deregulation and Monetary Control Act of 1980(Continued)The Depository Institutions Deregulation and Monetary Control Act of 1980Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Another important consequence of this law is that by the end of the 1990s, intense competition reduced the 40,000-plus financial institutions that existed at the beginning of the 1980s to a little more than half that number The lifting of the prohibition against interstate banking combined with further advances in electronic banking will create greater consolidationThe Depository Institutions Deregulation and Monetary Control Act of 198014-52Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Banking Act of 1999In 1980 the jurisdiction of the Federal Reserve had been extended to all commercial banks and thrift institutionsIn 1999 it was further extended to insurance companies, pension funds, investment companies, securities brokers, and finance companiesAll financial firms, including banks, can now sell all sorts of investments14-53Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.