Exam 3 - Study Guide PDF

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I.

Chapter 13: Central Banks and the Federal Reserve System a. Origins of the Federal Reserve System i. Resistance to establishment of a central bank 1. Fear of centralized power 2. Distrust of moneyed interests ii. No lender of last resort 1. Nationwide bank panics on a regular basis 2. Panic of 1907 so severe that the public was convinced a central bank was needed iii. Federal Reserve Act of 1913 1. Elaborate system of checks and balances 2. Decentralized-12 Regional Federal Reserve Banks b. Structure and Responsibility for Policy Tools in the Fed

i.

c. Federal Reserve Banks i. Quasi-public institution owned by private commercial banks in the district that are members of the Fed system ii. Member banks elect six directors for each district; three more are appointed by the Board of Governors 1. Three A directors are professional bankers 2. Three B directors are prominent leaders from industry, labor, agriculture, or consumer sector 3. Three C directors appointed by the Board of Governors are not allowed to be officers, employees, or stockholders of banks iii. Member banks elect six directors for each district; three more are appointed by the Board of Governors (cont’d) 1. Designed to reflect all constituencies of the public iv. Nine directors appoint the president of the bank subject to approval by Board of Governors v. Open-market operations – the purchase and sale of government securities that affect both interest rates and the amount of reserves in the banking system d. Functions of the Fed i. Clear checks ii. Issue new currency iii. Withdraw damaged currency from circulation iv. Administer and make discount loans to banks in their districts v. Evaluate proposed mergers and applications for banks to expand their activities

vi. Act as liaisons between the business community and the Federal Reserve System vii. Examine bank holding companies and state-chartered member banks viii. Collect data on local business conditions ix. Use staffs of professional economists to research topics related to the conduct of monetary policy e. Federal Reserve banks and Monetary Policy i. Directors “establish” the discount rate ii. Decide which banks can obtain discount loans iii. Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the Board of Governors and provides information to help conduct monetary policy iv. Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC) f. Member Banks i. All national banks are required to be members of the Federal Reserve System 1. National Banks – commercial banks chartered by the Office of the Comptroller of the Currency ii. Commercial banks chartered by states are not required but may choose to be members iii. Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities g. Board of Governors of the Federal Reserve System i. Seven members headquartered in Washington, D.C. ii. Appointed by the president and confirmed by the Senate iii. 14-year non-renewable term (but may be appointed to fill part of someone else’s term and then receive another full term) iv. Required to come from different districts v. Chairman is chosen from the governors and serves four-year term 1. Duties of the Board of Governors a. Votes on conduct of open market operations b. Sets reserve requirements c. Controls the discount rate through “review and determination” process d. Sets margin requirements e. Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank’s budget f. Approves bank mergers and applications for new activities

g. Specifies the permissible activities of bank holding companies h. Supervises the activities of foreign banks operating in the U.S. vi. Chairman of the Board of Governors 1. Advises the president on economic policy 2. Testifies in Congress 3. Speaks for the Federal Reserve System to the media 4. May represent the U.S. in negotiations with foreign governments on economic matters h. Federal Open Market Committee (FOMC) i. Meets eight times a year ii. Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks iii. Chairman of the Board of Governors is also chair of FOMC iv. Issues directives to the trading desk at the Federal Reserve Bank of New York v. Federal Funds Rate – the interest on overnight loans from one bank to another vi. FOMC Meeting 1. Formal discussions about regional economic conditions 2. Reports heard on various projections for economic activity 3. All presidents get their say as do the members of the board vii. Tightening of Monetary Policy – a rise in the federal funds rate viii. Easing of Monetary Policy – a lowering of the federal funds rate i. Why the Chairman of the Board of Governors Really Runs the Show i. Spokesperson for the Fed and negotiates with Congress and the President ii. Sets the agenda for meetings iii. Speaks and votes first about monetary policy iv. Supervises professional economists and advisers j. How Independent is the Fed? i. Instrument independence - the ability of the central bank to set monetary policy instruments ii. Goal independence – the ability of the central bank to set the goals of monetary policy iii. Independent revenue and budget iv. Fed’s structure is written by Congress, and is subject to change at any time (limits independence) v. Presidential influence

vi. Influence on Congress vii. Appoints members of board viii. Appoints chairman although terms are not concurrent k. Should the Fed be Independent? i. The Case for Independence 1. The strongest argument for an independent central bank rests on the view that subjecting it to more political pressures would impart an inflationary bias to monetary policy 2. Political pressure would impart an inflationary bias to monetary policy 3. Political business cycle (Nixon-Burns paper) – just before an election, expansionary policies are pursued to lower unemployment and interest rates a. After the election, high inflation and high interest 4. Could be used to facilitate Treasury financing of large budget deficits: accommodation 5. Too important to leave to politicians—the principal-agent problem is worse for politicians ii. The Case Against Independence 1. Proponents of a Fed under the control of the president or Congress argue that it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one 2. Undemocratic 3. Unaccountable 4. Difficult to coordinate fiscal and monetary policy 5. Has not used its independence successfully l. Explaining Central Bank Behavior i. One view of government bureaucratic behavior is that bureaucracies serve the public interest (this is the public interest view). Yet some economists have developed a theory of bureaucratic behavior that suggests other factors that influence how bureaucracies operate ii. The theory of bureaucratic behavior may be a useful guide to predicting what motivates the Fed and other central banks iii. Theory of bureaucratic behavior: objective is to maximize its own welfare which is related to power and prestige 1. Fight vigorously to preserve autonomy 2. Avoid conflict with more powerful groups iv. Does not rule out altruism (selflessness) m. Structure and independence of the European Central Bank

i. Patterned after the Federal Reserve ii. Central banks from each country play similar role as Fed banks iii. Executive Board 1. President, vice-president and four other members 2. Eight year, nonrenewable terms iv. Governing Council n. Differences Between the European System of Central Banks and the Federal Reserve System i. National Central Banks control their own budgets and the budget of the ECB ii. Monetary operations are not centralized iii. Does not supervise and regulate financial institutions o. How Independent is the ECB? i. Most independent in the world ii. Members of the Executive Board have long terms iii. Determines own budget iv. Less goal independent 1. Price stability v. Charter cannot by changed by legislation; only by revision of the Maastricht Treaty

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p. Structure and Independence of Other Foreign Banks i. Bank of Canada 1. Essentially controls monetary policy ii. Bank of England 1. Has some instrument independence. iii. Bank of Japan 1. Recently (1998) gained more independence iv. The trend toward greater independence Chapter 14: The Money Supply Process a. Three Players in the Money Supply Process i. Central bank (Federal Reserve System) ii. Banks (depository institutions; financial intermediaries) iii. Depositors (individuals and institutions) b. The Fed’s Balance Sheet i. Federal Reserve System ii. Assets

iii. Liabilities

iv. Securities

v. Currency in circulation (outside banks)

vi. Loans to Financial Institutions

vii. Reserves (vault cash and deposits at Fed)

viii. Monetary base – The Sum of the Fed’s monetary liabilities and the US Treasury’s liabilities ix. Liabilities 1. Currency in circulation: in the hands of the public 2. Reserves: bank deposits at the Fed and vault cash x. Assets 1. Government securities and other financial assets: holdings by the Fed that affect money supply and earn interest 2. Discount loans: provide reserves to banks and earn the discount rate c. Control of the Monetary Basis i.

ii. MB or High-powered money 1. All items in MB are usable as reserves if the banks can get them. They are called high-powered because each dollar in MB can create many dollars of money supply d. Federal Reserve Open Market Operations i. Open Market Purchase from a Bank

Banking System Assets

Liabilities

Securities

$100m

Reserves

+$100m Federal Reserve System

Assets Securities

Liabilities +$100m Reserves

+$100m

1. Net result is that reserves have increased by $100 2. No change in currency 3. Monetary base has risen by $100 ii. Open Market Purchase from the Nonbank Public

1. Person selling bonds to the Fed deposits the Fed’s check in the bank 2. Identical result as the purchase from a bank Nonbank Public Assets

Federal Reserve System Liabilities

Securities

-$100m

Currency

+$100m

Assets Securities

Liabilities +$100m

Currency in circulation

3. The person selling the bonds cashes the Fed’s check 4. Reserves are unchanged 5. Currency in circulation increases by the amount of the open market purchase 6. Monetary base increases by the amount of the open market purchase 7. The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits

+$100m

8. The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency iii. Open market Sale Nonbank Public

Federal Reserve System

Assets

Liabilities

Securities

+$100m

Currency

-$100m

Assets Securities

Liabilities -$100m

Currency in circulation

1. Reduces the monetary base by the amount of the sale 2. Reserves remain unchanged 3. The effect of open market operations on the monetary base is much more certain than the effect on reserves e. Shifts from Deposits into Currency

i. Net effect on monetary liabilities is zero; Reserves are changed by random fluctuations; Monetary base is a more stable variable

-$100m

f. Loans to Financial Institutions

i. Monetary liabilities of the Fed have increased by $100 ii. Monetary base also increases by this amount g. Other Factors that Affect the Monetary Base i. Treasury deposits at the Federal Reserve ii. Interventions in the foreign exchange market (Fed can buy or sell foreign exchange—changes its assets and liabilities) iii. Float – the temporary net increase in the total amount of reserves in the banking system occurring from the Fed’s check-clearing process

h. Overview of the Fed’s Ability to Control the Monetary base i. Open market operations are controlled by the Fed ii. The Fed cannot determine the amount of borrowing by banks from the Fed iii. Borrowed Reserves – the nonborrowed monetary base that is formally defined as the monetary base minus borrowings from the Fed iv. Split the monetary base into two components 1. MBn= MB - BR v. The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Fed vi. Although Float and Treasury deposits with the Fed undergo substantial short-run fluctuations, which complicate control of the monetary base, they do not prevent the Fed from accurately controlling it i. Multiple Deposit Creation: A Simple Model i. Multiple Deposit Creation – When the Fed supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount ii. Deposit Creation: Single Bank

1. Excess reserves increase; Bank loans out the excess reserves; Creates a checking account; Borrower makes purchases; The Money supply has increased 2. As a result, a bank cannot safely make a loan for an amount greater than the excess reserves it has before it makes a loan

iii. The Banking System

1. Whether a bank chooses to use its excess reserves to make loans or purchase securities, the effect on deposit expansion is the same 2. Simple Deposit Multiplier – the multiple increase in deposits generated from an increase in the banking system’s reserves

3. Deriving the Formula for Multiple Deposit Creation a.

4. Critique of the Simple Model a. Holding cash stops the process b. Currency has no multiple deposit expansion

c. Banks may not use all of their excess reserves to buy securities or make loans. d. Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change. j. Factors that Determine the Money Supply i. Changes in the Nonborrowed Monetary Base, MBn 1. The Money supply is positively related to the nonborrowed monetary base MBn ii. Changes in Borrowed Reserves, BR, from the Fed 1. The Money supply is positively related to the level of borrowed reserves, BR, from the Fed iii. Changes in the Required Reserve Ratio, rr 1. The money supply is negatively related to the required reserve ratio rr iv. Changes in Currency holdings 1. The money supply is negatively related to currency holdings v. Changes in Excess reserves 1. The money supply is negatively related to the amount of excess reserves

k. The Money Multiplier i. Money Multiplier – tells us how much the money supply changes for a given change in the monetary base 1. The relationship between the money supply M, the money multiplier, and the monetary base is described by: a. M = m x MB ii. Deriving the Money Multiplier (M1 multiplier) 1. Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D. 2. Then, c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio 3.

4.

ves (R):

MB = C + R = C + (r x D) + ER 5. Equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.

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iii. Intuition behind the Money Multiplier

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l. Application: The Great Depression Bank Panics, 1930–1933, and the Money Supply i. Bank failures (and no deposit insurance) determined: 1. Increase in deposit outflows and holding of currency (depositors) 2. An increase in the amount of excess reserves (banks) ii. For a relatively constant MB, the money supply decreased due to the fall of the money multiplier. m. Application: The 2007-2009 Financial Crisis and the Money Supply

i. During the recent financial crisis, as shown in Figure 4, the monetary base more than tripled as a result of the Fed's purchase of assets and new lending facilities to stem the financial crisis

ii. Figure 5 shows the currency ratio c and the excess reserves ratio e for the 2007-2009 period. We see that the currency ratio fell somewhat during this period, which our money supply model suggests would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion. However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e

III.

Chapter 15: Tools of Monetary Policy a. The Market for Reserves and the Federal Funds Rate i. The market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the level of the federal funds rate 1. Federal Funds Rate – the interest rate changed on the loans of these reserves ii. Excess reserves are insurance against deposit outflows 1. The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ier b. Demand in the Market for Reserves i. Since the fall of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target. ii. When the federal funds rate is above the rate paid on excess reserves, ier, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises iii. Downward sloping demand curve that becomes flat (infinitely elastic) at ier c. Supply in the Market for Reserves i. Two components: non-borrowed and borrowed reserves ii. Cost of borrowing from the Fed is the discount rate iii. Borrowing from the Fed is a substitute for borrowing from other banks iv. If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero 1. iff – federal funds rate 2. id – discount rate v. The supply curve will be vertical vi. As iff rises above id, banks will borrow more and more at id, and re-lend at iff vii. The supply curve is horizontal (perfectly elastic) at id

d. Equilibrium in the Market for Reserves

e. How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate i. Effects of an open market operation depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section. ii. An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward sloped section). iii. Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve. iv. If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate. v. If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate vi. When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.

f. Response to an Open Market Operation

g. Response to a Change in the Discount Rate

h. Response to a Change in Required Reserves

i. Response to a Change in the Interest Rate on Reserves

i. When the federal funds rate is at the interest rate paid on reserves, a rise in the interest rate on reser...