The Banks Bank: Federal Reserve and the Banking System

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The Banks Bank Federal Reserve and the Banking
System
ECON 1101 Economics for Non-Majors

• Chapter 15

I guess I should warn you, if I turn out to be
particularly clear, you have probably
misunderstood what I said. Alan Greenspan Fed
Chairman, 1987 - 2006
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A Bank for All Reasons

• The Federal Reserve (Fed)
• Central Bank of the United States, established in
  1913 as lender of last resort to maintain
  liquidity
• Banks Bank
• Governments Bank
• Four Main Responsibilities
• Formulate and implement nations monetary policy
• Supervise and regulate banking institutions and
  protect the rights of consumers who use credit
• Maintain stability of the financial system
• Provide financial services to US government, the
  public, financial institutions, and foreign
  government institutions

Ch 15 The Banks Bank Federal Reserve
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A Bank for All Reasons

• Three Primary Components of Fed
• Twelve District Banks
• Charlottes district bank is in Richmond
• Check-clearing services (now use ACH auto
  clearing house)
• Maintain accounts for commercial banks in
  district
• Issue currency to commercial banks
• Board of Governors
• Seven members, appointed by President, confirmed
  by Congress
• Serve 14-year terms to ensure non-partisanship
• Establish banking regulations, oversee banking
  operations, economy in general.
• One member is appointed as chair, another as vice
  chair (who is the current chair??)
• Federal Open Market Committee (FOMC)
• Consists of Board of Governors, NY bank
  president, and five other district bank
  presidents.
• Conduct open market operations as tool of
  monetary policy.

Ch 15 The Banks Bank Federal Reserve
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A Bit of Background on Banking

• Fractional Reserve Banking (How Money Supply
  Increase or Decrease)
• Banks are required to keep a certain percentage
  of checking account balances on hand in their
  vault or in their account at the Federal Reserve
  Bank.
• The reserve requirement is a percentage
  established by the Federal Reserve.
• For example, if the reserve requirement is 10,
  and Wachovia Bank has 10 million deposited into
  checking accounts at their banks, Wachovia must
  always have at least 1 million (10 million x
  10) on hand in vault cash or in their cash
  account at the Fed.
• Banks can then make loans to consumers and
  businesses with the other 90 of their checking
  deposits, thereby creating money in the money
  supply.

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Monetary Moves

• Monetary Policy
• We often refer to the Fed as controlling the
  money supply, though they do not actually
  CONTROL it.
• The Fed influences the demand for and supply of
  money and loanable funds, influencing interest
  rates, the availability of money and credit, and
  ultimately the economy (through consumption,
  investment, etc).
• The Fed does not SET the economys interest
  rates, it only influences them in the direction
  they need them to move.

Ch 15 The Banks Bank Federal Reserve
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Monetary Moves

• The Federal Reserve
• The Feds most important function is to engage in
  monetary policy to achieve certain goals for the
  United States economy.
• Two Types of Monetary Policy
• Expansionary Policy
• Designed to expand (speed up, boost, jumpstart)
  the economy.
• Increase in money supply, increase in
  consumption, increase in output
• Contractionary Policy
• Designed to contract (shrink, slow down) the
  economy.
• Decrease in money supply, decrease in
  consumption, decrease in output.

Ch 15 The Banks Bank Federal Reserve
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• Three Tools of Monetary Policy
• Reserve Requirement
• Percentage of deposits that banks are required to
  hold in reserve.
• Expansionary lower reserve requirement
• Contractionary raise reserve requirement
• Discount Rate
• Interest Rate that the Federal Reserve Bank
  charges commercial banks for borrowing money.
• Expansionary lower discount rate
• Contractionary raise discount rate
• Open Market Operations
• Buying and selling government bonds and
  securities in the bond market.
• Expansionary buy bonds
• Contractionary sell bonds

A Bank for All Reasons
Ch 15 The Banks Bank Federal Reserve
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How Money is Created
How Does Money Supply Increase or
Decrease? Assume banks loan all excess reserves,
and borrowers deposit entire amount back into a
bank.
Injection into the money supply by the Federal
Reserve Bank.
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How Money is Created

• With fractional reserve banking, the initial
  injection into the banking system has a
  multiplier effect on the money supply. Amount of
  the impact depends on the reserve requirement.
• Money (deposit) multiplier reciprocal of
  reserve requirement
• If reserve requirement is 10, money multiplier
  1/.10 10.
• Deposit of 100,000 can impact the money supply
  by
• 10 x 100,000 1 million.
• In order to increase the impact a deposit would
  have on the money supply, would we raise or lower
  the reserve requirement?
• If reserve requirement is 5, money multiplier
  1/.05 20.
• Deposit of 100,000 can impact the money supply
  by
• 20 x 100,000 2 million.

Ch 15 The Banks Bank Federal Reserve
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Monetary Policy Stepping in the Gas, Hitting the
Brakes
ECON 1101 Economics for Non-Majors

• Chapter 16

The business cycle is doomed, thanks chiefly to
the government. Paul Samuelson Nobel-winning
Economist
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Monetary Policy in Action

• Goal To maintain a stable, growing economy with
  low inflation and unemployment.
• During expansion, Fed should hit the brakes.
• Aka tightening, or tight policy
  (contractionary)
• Target higher interest rates
• Slow growth of money supply
• Take away the punch bowl just when the party
  gets good.
• During recession, Fed should step on the gas.
• Aka loosening or loose policy
• Give the economy a soft landing
• Target lower interest rates
• Increase growth of money supply

Ch 16 Stepping in the Gas, Hitting the Brake
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Monetary Policy in Action

• Factors that complicate the process
• Time lags
• Recognition lag
• Action lag
• Response lag
• Lags require Fed to anticipate changes in the
  economy, and implement proper policies for those
  anticipated changes (ie, cant wait for inflation
  to hit the brakes)
• Other factors, outside of Feds purview, affect
  inflation and unemployment
• Fiscal Policy (taxes and govt spending)
• Developments overseas
• Conditions in financial markets
• Technological changes

Ch 16 Stepping in the Gas, Hitting the Brake
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Monetary Policy in Action

• How the Fed Gets the Word Out
• Monetary Policy report to Congress
• Twice a year, mandated by law
• Statement delivered by chairman, usually Feb and
  July
• Includes report on key economic variables
  (unemployment, inflation, GDP, productivity,
  wages, exchange rates, etc)
• Ends with Fed forecast of economic growth
• Commentary on Current Economic Conditions
• Informal survey of all 12 banks, published 8
  times a year.
• Called The Beige Book
• Info summarized by district and industrial sector
  (ag, manufacturing, etc)
• Interviews with economists, business execs, etc)
• Statements after FOMC Meetings
• Released at 215 on last day of FOMC meetings.
• Includes target for fed funds rate, explanation,
  clues about what Fed thinks of economy, and votes
  of all members.

Ch 16 Stepping in the Gas, Hitting the Brake
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Monetary Policy in Action

• Release Date June 25, 2008
• The Federal Open Market Committee decided today
  to keep its target for the federal funds rate at
  2 percent.
• Recent information indicates that overall
  economic activity continues to expand, partly
  reflecting some firming in household spending. 
  However, labor markets have softened further and
  financial markets remain under considerable
  stress.  Tight credit conditions, the ongoing
  housing contraction, and the rise in energy
  prices are likely to weigh on economic growth
  over the next few quarters.
• The Committee expects inflation to moderate later
  this year and next year.  However, in light of
  the continued increases in the prices of energy
  and some other commodities and the elevated state
  of some indicators of inflation expectations,
  uncertainty about the inflation outlook remains
  high.
• The substantial easing of monetary policy to
  date, combined with ongoing measures to foster
  market liquidity, should help to promote moderate
  growth over time.  Although downside risks to
  growth remain, they appear to have diminished
  somewhat, and the upside risks to inflation and
  inflation expectations have increased.  The
  Committee will continue to monitor economic and
  financial developments and will act as needed to
  promote sustainable economic growth and price
  stability.
• Voting for the FOMC monetary policy action were
  Ben S. Bernanke, Chairman Timothy F. Geithner,
  Vice Chairman Donald L. Kohn Randall S.
  Kroszner Frederic S. Mishkin Sandra Pianalto
  Charles I. Plosser Gary H. Stern and Kevin M.
  Warsh.  Voting against was Richard W. Fisher, who
  preferred an increase in the target for the
  federal funds rate at this meeting.

Ch 16 Stepping in the Gas, Hitting the Brake
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Monetary Policy in Action
Ch 16 Stepping in the Gas, Hitting the Brake
RECESSION