Class Notes for CH 4(1) Summary - book \"Financial Markets and Institutions\" PDF

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Class Notes for CH 4: The Federal Reserve System, Monetary Policy, and Interest Rates-Inflation Example, see Bernstein book“Our main problem is to keep the rate of spending in line with the production of goods and services- neither so low that prices and demand collapse nor so high that an inflation...

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Class Notes for CH 4: The Federal Reserve System, Monetary Policy, and Interest Rates -Inflation Example, see Bernstein book “Our main problem is to keep the rate of spending in line with the production of goods and servicesneither so low that prices and demand collapse nor so high that an inflationary spiral begins” -Peter Bernstein Ch. 4: Federal Reserve  Can shift the supply curve  Upside: more borrowing, investing, hiring  Risk: Inflation Inflation Examples  Family spends $6,000 on goods and services  Inflation is 10%  now they need $6,600 to maintain  What are their options? o Borrow $  not long term solution o Work more hours  reduces quality of life o Ask for a raise  employer has to raise prices more inflation o Cut back on health insurance  reduces quality of life o Use savings  not long term solution o NO GOOD OPTIONS Money Supply: cash and checking accounts suitable for payment (exchange medium)  Why use a bank? o Safe keeping o Deposit Money 

o Loan How does using a bank change the money supply?

-Banking Example (Bernstein Book)

1. Borrow money from a friend William borrows $50 from Brooks Deposits at Bank Ross Brooks William Total (money supply)

Before $ 100 $ 100 $ 100 $ 300

After $ 100 $ 50 $ 150 $ 400

NO CHANGE

1A. Alternative: Borrow money from a friend, who uses another bank.

Deposits at Bank 1 Before Ross $ 100 Brooks $ 100 William $ 100 Total $ 100 Nicole borrowed 50 from ross

After $ 50 $ 100 $100 $250

Deposits at Bank 2 Before Nicole $ 100 Shannon $ 100 Casey $ 100 Total $ 300 2. Purchase at a store (cash)

After $ 150 $ 100 $ 100 $ 350

No change

Brianna buys $50 of clothes Deposits at Bank Store Customer Total

Before $ 500 $ 100 $ 600

After $ 550 $ 50 $ 600 NO CHANGE

3. Purchase at a store (credit) Deposits at Bank Store Customer Credit Card (company) Total

Before $ 500 $ 100 $ 300 $ 900

Step 1 $ 550 $ 100 $ 250 $ 900

Step 2 $ 550 $ 50 $ 300 $ 900

4. Store Pays Worker or a Supplier at different bank (pays them $50) Deposits at Bank 1 Store Total

Before $ 300 $ $ 300

After $ 200 $ $ 200

Deposits at Bank 2

Before

After

Worker Supplier

$ 50 $ 50 $ $ 100

$ 100 $ 100 $ $ 200 no change

Total

5. Bank makes a loan- the bank is outside the system of depositors, they can inject money into that system ** Deposits at Bank Store

Total

Before $ 500 $ $ $

After $ 600 $ $ $

No change

6. Initial Public Offering (IPO) Deposits at Bank Store (Issuer) Investor Total

Before $ 500 $ 200 $ 700

After Sale of Securities $ 600 $ 100 $ 700 No change

7. Store sells government securities (T-Bonds), Bank buys government securities Deposits at Bank

Before

Store Buyer/Dealer ???? Total

$ 500 $ 100 $ $ 600

After Sale of Securities After Bank Buys Secs. $ 600 $ 600 $0 $ $ $ 100 $ 600 $ 700

-Functions of the Fed Federal Reserve: is the central bank of the U.S.   

Founded by congress is 1913 Determine, implement and control the monetary policy in their home countries Objectives included economic growth in line with the economy’s potential to expand, a high level of employment, stable prices, and moderate long-term interest rates

 LG 4-1. Understand the major functions of the Federal Reserve System 1.  

Conduct Monetary Policy: by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates Dual mandate: maximize employment They want a reasonable amount of inflation: stable prices, moderate long-term interest rates

(Note: The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals.) 2. 

Supervise and Regulate depository institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers Ex: Regulation for Bank of America

3. Maintain Stability of the financial system: and contain systemic risk that may arise in financial markets (not regulator for NYSE and other markets) 4. Produce payment and other financial services to depository institutions, the U.S. government, and foreign official institutions

“Structure of the Federal Reserve System”  Consist of 12 federal reserve banks located in main cities  7 board members  12 Federal Reserve banks (NY, Chi, ATL, SF)  1-A: Boston  2-B: NY  3-C: Philly  4-D: Cleveland  5-E: Richmond  6-F: Atlanta  7-G: Chicago  8-H: St. Louis  9-1: Minneapolis  10-J: Kansas City  11-K: Dallas  12-L: SF  7 members of the Board of Governors (DC) o structure was implemented in 1913 to spread power along regional lines between government & private business, regions & national  12 members of the Federal Open Market committee (meets in DC, but members from all over) o Keep in mind: They want a Balance of interests government & private business, regions & national  Organization of the Federal Reserve System o Divided into 12 Federal reserve districts that are the operating arms of the central banking system o Each district has one main bank o Acts as a depository system for the banks in its district (pg. 93 map) o Operates under the general supervision of the Board of Governors of the Federal Reserve o Each bank as 9 members board of directors  3 professional bankers (elected by members banks in district)  3 business people (elected by members banks in district)  3 appointed by board of governors (people in this group are prohibited from being employees, officers or stockholders of a member bank  these 9 members are responsible for electing the president of their Federal Reserve Bank o Nationally charted banks, those chartered through the OCC are required to become members of the federal reserve system (FRS) o primary advantage of the FRS membership is direct access to the federal funds wire transfer network for interbank borrowing and lending of reserves o Commercial banks are required to buy stock in the FRS, making is quasi-public

o o

FRB operate as nonprofit organizations Generate income through  Interest earned on governments securities acquired in the course of Federal Reserve open market transactions  Interest earned on reserves that banks are required to deposit at the Fed  Fees from the provision of payment and other services to member depository institutions

Functions performed by the Federal Reserve Banks  Assistance in the conduct of monetary policy: Federal reserve bank presidents serve on the FOMC, FRMs set and change discount rate o Discount rate: the interest rate on loans made by federal reserve banks to depository institutions o Discount window: the facility through which federal reserve banks issue loans to depository institutions o Also have the discretion on deciding which banks qualify for discount window loans o While the federal reserve’s conduct of monetary policy is primarily designed to affect the US economy, in our ever increasing global economy, any policy changes made by the Fed also influences, and are influenced by international developments  Supervision and Regulation: FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district o The conduct of examinations and inspections of member banks, bank holding companies and foreign bank offices by teams of bank examiners o The unity to issue warnings (cease and desist orders should some banking activity be viewed as unsafe or unsound) o The authority to approve various bank and bank holding company applications for expanded activities (mergers and acquisitions)  Consumer Protections and Community Affairs: FRBs write regulations to implement many of the major consumer protection laws and establish programs to promote community development and fair and impartial access to credit o Writing and interpreting regulations to carry out many of the major consumer protections laws, reviewing bank compliance with the regulations, investigating complaints from the public about state members banks’ compliance with consumer protection laws, testifying before congress on consumer protection issues  Government Services: FRBs serve as the commercial bank for the US treasury o Each year government agencies and departments deposit and withdraw billions of dollars from US Treasury operating accounts held by Federal Reserve Banks o Ex: receive payroll deduction taxes, and deposits relating to federal unemployment taxes o Not collateralized at all times o Responsible for the operation of US saving bond scheme, the issuance of Treasury securities, and other government sponsored securities

 New Currency Issue: FRBs are responsible for the collection and replacement of damaged currency from circulation o Distribute new currency to meet publics needs to cash  Check Clearing: FRBs, process route and transfer funds from on bank to another as checks clear through the Federal Reserve System o All depository institutions have accounts with the Federal Reserve Bank in their district for this purpose o Industry consolidation and greater use of electronic products has resulted in a reduction in the number of checks written and thus cleared through the FRS o Check 21 Act (paperless environment) prompted by 911  Wire Transfer Service: FRBs and their member banks are linked electronically through the Federal Reserve Communications System o This allows these institutions to transfer funds and securities nationwide in a matter of minutes o Fedwire and Automated Clearinghouse o Fedwire are typically large dollar payments o FEdwire and ACH have grown significantly in compared to check processing  Research Services: each FRB has a staff of professional economists who gather, analyze and interpret economic data and developments in the banking sector in their district and economy wide o Used in the conduct of monetary policy by the Federal Reserve o One of the best resources for economists, investors and FI managers

Table 4-1 Functions Performed by the Federal Reserve Banks 1. Assistance in conduct of monetary policy

More Details

2. Supervision and regulation

Examine member banks, issue warnings about unsafe or unsound practices, approve mergers, etc.

3. consumer protection and community affairs

4. Government services

Operate discount window for banks

Example/Note



FRB presidents serve on FOMC

Implement federal laws intended to protect consumers by writing and interpreting regulations, reviewing bank compliance.



Community reinvestment act



Protect low/moderate income borrowers

Serve as the bank for the US Treasury (US government)



Receive deposits related to tax withholding

5. New Currency Issue

Collect and replace currency

Y2K $697B in currency

6. check clearing

Central check clearing system for US banks

September 11 planes grounded, so check could not be sent. 11.5 M checks per day

7. Wire transfer services

Operate Fedwire and Automate Clearing House (ACH)

Closing on home

8. Research Services

Staff of professional economists

 

Volker Chicago Fed

Board of Governors of the Federal Reserve (aka Federal Reserve Board)    

  

 

7 members (currently 5 due to resignations) headquartered in DC appointed by the president, and approved by the senate serve a nonrenewable 14 year term Designed to avoid political influence o Often members are ones with PHds in economics o Staggered so that one members term expires every January President assigns two members to be prez and vp of the board for 4 years Usually meets several times per week current chair is Janet Yellen o Previous was Ben Benanke o Advises the president on economic policy o Serves as spokesman for the FRS in congress and to the public Bernanke was appointed by Bush and reappointed by Obama (bottom line- DC is not wrapped up in the Federal reserve) Primary Responsibilities o Formulation of monetary policy and conduct of monetary policy  Set discount rate (1st monetary policy tool)  Set reserve requirements (2nd monetary policy tool)  Ex: banks keep 10% of deposits on hand o Supervision and regulation of:  All bank holding companies and their non bank subsidiaries and their foreign subsidiaries  State charter banks that are members of the FRS  Edge Act and agreement corporations (through which US banks conduct foreign operations  Primary regulators for bank holding companies (financial holding companies)  JP Morgan, Bank of America  Approve bank mergers  Development and administration of regulations governing fair provision of consumer credit (ex: Truth in lending laws) o All members serve on FOMC o

All board members share the duties of conferring with officials of other gonverment agencies, representatives of banking industry groups, officials of the central banks of other countries and members of congress

 Federal Open Market Committee (FOMC) o The major monetary policy-making boy of the FRS o

o

FOMC consist of 7 members of the federal board of governors, the president of the federal reserve bank of NY and the presidents of 4 other Federal Reserve Banks (on a rotating system) Chairman of the Board of Governors is also the chair of the FOMC

Required to meet 4 times a year in DC, 8 regularly scheduled meetings since 1980 12 members:  7 members of board of governors  1 president of FRB NY  4 presidents of other FRBs (rotating basis)  8 scheduled meetings per year Main responsibility of FOMC is to Formulate polices to promote  Full employment  Economic growth  Price stability  Sustainable pattern of international trade Seek to accomplish this by setting guidelines regarding open market operations o o

o

o o

Open Market Operations: the purchase and sale of US government and federal agency securities—is the main policy tool that the Fed uses to achieve its monetary targets

Balance Sheet of Federal Reserve System

Assets US Treasury securities US Government agency securities Federal Reserve Loans to Domestic Banks (Discount window) Other Liabilities Depository institution reserves Currency outside banks Other

Dec 2004 $797B 85% 0.0% 0.0%

Dec 2008 $2,271 B 21% 0.8% 25%

March 2010 $2,339B 33% 53% 0.5%

March 2014 $4,29 0 54% 39% 0.0%

2.9% 85.8%

38% 37%

45% 38%

57% 28%

 Liabilities o Major liabilities in the Fed’s balance sheet are currency in circulation and reserves (depository institutions vault cash plus reserves deposited at FRBs) o Monetary base: currency in circulation and reserves held by the federal reserve  Reserves: depository institution reserve balances at the Fed plus vault cash  Money Base: currency in circulation plus reserves o Increases (decreases) in either or both of these balances (currency in circulation or reserves) will lead to an increase (decrease) in the money supply  Reserve Deposits: o Largest liability on the Federal Reserve’s balance sheet o All banks hold reserve accounts between depository institutions when checks and wire transfers are cleared o Total reserves are classified into 2 categories:  Required Reserves: reserved the FR requires banks to hold  Excess Reserves: additional reserves banks choose to hold o Required reserves expand or contract with the level of transaction deposit and with the required reserve ratio set by the Federal Reserve Board o Because these deposits earn little interest, banks try to keep excess reserves to a minimum  Currency Outside of Banks o Second largest liability o At top of bill is the federal reserve that issued it  Assets o Treasury and Government agency (Frannie Mae, Freddie Mac) securities, treasury currency and gold and foreign exchange  Treasury Securities o They represent feds holdings

An increase (decrease) in treasury securities held by the Fed leaders to an increase (decrease) in the money supply  US Government Agency Securities o Increased during the market crash  Gold and Foreign Exchange and Treasury Currency o Holds gold certificates that are redeemable at the US treasury for gold o

Holds small amounts of treasury issued coinage and foreign denominated assets to assist in foreign currency transactions or currency swap agreements wit the central banks of other nations  Interbank Loans o Depository institutions in need of additional funds can borrow at Federal Reserve’s discount window o Interest rate is often lower  Miscellaneous Assets o Small portion of the Fed’s assets o Under the financial crisis, the fed undertook various sectors (ex: provided AIG with a loan to prevent failure) o

Monetary Policy Tools LG 4-3. Identify the monetary policy tools used by the Federal Reserve Required Reserves and Excess Reserves Federal Funds Loans- function of supply and demand Ex: Bank of America Deposits $100M Required Reserves 10% Reserves $10M (cash in vault reserves at FRB) Loans $90M JP Morgan Chase Deposits $150M RR 10% Reserves $15M Loans $135M $140M (change their loan to 140, only have 10M left in our vault, they are short for the reserve requirement. Bank of America has extra in their account, so they loan out to JP so JP morgan and chase has money in the vault) **one bank gained reserves, another bank lost reserves no change in overall Monetary Policy Tools  Regardless of the tool used, the major link by which monetary policy impacts the macro economy occurs through the Federal Reserve influencing the market for bank reserves (required and excess reserves held as depository institution reserve balances in accounts at Federal Reserve Bank plus the vault cash on hand of commercial banks

 The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate o Fed funds rate is a function of the supply and demand for federal funds among banks and the effects of the Fed’s trading through the FOMC o Used to guide monetary policy o Fed can take one of two basic approaches to affect hre market banks excess reseves  It can target the quantity of reserves in the market based on FOMC’s objectives for the growth in the monetary vase (the sum of currency in circulation and reserves)  Can target the interest rate on those reserves o Fed can only target and influence the federal funds rate, it cannot directly set the rate o One day loans between commercial banks

Three main monetary policy tools 1. Open Market Operations: purchases and sales of US government and federal agency securities by the Federal Reserve. (buy and sell T Bills)  When a targeted monetary aggregate or interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk through a statement called the policy directive.  The manager of the trading desk uses the policy directive to instruct traders on the daily amount of open market purchases or sales to transact  These transactions typically occur in the U.S. Treasury securities market (an over-thecounter market in which traders are linked to each other electronically)  To determine the days activity for open market operations, the staff at the FRBNY begins each day with a review ...