Understanding the American Federal Reserve

Transcription

1 Understanding the American Federal Reserve The Federal Reserve headquarters is in Washington, DC. The basic structure of the Federal Reserve System includes: The Federal Reserve Board of Governors The Federal Open Market Committee The Federal Reserve Banks The member banks The Federal Reserve Board of Governors: The seven members of the board are appointed by the President and confirmed by the Senate. Members are selected to terms of 14 years (unless removed by the President), with the ability to serve for no more than one term. Each privately owned Federal Reserve Bank and each member bank of the Federal Reserve System is subject to oversight by a Board of Governors. Tools of Monetary Policy: The Federal Reserve essentially has three tools of monetary policy at its disposal: i) Open Market Operations, ii) Interest Rates (The Discount Rate and the Federal Funds Rate), and iii) The Reserve Ratio Of the three tools, the method most popularly used by the Fed is open market operations. Sidebar: Treasury Securities Often referred to as Treasuries, treasury securities are government bonds issued by the United States Department of the Treasury through the Bureau of the Public Debt. They are the debt financing instruments of the U.S. Federal government. All treasury securities except savings bonds are very liquid and are heavily traded on the secondary market. There are four types of treasury securities: Treasury Bills: mature in one year or less; they do not pay interest prior to maturity (ie. no coupons); instead, they are sold at a discount of the par value to create a positive yield to maturity. Treasury Notes: mature in two to ten years; coupon payment every six months; denominations from $1,000 to $1,000,000. Treasury Bonds: mature between ten to thirty years; coupon payment every six months. Savings Bonds: treasury securities for individual investors; they do not have coupons; rather, interest payments are compounded or accrued, which means they are added to the value of the bond and paid out only upon the bond's redemption; after a one-year holding period they can be redeemed with the Treasury at any time, making them very liquid; since they are registered securities, physical possession of a savings bond is of no legal consequence.

2 Open Market Operations The Federal Open Market Committee (FOMC) The FOMC is comprised of the 7 members of the Board of Governors and 5 representatives selected from the Federal Reserve Banks. Control of the Money Supply: The Federal Reserve System controls the size of the money supply by conducting open market operations, in which the Federal Reserve lends or purchases specific types of securities with authorized participants, known as primary dealers. All open market operations in the United States are conducted by the Open Market Desk at the Federal Reserve Bank of New York, with an aim to making the federal funds rate as close to the target rate as possible. The Open Market Desk has two main tools to adjust the monetary supply: i) repurchase agreements, and ii) outright transactions. Repurchase Agreements (aka Repos): The Fed can smooth temporary or cyclical changes in the monetary supply by engaging in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. How a Repo Works: On the day of the transaction, the Fed deposits money in a primary dealer s reserve account, and receives securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer s reserve account for the principal and accrued interest. The term of the repo (the time period between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days. The Fed most commonly conducts overnight and 14-day repos. Since there is an increase of bank reserves during the term of the repo, repos temporarily increase the money supply. The effect is temporary since all repo transactions unwind. The only lasting net effect will be a slight depletion of reserves caused by the accrued interest (not a lot, given that one day of interest at, for example, 4.5% is only % per day).

3 Reverse Repos: April 30, 2007 [Art Lightstone, HTS School of Economics] The Fed can also temporarily shrink the money supply through reverse repos. In a reverse repo, the Fed will borrow money from the reserve accounts of primary dealers in exchange for Treasury securities as collateral. At maturity, the Fed will return the money to the reserve accounts with the accrued interest, and collect the collateral. Outright Transactions: The other main tool available to the Open Market Desk is the outright transaction. Outright Purchase: In an outright purchase, the Fed buys Treasury securities from primary dealers. The Fed finances the purchases by depositing newly created money in the dealer s reserve account at the Fed. Since this operation does not unwind at the end of a set period, the resulting growth in the monetary supply is permanent. That is to say that the principal growth is permanent, but a yield on maturity of the security is still charged. Outright Sale: The sale of Treasury securities results in a permanent decrease in the money supply, as the money used as payment for the securities from the primary dealers is removed from their reserve accounts, thus working the money multiplier process in reverse. The sale of treasuries outright has been exceedingly rare since the 1980s. On Outright Transactions, the Desk selects offers with the lowest prices (highest yields) for its purchases, and bids with the highest prices (lowest yields) for its sales.

4 Interest Rates The other main tools available to the Fed are related to interest rates. The Federal Funds Rate: Similar to Canada s overnight rate, the US has their Federal Funds Rate. This is the rate that banks charge each other on short term loans. This rate is really a target interest rate. While the Fed can declare such a target, such a declaration serves only as a signal to the market. In order to actually reach the target, the Fed engages in the open market operations (buying and selling of securities) that we explored earlier. Increasing the Federal Funds Rate will reduce borrowing, which will reduce the money supply, and vice versa. Discount Rate: Similar to Canada s Bank Rate, the US has their Discount Rate. When banks want to borrow money from the Fed, they are charged the Discount Rate. Increasing the Discount Rate will reduce borrowing, which will reduce the money supply, and vice versa. Reserve Ratio The final tool available to the Fed is the reserve ratio. The required reserve ratio is the fraction of deposits that banks must keep in reserve (i.e. not loan out). As we have studied before, the more money that banks are required to keep on reserve, the less money they are able to loan out, and vice versa. Given that bank loans will increase the money supply through the bank money multiplier, the more that banks are able to loan out, the more the money supply will grow. Thus, increasing the reserve ratio (increasing the amount of deposits that banks must keep in reserve) will lower the money supply, while decreasing the reserve ratio will increase the money supply.

5 Test Your Knowledge! Exercise 1: Fed Actions and Their Effects For each of the following Federal Reserve actions, circle the correct arrow ( for increase, for decrease) to indicate the effect on the bank reserves, money supply, and the Fed Funds Rate. A B Federal Reserve Action Bank Reserves Money Supply Fed Funds Rate Sell Treasury securities on the open market: Buy Treasury securities on the open market: C Raise the discount rate: D E F Lower the discount rate: Raise the reserve requirement: Lower the reserve requirement:

6 Exercise 2: Understanding the Tools of Monetary Policy Complete the following table by indicating how the Federal Reserve could use each of the three monetary policy tools to pursue an expansionary (easy money) policy and a contractionary (tight money) policy. Monetary Policy Tool Expansionary Policy Contractionary Policy A Open Market Operations B Discount Rate C Reserve Requirements

7 Exercise 3: Working with the Bank Money Multiplier Complete the following table by calculating the bank money multiplier, and then calculating the total money supply that would be generated from the bank reserves indicated. Reserve Ratio Bank Reserves Bank Money Multiplier Total Money Supply A 4% $20 million B 10% $30 million C 25% $10 million Exercise 4: Explaining the Effects of Expansionary Monetary Policy Suppose that the economy is operating at full capacity, but then assume that the Fed implements an expansionary monetary policy in order to reduce interest rates. Complete the table below by circling the arrows that would illustrate the short-run (immediate) and the long-run (secondary) effects that an expansionary policy would have on nominal interest rates, real interest rates, output, price level, and employment. Nominal Interest Rates Consumption Output Employment Price Level Real Interest Rates Short-Run (Immediate) Long-Run (Secondary Reactions)

8 Exercise 5: Graphing Changes in the Money Supply Using money supply (MS) and money demand (MD) curves, illustrate the effect that an increase in the money supply will have on interest rates under both the Monetarist and the Keynesian schools of thought. Be sure to title your graphs as Monetarist Perspective and Keynesian Perspective, and don t forget to properly label both the Y and the X axis of each graph. Exercise 6: Graphing Monetary Policy Effects on the Economy Using short-run aggregate supply (SRAS), long-run aggregate supply (LRAS), and aggregate demand (AD) curves, illustrate the effect that an expansionary monetary policy will have on the economy under two conditions: i) the economy is already at full capacity, and ii) the economy is operating below capacity. Be sure to title your graphs as Starting at Full Capacity and Starting Below Full Capacity, and don t forget to properly label both the Y and the X axis of each graph.