The Federal Reserve System and Open Market Operations

1. The Federal Reserve System and Open Market Operations

2. What Is the Federal Reserve System? The U.S. Money Supplies Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier How the Fed Controls the Money Supply The Federal Reserve and Systemic Risk Revisiting Aggregate Demand and Monetary Policy Who Controls the Fed? For applications, click here To Try it! questions To Video

4. Introduction • 2008—The worldwide financial system was in a crisis and banks and other financial institutions wanted to borrow more than $2 trillion. What could be done?

5. Introduction • Studying this chapter we learn… • What the Federal Reserve does and how. • What is meant by the money supply. • How the Fed is able to influence the money supply. • How the Fed has more influence over AD than anyone else.

6. What Is the Federal Reserve System? • As the Central Bank of the United States, the Fed… • can issue and create money. • is a Bank with two Customers. • It is the government’s bank. • Maintains the bank account of the U.S. Treasury. • It manages government borrowing. • Issuing, transferring, and redeeming of U.S. Treasury bonds, bill, and notes.

7. What Is the Federal Reserve System? • A Bank with two Customers • It is the banker’s bank. • Banks keep their own accounts at the Fed. • Banks can borrow from the Fed. • The Fed Also… • Regulates other banks. • Manages the nation’s payment system. • Protects financial consumers with disclosure regulations. • Most important function: Regulating the U.S. money supply.

8. The U.S. Money Supplies • Money is anything that is widely accepted as means of payment. • The most important assets that serve • as money in the U.S. today are: • Currency—Paper bills and coins. • Total reserves held by banks at the Fed. • Checkable deposits—your checking or debit account. • Savings deposits, money market mutual funds, and small-time deposits. Early U.S. Money: Continental “Third of a Dollar”

9. The U.S. Money Supply • Major Means of Payment in the U.S. (2010)

10. The U.S. Money Supplies • Money • Currency— Almost $900 billion or $3,000 per person. • A lot is held by people in other countries. • Panama, Ecuador, and El Salvador use the U.S. dollar as their official currency. • Dollars are held by others in unstable countries to protect their wealth. • Total reserves— All major banks have accounts at the Federal Reserve System. • Can be easily converted into currency.

11. The U.S. Money Supplies • Money • Checkable deposits— are deposits you can write checks on or can access with a debit card. • Savings accounts, Money Market Mutual Funds, Small-time deposits. • Not as liquid as the other means of payment. • Each can be used to pay for goods and services, but this requires a little extra effort.

12. The U.S. Money Supplies • Money • What is meant by a “liquid asset”? • Liquid asset: An asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments. • The money supply can be defined in different ways depending on exactly what kinds of liquid assets are included.

13. To next Try it! Which of the following assets would you classify as being most liquid? demand deposits small-time deposits a home gold bullion

14. The U.S. Money Supplies • Money • The three most important definitions of the money supply are: • The monetary base (MB):currency outstanding and total reserves at the Fed. • M1: currency outstanding and checkable deposits. • M2: M1 plus saving deposits, money market mutual funds, and small-time deposits.

15. The U.S. Money Supplies • The Money Pyramid

16. To next Try it! The monetary base (MB) refers to: currency. currency plus total reserves held at the Fed. currency plus checkable deposits. currency, savings deposits, money market mutual funds, and small time deposits.

17. The U.S. Money Supplies • Difficulty of Central Banking • The Fed has direct control only over the monetary base. • Uses control over MB to influence M1 and M2. • Problems: • M1 and M2 can shrink or grow independent of what the Fed does. • Aggregate demand can shrink or grow for other reasons than changes in M1 and M2.

18. Fractional Reserve Banking, Reserve Ratio, Money Multiplier • Fractional reserve banking: Asystem where banks hold only a fraction of deposits on reserve, lending the rest. • Causes the banking system to be able create money. • The amount of money created depends on… • The reserve ratio (RR): the fraction of deposits held on reserve:

19. Fractional Reserve Banking, Reserve Ratio, Money Multiplier • Fractional reserve banking • The reserve requirement is determined primarily by how liquid banks wish to be. • The Fed sets a minimum RR. • The money multiplier (MM): the amount the money supply expands with each dollar increase in reserves:

20. Fractional Reserve Banking, Reserve Ratio, Money Multiplier • How is money created? Fractional reserve banking, RR, and MM all work together to create money. • Suppose the Fed credits your banking account with an additional $1,000. • This increases reserves by $1,000. • If your bank’s RR is 10%, they will loan out $900 (90%) of your increased deposit. • Sam borrows the $900 and deposits it in his bank. Total ↑M = $1,900… or ($1,000 + $900)

21. Fractional Reserve Banking, Reserve Ratio, Money Multiplier • Money Creation • Assume Sam’s bank has the same RR (10%). They will loan out $810 (90%) of his increased deposit. Total ↑M = $2,710… or ($1,000 + $900 + $810) • The rippling process continues until the total change in the money supply is given by: • The ultimate change in the money supply = the original amount the Fed injected into the economy ($1,000) times the money multiplier.

22. To next Try it! Suppose the reserve ratio is 20% for all banks. If the Fed increases bank reserves by $200, then the money supply will: decrease by $400. increase by $400. decrease by $1,000. increase by $1,000.

23. How the Fed Controls the Money Supply • Three Major Tools the Fed Uses to Control the Money Supply • Open market operations: buying and selling of U.S. government bonds on the open market. • Discount ratelending and the term auction facility—Federal Reserve lending to banks and other financial institutions. • Required reservesand payment of interest on reserves—Changing the minimum RR; paying interest on any reserves held by banks at the Fed.

24. How the Fed Controls the Money Supply • Open Market Operations • When the Fed buys anything (even apples) reserves increase. • Because government bonds can be stored and shipped electronically, and the market for government bonds is liquid and deep, the Fed can buy and sell billions of dollars worth of government bonds in a matter of minutes. • The Fed usually buys and sells short-term bonds called Treasury bills or T-bills (sometimes called Treasury securities or Treasuries).

25. How the Fed Controls the Money Supply • Open Market Operations • If the Fed wants to increase the money supply, they will buy T-bills: • If the Fed wants to decrease the money supply, they will sell T-bills: M↑ as the money creation process ripples through the economy Fed electronically ↑reserves of the seller With more reserves, bank ↑ loans To pay for the T-bills M↓ as the money creation process ripples in reverse through the economy With fewer reserves, bank ↓ loans Fed sells T-bills ↓reserves of the buyer

26. To next Try it! If the Fed buys government bonds, then all of the following will likely increase except: the monetary base. M1. the Federal Funds rate. bank reserves.

27. How the Fed Controls the Money Supply • Open Market Operations • Recall: the change in the money supply is given by: • A complicating factor: • When banks are eager to lend, they keep reserves low, and MM will be high. • Changes in MB will have a larger effect on the money supply. • When banks are reluctant to lend, they hold reserves high, and MM will be low. • Changes in MB will have a smaller effect.

28. How the Fed Controls the Money Supply • Open Market Operations • Summary • The Fed can increase or decrease the money supply by buying and selling government bonds. • The increase in reserves boosts the money supply through a multiplier process. • The size of the multiplier is not fixed but depends on how much of their assets banks want to hold as reserves.

29. Open Market Operations • Open market operations and interest rates. • Buying and selling government bonds has another advantage: • Not only the monetary base changes but interest rates change as well: ↑Demand for bonds ↑Price of bonds ↓Interest rates Fed buys bonds ↓Demand for bonds ↓Price of bonds ↑Interest rates Fed sells bonds

30. Open Market Operations • Buying bonds stimulates the economy in two ways: • Increased money supply → increased supply of loans. • Lower interest rates → increased demand for loans. • The Fed doesn’t “set” interest rates. • Interest rates are determined by the supply and demand for loans. • The Fed works through supply and demand.

31. Open Market Operations • The Fed controls a real rate of interest only in the short-run. • Why is this important? • Lending and borrowing decisions depend on the real interest rate. • The Fed has greatest influence over the Federal Funds rate. • Federal Funds rate: is the overnight lending rate that banks charge each other.

32. Open Market Operations • Monetary policy is usually conducted around the Federal Funds rate. • It is a convenient signal of monetary policy. • It responds quickly to actions by the Fed. • It can be monitored on a day-to-day basis. • Click here for historical Federal Funds rates. • M1 and M2 are more difficult to measure and monitor. • Don’t forget: the Fed controls the Federal Funds rate through its control of the monetary base.

33. Discount Rate Lending and the Term Auction Facility • Discount Rate Lending • Because the Fed can create money at will, it is lender of last resort. • A lender of last resort loans money to banks and other financial institutions when no one else will.

34. Discount Rate Lending and the Term Auction Facility • Discount rate: the interest rate the Fed charges banks for loans. • These loans increase the monetary base. • When the banks repay the loans the monetary base shrinks back.

35. Discount Rate Lending and the Term Auction Facility • Market traders read the discount rate as a signal of the Fed’s willingness to allow the money supply to increase. • The “discount window” is intended to • help banks that are in financial stress. • Banks in good health usually borrow from other banks. • There is a stigma to borrowing from the Fed. • The very existence of the discount window makes private bank loans work more smoothly.

36. Discount Rate Lending and the Term Auction Facility • Two financial problems banks can get into: • Solvency crisis: when the value of the bank’s loans falls and the bank can no longer pay back its depositors. • An “insolvent bank” has liabilities that are greater than its assets. • To avoid this, banks hold “capital.” • “Capital” in this legal sense—means assets in relatively safe forms (e.g. T-bills). • The Fed sets capital requirements.

37. Discount Rate Lending and the Term Auction Facility • Liquidity crisis: occurs when banks are illiquid. • Illiquid bank: has short-term liabilities that are greater than its short-term assets but overall has assets that are greater than its liabilities (not the same as insolvent). Too many depositors want their money back at the same time.

38. Discount Rate Lending and the Term Auction Facility • Banks may be solvent with lots of good loans, but they can’t meet depositors demands at the moment. • Fear and panic can turn solvent banks into illiquid banks. • To avoid these crises, the FDIC was created during the Great Depression. A recent bank run: UK’s Northern Rock: September 2007 Source: Alex Gunningham http://www.flickr.com/photos/89319548@N00/1378965141/ Northern Rock Customers, Golders Green.

39. Bank Panics • Bank run during the Great Depression in the United States, 1933. A poster for the 1896 Broadway melodrama The War of Wealth depicts a typical 19th-century bank run in the U.S.

40. Discount Rate Lending and the Term Auction Facility • 2008—the U.S. treasury acted to “recapitalize” parts of the U.S. banking system by investing additional money into these banks. • While not formally “monetary policy” this action has many of the same effects as monetary policy.

41. Discount Rate Lending and the Term Auction Facility • What if a bank is insolvent? • Usually, depositors are paid off by the FDIC and the bank is closed. • An exception to this occurred in 2008. • Because too many banks might be insolvent for the economy to survive widespread bank closures, the treasury decided to offer aid to banks instead.

42. Discount Rate Lending and the Term Auction Facility • Financial Crisis of 2007-2008—the Fed went beyond its traditional role. • The Term Auction Facility • Fed auctioned a fixed quantity of reserves until the interest rate was low enough that banks would borrow the money. • The Fed also… • Reduced collateral standards for loans. • Stressed that there would be no stigma.

43. Discount Rate Lending and the Term Auction Facility • The amount of extra lending by the Fed during the financial crisis was staggering. • December 2007 – May 2008 ≈ $475 billion. • December 2007 – December 2008 over $2 trillion (over $6,000 for every person in the U.S.)

44. Payment of Interest on Reserves • Required Reserves: the portion of their deposits that banks are required by law to hold as reserves • Recently, the Fed has begun paying interest on reserves • It can (and does) vary the rate of interest it pays on reserves to achieve its goals Banks ↓reserves ↑loans Fed ↓interest rate on reserves ↑Ms

45. Choose the correct answers. The Fed wants to lower interest rates: It does so by (buying/selling) bonds in an open market operation. By doing this, the Fed (adds/subtracts) reserves and through the multiplier process (increases/decreases) the money supply.

46. The Federal Reserveand Systemic Risk • Systemic Risk: the risk that the failure of one financial institution can bring down other institutions as well. • March 2008—the Fed made extensive loan guarantees to JP Morgan which was purchasing a failing company, Bear Sterns. • Bear Sterns was an “investment bank” which is regulated by the Securities and Exchange commission not the Fed. • Fed’s rationale: Bear Sterns owed a lot of money to banks, and its failure would cause those banks to fail as well.

47. To next Try it! When the Fed set up a Term Auction Facility in 2007–2008, its goal was to: inject a certain quantity of reserves into banks. set the discount rate to a certain percentage. tighten control on legal requirements on banks. All of the answers are correct.

48. The Federal Reserve and Systemic Risk • Preventing the spread of systemic risk is one of the Fed’s most important tasks • There is a problem with doing this… • Whenever the Fed acts to limit systemic risk, it creates moral hazard. • Moral hazard—The tendency for banks and other financial institutions to take on too much risk, hoping that the Fed and regulators will bail them out. • Conclusion: Limiting systemic risk while checking moral hazard is a challenge.

49. Many Americans still don't understand what has happened to the economy. How did it all go so bad so quickly? Who is responsible? How effective has the response from Washington and Wall Street been? Those are the questions at the heart of FRONTLINE’s Inside the Meltdown.". (56:23 minutes) http://www.pbs.org/wgbh/pages/frontline/meltdown/view/ ! Back to

50. To next Try it! The financial crisis of 2008 illustrates that: systemic risk is no longer a serious concern for the U.S. economy. the Fed does not concern itself with the actions of investment banks. the Fed has the power to veto the President's responses to a financial crisis. the Fed has the power to step outside its normal functions and lend to investment banks as well as traditional commercial banks if it perceives the risk of financial contagion.