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Chapter 27

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

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  1. Chapter 27 The Federal Reserve System and Monetary Policy Gottheil — Principles of Economics, 7e

  2. 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, 7e

  3. Economic Principles • Money supply versus interest rate targets • Countercyclical monetary policy Gottheil — Principles of Economics, 7e

  4. 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, 7e

  5. 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, 7e

  6. 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, 7e

  7. 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, 7e

  8. 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, 7e

  9. 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, 7e

  10. 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, 7e

  11. 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, 7e

  12. 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, 7e

  13. 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, 7e

  14. 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, 7e

  15. 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, 7e

  16. 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, 7e

  17. 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, 7e

  18. 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, 7e

  19. 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, 7e

  20. EXHIBIT 2 THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM Gottheil — Principles of Economics, 7e

  21. 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, 7e

  22. EXHIBIT 3 NATIONAL BANKS AND STATE BANKS 2011 Source: Federal Deposit Insurance Corporation, Institution Directory, 2011 (Washington, D.C.: FDIC, 2011). Gottheil — Principles of Economics, 7e

  23. Exhibit 3: National Banks and State Banks 2011 How many banks are chartered nationally? Of the 7,519 banks in the country, fewer than 1,400 are chartered nationally. Gottheil — Principles of Economics, 7e

  24. Exhibit 3: National Banks and State Banks 2011 How many state-chartered banks are members of the Fed? Of the 4214 state-chartered banks in the country, 816 banks are members of the Federal Reserve System. Gottheil — Principles of Economics, 7e

  25. 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, 7e

  26. 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, 7e

  27. 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, 7e

  28. 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, 7e

  29. EXHIBIT 5 IDENTIFYING LETTERS AND DISTRICT BANKS Gottheil — Principles of Economics, 7e

  30. 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, 7e

  31. The Federal Reserve System Discount rate • The interest rate the Fed charges banks that borrow reserves from it. Gottheil — Principles of Economics, 7e

  32. EXHIBIT 6 BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE Gottheil — Principles of Economics, 7e

  33. 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, 7e

  34. EXHIBIT 7A FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP Gottheil — Principles of Economics, 7e

  35. EXHIBIT 7B FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP Gottheil — Principles of Economics, 7e

  36. EXHIBIT 7C FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP Gottheil — Principles of Economics, 7e

  37. 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, 7e

  38. Controlling the Money Supply Countercyclical monetary policy • Policy directives used by the Fed to moderate swings in the business cycle. Gottheil — Principles of Economics, 7e

  39. 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, 7e

  40. 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, 7e

  41. 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, 7e

  42. EXHIBIT 9 CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN Gottheil — Principles of Economics, 7e

  43. 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, 7e

  44. 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, 7e

  45. 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, 7e

  46. 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, 7e

  47. EXHIBIT 10 CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED Gottheil — Principles of Economics, 7e

  48. 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, 7e

  49. 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, 7e

  50. 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, 7e

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