Chapter 15 MODERN PRINCIPLES OF ECONOMICS Third Edition The Federal Reserve System and Open Market Operations
Outline What Is the Federal Reserve System? The U.S. Money Supplies Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier How the Fed Controls the Money Supply The Federal Reserve and Systemic Risk Revisiting Aggregate Demand and Monetary Policy Who Controls the Fed? 2
Money 3
Money 4
Money 5
Money 6
Money 7
Money 8
Quotes & Videos Paper money will always return to its intrinsic value. Nothing. Voltaire The Fed Turned the Stock Market Into a 'Hall of Mirrors (7:00) https://www.youtube.com/watch?v=dmyflsf-tws Why Not Print More Money? https://www.youtube.com/watch?v=zkybnaycuhw 9
Introduction Through its influence over the money supply, the Federal Reserve has more influence over aggregate demand than any other institution. Shifts in aggregate demand can greatly influence the economy in the short run. This chapter looks at the Federal Reserve System and the tools it uses to influence money supply, aggregate demand, and the economy. 10
Federal Reserve System The Federal Reserve has the power to create money. It doesn t have to literally print money, it can add reserves to bank accounts held at the Fed. This new money can be given away or lent out in a way that increases aggregate demand. The Fed s most important job is to regulate the money supply. 11
Federal Reserve System As the government s bank, the Fed: Maintains the bank account of the U.S. Treasury. Manages government borrowing through U.S. Treasury bonds, bills, and notes. The Fed is also the banker s bank It regulates other banks and lends them money. It manages the nation s payment system. It protects financial consumers with disclosure regulations. 12
Self-Check Which of the following is NOT a function of the Federal Reserve? a. Maintaining the US Treasury bank account. b. Lending money to other banks. c. Lending money to consumers. Answer: c lending money to consumers. 13
Definition Money: A widely accepted means of payment. 14
The U.S. Money Supplies Most important assets that serve as means of payment in the U.S. today: Currency paper bills and coins. Total reserves held by banks at the Fed. Checkable deposits your checking or debit account. Savings deposits, money market mutual funds, and small-time deposits. 15
The U.S. Money Supplies Major Means of Payment in the United States 16
The U.S. Money Supplies Currency is coins and paper bills held by people and nonbank firms. Total currency amounts to about $4,300 per person. Quite a bit of U.S. cash is used in other countries. Panama, Ecuador, El Salvador and others use the U.S. dollar as their official currency. Dollars are also used unofficially in unstable countries as a means of preserving wealth. 17
The U.S. Money Supplies Total reserves play an important role in the financial system. All major banks have accounts at the Federal Reserve that they use for trading with other banks and the Fed itself. It s not currency but electronic claims that can be converted into currency if the bank wishes. 18
The U.S. Money Supplies Checkable deposits are deposits that you can write checks on or access with a debit card. These are deposits used most often in making daily transactions. They are also called demand deposits because you can access this money on demand. 19
The U.S. Money Supplies The largest means of payment are savings accounts, money market mutual funds, and small-time deposits (also called certificates of deposit or CDs). Extra work is required to use them as a means of payment. Typically you must transfer the money to a checking account before you can use it. 20
Self-Check The largest means of payment in the US. is: a. Currency. b. Checkable deposits. c. Savings deposits. Answer: c savings deposits. 21
Definition Liquid asset: an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments. 22
Definition Liquid asset: an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments. 23
The U.S. Money Supplies The money supply can be defined in different ways depending on which liquid assets are included in the definition. The three most important definitions of the money supply are: The monetary base (MB): Currency and total reserves held at the Fed. M1: Currency plus checkable deposits. M2: M1 plus savings deposits, money market mutual funds, and small time deposits. 24
The U.S. Money Supplies The Money Pyramid, 2014 25
The U.S. Money Supplies Difficulty of Central Banking The Fed has direct control only over the monetary base. Uses control over MB to influence M1 and M2. Problems: M1 and M2 can shrink or grow independent of what the Fed does. Aggregate demand can shrink or grow for other reasons than changes in M1 and M2. 26
Self-Check The monetary base includes: a. Currency and reserves held by banks at the Federal Reserve. b. Currency and checkable deposits. c. Currency and savings deposits. Answer: a currency and reserves held by banks at the Federal Reserve. 27
Definition Fractional Reserve Banking: A system where banks hold only a fraction of deposits in reserve, lending the rest. 28
Fractional Reserve Banking When money is deposited in an account, the bank holds a fraction of the account balance in reserve and uses the rest to make loans. Banks earn profit on these loans. Banks share some of the profit with you by paying interest on the money you provide. They also provide services like check writing and check clearing. 29
Fractional Reserve Banking The law and the Federal Reserve require banks to keep some reserves. Banks need those reserves to meet depositor demands for currency and payment services. Reserves involve opportunity costs: money held in reserve isn t being lent, and lending is where banks earn most of their profits. Banks balance these benefits and costs when deciding on the ratio between reserves and deposits. 30
Definition Reserve Ratio (RR): The ratio of reserves to deposits. Money Multiplier (MM): The amount the money supply expands with each dollar increase in reserves. MM = 1/RR. 31
Reserve Ratio If $1 in cash is held in reserve for every $10 of deposits, the reserve ratio is:.10 The reserve ratio is determined primarily by how liquid banks wish to be. 32
Money Multiplier The inverse of the reserve ratio (1/RR) is called the money multiplier, MM. The money multiplier is the ratio of deposits to reserves; in our case, 10 The money multiplier tells us how much deposits expand with each dollar increase in reserves. 33
Money Multiplier CUSTOMER BANKS $1000 DEPOSITS $900 $810 $810 $900 $1000 $1000 is deposited Bank keeps 10% reserve, loans $900 Bank keeps 10% reserve, loans $810 So far, banks created 810 + 900 = $1710 in additional money.
Money Multiplier The process continues until there are no excess reserves to lend. With a reserve ratio of 10%, the money multiplier = 1/0.10 = 10. The initial $1000 increase in reserves can expand total deposits (money supply) by: Change in reserves x MM = Change in money supply $1000 x 10 = $10,000. 35
Printing Money 36
Self-Check If the reserve ratio is 5%, the money multiplier is equal to: a. 20. b. 10. c. 2. Answer: a the money multiplier is the inverse of the reserve ratio, 1/.05 = 20. 37
Controlling the Money Supply The Fed has two major tools to control the money supply: 1. Open market operations. 2. Paying interest on reserves held by banks at the Fed. 38
Definition Open market operations: Occur when the Fed buys or sells government bonds. 39
Open Market Operations The Fed changes the money supply by buying or selling government bonds (T-bills). To pay for the T-bills, the Fed electronically increases the reserves of the seller, usually a bank or large dealer. With more reserves, the bank makes additional loans, which are used to buy goods and pay wages. The new deposits increase the reserves of other banks, which will also make more loans. 40
Open Market Operations The payments for goods and wages will be deposited into other banks The new deposits increase the reserves of other banks, which will also make more loans. 41
Open Market Operations The Fed controls the monetary base, but it does not control how much or how quickly the base will change loans and the money supply. The money multiplier is determined by the reserve ratio, which is determined by banks. When banks are confident, they will keep their reserves low so the MM will be large. When banks are reluctant to lend the MM will be low and a change in the monetary base will not change the money supply by much. 42
Open Market Operations When the Fed buys or sells bonds, it changes the monetary base and influences interest rates at the same time. When the Fed buys bonds, the demand for bonds increases, pushing up the price of bonds and lowering the interest rate. Buying bonds stimulates the economy through higher money supplies and lower interest rates. When the Fed sells bonds, the process works in reverse. 43
Open Market Operations Buying and selling government bonds changes interest rates: Fed buys bonds Demand for bonds Price of bonds Interest rates Fed sells bonds Demand for bonds Price of bonds Interest rates 44
Open Market Operations Usually, the Fed conducts open market operations by buying and selling short-term debt. When the economy requires an extra boost, the Fed may influence long-term rates through quantitative easing. This involves buying longer-term government bonds, or other longer-term securities, in the 10- to 30-year range. 45
Open Market Operations The Fed usually focuses on the Federal Funds rate, or the overnight rate. It is a convenient signal of monetary policy. It responds quickly to actions by the Fed. It can be monitored on a day-to-day basis. Instead of increasing the money supply, the Fed can buy bonds until the Federal Funds rate drops by the desired amount. The Fed can also increase the Federal Funds rate by selling bonds. 46
Definition Federal funds rate: The overnight lending rate from one major bank to another. 47
Quantitative Easing During the recession of 2008 2009, the Fed dramatically increased reserves. It pushed the Federal Funds rate very close to zero ( zero lower bound ). The economy still wasn t responding. The Fed moved to buying and selling longerterm government bonds. This quantitative easing is used when the Federal Funds rate is near the zero lower bound. 48
Definition Quantitative easing: When the Fed buys longer-term government bonds or other securities. Quantitative tightening: When the Fed sells longer-term government bonds or other securities. 49
Self-Check The Fed influences short-term rates through: a. Quantitative easing. b. Open market operations. c. The reserve ratio. Answer: b the Fed influences short-term rates through open market operations, or buying and selling government bonds. 50
Payment of Interest on Reserves Normally, the Fed would influence the Federal Funds rate by changing the supply of reserves. During the 2008 financial crisis, the Fed wanted to separate these two aspects of monetary policy. It wanted banks to have lots of reserves to avoid bank runs. It also wanted to keep interest rates close to a certain level. 51
Payment of Interest on Reserves Paying interest on reserves allowed the Fed to separate the two channels of monetary policy. Starting in 2008, it increased excess reserves in the banking system from $2 billion to $2.8 trillion. Even though the Fed pays a very low interest rate on reserves, banks are willing to hold lots of reserves because interest rates for other low-risk investments are also close to zero. 52
Payment of Interest on Reserves Excess Reserves of Financial Institutions 53
Payment of Interest on Reserves Changing the supply of reserves is no longer very effective because banks have more than enough reserves for all their requirements. The Fed can change the demand for reserves. It raises the interest it pays on reserves. Banks earn more interest so are less willing to lend those reserves, pushing up market interest rates. Borrowing declines, and the money supply grows less quickly. 54
Payment of Interest on Reserves There is uncertainty as to how much these actions can influence real economic activity. Bank lending is no longer constrained by reserves. When interest rates are very low, it may not be constrained very much by interest rates either. When interest rates are so low that lowering them further is not possible or effective at increasing aggregate demand, the economy is sometimes said to be in a liquidity trap. 55
Definition Lender of last resort: Loans money to banks and other financial institutions when no one else will. 56
Lender of Last Resort Under certain conditions, depositors may panic and then all try to withdraw their money at once, causing a bank run. Depositors can t tell whether the bank is really insolvent or just illiquid. That s where deposit insurance and the Federal Reserve come in. 57
Definition Insolvent Institution: An institution that has liabilities that are greater than its assets. 58
Definition Illiquid Asset: An asset that is worth a lot in the future, but it can only be sold today at a much lower price. A bank may be illiquid but not insolvent. 59
Lender of Last Resort Traditionally, the Fed lent to solvent but illiquid banks. In a panic, the Fed may also lend to insolvent institutions to avoid systemic risk. During the 2008 financial crisis, the Fed bought trillions of dollars worth of longer-term government bonds and mortgage-backed securities, and lent over a trillion dollars to financial intermediaries. 60
Definition Systemic Risk: The risk that the failure of one financial institution can bring down other institutions. 61
Lender of Last Resort Total Fed Lending 62
Lender of Last Resort When individuals or institutions are insured, they tend to take on too much risk. Institutions that are too big to fail have too little incentive to make responsible financial investments. This is the problem of moral hazard. The Fed has the responsibility of regulating banks: to minimize reckless bank behavior. The fundamental problem is limiting systemic risk while checking moral hazard. 63
The Fed Tools 64
AD and Monetary Policy The Fed uses monetary policy to influence aggregate demand (AD). For example, to increase AD it can: Buy bonds in an open market operation. This expands the monetary base, increasing deposits and loans by the multiplier process. This also lowers short-term interest rates, stimulating investment and consumption borrowing. If all goes well, AD increases. 65
AD and Monetary Policy 66
AD and Monetary Policy To estimate the effect on AD, the Fed must try to predict and monitor the following: Will banks lend out all the new reserves or only a portion? How quickly will increases in the monetary base translate into new bank loans? Do businesses want to borrow? How low do shortterm interest rates have to go to stimulate more investment borrowing? If businesses do borrow, will they hire labor and capital, or just hold the money as a precaution? 67
Who Controls the Fed? The Fed has a seven-member Board of Governors who are appointed by the president for 14-year terms and confirmed by the Senate. The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years. The Fed is made up of 12 Federal Reserve Banks, each headquartered in a different region of the country. 68
Who Controls the Fed? The Federal Reserve is one of the most independent agencies in the U.S. government. Its considerable power is dispersed: No one president appoints all the governors. The governors do not have complete control over Fed policy. The regional bank presidents come from all over the United States. Regional bank presidents are appointed by directors from many sectors, not just banking. 69
Who Controls the Fed? The Fed has a seven-member Board of Governors, who are appointed by the president for 14-year terms and confirmed by the Senate. The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years. The Fed is not just one bank but 12 Federal Reserve Banks, each headquartered in a different region of the country. 70
Takeaway At least five factors amplify economic shocks: Labor supply and intertemporal substitution Uncertainty and irreversible investment Labor adjustment costs Time bunching Collateral shocks 71