Federal Reserve System INFORMAL STRUCTURE

NOTES V Chapter 13 Federal Reserve System INFORMAL STRUCTURE FORMAL STRUCTURE Fed Board of Governors 7 members, each chosen by US president and approved by US senate for 14 years. Members are chosen in two years intervals, and can serve only one full 14 year tenure. The board chairman is picked by US president and approved by US senate for 4 years. FOMC 12 voting members are 7 governors and 5 of the 12 presidents of Federal reserve banks. President of NY bank is always a member, 4 voting members alternate for a one year tenure. 12 Federal Reserve Banks Each headed by a president (chairman of a board of 9 directors. 3 directors(including chairman and vice-chairman) are designated by Board of Governors; remaining 6 are voted by three groups of banks according to its sizes (smallest third, middle third and large third elect each one director from bankers and one from commerce agriculture 3 main functions of the Fed: 1. Regulates banks 2. Clears checks 3. Conducts monetary policy 43

Independence of central Bank SUPPLY OF MONEY Chapter 14 Should Fed be Independent? Case For: 1. Independent Fed likely has longer-run objectives, politicians don't: evidence is better policy outcomes 2. Avoids political business cycle 3. Less likely deficits will be inflationary Starring: 1. Central bank (the Fed) as a controller of MB Also featured: 2. Banks (commercial banks) 3. Depositors 4. Borrowers from banks Federal Reserve Balance Sheet (sum of 12 Fed Banks) Case Against: 1. Fed may not be accountable 2. Hinders coordination of monetary and fiscal policy 3. Fed has often performed badly Central Bank Independence and Macro Performance in 17 Countries Monetary Base = MB = C + R = =(Fed notes)+(bank deposits)+(treasury currency) (coins) 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 Asset = Liabilities of Fed balance sheet => (Fed notes) + (bank deposits) = (securities) + (discount loans) + (gold and SDRs) + (coins) + (cash items in process of collection) + (other Fed assets) (Treasury deposits) (foreign and other deposits) (deferred-availability cash items) (other Fed liabs) Define: Float = (cash items in process of collection) (deferred-availability cash items) MB = (securities) + (discount loans) + (gold and SDRs) + (float) + (other Fed assets) + (Treasury currency) (Treasury deposits) (foreign and other deposits) (other Fed liabs) 44

NOTES W Summary: Factors that Affect the Monetary Base 2. New Discount Loan The Banking System The Fed Reserves + $100 Discount Discount Reserves + $100 Loan +$100 Loan +$100 New Discount Loan MB $100 Conclusion: Fed has better ability to control MB than R or C CREATION OF DEPOSITS Assume that Fed buys $100 of gov. bonds on the open market from banks. Also assume that Required Reserve Ratio = rd= 10%: The Banking System.. $100 of excess reserves in Fed Securities $100 Reserves in Fed + $100 1a. Open Market Purchase from Bank Control of the Monetary Base The Banking System The Fed Securities $100 Securities + $100 Reserves + $100 Reserves + $100 1b. Open Market Purchase from Public The Public The Fed Securities $100 Securities + $100 Reserves + $100 Deposits + $100 The Banking System Assets Liabilities Reserves +100 Deposits -100 1c. Open Market Purchase from Public (buyer cashes its check) The Public The Fed Securities $100 Securities + $100 Currency + $100 Currency + $100 in circulation Open market purchase MB $100 Banking system can use reserves to give a loan of $100 in cash. The Banking System.. $100 of excess reserves in Cash Securities $100 Reserves in Fed +$100 $100 Reserves in Cash +$100 So the banking system gets cash delivered from Fed (above) and give the loan (below). The Banking System.. No excess reserves Securities $100 Reserves in Fed +$100 $100 Reserves in Cash $100+$100 Loan + $100 %#@&! The loan is used by a debtor and the cash is deposited back to banks!!! The Banking System.. $90 of excess reserves Securities $100 Deposits + $100 Reserves in Cash + $100 Loan + $100 Indeed, the banking system can give $1000 of new loans and get $100 of new deposits: The Banking System Securities $100 Deposits +$1000 Reserves + $100 Loan + $1000 45

How does it really work? First National Bank A Securities - $100 Reserves + $100 Deposits + $100 Loan + $100 Bank A Bank B Reserves + $10 Deposits + $100 Reserves + $90 Deposits + $90 Loans + $90 Bank B Reserves + $ 9 Deposits + $90 Loans + $81 Review Federal Reserve System (Fed) Informal Structure of Fed 3 policy tools of Fed 3 functions of Fed Board of Governors Chairman of Fed FOMC Federal Reserve Bank Reserve Requirements Open Market Operations Discount Rate/ Discount Loans Independence of Central Bank Excess Reserves Required Reserves Monetary Base Required reserve Ratio Currency = Federal Reserve notes Creation of Deposits Simple Deposit Multiplier SUPPLY OF MONEY Money Multiplier M = m MB Deriving Money Multiplier: R = RR + ER RR = r D D R = (r D D) + ER Adding C to both sides C + R =MB =(r D D) + ER + C 1. Tells us amount of MB needed support D, ER and C 2. $1 of MB in ER, does not not support D or C Simple Deposit Multiplier: 1 D = R Critique of Simple Model: r D Deposit creation stops if 1. Some proceeds from banks are kept in cash 2. Banks hold excess reserves MB = (rd D) +({ER/D} D )+ ({C/D} D) = (rd + {ER/D} + {C/D}) D 1 D = MB r D + {ER/D} + {C/D} Since M = D+C, thus M = D + ({C/D} D ) = (1 + {C/D}) D 1 + {C/D} 1 + {C/D} M = MB m = r D + {ER/D} + {C/D} r D + {ER/D} + {C/D} m < 1/r D because no multiple expansion for currency and because as D so ER Full Model M = m (MBn + DL) MBn = non-borrowed MB DL = discount loans 46

NOTES X Monetary Tool Open Market Operation Required Reserve Ratio Discount Interest Rate --- --- Player Variable Money Supply Response and Reason Federal Reserve System Banks Depositors Nonborrowed monetary base, MB n Required reserve ratio, rr Borrowed reserves, BR More MB for deposit creation Less multiple deposit expansion More MB for deposit creation Excess reserves Less loans and deposit creation Currency holdings Less multiple deposit expansion Examples: Money Supply and Monetary Base 1929 33 2007-2014 47

Open Market Operations 2 Types 1. Dynamic: Meant to change MB 2. Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1. Fed has complete control 2. Flexible and precise 3. Easily reversed 4. Implemented quickly Discount Loans 3 Types 1. Primary Credit 2. Secondary Credit 3. Seasonal Credit Lender of Last Resort Function 1. To prevent banking panics (FDIC fund not big enough) Example: Continental Illinois 2. To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident 48

NOTES Y Chapter 16 21- - Conduct of Monetary Policy Goals of Monetary Policy Goals 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict Central Bank Tactics 49

C e n t r a l B a n k S t r a t e g y Criteria for Choosing Targets Criteria for Intermediate Targets 1. M easurability 2. Controllability 3. Ability to predictably affect goals Interest rates aren t clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates Criteria for Operating Targets Same criteria as above Reserve aggregates and interest rates about equal on criteria 1 and 2. For 3, if intermediate target is M s, then reserve aggregate is better Resulting Money Fluctuations M o n e y S u p p ly Ta rg e t In te re s t R a te Ta rg e t 1. M d flu ctu a tes b etw ee n M d ' a n d M d '' 2. W ith M -ta rget a t M *, i flu ctu a te s b etw een i' a n d i'' 1.M d flu ctu a tes b etw een M d ' a n d M d '' 2.To set i-ta rget a t i* M s flu ctu a tes b etw een M ' a n d M '' History of Fed Policy Procedures Early Years: Discounting as Primary Tool 1. Real bills doctrine 2. Rise in discount rates in 1920: recession 1920 21 Discovery of Open Market Operations 1. Made discovery when purchased bonds to get income in 1920s Great Depression 1. Failure to prevent bank failures 2. Result: sharp drop in M s Reserve Requirements as Tool 1. Banking Act of 1935 2. Required reserves in 1936, 1937 to reduce idle reserves: Result: M s and severe recession in 1937 38 Pegging of Interest Rates: 1942-51 1. To help finance war, T-bill at 3/8%, T-bond at 2 1/2% 2. Fed-Treasury Accord in March 1951 Money Market Conditions: 1950s and 60s 1. Interest Rates A. Procyclical M Y i MB M π π e i MB M Targeting Monetary Aggregates: 1970s 1. Fed funds rate as operating target with narrow band 2. Procyclical M 50

NOTES Z Chapter 19 - Demand for Money Change in Velocity from Year to Year 1915 2002 Is velocity constant? 1. Classical Economists thought V is constant because they didn t have good data 2. After Great Depression, economists realized velocity is not constant Keynes s Liquidity Preference Theory 3 Motives 1. Transactions motive positively related to Y M d Classical Economists => = f(y) (V constant) P + 2. Precautionary motive positively related to Y 3. Speculative motive negatively related to i M d Keynes => P = f(i, Y) + Implication: Velocity not constant P 1 PY Y = => V = = M d f(i,y) M f(i,y) Multiply both sides by Y and substitute in M = M d Transactions Demand Conclusion: Higher is i and income gain from holding bonds, less likely to hold cash: Therefore i, M d Transactions Motive positively related to Y and negatively related to i Precautionary Demand Similar tradeoff to Baumol-Tobin framework 1. Benefits of precautionary balances 2. Opportunity cost of interest foregone Conclusion: i, opportunity cost, hold less precautionary balances, M d Precautionary Motive positively related to Y and negatively related to i 51

1. i, f(i,y), V 2. Change in expectations of future i, change f(i,y) and thus V changes Cash Balance in Baumol-Tobin Model Baumol-Tobin Model of Transactions Demand Assumptions 1. Income of $1000 each month 2. 2 assets: money and bonds (a) If keep all income in cash 1. Yearly income = $12,000 2. Average money balances = $1000/2 => Velocity = $12,000/$500 = 24 (b) Keep only 1/2 payment in cash 1. Yearly income = $12,000 2. Average money balances = $500/2 = $250 => Velocity = $12,000/$250 = 48 Trade-off of keeping less cash 1. Income gain = i $500/2 2. Increased transactions costs Speculative Demand Problems with Keynes s framework: Hold all bonds or all money: no diversification Tobin Model: 1. People want high R e, but low risk 2. As i, hold more bonds and less M, but still diversify and hold M Problem with Tobin model: No speculative demand because T-bills have no risk (like money) but have higher return Friedman s Modern Quantity Theory Theory of asset demand: M d function of wealth (Y P ) and relative R e of other assets M d = f(y P, r b r m, r e r m, π e r m ) P + Differences from Keynesian Theories 1. Other assets besides money and bonds: equities and real goods 2. Real goods as alternative asset to money implies M has direct effects on spending 3. r m not constant: r b, r m, r b r m unchanged, so M d unchanged: i.e.,interest rates have little effect on M d 4. M d is a stable function Implication of 3: M d Y = f(y P ) V = P f(y P ) Since relationship of Y and Y P predictable, 4 implies V is predictable: Get Q-theory view that change in M leads to predictable changes in nominal income, PY Empirical Evidence on Money Demand i Interest Sensitivity of Money Demand Is sensitive, but no liquidity trap Stability of Money Demand 1. M1 demand stable till 1973, unstable after 2. Most likely source of instability is financial innovation 3. Cast doubts on money targets KEYNES FRIEDMAN Md i Md 52