The Federal Reserve System Chapter 14
Federal Reserve System • Passed through Congress narrowly in December 1913 • Regional banks to disperse power and allay fears of monopoly capitalism
Lender of Last Resort • Fed would stand ready to lend to banks that were solvent but illiquid. • Loans would be made through discounting high grade loans—the bank would sell an IOU from a credit-worthy borrower, the Fed would take the present value of the face value using the “discount rate.” • Today the Fed lends directly but the interest rate is still called the discount rate.
Discount Rate Set one percentage point above the Fed funds target. Currently at 5.5%.
12-7-12 12 Fed banks 7 members of the Board of Governors 12 members of the Federal Open Market Committee
Member bankers’ bank (keeps deposits and makes loans when reserves are too low) Clear checks Issue new currency and withdraw old Oversee bank mergers Liaison with the business community and collect data Bank examinations Research for input into monetary policy decisions Functions of the Fed Banks
Board of Governors • 7 members. • 14 year non-renewable terms, one opens up every second January. • Chairman has 4 year renewable term. • http://www.federalreserve.gov/bios/
Federal Open Market Committee • 12 members • 7 members of the Board of Governors + 5 Fed bank presidents (always including the President of the FRBNY) • http://www.federalreserve.gov/FOMC/
FOMC Books • Green (national forecast) • Blue (projected monetary aggregates) • Beige (regional banks assessment of economy)
Central Bank Independence Factors making Fed independent 1. Members of Board have long terms 2. Fed is financially independent: This is most important Factors making Fed dependent 1. Congress can amend Fed legislation 2. President appoints Chairmen and Board members and can influence legislation Overall: Fed is quite independent
Do we need a central bank? "I am more convinced than ever that if we ever again are going to have a decent money, it will not come from government: it will be issued by private enterprise, because providing the public with good money which it can trust and use can not only be an extremely profitable business; it imposes on the issuer a discipline to which the government has never been and cannot be subject." Friedrich Hayek
Arguments for Fed Lender of last resort. Elastic currency. Counter Argument Did not function during the Depression Ability to expand money supply can be misused. Economic growth with fixed money implies steadily declining prices—a healthy deflation. Case for Central Bank
The Money Supply Process Chapters 15 & 16
Consider the narrowest definition of money: M1. Consists of … • currency • checkable deposits • travelers checks
Currency = $626.5 billion + FED (90%) TREASURY (10%)
Checkable Deposits Demand Deposits Other Checkable Deposits $290.7 billion $281.2 billion
Traveler’s Checks $7.7 billion Therefore, total M1 = $1,206.1 billion. Where did it come from?
How do banks create new deposits? • They must have excess reserves. • When they make a loan with the excess reserves, a new deposit is created.
Bank reserves consist of …. • Vault cash (includes cash in ATM’s). • Deposits at the Fed.
Excess (ER) versus Required (RR) Reserves • Reserve requirements are set by the Board of Governors of the Federal Reserve. • Requirements can be expressed as a fraction of deposits. • Small banks tend to hold more excess reserves. What do large banks do with their excess reserves?
Fed Assets Fed Liabilities Government securities Discount loans Fed notes in circulation Deposits of member banks
Monetary Base (aka High Powered Money) Currency in circulation + Bank Reserves = Fed notes and coins in circulation + vault cash + bank deposits at Fed
Money Supply Process: Simple Model Assumptions: • 10% required reserve ratio. • Banks hold no excess reserves. • No currency. What happens to the money supply when the Fed purchases $100 of Treasury securities?
Deposit Creation:Banking System as a Whole Banking System Assets Liabilities Securities – $100 Deposits + $1000 Reserves + $100 Loans + $1000
Formula for Money Multiplier … … can be derived from R = RR = r * D Critique of Simple Model Deposit creation stops if: 1. Proceeds from loan kept in cash 2. Bank holds excess reserves