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Chapter 27. The Federal Reserve System and Monetary Policy. Economic Principles. The Federal Reserve System as a central bank The discount rate as a tool of monetary policy Open market operations as a tool of monetary policy. Economic Principles. Money supply versus interest rate targets

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chapter 27

Chapter 27

The Federal Reserve System and Monetary Policy

Gottheil — Principles of Economics, 6e

economic principles
Economic Principles
  • The Federal Reserve System as a central bank
  • The discount rate as a tool of monetary policy
  • Open market operations as a tool of monetary policy

Gottheil — Principles of Economics, 6e

economic principles1
Economic Principles
  • Money supply versus interest rate targets
  • Countercyclical monetary policy

Gottheil — Principles of Economics, 6e

a glimpse at history
A Glimpse at History

Bank note

  • A promissory note, issued by a bank, pledging to redeem the note for a specific amount of gold or silver. The terms of redemption are specified on the note.

Gottheil — Principles of Economics, 6e

a glimpse at history1
A Glimpse at History

In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies.

Gottheil — Principles of Economics, 6e

a glimpse at history2
A Glimpse at History

The first real U.S. money was the Continental Note.

  • Since Congress had no taxing authority, it printed Continental Notes to finance the Revolution.
  • Excessive printing rendered the Continental Note nearly useless.

Gottheil — Principles of Economics, 6e

a glimpse at history3
A Glimpse at History

State-chartered bank

  • A commercial bank that receives its charter or license to function from a state government and is subject to the laws of that state.

Gottheil — Principles of Economics, 6e

slide8

EXHIBIT 1 GROWTH OF STATE BANKS: 1784–1860 ($ MILLIONS)

Source: U.S. Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, D.C.: U.S. Government Printing Office, 1949,) pp. 261–263.

Gottheil — Principles of Economics, 6e

exhibit 1 growth of state banks 1784 1860 millions
Exhibit 1: Growth of State Banks: 1784-1860 ($ millions)

What are some reasons for the rapid growth of state banks?

  • The money supply was inadequate to finance the growing number of farms, factories, and businesses.

Gottheil — Principles of Economics, 6e

a glimpse at history4
A Glimpse at History

Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government.

Gottheil — Principles of Economics, 6e

a glimpse at history5
A Glimpse at History
  • Congress accepted Hamilton’s plan and created the First Bank of the United States in 1791.
  • This central bank dampened the inclination of state-chartered banks to overissue notes by demanding that the notes be redeemed in silver and gold.

Gottheil — Principles of Economics, 6e

a glimpse at history6
A Glimpse at History

Nationally chartered bank

  • A commercial bank that receives its charter from the comptroller of the currency and is subject to federal law as well as the laws of the state in which it operates.

Gottheil — Principles of Economics, 6e

a glimpse at history7
A Glimpse at History

When the 20-year charter of the First Bank of the U.S. expired in 1811, advocates of states’ rights in Congress prevailed, and the charter was not renewed.

Gottheil — Principles of Economics, 6e

a glimpse at history8
A Glimpse at History

In 1816 Congress created the Second Bank of the U.S., which again stabilized state banking practices. As with the First Bank, however, political pressure led to the failure of Second Bank of the U.S. in the 1830s.

Gottheil — Principles of Economics, 6e

a glimpse at history9
A Glimpse at History

During the Civil War, Congress passed the National Bank Act, which created a national banking system and the office of the comptroller of the currency, which chartered national banks.

Gottheil — Principles of Economics, 6e

a glimpse at history10
A Glimpse at History

National banks had to buy Treasury Bonds equal to one-third of their capital, and could issue notes only in proportion to their Treasury bond holdings.

Gottheil — Principles of Economics, 6e

a glimpse at history11
A Glimpse at History

In 1907 the highly respected Knicker-bocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913.

Gottheil — Principles of Economics, 6e

the federal reserve system
The Federal Reserve System

The Federal Reserve Act of 1913 created the Federal Reserve System (the “Fed”). The Fed has 12 regional district banks that serve as the region’s central bank.

Gottheil — Principles of Economics, 6e

the federal reserve system1
The Federal Reserve System

Does the president of the U.S. control the Fed?

  • No. Although the Fed was created by and responsible to Congress, the Fed pursues an independent monetary policy that at times may conflict with policies pursued by the president or Congress.

Gottheil — Principles of Economics, 6e

slide20

EXHIBIT 2 THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM

Gottheil — Principles of Economics, 6e

exhibit 2 the geography of the federal reserve system
Exhibit 2: The Geography of the Federal Reserve System
  • In what Federal Reserve Bank district do you live?
  • What is the reserve bank city for your district?

Gottheil — Principles of Economics, 6e

slide22

EXHIBIT 3 NATIONAL BANKS, STATE BANKS, AND TOTAL DEPOSITS ($ BILLIONS)

Source: Federal Deposit Insurance Corporation, Statistics on Banking, 2000 (Washington, D.C.: FDIC, 2000).

Gottheil — Principles of Economics, 6e

exhibit 3 national banks state banks and total deposits
Exhibit 3: National Banks, State Banks, and Total Deposits

Of the following, which had the largest number of banks in 2000?

a. National banks

b. State banks (Fed member)

c. Savings institutions

Gottheil — Principles of Economics, 6e

exhibit 3 national banks state banks and total deposits1
Exhibit 3: National Banks, State Banks, and Total Deposits

Of the following, which had the largest number of banks in 2000?

a. National banks

b. State banks (Fed member)

c. Savings institutions

Gottheil — Principles of Economics, 6e

slide25

EXHIBIT 4 ORGANIZATIONAL STRUCTURE OF THE FEDERAL RESERVE SYSTEM

Source: Board of Governors of the Federal Reserve System, Division of Support Services, Purposes & Functions, 1984.

Gottheil — Principles of Economics, 6e

exhibit 4 organizational structure of the federal reserve system
Exhibit 4: Organizational Structureof the Federal Reserve System

What is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)?

  • The Board of Governors

Gottheil — Principles of Economics, 6e

the federal reserve system2
The Federal Reserve System

The Fed’s main charge is to safeguard the proper functioning of our monetary system (money supply, interest rates, and the economy’s price level).

Gottheil — Principles of Economics, 6e

the federal reserve system3
The Federal Reserve System

Federal Open Market Committee

  • The Fed’s principal decision-making body, charged with executing the Fed’s open market operations.

Gottheil — Principles of Economics, 6e

slide29

EXHIBIT 5 IDENTIFYING LETTERS AND DISTRICT BANKS

Gottheil — Principles of Economics, 6e

exhibit 5 identifying letters and district banks
Exhibit 5: Identifying Letters and District Banks

If you look at the seal to the left of George Washington’s picture on a $1 bill and see the letter “L,” in what district bank was that $1 bill issued?

  • San Francisco

Gottheil — Principles of Economics, 6e

the federal reserve system4
The Federal Reserve System

Discount rate

  • The interest rate the Fed charges banks that borrow reserves from it.

Gottheil — Principles of Economics, 6e

slide32

EXHIBIT 6 BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE

Gottheil — Principles of Economics, 6e

exhibit 6 bank transactions triggered by brian s purchase
Exhibit 6: Bank Transactions Triggered by Brian’s Purchase

Why does Brian’s check go to the Atlanta Fed and the Cleveland Fed?

  • One of the functions of a district Fed is to clear checks.

Gottheil — Principles of Economics, 6e

slide34

EXHIBIT 7A FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

Gottheil — Principles of Economics, 6e

slide35

EXHIBIT 7B FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

Gottheil — Principles of Economics, 6e

slide36

EXHIBIT 7C FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

Gottheil — Principles of Economics, 6e

exhibit 7 from changes in the money supply to changes in real gdp
Exhibit 7: From Changes in the Money Supply to Changes in Real GDP

How does an increase in the money supply lead to an increase in real GDP?

  • Increasing the money supply leads to lower interest rates, which promotes increased investment spending, which increases aggregate demand.

Gottheil — Principles of Economics, 6e

controlling the money supply
Controlling the Money Supply

Countercyclical monetary policy

  • Policy directives used by the Fed to moderate swings in the business cycle.

Gottheil — Principles of Economics, 6e

controlling the money supply1
Controlling the Money Supply

Reserve requirement

  • The minimum amount of reserves the Fed requires a bank to hold, based on a percentage of the bank’s total deposit liabilities.

Gottheil — Principles of Economics, 6e

slide40

EXHIBIT 8 RESERVE REQUIREMENTS (JULY 2006)

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., July 2000).

Gottheil — Principles of Economics, 6e

exhibit 8 reserve requirements july 2006
Exhibit 8: Reserve Requirements (July 2006)

Do reserve requirements imposed by the Fed depend on the bank’s total deposits?

  • Yes. Banks with more than $42.8 million in checking account balances must hold 10 percent of those deposits on reserve. Smaller banks only need to hold 3 percent of checking account balances on reserve.

Gottheil — Principles of Economics, 6e

slide42

EXHIBIT 9 CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN

Gottheil — Principles of Economics, 6e

exhibit 9 change in the dallas fed s accounts after providing a 5 000 loan to pfn
Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN

If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply?

  • Money held by the Fed is not counted in the money supply.

Gottheil — Principles of Economics, 6e

exhibit 9 change in the dallas fed s accounts after providing a 5 000 loan to pfn1
Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN

If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply?

  • Money held by the Fed is not counted in the money supply.
  • PFN can loan out much of the money it borrowed from the Fed.

Gottheil — Principles of Economics, 6e

controlling the money supply2
Controlling the Money Supply

Federal funds market

  • The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight.

Gottheil — Principles of Economics, 6e

controlling the money supply3
Controlling the Money Supply

1. If a private bank has $5,000 in new reserves and the reserve requirement is 20 percent, then what is the maximum amount of new money supply that can be created from this $5,000?

  • $5,000 × (1/0.2) = $25,000.

Gottheil — Principles of Economics, 6e

slide47

EXHIBIT 10 CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED

Gottheil — Principles of Economics, 6e

exhibit 10 change in pfn s accounts after receiving a 5 000 loan from the dallas fed
Exhibit 10: Change in PFN’s Accounts after Receiving a $5,000 Loan from the Dallas Fed

If the Dallas Fed loans money to a private bank such as PFN, does this generate a liability for PFN?

  • Yes. The liability is the borrowed money that PFN owes to the Fed.

Gottheil — Principles of Economics, 6e

slide49

EXHIBIT 11 FEDERAL RESERVE BANK OF NEW YORK DISCOUNT RATES: 1990–2008 (selected dates)

Source: Federal Reserve Bank, New York, July 2008.

Gottheil — Principles of Economics, 6e

exhibit 11 federal reserve bank of new york discount rates 1990 2008
Exhibit 11: Federal Reserve Bank of New York Discount Rates, 1990–2008

What was the lowest discount rates charged by the New York Fed, and when did that take place?

  • The New York Fed charged .75 percent on November 6, 2002.

Gottheil — Principles of Economics, 6e

controlling the money supply4
Controlling the Money Supply

Federal funds rate

  • The interest rate on loans made by banks in the federal funds market.

Gottheil — Principles of Economics, 6e

controlling the money supply5
Controlling the Money Supply

Open market operations

  • The buying and selling of government bonds by the Federal Open Market Committee.

Gottheil — Principles of Economics, 6e

controlling the money supply6
Controlling the Money Supply

2. If the Fed wanted to reduce the money supply, would it purchase or sell government securities?

  • It would sell government securities. Money used to buy the securities from the Fed would leave the money supply.

Gottheil — Principles of Economics, 6e

slide54

EXHIBIT 12 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM PFN ($ millions)

Gottheil — Principles of Economics, 6e

exhibit 12 change in the fed s accounts after buying 10 million of securities from pfn
Exhibit 12: Change in the Fed’s Accounts after Buying $10 Million of Securities from PFN

What was the change in the Fed’s liabilities after buying $10 million of securities from PFN?

  • The Fed’s liabilities increased by $10 million due to a $10 million increase in PFN’s reserve.

Gottheil — Principles of Economics, 6e

slide56

EXHIBIT 13 CHANGE IN PFN’S ACCOUNTS AFTER SELLING $10 MILLION OF SECURITIES TO THE FED ($ millions)

Gottheil — Principles of Economics, 6e

exhibit 13 change in pfn s accounts after selling 10 million of securities to the fed
Exhibit 13: Change in PFN’s Accounts after Selling $10 Million of Securities to the Fed

If the Fed buys $10 million of securities from PFN, how much of the proceeds from this sale can PFN loan out?

  • PFN can loan out all $10 million because these represent excess reserves.

Gottheil — Principles of Economics, 6e

slide58

EXHIBIT 14 CHANGE IN PFN’S ACCOUNTS AFTER MARIA SELLS $10 MILLION OF SECURITIES ($ millions)

Gottheil — Principles of Economics, 6e

exhibit 14 change in pfn s accounts after maria sells 10 million of securities
Exhibit 14: Change in PFN’s Accounts after Maria Sells $10 Million of Securities

Suppose that the Fed bought $10 million of securities from a private individual (Maria) rather than from PFN. Would this still increase the money supply?

  • Yes, but not by as much. If she deposits the check at the bank, the bank can loan out only $8 million of the new demand deposit. The other $2 million are required reserves.

Gottheil — Principles of Economics, 6e

slide60

EXHIBIT 15 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM MARIA ($ MILLIONS)

Gottheil — Principles of Economics, 6e

exhibit 15 change in the fed s accounts after buying 10 million of securities from maria
Exhibit 15: Change in the Fed’s Accounts after Buying $10 Million of Securities from Maria

If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?

  • The Fed’s assets increase by $10 million because it owns more securities.

Gottheil — Principles of Economics, 6e

exhibit 15 change in the fed s accounts after buying 10 million of securities from maria1
Exhibit 15: Change in the Fed’s Accounts After Buying $10 Million of Securities from Maria

If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?

  • The Fed’s assets increase by $10 million because it owns more securities.
  • The Fed’s liabilities increase by $10 million from clearing the check for PFN.

Gottheil — Principles of Economics, 6e

slide63

EXHIBIT 16 CHANGE IN PFN’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES ($ MILLIONS)

Gottheil — Principles of Economics, 6e

exhibit 16 change in pfn s accounts after buying 10 million of securities
Exhibit 16: Change in PFN’s Accounts after Buying $10 Million of Securities

What happens to the money supply as a consequence of the transaction shown in Exhibit 16?

  • By selling securities to PFN, the Fed reduces PFN’s reserves by $10 million. PFN is no longer in a position to loan that $10 million, which reduces the money supply.

Gottheil — Principles of Economics, 6e

slide65

EXHIBIT 17 THE FED’S TARGET OPTIONS

Gottheil — Principles of Economics, 6e

exhibit 17 the fed s target options
Exhibit 17: The Fed’s Target Options

If Fed targets the money supply, as in Panel a, what countercyclical policy is no longer available to the Fed?

  • The Fed can no longer control the interest rate, since the interest rate depends on the positioning of the demand for money.

Gottheil — Principles of Economics, 6e

controlling the interest rate the fed s alternative target option
Controlling the Interest Rate: The Fed’s Alternative Target Option
  • If the Fed targets the money supply, it cannot at the same time control the interest rate.
  • Likewise by choosing to target the interest rate, the Fed loses control over the money supply.

Gottheil — Principles of Economics, 6e

controlling the interest rate the fed s alternative target option1
Controlling the Interest Rate: The Fed’s Alternative Target Option

The Fed’s countercyclical monetary policy works either way, by changing interest rates or by changing the money supply.

Gottheil — Principles of Economics, 6e

past fed governor martha seger describes how the fomc works
Past Fed Governor Martha Seger Describes How the FOMC Works

According the Honorable Martha Seeger, what is the biggest difference between the Fed as textbook writers describe it, and how it really is?

  • It is much more difficult for the Fed to make decisions than the process described by textbook writers.

Gottheil — Principles of Economics, 6e

controlling the interest rate the fed s alternative target option2
Controlling the Interest Rate: The Fed’s Alternative Target Option

Margin requirements

  • The maximum percentage of the cost of a stock that can be borrowed from a bank or any other financial institution, with the stock offered as collateral.

Gottheil — Principles of Economics, 6e

the fed s countercyclical monetary policy
The Fed’s CountercyclicalMonetary Policy

Why is the Fed a “reluctant” regulator?

  • The Fed’s 2008 bailout of the government-run Fannie and Freddie as well private investment banks forced the Fed to request regulatory authority from Congress to oversee these bailouts.

Gottheil — Principles of Economics, 6e

slide72

EXHIBIT 18 THE FED’S COUNTERCYCLICAL OPERATIONS

Gottheil — Principles of Economics, 6e

exhibit 18 the fed s countercyclical operations
Exhibit 18: The Fed’s Countercyclical Operations

What countercyclical Fed policies are used during the recovery and prosperity phase of the business cycle?

  • Containment of the money supply by raising reserve requirements, raising the discount rate, or selling bonds on the open market.

Gottheil — Principles of Economics, 6e

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