BANKING

1
Chapter 15 and 16

• BANKING
• PART I

2
BANKING, MONEY AND THE FED

• What is money?
• Why do we need it?
• How can we get it?
• Is there ever enough?
• Is there ever too much????
• What backs the dollar?

3
What Gives Money Its Value?

• Our money today has value because of its
  general acceptability.

4
Three Kinds of Economic Goods

• Consumer goods (end product)
• Capital goods (human, tools,machinery)
• Money (medium of exchange-store of value- a
  liquid asset- deferred payment- basis for quoting
  prices)
• Money is the most important part of market
  economy-it is at least one part of a barter
  transaction and whatever affects money affects
  everything else.
• The larger the money supply gtour demand for G
  S.
• More money available the more willing to spend

5
Money Differs From Other Economic Goods

• Its supply must remain scarce for it to be
  valuable
• By itself it is nothing.. Must be circulated in
  the economy by consuming or saving.
• If quantities of dollars increase in economy,
  benefits go to those who get it first rather than
  who gets it last, because the first with the
  can spend it with lower prices
• It is only useful for what it gets you in
  exchange for what you want.
• Last to get the run the risk of inflation
  having set in.

6
Money vs. Barter

• Money - Any good that is widely accepted for
  purposes of exchange and in the repayment of
  debt.
• Barter - Exchanging goods and services for other
  goods and services without the use of money.

7
HISTORY OF MONEY

• Barter was symbol of primitive culture
• Homer wrote about cattle being used as barter in
  the Illiad
• What are some of the things used as money?
• rats, pigs, whales, teeth, tobacco,
• beads, women, cattle
• Why was gold and silver best used as money?
• durable, convenient to handle,
  portable,difficult for supply to be increased,
  gold glistened

8
Barter is inefficient and expensive

• Deteriorates after few trades
• Requires a double co-incidence of wants.
• Too costly to travel long distances(trading a
  cow for a fuzzy fleece from L.L. Bean)

9
Coins were adopted

• Money concept was born
• Silver-
• Gold

10
Path of Coinage

• Coinage first began in 650 B.C.
• By 550 B.C. gold and silver coins were major
  trading coins for next 2500 years.
• Governments moved to take over money by
• monopoly of the mint legal tender laws
• establishing paper currency

11
COMPONENTS OF MONEY

• M1 Currency coins, demand deposits, travelers
  checks
• M2M1Savings deposits, small time deposits
  (under 100,000), money market mutual funds.
• M3M1M2large denomination time deposits (over
  100,000)
• LM3 liquid assets (T-bills,
• U.S.Savings bonds, commercial paper)

• Near Monies
• Credit cards
• Stocks and Bonds
• IRAs
• Keogh Accounts

12
Four functions of money

• Medium of exchange
• Basis for quoting prices
• Store of value (can accumulate wealth by saving)
• Standard of deferred payment (buy now, pay later
  no payments until 2020) Money will be good to pay
  in 2020 as is today.

13
Are Credit and Debit Cards Money?Yes!

• Credit card use represents loans which must be
  repaid. They represent the use of someone else's
  money.
• Debit cards give access to checkable deposits
  which are already part of the money supply.

14
Value of Money

• How much money do you have
• in your pocket
• in your checking account
• in your savings account
• Money has value- too much in circulation,
  decreases its value. inflation is BAD
• What backs our currency?
• Our money is called what?
• What will a dollar buy today?

15
MONEY SUPPLY
Key to money isdo people have faith in it? If
not, they rush out and spend it.. No
savings! SO what do we have today in our
economy- high/low savings rate What has the
federal government done lately to increase our
spending? Money supply means- all the money
available for spending at any one time. Fed used
to use M1 as barometer. Today, they use M2.
16

• History of Why American Banks were created

17
The war left us in debt. Some states were
bankrupt. We needed one unified currency ...
Hamilton suggested a central bank. The First
Bank's charter was drafted in 1791 by the
Congress and signed by George Washington. In
1811, Congress voted to abandon
18
EARLY PROBLEMS OF U.S. BANKING SYSTEM.

• Before the Fed was established 1913- U.S. could
  not adjust supplies of money to business activity
• Banks were often short of cash- if people
  deposited their money- wanted it on the spot, had
  legal right to withdraw it.
• Banks often kept some in their reserve accts,
  and deposited money in other banks.
• Sometimes demand for currency was gtthan the
  amount of money on hand.
• Banks would draw on deposits from other banks and
  sell other assets such as government securities.

19
Previous cyclical depressions prior to Federal
Reserve being created

• 1819 Several years of inflation engineered by
  the 2nd Bank of the U.S.
• 1836 2nd Bank of U.S. went down after Andrew
  Jackson did away with central banking. He felt
  central banking was inherently inflationary.
• 1857 depression in northern states and not
  southern states.. Reflected by state chartered
  banks requiring state banks to buy state bonds by
  state govts.
• 1893 happened as a result of silver
  legislation- caused inflated currency- lasted 4
  years.
• 1907 Panic set the stage for Federal Reserve
  System.

20
Continued banking system problems

• Pressure from depositors often caused a chain
  reaction of money shortage in a number of banks.
• People panicked. If bank could not meet its
  demand for currency- it failed
• Bank closings brought on periods of economic
  depression called money panics (people lost
  confidence in their bank and wanted their money
  out)
• Panic of 1907- Congress decided the U.S. needed a
  central banking system where money supply could
  expand and contract.- Federal Reserve System-
  1913

21
http//www.youtube.com/watch?vMJJN9qwhkkE Run
on Bank
22
HISTORY OF U.S. BANKING IN BRIEF

• Four Banking Periods
• Period 1 1791 1832
• Bank of U.S. a central bank founded at proposal
  of Alexander Hamilton, nations first Secretary
  of Treasury.-charter expired and
• Second Bank of U.S. was founded.- lasted sixteen
  years and went out of business

23
PERIOD TWO for U.S. Banking

• Covered the years 1832- 1864
• State governments took charge of banks
• State banks issued own currency based on amount
  of silver or gold they held
• Flood of bank notes circulating caused many banks
  to fail
• Congress passed National Currency Act to cope
  with counterfeiting
• President Lincoln signed law in 1864 to establish
  new system of national banking and the Office of
  the Controller of the Currency (OCC).
• Federal Reserve notes were designed to replace
  the national bank notes above.

24
PERIOD THREE OF U.S. BANKING

• Years 1920 1933
• In 1920 there were 30,000 banks. In 1933 15,000
• Panic began to set in and runs on banks.
• Banking system proved inadequate
• FDR ordered all banks closed for two weeks and
  OCC (office of Comptroller of the Currency) to
  examine banks assets.
• RememberFederal Reserve Created 1913
• Congress passed FDIC, June 1933 insuring each
  depositor 2500 (now the sum is
  100,000)Emergency Economic Stabilization Act
  of 2008 temporarily increased FDIC deposit
  insurance from 100,000 to 250,000 per depositor
  through 12/31/09. This gave/and gives depositors
  confidence in banks but slowly.

25
What caused the bank failure in the early 30s?

• Depositors believed money not secure
• Government tools were just ignored
• Deposit insurance was not yet in existence
• Economy was tumbling downward so fast, confidence
  in much of anything was non-existent.
• FDR said The only thing we have to fear is fear
  itself.

26
Fourth Period of U.S. Banking

• Years 1970 Present
• Technology has changed banking
• No cancelled checks, electronic transfers, Online
  banking, etc.
• See a lot of banks merging
• Services of banking changed today from 1970
• Many new regulations, Monetary Deregulation Act
  (80s) other regs later after massive bank and
  SL failures in late 80s early 90s.

27
Government in Banking-Help or Hindrance?

• SL Debacle! (late 80s)
• Worst financial disaster since Great Depression
  until now
• Inflation was eating away at profits for SLs
• Began to make very risky mortgage loans.
• Could not recoup from all loans that were made at
  such low rates- Went bankrupt.
• Then Congress deregulated the SL to allow them
  to act like banks. Beginning of our current
  debacle.
• Monetary Deregulation Act of 1980 This created a
  tumble in the market then the Fed had to bail out
  at taxpayers expense.
• FDIC actually took over Continental Illinois Bank
  (too big to fail.)

28
Today. Its TARP

• Troubled Assets Relief Program (TARP) In October
  2008, Congress enacted the Emergency Economic
  Stabilization Act (EESA) to respond to
  instability in U.S. financial institutions,
  caused particularly by these institutions' being
  saddled by delinquent mortgages. That legislation
  created the Troubled Asset Relief Program (TARP).

29
So whats the bottom line?

• Beginning government attempt at national
  banking that failed
• States wanted to control banking and that failed.
• Chaos evident with no confidence and market
  crashes/ depression- banks failed attempt to
  re-build national stability
• For a period of years, banking stability seemed
  assured.
• Today,(2009) we have seen that banking took
• a turn of strong instability.

30
Banks Today!

• Community Reinvestment Act (Carter
  Administration)- required banks to provide loans
  to low-income families.
• Continued with no-income families.
• Banks bundled the risky loans- sold paper- good
  investment for other banks, financials, global
  players entered here also.
• Continued for about 10 years, with banks
  continuing the risky loans.
• Hedge fund investors played their cards, and
  entered the scene.
• Off to the races!

31
Bailout Begins!_at_ U.S. Government.gov

• Federal Reserve/Treasury Department have
  orchestrated the biggest bailout of banks,
  financials, Fannie and Freddie, AIG, etc. etc.
  The automobile industry is also in on the act.
• Fed has pumped billions into system
• Treasury has trillions extra and
• 200 billion for Fannie and Freddie

32
What is a billion?

• A billion seconds ago it was 1959
• A billion hours ago our ancestors were living in
  the Stone Age.
• Approximately 250 billion was requested to
  re-build New Orleans.
• Here is how many million it takes to equal 1
  Billion1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
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  1,000,000.00 1,000,000.00 1,000,000.00
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  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
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  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00 1,000,000.00
  1,000,000.00 1,000,000.00

33
EARLY BANKING

• Under what authority can the U.S. Treasury print
  dollars?
• (Article I, Section 8, clause 5)
• In early days
• most banks were state banks issued their own
  currency backed by their own supply of either
  gold or silver

• Bank of the U.S. only national bank- acted much
  like the U.S. Treasury by collecting and paying
  debts owed to the federal government
• No regulation of state banks-no limit on amount
  of currency they could print.
• Early years- many banks went bankrupt.

34
Additional info on Banking.legalities

• Has Congress the power to incorporate a bank?
  (Yes, necessary and proper clause
• to make all laws which shall be necessary and
  proper for carrying into execution the expressed
  powers in the Constitution.
• May a state tax a U.S. Bank?
• (No, the power to tax involves the power to
  destroy. Such a tax could be used to destroy an
  institution vitally necessary to carry out the
  operations of the federal government, and
  therefore is unconstitutional and void. McCulloch
  vs. Maryland (1819)

35
Early Banking continued

• In beginning Civil War- 1861- Congress authorized
  printing of demand notes- later called Greenbacks
  (ink was green)
• People skeptical- so National Banking System was
  created and national bank notes were printed.
• 1863- Gold certificates were issued- This was
  paper currency backed by gold on deposit with
  U.S. Treasury
• 1866- federal government issued Silver
  Certificates- modeled after gold certificates and
  backed by silver coins. (remember the parable of
  Wizard of OZ?)

36
Early Banking continued

• GOLD STANDARD- 1900 Congress passed the Gold
  Standard Act- tied to the basic unit of currency
  and equal to it. Currency could be traded in for
  gold- people felt secure.
• Advantage confidence of people- prevented
  government from printing too much currency.
• Disadvantage- economic growth is tied to the
  money supply no flexibility for productive
  growth.
• Most countries between 1871 and 1914 were on Gold
  Standard. U.S was last to get on.

37
Early Banking Continued

• 1933- U.S. government went off the gold standard
• Britain went of two years earlier.
• 1934 Gold Reserve Act passed- required citizens
  to turn in their gold and gold certificates-
  people were given Federal Reserve Notes in
  exchange- those who refused to turn in gold had
  their gold confiscated
• 1971- President Nixon declared no gold backing
  whatever for dollar- placed the exchange
  equivalent with other currencies (dollar v pound
  v yen v mark) (now in 2008 dollar v pound v
  Euro) Gold window was closed!
• And as we know, the dollar will fluctuate with
  currency market. .Referred to as
• Exchange rate.

38
Supply and Demand for Credit

• Banks and other lending institutions lend money-
  expect to be paid for its use.
• Amount they lend (subject to some legal
  restrictions) is determined by how much they have
  to lend and how much the borrower is willing to
  pay.
• This charge or price for use of money interest

39
Demand for Money

• Represents the inverse relationship between the
  quantity demanded of money balances and the price
  of holding money balances.
• Interest rate is the price (opportunity cost) of
  holding money balances.

40
The Supply of Money
The supply curve of money is a vertical line at
the quantity of money, which is largely, but not
exclusively, determined by the Fed.
41
Equilibrium in the Money Market

• At an interest rate of i1, the money market
  is in equilibrium There is neither an excess
  supply of money nor an excess demand for money

42

• Interest rates fluctuate with changes in demand
  for money in relationship to changes in supply of
  money available.
• Money becomes valuable just like other value
  created for other commodities (demand relative to
  supply)
• So when the FED began lowering the FF Rate, and
  money was almost free, did this affect our
  financial crisis today????

43
HOW DID WE GET FRACTIONAL BANKING SYSTEM?

• Goldsmiths Knights brought back gold when making
  conquestswhat to do with it?
• Gold treasure more than King could use- took to
  Goldsmiths
• Receipt was given for deposits
• People who had gold began to deposit with
  Goldsmiths- receipts given
• Church entered and said it was fraudulent for
  Goldsmiths to do this.

44

• Easier to exchange receipts than pick up actual
  gold and exchange for g/s
• Goldsmiths began to make loans on deposits not
  claimed kept a fraction on reserveloaned out
  rest

45
COMMERCIAL BANKS loan making criteria

• 1. History
• Are you credit worthy
• Employed- how long
• Residence stay
• 2. Security
• How much income
• Other assets
• Obligations
• Collateral
• Guaranties- co-signers

• 3. Purpose
• Are you a minority
• Business or personal
• Do you have credit past?
• Today- get credit number rating for different
  purposes. FICO scores. Go to http//www.myfico.co
  m
• Past- know the bank President.

46
Part II Federal Reserve
47
FEDERAL RESERVE STRUCTURE
One of 7 is Chairman
Board of Governors 7 Members
12 District Banks
Member Banks
48
FED Can Issue Federal Reserve Notes.

• Have you ever seen a Federal Reserve Note?
• Do any of you have any Federal Reserve Notes?
• ABoston
• B New York
• C Philadelphia
• D Cleveland
• E Richmond, VA
• F Atlanta
• G Chicago
• H St. Louis
• I Minneapolis
• J Kansas City
• K Dallas
• L San Francisco

49

• The Dollars eye The back of the dollar bill has
  a picture of a pyramid with an eye above it.
  What does this symbolize?

50

• The pyramid of progress- on the Great Seal of the
  U.S. 1782
• Egyptian influence birthplace of civilization
• Pyramid represents solid strength and duration.
• Unfinished pyramid symbolizes the goal of the
  U.S. to continue building, growing and improving
  with a continuous evaluation of truth.
• The 13 layers of the pyramid represent the 13
  states, the separate stones self-government

51

• The eye of Providence or All Seeing eye is also
  of Middle Eastern origin and indicates the
  supremacy of the spiritual over the material.
• The eye also represents education and freedom of
  knowledge
• Annuit coeptis means God has favored our
  undertakings which contains 13 letters
  symbolizing the 13 states.
• Novus odo seclorum means the new order of the
  ages beginnin in 1776 with adoption of
  Declaration of Independence.

52

• 12 District Banks.
• Dallas is the 11th District K
• http//www.dallasfed.org/
• 25 Regional Banks.
• Dallas has region banks in El Paso, San Antonio,
  Houston.

53
12 Regional Banks
1. A.Boston 2. B. NY 3.C. Philadelphia 4.D.
Cleveland 5.E. Richmond,VA 6.F. Atlanta 7. G.
Chicago 8.H. St. Louis 9. I. Minneapolis
10. J. Kansas City 11. K. Dallas 12.L. San
Francisco

54
BOARD OF GOVERNORS DUTIES

• Appointed by Pres/confirmed by Senate-
• Serve 14 year terms-2 years rotational
• One appointed Chairman
• Supervises the issuance and distribution of
  federal reserve notes.
• Regulates all money and credit policies in U.S.
• Supervises all 12 District Banks

55
Duties Continued

• Sets Reserve Requirements- all banks required
  today.
• Sets Discount Rate
• Serves as Majority of FOMC
• Sets Margin Rates for purchasing stocks
• Maintain stability of financial system
• Provide certain financial services for U.S. govt
• Regulates state banks that join.

56
Is the Fed effective???---------

• What is the Discount Rate today? 11/20/09 .50
• 4/20/09 .50
• 11/17/08 1.25
• 4/15/08 2.50
• 4/16/07 6.25
• 6/29/06 6.00
• 4/17/06 5.75
• 11/21/05 5.00
• Spring, 2005 3.75
• Dec. 2004, 3.00

57

• What is the Federal Funds Rate Today? .25
• 4/20/09 .25
• 11/17/08 1.00
• 4/15/08 2.25
• 4/16/07 5.25
• 6/29/06 5.18
• 4/17/06, 5.00
• 11/21/05, 4.15
• Was 2.875(spring, 2005)
• (was 2 12/2004)
• (2003, FFR was 1.0)

58

• Prime Rate? 11/20/09 3.25
• 4/20/09 3.25
• 11/17/08 4.00
• 5/15/08 5.25
• 4/16/07 8.25
• 6/29/06, 8.00
• 4/17/06, 7.75,
• 11/21, 7.00
• (was 5.75 in spring 2005)
• (was 5.00 12/2004)
• What is the Fed attempting to do now in 2009?
• Where does fiscal policy enter in here?
• What would constitute a counter cyclical move by
  either the Federal government or the Federal
  Reserve?

59
Lets Take a Trip to the FED.

• http//research.stlouisfed.org/
• http//www.dallasfed.org
• http//www.federalreserve.gov

60
WHO BELONGS TO THE FED?

• All National Banks
• State Banks may opt to join
• Monetary Control Act 1980 brought about big
  changes in banking nominal difference exists
  now between member/non-member
• ALL Depository institutions in U.S. are now under
  the jurisdiction of the Fed-which applies
  regulations on each and offers services to each (
  check-clearing service used to be a money-maker-)
  Big banks have always exchanged checks among
  themselves. Others send to District for clearing.
  What has the Debit Card done to this service?

61
12 DISTRICT BANK STRUCTURE/DUTIES

• Each bank has 9 on Board of Directors
• 6 members chosen by member banks,
• 3 chosen by BOG only 3 may be bankers- why?
• Oversees operations of member banks
• Set interest-rate bank may charge for short-term
  collateral loans-
• Approve member banks Pres and VP
• Clearing house for check from all regions
• Researches the economic health of the
  region-beige book.

62
AUTONOMY OF FEDERAL RESERVE
Fed operates independently of Congress or
Executive Branch- autonomous Congress does not
fund the Fed. Earnings made on financial assets,
mostly government bonds- provides more funding
than needed- rest returned to Treasury. Each
District Bank receives a of assets from member
banks and other services DB provides (check
clearing/not much anymore why? Revenue lost by
Fed????) Fed does not undergo GAO Audits
(Government Accountability Office) Was set-up to
be apolitical.
63
3 Monetary Tools for the FED

• Reserve Requirement
• Discount Rate
• FOMC

64
One Tool to Control Money Supply Reserve
Requirement

• Lowering RR creating more money to loan
• Raising the RR decreasing money creation.
• RRs do not change very often.
• Changes in RR can be disruptive of banking
  operations. RR change could force banks to sell
  securities quickly or call in loans to meet the
  Fed requirement.
• Current 3 0-46.5 Mil
• 10 46.5

• The Fed requires banking institutions, including
  SLs, Credit Unions, Loan Assns, to maintain
  reserves against the demand deposits of their
  customers. Required and excess are important
  concepts
• Required Reserves are vault cash and deposits
  held for them at the Fed.
• This RR can alter the loans that members can make
  by

65
How Fractional Banking WorksFed RR is 20(bank
required to hold a percentage of its deposits on
RR

• Deposit made 100,000
• -20,000 (bank holds in reserve
• 80,000 (bank can loan this amount)
• This 80,000 is considered new money
• Whoever receives the 80,000 as a loan then
  deposits it into an account and can write checks
  immediately, but the bank views it as never seen
  before.

66
CONTINUED RR/FRACTIONAL BANKING EXAMPLE
80,000 -16,000 (20 reserve
required) 64,000 (potential new loan which can
be created and loaned out to another
customer 64,000 new deposit in mind of bank
- 12,800 (20 must be kept in reserve)
51,200 considered new money available for loan
67
CONTINUED RR/FRACTIONAL EXAMPLE
This cycle keeps going on and on- The multiplier
factor for 20 RR is 5 to 1 Using the above
example- banks could create 5 times the 100,000
at 20 reserve required or in other words, it can
create 500,00 NEW MONEY At 25 required as
opposed to say 10- higher requirement would
lower the multiplier effect from 10 to 4 which in
turn would not allow banks to have as much money
to loan- or would be taking money out of
circulation.
68
Summary/RR/Fractional Banking/Multiplier

• The higher the required reserve- the lower the
  multiplier.
• The potential deposit expansion multiplier is
  merely the reciprocal of the required reserve
  ratio (r ) In case of 20 example or l/5 of
  total deposits to be held- deposit expansion
  multiplier is 5
• If 10 was to be held- deposit expansion
  multiplier is 10.

69
DOES MULTIPLIER ALWAYS WORK? no

• Creating New Money with the deposit expansion
  multiplier effect will not work if
• All excess reserves are tied up. (purchase
  securities, loans, etc.)
• If person receiving the loan decides to hold
  currency rather than deposit it into the bank
• If banks decide not to extend loans even though
  they have excess reserves available (referred in
  the early 90s as credit crunch. And is
  happening today!

70
WAMU Syndrome

• Confidence!
• Do you have confidence in your bank?
• If no take your money and run
• Self-fulfilling prophecy.

71
SECOND TOOL TO CONTROL MONEY SUPPLY- DISCOUNT
RATE

• There are two types of interest Simple and
  discount.
• Simple- paid each time a payment is made on the
  loan.
• Discount- entire amount of interest owed is
  deducted from loan before it is issued

72
Discount Rate Continued

• The Discount Rate is the interest rate charged to
  member banks that borrow from the Fed District
  Banks.
• Why would a member bank need to borrow from the
  mother fed?

73
Discount Rate Continued

• -Member banks lent out (have no money to loan
  and a good corporate customer wants a loan)
• - Need to pay out customer request for deposited
  funds and poor management of prior loans left
  bank short of cash

74
DISCOUNT RATE CONTINUED

• District Bank is not a charity bank charges
  interest on money loaned to member banks.
• If Member Bank borrows 100,000 at 10
• The interest is discounted up-front- Member has
  90,000 to take back to loan.
• Member bank is not going to loan at 10
• Adds 2 to 3 points to constitute prime rate. In
  this example is 13

75
Discount Rate continued

• If ordinary citizen wants to borrow, points added
  to prime depending on type of loan, collateral,
  history, etc.
• Prime rate is always higher than discount- each
  bank sets own prime, but large banks tend to all
  have the same.
• Prime is rate given to best corporate customers.

76
DISCOUNT RATE CONTINUED

• If Fed wants to cut down on bank loans, they can
  raise the discount rate.
• Recently the Fed lowered the discount rate to
  encourage loans
• Banks will borrow from Federal Funds Rate
  before going to the Fed to borrow. Too many
  trips to the Fed to borrow signals poor fiscal
  management of the bank
• What is the Federal Funds Rate? The rate banks
  can charge (as set by the BOG) for short-term
  loans between each other often overnight.
• Federal Funds rate will be lower than discount
  rate. Why?
• 1.25 vs 1.00 (11/24/08) Today .50 vs .25

77
ON May 17, 2002- Fed revised Discount program

• Type of discount would be called Primary Credit.
• Available for very short term back-up source of
  liquidity to depository institutions in sound
  financial condition.
• Would be extended at a rate above the usual
  level of short-term federal funds rate.
• Interest rate on primary credit would be 100
  basis points above targeted federal funds rate.
• If FF rate is .5 the primary credit would be 1.5
• This encourages banks to borrow from each other
  rather than going to Fed. Allows Fed to
  eliminate a lot of bank investigations and
  paperwork.
• Also establishing a secondary credit another 50
  basis points to financial depositories not quite
  as sound.

NOT!!!!!!!!!!
78
THIRD TOOL TO CONTROL OPEN MARKET COMMITTEE
(FOMC)

• This is the most common tool used by Fed to alter
  the money supply.
• Buying and Selling of U.S. securities on the open
  market
• FOMC meets about every six weeks.
• FOMC all 7 BOG, 12 District Presidents
• N.Y. President permanent member, other 11
  Presidents rotate on the voting 12 on yearly
  basis.
• FOMC constitutes 12 persons.
• Can directly influence the money supply in a
  non-disruptive way.

79
FOMC Continued

• FED can write a check without funds in an account
  so to speak.
• FED holds large portfolio of U.S. government
  securities
• FED engages in open market trading with
  approximately 3 dozen major securities dealers.
• A SELL OPERATION
• When Fed wishes to restrain money supply growth,
  the Fed sells U.S. government securities on the
  open market.

80
FOMC Continued

• Securities dealers then pay the Fed from deposits
  held at their banks, and the Fed simply deducts
  an equivalent amount from the banks reserve
  account.
• As result- banks have less credit in
  reserve-(taken from excess reserves) and cannot
  make as many loans
• Banks might even have to sell some of their
  investments reduced supply of credit throughout
  the banking system.

81

• FED controls this operation by enticing banks to
  buy government securities by offering good
  deals.
• Example Treasury Bond issued to FED. 10,000.
  FED offers this Bond interest to pay a fixed rate
  of 10 yearly until bond expires.- Fed goes to
  bank and says (sell this 10,000 bond for 8,000
  still pay the 10- (this is selling below par)
• This pulls lump sum out of circulation (actual
  rate bank will make over bond life is 12l/2 .
  Money supply has shrunk.
• If the banks elect to buy- less money to loan.
• Banks can only buy government
  securities..Cannot buy corporate bonds.

82
FOMC CONTINUED

• BUY OPERATION
• When FED wants to increase the money supply, it
  reverses the procedure and purchases U.S.
  government securities on the open market. It
  then credits the reserve accounts of the banks in
  which securities dealers keep their deposits.
  End result is that banks have more funds to lend.
• Example Fed offers to buy the 10,000 bond sold
  on open market for 12,000. Bank sells- this
  puts money in circulation or creates potential
  for banks to loan more to member banks.

83
FOMC CONTINUED

• Open Market is not in the business to make money-
  they actually lose money on most transactions
• Main function is to control loans the banks can
  make.
• Securities desk in N.Y. puts the bonds for buy or
  sell out to Security dealers for best bid.
• Every security purchased lowers the money supply.
• FED can use this tool as major way to offset
  cyclical economic swings. Can also supply money
  for seasonal adjustment demands made by business
  and consumers. Or, as we saw, provide money when
  disaster strikes.

84

• FOMC assesses growth operations directed to 4
  objectives
• full employment,
• economic growth,
• stable prices and
• balance of payments.

85

• No bank will ever loan out ALL of its excess
  reserves-
• This would leave them with no flexibility in
  buying Govt Securities.
• Banks are in business to make a profit!

86
Chairman

• Ben Bernanke
• Prior to his job on FOMC, he was Chairman of the
  Presidents council of Economic advisors.
• Now. Fed Reserve Chairman.

87

• Voting FOMC members
• Chairman Ben Bernacke
• 7 Federal Board of Governors
• 5 regional Reserve Bank presidents
• Guess who is boss?
• His term as a member of BOG expires in 2020.
• His term as Chairman could find him replaced by
  President Obama after 4 years.

88
PART III
FEDERAL RESERVE AND MONETARY POLICY
89
FED AS THE NATIONS CENTRAL BANK

• MONETARY POLICY AS REQUIRED BY Congress
• Provide a flow of credit and money that will
  foster economic stability and growth
• Establish a high level of employment
• Provide stability in purchasing power of the
  dollar.
• Reminder- Fed is autonomous
• Three principal tools to implement monetary
  policy
• Reserve requirements
• Discount rate
• Open market operations

90
What Indicators does the Fed check?

• Real Gross Domestic Product (GDP)
• Consumer Price Index (CPI)
• Nonfarm Payroll Employment
• Housing Starts
• Industrial Production/Capacity Utilization
• Retail Sales

• Business Sales and Inventories
• Advance Report on Durable Goods Shipments
• Light-Weight Vehicle Sales
• Yield on 10-year Treasury Bond
• SP 500 Stock Index
• M2 Money Supply

91
Money and Production

• Money is the means of helping to facilitate our
  economic purposes of production, distribution,
  and consumption of goods and services
• Relationship between money supply, price levels
  and business is important aspect of macro theory.
• Equation of Exchange MVPT or MVPQ
• Money x Velocity Prices x Business Transactions
  (real levels of output)
• MV total spending for the year (velocity is
  times turns over in a year )
• PQ total business for that year.
• If any of these get out of balance- economy out
  of sync.

92
Equation of Exchange

• M x V P x Q

where M represents Money Supply V represents
Velocity means must be equal to P represents
Price Q represents Real GDP The average number
of times a dollar is spent to buy final goods and
services in a year
93

• We want the economy to grow, but
• while growing maintain stable price levels.
• Necessary to balance an increase in actual
  production (T) with an increase in spending or
  (MV)

94
Federal Reserve Has Power

• In 1980s Fed Chairman, Paul Volker exercised
  very unpopular decisions to bring inflation under
  control. The growth experienced through the 90s
  was a result of that hard-choice decision.
• In 1990- Chairman Greenspan, proved he can make
  the necessary decisions. Convention wisdom says
  that he orchestrated the economy out of
  recession. Today he is receiving flak!
• The Fed alone does not have complete control. The
  other factors (geopolitical, global economics,
  fiscal policy, and consumer confidence for
  starters have big influence)

95
Central Bankers accept that inflation is always
and everywhere a monetary phenomenon!

• They Accept that the Crucial Function of a
  Central Bank is to
• Produce price stability
• Which means relatively steady recorded rate of
  inflation
• Use the gauges for regulating inflation to signal
  the ability for growth to occur.

96
Milton Friedman, Ph.D. Economicsbelieves and has
written

• After seven decades of poor performance, the Fed
  has improved markedly over the last 15 years.
• Has done better achieving price stability because
  it abandoned Keynesian theory
• Keynes taught that the quantity of money did not
  matter but that the spending and turnover of
  money in the economy was the key.

97
Uncle Miltys comments continued

• Under Keynes. The role of monetary policy was to
  keep interest rates low to promote investment and
  thereby full employment.
• Inflation, he claimed was produced primarily by
  pressures on cost that could best be restrained
  by direct control on prices and wages.

98
BIG PICTURE FOR FED

• To forestall depressions in period of prosperity
• To stimulate the economy in period of declining
  economic activity.
• I.E. To smooth out the swings of the business
  cycle uses counter-cyclical moves

99
HOW MONETARY POLICY CAN AFFECT INTERNATIONAL TRADE

• Contractionary Monetary Policy
• (decrease the growth in money supply
• Increase in interest rates
• Encourages foreign financial investors in U.S.
• Strengthens the international value of dollar
• Increases imports
• Decrease exports
• Employment may decrease
• Inflation may decrease

• Expansionary Monetary Policy
• (increases rate of growth in money supply)
• Decreases interest rates
• Discourages foreign financial investment in the
  U.S.
• Weakens the international value of the dollar
• Decreases imports
• Increases exports
• Employment may increase..Inflation may increase

100
U.S. has a Stop/Go Monetary Policy

• Expansion

• Contraction

S1
S
S
S1
Interest rate
Interest rate
D
D
Quantity of money
Quantity of money
101
Remember!

• Inflation is Bad!!!
• Inflation is Bad!!!
• Inflation is Bad!!!

102
MONETIZING THE DEBT

• When the government borrows to
• Cover a deficit in the federal budget,
• Interest rates tend to rise because of the
• Increased demand for credit (raising the
• Possibility of crowding out.

• S1 S2

Supply of Money Before expansion
Supply of Money After Expansion
Interest rate
Demand After Government Borrowing
12
10
Demand Before Government borrowing
2. If the Fed expands the money supply just
enough To offset the borrowing, interest rates
may remain Unchanged.
D1
D
Quantity of money
What are the long-run effects of monetizing the
debt?
103
STAY TUNED... FED IS WORKING IT'S MAGIC AS WE
SPEAK!
104
So, are you better off?

• Or is the federal government the Grinch?