The Federal Reserve System

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The Federal Reserve System
1. Functions of the Fed 2. Fed Policy
Levers 3. Interest Rates 4. Inflation
Implications 5. Money Definitions 6.
Banking 7. Money Creation 8. Fed Policy
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• 1. Functions of the Fed
• http//www.federalreserve.gov about the Federal
  Reserve System
• Conducting the nation's monetary policy by
  influencing the money and credit conditions in
  the economy in pursuit of full employment and
  stable prices
• Supervising and regulating banking institutions
• Maintaining the stability of the financial
  system and containing systemic risk that may
  arise in financial markets
• Providing certain financial services

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2. Fed Policy Levers
Influence Bank Reserves to change Money Supply
and Federal Funds Rate Discuss later in which
ways bank reserves may be changed. Short-run and
Long-run implications of changing Bank Reserves
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Market for Bank Reserves
Supply of Reserves
Federal Funds Rate
c
a
b
Demand for Reserves
Bank Reserves
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Implications
Bank Reserves up -gt Money Supply up, Fed Funds
Rate down -gt Market Rates down -gt 1. stock
prices increase, 2. dollar
(exchange rate) depreciates, 3. investment and
consumer durables demand increase.
4. first production increases,
then the price level.
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Market for Bank Reserves
Supply of Reserves
Federal Funds Rate
c
a
b
Demand for Reserves
Bank Reserves
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Interest Rates over Time
Market Rates
Time
Time of temporary increase in growth rate of bank
reserves
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Interest Rates over Time
Rate end up permanently higher due to higher
inflation
Market Rates
Time
Time of permanent increase in growth rate of bank
reserves
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3. Nominal and Real Interest Rates (or returns)

• Observed market rates are Nominal
• Taxes are based on market rates.
• Real returns take inflation into account.
• Due to x inflation, a loan is worth x less in
  real terms after one year.
• For the lender the return per of the loan is
  the nominal interest - x. Same for the cost
  of the borrower.

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Nominal and Real rates (continued)

• Thus real Interest nominal interest -
  inflation .
• After-tax real interest (1 - tax rate) x
  (nominal interest ) - inflation .
• Fischer Effect fully anticipated 1 higher
  inflation should raise nominal interest rates by
  1 (by more if taxes are considered less in
  reality).

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4. Inflation Implications

• Eliminate our current 2 inflation rate?
• Inflation change in level of all prices
  (includes wages in principle).
• Anticipated versus Unanticipated.
• Anticipated inflation Misconceptions

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Misconceptions Costs of Anticipated Inflation

• Real wages decrease systematically.
• Costs increase.
• Galloping inflation imminent.
• Taxes increase bracket creep.
• Loss to society.
• Redistribution of wealth (lenders lose, borrowers
  gain).

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True costs of anticipated inflation

• Menu costs, Shoe leather costs
• People on fixed incomes suffer.
• Even if income tax brackets adjust capital
  gains tax due to inflation, depreciation at
  original cost.
• High inflation implies variable inflation, larger
  Unanticipated inflation changes.

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Costs of Unanticipated Inflation

• Arbitrary redistribution
• Real wages affected if labor contracts Firms
  affected in opposite direction.
• Borrowers and lenders affected in opposite ways.
  
• Confused Market signals
• Firms do not know if their price went up due to
  inflation or increased popularity.
• Relative prices change

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Price Stability

• Should we strive for 0 inflation?
• Unknown risks of deflation.
• Temporarily higher unemployment.
• People on fixed incomes benefit.
• Underground economy and our foreign creditors
  benefits.
• Harder to cut salaries.

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5. What Counts as Money?
M1 Currency in hands of the public (coins
paper money), Checkable Deposits, Travelers
Checks. M2 M1 Savings Deposits, MMDAs,
MMMFs (retail), Small Time Deposits. M3
M2 Large Time Deposits, MMMFs
(institutional), Repurchase Agreements,
Eurodollars. Credit Cards??
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6. The Banking System
Fractional Reserve Banking only part of the
checking deposits is backed by Bank
Reserves. Bank Reserves Currency in Vault
Accounts at the Fed. Required
Reserves Excess Reserves Profitability,
Solvability, Liquidity
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Bank Balance Sheet
Assets Typical Bank Liabilities Currency
Checking Deposits Accounts at Fed Savings
and Time Loans and Deposits Securities
Capital
x x
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7. Money Creation
Money Multiplier relation between money created
by Fed and total Money Supply Monetary Base
money created by Fed All Currency Bank
Accounts at Fed Bank Reserves Currency
in Circulation. Why is Money Multiplier greater
than 1? 1 in new bank reserves -gt banks lend
out -gt part comes back to banks in form of
checking accounts -gt hold 10 to back up checking
acounts (fractional reserve banking) -gt lend out
the rest.
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?Money Supply (Money Multiplier) x
(? Monetary Base) Money multiplier gives the
increase in money per unit of base money created
by Fed. In practice about 2.2 for
M1. Realistic? --banks always get rid of excess
reserves fast --people hold cash about 50c per
--banks hold excess reserves voluntarily.
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8. Federal Reserve Policy
Origin of Fed Bank Panics (last in 1907) -gt need
for Lender of Last Resort. (1913) Board of
Governors 12 Fed Reserve District Banks (24
branch banks) Federal Open Market Committee
(FOMC) Member Banks (mostly National Banks) Bank
Runs during depression led to Federal Depository
Insurance Corporation (FDIC)
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Tools for affecting Money
1. Open Market Operations (NY Fed) 2. Discount
Loans to Banks 3. Changes in Reserve
Requirements OMOs most common, First two affect
Bank Reserves, Third affects money multiplier.
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Policy Question
Should Greenspan further lower FFR? Yes Economy
slowing down, World needs a boost, Exchange rate
too high, Liquidity needs (LTCM), Good for Banks,
Avoids Deflation. No Irrational exuberance,
Inflationary (due to both lower exchange rate and
lower interest), Dont let inflation genie out.
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