Macroeconomics

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Macroeconomics

• Unit 14
• The Federal Reserve
• The Top Five Concepts

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Introduction

• This unit discusses the role of the Federal
  Reserve. Did you know that the Federal Reserve
  is responsible for determining the rates that
  most of the banks use to establish their rates
  for savings accounts, time deposits and loans?
• The impact of changes in Federal Reserve policy
  on banks, businesses and consumers is also
  discussed.
• Finally, a simple calculation to determine the
  yield on a bond is discussed.

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Concept 1 Federal Reserve Structure

• The Federal Reserve System consists of 12 Federal
  Reserve Banks located throughout the United
  States.
• Regional Federal Reserve Banks provide services
  to private banks in their area.
• Four main services are provided check clearing,
  holding bank reserves, providing currency and
  coins, and providing loans to private banks.

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Concept 1 Federal Reserve Structure

• The Federal Reserve System is governed by its
  Board of Governors.
• The board of governors consists of 7 members
  appointed by the U.S. president to 14-year terms.
• The U.S. president selects one governor to be the
  chair.
• The chair serves a four-year term and can be
  reappointed. The current chair of the Federal
  Reserve is Ben Bernanke who recently replaced
  Alan Greenspan as chair.

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Concept 1 Federal Reserve Structure

• The Federal Reserve also contains a group called
  the Federal Open Market Committee.
• This group has 12 members consisting of the
  Federal Reserve Bank governors (7) plus 5 of the
  12 regional Federal Reserve Bank presidents.
• The committee is responsible for directing
  Federal Reserve transactions in the money market
  (buying and selling securities). They also
  determine the amount of reserves that private
  banks are required to maintain.

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Monetary Tools

• The Federal Reserve can change the supply of
  money using one or more of the following policy
  instruments
• Changing bank reserve requirements (reserve
  ratio).
• Changing bank discount and federal funds rates.
• Through open market operations the buying and
  selling of government securities.

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Concept 2 Reserve Requirements

• By changing the reserve ratio, the Federal
  Reserve can increase or decrease the supply of
  money available to banks for lending activity.
• If the banking system has total deposits of 100
  billion, and the reserve ratio is .20, then the
  banks have required reserves of (100 billion X
  .20) 20 billion.
• Excess reserves are calculated based upon the
  amount of additional deposits banks have to lend
  after the reserve requirement is met.

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Concept 2 Reserve Requirements

• Excess reserves Total reserves required
  reserves.
• Any dollar amount of reserves being held by a
  bank that is over the required reserve amount is
  excess reserves.
• In our example, 100 billion of total reserves
  (deposits) exists in the banking system. The
  required reserve ratio is .20. The required
  reserve equals .20 X 100 billion 20 billion.
• Excess reserves 100 billion - 20 billion
  80 billion.

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Concept 2 Reserve Requirements

• Federal Reserve policy is concerned with what
  happens to bank excess reserves.
• If the 80 billion was used for loans, we can
  calculate the total economic effect using the
  money multiplier.
• Money multiplier 1/required reserve ratio.
• 1/.20 5
• 5 X 80 billion 400 billion increase in the
  money supply.

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Concept 2 Reserve Requirements

• Federal Reserve policy can increase or decrease
  the reserve requirement.
• By changing the reserve requirement, the Federal
  Reserve can increase or decrease the supply of
  money.
• If the reserve ratio is increased, banks have
  less money to lend. The supply of money is
  reduced.
• If the reserve ratio is decreased, banks have
  more money to lend. The supply of money is
  increased.

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Impact of an Increased Reserve RequirementNotice
that when the reserve ratio increases, excess
reserves decline.
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Concept 2 Reserve Requirement

• Changes in the reserve requirement cause a change
  in the following
• Excess reserves.
• The money multiplier.
• The lending capacity of the banking system.
• Banks will try to keep their excess reserves to a
  minimum in order to improve their profitability.
  If significant excess reserves and the bank is
  unable to loan them, most banks will purchase
  government securities to provide some additional
  income.

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Concept 3 The Discount Rate

• At times banks may need to borrow money from the
  Federal Reserve in order to meet minimum reserve
  requirements.
• If a bank borrows money from the Federal Reserve
  to cover reserve requirements, it borrows at the
  discount rate.
• The discount rate is the rate of interest the
  Federal Reserve charges for lending reserves to
  private banks.
• The discount rate is determined by current
  Federal Reserve policy.

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Concept 3 The Discount Rate

• Banks may also borrow money from other banks to
  meet reserve requirements. When loans of this
  type occur, the funds are borrowed at the federal
  funds rate of interest. The federal funds rate
  is the interest rate for interbank reserve loans.
• The federal funds rate is controlled by the
  Federal Reserve through its Open Market
  Committee. Additional information about the
  federal funds rate and the discount rate can be
  obtained at http//www.federalreserve.gov/policy.h
  tm.
• Click on the links for the discount rate and open
  market operations.

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Concept 3 The Discount Rate

• If the Federal Reserve wishes to increase the
  supply of money, it can lower the discount and
  federal funds rates. This causes the rates that
  banks charge for loans to fall and increases
  lending activity.
• If the Federal Reserve wishes to decrease the
  supply of money, it can raise the discount and
  federal funds rates. This causes the cost of
  banks loans to rise which reduces the demand for
  loans.
• Rate changes also make it more or less expensive
  for banks to borrow money to cover reserve
  requirements.

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Concept 4 Open Market Operations

• The third tool of monetary policy implemented by
  the Federal Reserve is called Open Market
  Operations.
• Open Market Operations are one of the primary
  tools used to directly alter the reserves of the
  banking system.
• Open Market Operations is the process where the
  Federal Reserve makes federal government bonds
  more or less attractive as an investment to the
  private sector, including banks.

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Concept 4 Open Market Operations

• The Federal Reserve is one of the U.S.
  governments largest bond holders. Bonds can be
  bought and sold in the open market.
• Prices of bonds are determined by their interest
  rates and the price paid for the bond.
• If the Federal Reserve lowers its price on
  government bonds it would like to sell, this will
  increase the demand for bonds and reduce bank
  deposits. Why? Individuals and businesses are
  attracted to federal government securities when
  they are sold at a discount price.

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Concept 4 Open Market Operations

• If the Federal Reserve buys government bonds at
  higher prices, the demand for them by other
  market participants (individuals, businesses) is
  reduced and more funds remain in the banking
  system. This activity by the Federal Reserve
  lowers bond yields and market interest rates
  while increasing the supply of money.
• Therefore, if the Federal Reserve sells an
  increasing number of bonds because of a price
  reduction, it is reducing the supply of money.
  Why? Because individuals and businesses will
  take their bank deposits and buy the securities.
  This reduces the amount of bank deposits
  available for deposit creation.

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Concept 4 Open Market Operations

• To summarize
• If the Federal Reserve wishes to increase the
  supply of money, it buys more federal government
  securities on the open market. Government
  securities investors are willing to sell because
  the Federal Reserve buys the securities at
  attractive premium prices.
• If the Federal Reserve wishes to decrease the
  supply of money, it sells more federal government
  securities on the open market. Government
  securities investors are willing to buy more
  securities because the Federal Reserve sells the
  securities at attractive discount prices.

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Concept 4 Open Market Operations

• If the money supply is increased by the actions
  of the Federal Reserve, the desired effect is to
  shift the aggregate demand curve to the right.
• If the money supply is decreased by the actions
  of the Federal Reserve, the desired effect is to
  shift the aggregate demand curve to the left.

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Concept 4 Open Market Operations

• Bond prices are determined by the interest rate
  and cost of the bond.
• Often the yield is an important calculation used
  to determine the value of a bond.
• The yield is the annual rate of return on a bond
  calculated by taking the annual interest payment
  and dividing it by the bonds price.

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Concept 5 Bond Yield

• Yield annual interest payment / price paid for
  the bond
• For example
• A 1000 face value bond, with a 4 interest rate.
  Annual interest payment .04 X 1000 40.
• If the bond was purchased for 900, what is its
  yield?
• Yield 40/900 4.4
• Notice that we do not use the face value of the
  bond to calculate the yield we use the cost of
  the bond.

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Bond Yield

• Bonds can also be bought and sold for more than
  their face value.
• For example, a 1000 bond with a 6 interest
  rate.
• Annual interest payment .06 X 1000 60
• If this bond was bought for 1100, what is its
  yield?
• Yield 60/1100 5.5
• Once again we use the cost or purchase price of
  the bond to calculate its yield.

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Bond Yield

• Why would someone buy a bond for more than its
  issue price or face value?
• Usually this occurs when the interest rate being
  paid on the bond is higher than the current
  market rates for similar bonds.
• When this occurs the bonds with higher interest
  rates become more costly to purchase (demand for
  these bonds is higher) thereby reducing the yield
  on the bonds to current market rates.

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Federal Reserve Policy Choices Summary

• To increase the supply of money the Federal
  Reserve can
• Lower reserve requirement.
• Lower discount and federal funds rates.
• Buy more government bonds.
• To decrease the supply of money the Federal
  Reserve can
• Increase reserve requirement.
• Increase discount and federal funds rates.
• Sell more government bonds.

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Monetary Control Act of 1980

• Prior to 1980, the Federal Reserve did not have
  authority or control over all banks.
• Upon passage of the Monetary Control Act of 1980,
  the Federal Reserve obtained control over all
  banks, savings and loans, savings banks, and most
  credit unions. All institutions are required to
  comply with the new Federal Reserve reserve
  requirements.
• The act also permitted banks to begin
  diversifying into other financial services to
  compete with other non-bank entities. It also
  gave all banks access to the Federal Reserves
  discount window.

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Summary

• Federal Reserve System.
• Federal Open Market Committee.
• Reserve requirement.
• Discount and federal funds rate.
• Open market operations.
• Monetary policy options.
• Monetary Control Act of 1980.
• More information about the Federal Reserve and
  its operations is available at
• http//www.stls.frb.org/publications/pleng/default
  .html