Chapter 13. The Federal Reserve System: Pre-Class & In-Class Activities Packet Name/I.D. Number: _______________________________________________________________ Section:____________ Date: _________ ______ 2. What are the differences between the Fed and the U.S. Treasury? __________________________________________________________ ___________ ____________________________________________________________________________________________________________________________ 4. Explain how an open market sale decreases the money supply._______________________________________________________________ __ ___________________________________________________________________________________________________________________________________ 6. Explain how a decrease in the required reserve ratio increases the money supply. _________________________________________ ____________________________________________________________________________________________________________________________ 8. The Fed can change the discount rate directly and the federal funds rate indirectly. Explain._____________________________ _____________________ ____________________________________________________________________________________________________________________________ 10. Explain how market forces would determine the money supply under free banking.___________________________________________ _____________ ____________________________________________________________________________________________________________________________

ECONOMICS ROGER A. ARNOLD THIRTEEN EDITION

CHAPTER 13 The Federal Reserve System > Controlling the Money Supply The Federal > Open Market Operations Reserve System > The Required Reserve Ratio ECONOMICS INTHISLECTURE > The Discount Rate and Overnight Loans The Federal Funds Rate Target CH 13 . 2 STRUCTURE OF THE FED FEDERAL RESERVE DISTRICTS AND FEDERAL RESERVE BANK LOCATIONS Board of Governors - The governing body of the Federal Reserve System. Federal Open Market Committee (FOMC) -The 12-member policymaking group within the Fed. The committee has the authority to conduct open market operations. Open Market Operations - The buying and selling of government securities by the Fed. BOARD OF GOVERNORS FEDERAL OPEN MARKET COMMITTEE I Board of Governors coordinates and controls - The Federal Open Market the activities of the Federal Reserve System. The board members serve 14-year terms and Committee (FOMC) is the major are appointed by the President with Senate policymaking group within the Fed. approval. Authority to conduct open market To limit political influence on Fed policy, the operations-the buying and selling of terms of the governors are staggered-with one new appointment every other year- so a government securities-rests with the president cannot "pack" the board. FOMC. The President also designates one member as The FOMC has 12 members: the 7- chairman of the board for a 4-year term. member Board of Governors and 5 Federal Reserve District Bank presidents.2 / 8 150% + FEDERAL OPEN MARKET COMMITTEE II MONETARY POLICY The president of the Federal Reserve . Changes in the money supply, or in the Bank of New York holds a permanent rate of change of the money supply, to seat on the FOMC because a large achieve particular macroeconomic amount of financial activity takes place PRESIDENT'S SIGNATURE in New York City and because the New ENACTS CURRENCY LAW York Fed is responsible for executing gon Dedianes If The First of Series of open market operations. President Wilson signs the The other four positions are rotated Federal Reserve Act on among the Federal Reserve District December 23, 1913. Bank presidents. CH 13 + 7 FUNCTIONS OF THE FED THE CHECK CLEARING PROCESS Control the money supply Supply the economy with paper money (Federal Reserve notes) Ursula and her Provide check clearing services Harry and Unuts Los Angeles Bank nd the Federal Res Both of San Francisco Sen Diego Bank Hold depository institutions' reserves Sburg Sar wat : 31,009 Supervise member banks San Francisco, which > Serve as the government's banker > Serve as the lender of last resort account of the San Diego Handle the sale of U.S Treasury Securities (Bills, notes, and bonds) CH 13 - 10 FED VS. U.S. TREASURY 1. The president of which Federal Reserve District Bank holds a permanent seat on the Federal Open Market Committee The U.S. Treasury is a budgetary agency; the Fed is a (FOMC)? monetary agency. When the federal government spends funds, the Treasury collects the taxes and borrows the funds SELFTEST needed to pay suppliers and others. In short, the Treasury has an obligation to manage the financial Federal Reserve Bank of New York. affairs of the federal government. Except for coins, the Treasury does not issue money. It cannot create money out of thin air as the Fed can. The Fed is principally concerned with the availability of money and credit for the entire economy. It does not issue Treasury securities. It does not have an obligation to meet the financial needs of the federal government. Its responsibility is to provide a stable monetary framework for the economy. 041 12 . 119 3 / 8 150% 2. What is the most important responsibility of the Fed? 3. What does it mean to say the Fed acts as "lender of last resort"? The Fed controls the money supply. SELFTEST SELFTEST Acting as the lender of last resort means the Fed stands ready to lend funds to banks that are suffering cash management, or liquidity, problems. CH 13 - 13 OF 3 - 14 REVIEW OF RESERVES, REQUIRED TOOLS FOR INCREASING AND RESERVES, AND EXCESS RESERVES DECREASING THE MONEY SUPPLY 1. A bank's reserves equal its bank deposits at the Fed (the balance in its reserve account at the Fed) plus its vault Open Market Operations cash. - Required Reserve Ratio Reserves = Bank deposits at the Fed + Vault cash - Discount Rate 2. A bank's required reserves are equal to the required reserve ratio (r) times its checkable deposits. Required reserves = r x Checkable deposits 3. A bank's excess reserves equal its reserves minus its required reserves. Excess reserves = Reserves - Required reserves The Federal Reserve Board I. A bank can use its excess reserves to create new loans To visit the Fed's web site, click above. CHU . 15 T -ACCOUNT OPEN MARKET OPERATIONS A REMINDER Open Market Purchase - The buying of . A simplified balance sheet that shows U.S. government securities by the Fed the changes in a bank's assets and Open Market Sale - The selling of U.S liabilities. government securities by the Fed1 8 150% + MONEY SUPPLY CREATION PROCESS MONEY SUPPLY CREATION PROCESS II We start with the definition of the MI money supply: For now we are going to assume that the entire $10,000 in MI - Currency held outside banks + Checkable deposits + checkable deposits is held in one bank: bank A. Traveler's checks We will also assume that the required reserve ratio is 10 percent Let's suppose that checkable deposits are $10,000 and that the and that bank A is currently holding $1,000 in required reserves other two components of the money supply equal $0. It follows and no excess reserves. Here is the relevant part of the balance that the money supply is $10,000. sheet for bank A: . Money supply - $10,000 Bank A Assets Liabilities Reserves $1,000 Checkable Deposits $10,000 Loans $9,000 CH 13 . 20 MONEY SUPPLY CREATION PROCESS III MONEY SUPPLY CREATION PROCESS IV The Fed conducts an open market purchase, which is The balance sheet for bank A shows $1,500 in reserves and $10,000 in a type of open market operation; specifically, it buys checkable deposits. If the required reserve ratio is 10 percent, bank A is required to hold only $1,000 in reserves. So bank A has $500 in excess government securities from a bank. reserves. In this example it buys $500 worth of government Suppose bank A takes the entire $500 in excess reserves and creates a loan for Jill. Specifically, it grants Jill a $500 loan in the form of a new securities from bank A. Bank A turns over the checkable deposit with a balance of $500. In other words, instead of government securities to the Fed, and, in return, the giving Jill $500 in currency, bank A simply tells Jill that she now has Fed must pay bank A $500. checkable deposit (a checking account) with the bank and that the balance in the account is $500. Bank A Assets Liabilities Reserves $1.500 Checkable Deposits $10,000 Loans 39.000 OF18 - 21 CH 13 - 22 MONEY SUPPLY CREATION PROCESS V MONEY SUPPLY CREATION PROCESS VI The money supply is now $10,500 Bank B now has $500 that it didn't have previously, increasing Jill now takes the $500 loan from bank A (in the form of a its reserves (assets) by $500 and liabilities (checkable new checkable deposit) and spends it. Specifically, she deposits) by $500. Bank B's balance sheet shows $500 in reserves and $500 in checkable deposita. writes a check for $500 to Joe for the materials she buys from him. Joe then takes the $500 (he received from Jill) But if the required reserve ratio is 10 percent, bank B is required to and deposits the full amount into his checking account at hold only $50 in reserves. B bank B. The situation for bank B looks like this: Bank B uses the entire $450 in excess reserves to create a loan of $450 for Jamal in the form of a checkable deposit, I cable deposit, In other words, Bank B bank B creates a new checkable deposit of $450. Assets Liabilities Reserves $500 Checkable Deposits $500 (joe's account) And the process continues See the next slide Join . 25 /8 150% + THE BANKING SYSTEM CREATES MONEY SUPPLY CONTRACTION CHECKABLE DEPOSITS (MONEY) PROCESS I Creation of New Checoche Deport . For now we are going to assume that the entire $10,000 in checkable deposits is held in one bank: bank A. () Biris told zero oxen rear Top 5500 increase in reserves for bank A as a rest of Feds open market purchase . We will also assume that the required reserve ratio is 10 percent Increase in New Required New Checkable Deposits Created by and that bank A is currently holding $1,000 in required reserves Bank Checkable Deposits Reserves Extending New Loans and no excess reserves. Here is the relevant part of the balance sheet for bank A: Bank A Assets Liabilities 4050 Reserves $1,0CO Checkable Deposits $10,000 Loans $9,000 01 13 - 25 CH J . 26 MONEY SUPPLY CONTRACTION CILMONEY SUPPLY CONTRACTION PROCESS II PROCESS III . The Fed conducts an open market sale, which is a type of open Reserves for bank A have gone from $1,000 to $600. market operation; specifically, it sells government securities to a Given that checkable deposits are $10,000, bank A is bank. reserve deficient. If the required reserve ratio is 10 In this example it sells $400 worth of government securities to percent, bank A is required to hold $1,000 in reserves bank A. The Fed turns over the government securities to the $10,000 0.10) . But after the open market sale, bank Bank A, and, in return, the Fed receives $400 from Bank A. A is holding only $600 in reserves, and so it is reserve deficient by $400. Bank A Assets Liabilities Reserves $600 Checkable Deposits $10.000 Loans $9,000 CHMONEY SUPPLY CONTRACTION OPEN MARKET OPERATIONS PROCESS IV . When a bank is reserve deficient", it can do a number of things: It can (1) try to get a loan from another bank; (2) try to get a How Open Market Operations Affect the Money Supply loan from the Fed; or (3) apply some of its loan repayments to the reserve deficiency position. In our example, it chooses Fed Purchase Increases Increases option 3. On the day bank A becomes reserve deficient, Harry of Government Securities Reserves Money walks into the bank and pays back the $400 loan he took out Supply months ago. Because the bank is reserve deficient, it keeps the $400 as Fed Sale Decreases reserves. As a result, checkable deposits decline by $400; so the of Government Decreases Money money supply declines by $400 to $9,600. from $10,000. Securities Heserves The situation that exists when a bank holds fewer reserves than pecified by the required reserve ratio.6/8 - 150% REQUIRED RESERVE RATIO WHY BANKS BORROW RESERVES The Fed rule that specifies the amount - To increase loan making ability of reserves a bank must hold to back up To meet required reserve deposits. requirements Maximum change in checkable deposits = (1/r) x AR (r=required reserve ratio; R = reserves) r - | in checkable deposits r - | in checkable deposits DH4 13 - 31 CHD - 12 THE DISCOUNT WINDOW AND THE FEDERAL FUNDS MARKET THE DISCOUNT WINDOW Discount Loan - A loan the Fed makes to a Fed sets discount rate below federal funds commercial bank. rate- Discount Rate - The interest rate the Fed charges depository institutions that borrow reserves from it; Banks borrow from Fed - the interest rate charged on a discount loan. Banks have more reserves - Federal Funds Rate - The interest rate in the federal Banks may make more loans and checkable funds market; the interest rate banks charge one deposits another to borrow reserves. Federal Funds Market - A market where banks lend Money supply rises reserves to one another, usually for short periods. FEDERAL FUNDS RATE TARGET FED MONETARY TOOLS AND THEIR EFFECTS ON THE MONEY SUPPLY . Normally, however, if the Fed wants to change the money supply, it takes two Fed Tools to change Money Supply measures: (1) It sets a federal funds rate target* and then (2) uses open market Open Atuber operations to change the federal funds rate so Required Flaserve Operation Discours Rune as to "hit" the target. pon Mark Open Atinn Lower " The interest rate that the Fed wants the federal funds market rate to be. Money Supply Money Supply Falls Of 13 . 25718 - 150% + TERM AUCTION FACILITY (TAF) RECENT FED ACTIONS DURING THE PROGRAM FINANCIAL CRISIS In this program, instead of banks asking for a EXTENDING THE LENDER-OF-LAST-RESORT FUNCTION BEYOND BANKS specific dollar loan (as in a discount loan), the As the lender of last resort for banks, the Fed ensures that banks can Fed first identifies the total amount of credit it obtain the funds they need. If a bank has financial problems, it can seek wants to extend (for example, $20 billion). funds from the Fed. During the financial crisis, the Fed extended its lender-of-last-resort function to institutions other than banks. Then it allows banks to bid on the funds. The BUYING SECURITIES FROM INSTITUTIONS OTHER THAN BANK bidding process determines the TAF rate During normal economic times, the Fed buys Treasury securities from (interest rate) for the loans. banks if it wants to increase reserves in the banking system to raise the money supply. During the financial crisis, the Fed not only bought securities from nonbank institutions, but often bought securities that were not Treasury issues. Often they were mortgage-backed securities that institutions owned that were declining in value. FREE BANKING 1. How does the money supply change as a result of (a) an increase in the discount rate, (b) an open market purchase, (c) an In today's world there is a central bank - The Fed. And as increase in the required reserve ratio? we know the Fed controls the money supply. But suppose there were no Fed. Who or what would then control the money supply. One option is free banking. SELFTEST a. The money supply falls. Under free banking monetary arrangement each b. The money supply rises. individual bank would issue its own currency (their own bank notes) based on, perhaps, commodity reserves. The c. The money supply falls. money supply would be determined by market forces; specifically the money supply would adjust (up or down) in response to changes in the public's demand for money 2. What is the difference 3 . If bank A borrows $10 million from bank B, what happens to the reserves in bank A? between the federal funds What happens in the banking system? rate and the discount rate? The federal funds rate is the interest Reserves in bank A rise; reserves in the SELFTEST rate that one bank charges another SELFTEST banking system remain the same (bank bank for a loan. The discount rate is B loses the reserves that bank A the interest rate that the Fed charges borrowed). a bank for a loan.8 /8 - 150% + 4. If bank A borrows $10 million WALL STREET JOURNAL from the Fed, what happens to the reserves in bank A? in The Wall Street Journal is a is a rich the banking system? source of information which provides real life examples of micro- and macro SELFTEST Reserves in bank A rise; reserves in the economic activities. Check today's banking system rise because there is issue to see the most current news. no offset in reserves for any other http://www.wsj.com bank