© 2005 Thomson C hapter 27 The Federal Reserve System and Monetary Policy

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CChapter 27hapter 27

The Federal Reserve The Federal Reserve System and System and

Monetary PolicyMonetary Policy

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

The Federal Reserve System as a central bank

The discount rate as a tool of monetary policy

Open market operations as a tool of monetary policy

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Economic PrinciplesEconomic Principles

Money supply versus interest rate targets

Countercyclical monetary policy

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A Glimpse at HistoryA Glimpse at History

Bank note

• A promissory note, issued by a bank, pledging to redeem the note for a specific amount of gold or silver. The terms of redemption are specified on the note.

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In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies.

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The first real U.S. money was the Continental Note.• Since Congress had no taxing authority, it printed Continental Notes to finance the Revolution.

• Excessive printing rendered the Continental Note nearly useless.

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State-chartered bank

• A commercial bank that receives its charter or license to function from a state government and is subject to the laws of that state.

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EXHIBIT 1 GROWTH OF STATE BANKS: 1784–1860 ($ MILLIONS)

Source: U.S. Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, D.C.: U.S. Government Printing Office, 1949,) pp. 261–263.

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Exhibit 1: Growth of Exhibit 1: Growth of State Banks: 1784-1860 State Banks: 1784-1860

($ millions)($ millions)What are some reasons for the rapid growth of state banks?• The money supply was inadequate to finance the growing number of farms, factories, and businesses.

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Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government.

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A Glimpse at HistoryA Glimpse at History• Congress accepted Hamilton’s plan and created the First Bank of the United States in 1791.

• This central bank dampened the inclination of state-chartered banks to overissue notes by demanding that the notes be redeemed in silver and gold.

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Nationally chartered bank

• A commercial bank that receives its charter from the comptroller of the currency and is subject to federal law as well as the laws of the state in which it operates.

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When the 20-year charter of the First Bank of the U.S. expired in 1811, advocates of states’ rights in Congress prevailed, and the charter was not renewed.

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In 1816 Congress created the Second Bank of the U.S., which again stabilized state banking practices. As with the First Bank, however, political pressure led to the failure of Second Bank of the U.S. in the 1830s.

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During the Civil War, Congress passed the National Bank Act, which created a national banking system and the office of the comptroller of the currency, which chartered national banks.

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National banks had to buy Treasury Bonds equal to one-third of their capital, and could issue notes only in proportion to their Treasury bond holdings.

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In 1907 the highly respected Knickerbocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913.

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The Federal Reserve The Federal Reserve SystemSystem

The Federal Reserve Act of 1913 created the Federal Reserve System (the “Fed”). The Fed has 12 regional district banks that serve as the region’s central bank.

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Does the president of the U.S. control the Fed?• No. Although the Fed was created by and responsible to Congress, the Fed pursues an independent monetary policy that at times may conflict with policies pursued by the president or Congress.

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EXHIBIT 2 THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM

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Exhibit 2: The Exhibit 2: The Geography of the Geography of the Federal Reserve Federal Reserve

SystemSystem• In what Federal Reserve Bank district do you live?

• What is the reserve bank city for your district?

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EXHIBIT 3 NATIONAL BANKS, STATE BANKS, AND TOTAL DEPOSITS: 2000 ($ BILLIONS)

Source: Federal Deposit Insurance Corporation, Statistics on Banking, 2000 (Washington, D.C.: FDIC, 2000).

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Exhibit 3: National Banks, Exhibit 3: National Banks, State Banks, and Total State Banks, and Total

Deposits: 2000 ($ billions)Deposits: 2000 ($ billions)

Of the following, which had the largest number of banks in 2000?a. National banks

b. State banks (Fed member)

c. Savings institutions

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Exhibit 3: National Banks, Exhibit 3: National Banks, State Banks, and Total State Banks, and Total

Deposits: 2000 ($ billions)Deposits: 2000 ($ billions)

Of the following, which had the largest number of banks in 2000?a. National banks

b. State banks (Fed member)

c. Savings institutions

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EXHIBIT 4 ORGANIZATIONAL STRUCTURE OF THE FEDERAL RESERVE SYSTEM

Source: Board of Governors of the Federal Reserve System, Division of Support Services, Purposes & Functions, 1984.

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Exhibit 4: Organizational Exhibit 4: Organizational Structure of the Federal Structure of the Federal

Reserve SystemReserve SystemWhat is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)?

• The Board of Governors

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The Fed’s main charge is to safeguard the proper functioning of our monetary system (money supply, interest rates, and the economy’s price level).

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Federal Open Market Committee

• The Fed’s principal decision-making body, charged with executing the Fed’s open market operations.

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EXHIBIT 5 IDENTIFYING LETTERS AND DISTRICT BANKS

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Exhibit 5: Identifying Exhibit 5: Identifying Letters and District Letters and District

BanksBanksIf you look at the seal to the left of George Washington’s picture on a $1 bill and see the letter “L”, in what district bank was that $1 bill issued?• San Francisco

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Discount rate

• The interest rate the Fed charges banks that borrow reserves from it.

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EXHIBIT 6 BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE

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Exhibit 6: Bank Exhibit 6: Bank Transactions Triggered Transactions Triggered

by Brian’s Purchaseby Brian’s PurchaseWhy does Brian’s check go to the Atlanta Fed and the Cleveland Fed?

• One of the functions of a district Fed is to clear checks.

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EXHIBIT 7A FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

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EXHIBIT 7B FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

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EXHIBIT 7C FROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

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Exhibit 7: From Changes in Exhibit 7: From Changes in the Money Supply to the Money Supply to Changes in Real GDPChanges in Real GDP

How does an increase in the money supply lead to an increase in real GDP?• Increasing the money supply leads to lower interest rates, which promotes increased investment spending, which increases aggregate demand.

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Controlling the Controlling the Money SupplyMoney Supply

Countercyclical monetary policy

• Policy directives used by the Fed to moderate swings in the business cycle.

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Reserve requirement

• The minimum amount of reserves the Fed requires a bank to hold, based on a percentage of the bank’s total deposit liabilities.

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EXHIBIT 8 RESERVE REQUIREMENTS (SEPTEMBER 2000)

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., December 2000), p. A9.

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Exhibit 8: Reserve Exhibit 8: Reserve Requirements Requirements

(September 2000)(September 2000)Do reserve requirements imposed by the Fed depend on the bank’s total deposits?• Yes. Banks with more than $42.8 million in checking account balances must hold 10 percent of those deposits on reserve. Smaller banks only need to hold 3 percent of checking account balances on reserve.

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EXHIBIT 9 CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN

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Exhibit 9: Change in the Exhibit 9: Change in the Dallas Fed’s Accounts Dallas Fed’s Accounts

After Providing a $5,000 After Providing a $5,000 Loan to PFNLoan to PFNIf the Dallas Fed loans money to a

private bank such as PFN, why does this increase the money supply?• Money held by the Fed is not counted in the money supply.

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Exhibit 9: Change in the Exhibit 9: Change in the Dallas Fed’s Accounts Dallas Fed’s Accounts

After Providing a $5,000 After Providing a $5,000 Loan to PFNLoan to PFN

• Money held by the Fed is not counted in the money supply.

• PFN can loan out much of the money it borrowed from the Fed.

If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply?

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Federal funds market

• The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight.

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1. If a private bank has $5,000 in new reserves and the reserve requirement is 20 percent, then what is the maximum amount of new money supply that can be created from this $5,000?• $5,000 × (1/0.2) = $25,000.

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EXHIBIT 10 CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED

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Exhibit 10: Change in Exhibit 10: Change in PFN’s Accounts After PFN’s Accounts After

Receiving a $5,000 Loan Receiving a $5,000 Loan from the Dallas Fedfrom the Dallas Fed

If the Dallas Fed loans money to a private bank such as PFN, does this generate a liability for PFN?• Yes. The liability is the borrowed money that PFN owes to the Fed.

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EXHIBIT 11 FEDERAL RESERVE BANK OF NEW YORK DISCOUNT RATES: 1985–2003 (% PER YEAR)

Source: Federal Reserve Bank, St. Louis.

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Exhibit 11: Federal Reserve Exhibit 11: Federal Reserve Bank of New York Discount Bank of New York Discount Rates: 1985-2003 (% per Rates: 1985-2003 (% per

year)year)What were the lowest discount rates charged by the New York Fed, and in what year(s)?

• The New York Fed charged 3 percent discount rates in 1992 and in 1994.

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Federal funds rate

• The interest rate on loans made by banks in the federal funds market.

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Open market operations

• The buying and selling of government bonds by the Federal Open Market Committee.

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2. If the Fed wanted to reduce the money supply, would it purchase or sell government securities?• It would sell government securities. Money used to buy the securities from the Fed would leave the money supply.

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EXHIBIT 12 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM PFN ($ MILLIONS)

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Exhibit 12: Change in the Exhibit 12: Change in the Fed’s Accounts After Fed’s Accounts After Buying $10 Million of Buying $10 Million of

Securities from PFN ($ Securities from PFN ($ millions)millions)What was the change in the Fed’s

liabilities after buying $10 million of securities from PFN?• The Fed’s liabilities increased by $10 million due to a $10 million increase in PFN’s reserve.

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EXHIBIT 13 CHANGE IN PFN’S ACCOUNTS AFTER SELLING $10 MILLION OF SECURITIES TO THE FED ($ MILLIONS)

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Exhibit 13: Change in PFN’s Exhibit 13: Change in PFN’s Accounts After Selling $10 Accounts After Selling $10 Million of Securities to the Million of Securities to the

Fed ($ millions)Fed ($ millions)If the Fed buys $10 million of securities from PFN, how much of the proceeds from this sale can PFN loan out?• PFN can loan out all $10 million because these represent excess reserves.

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EXHIBIT 14 CHANGE IN PFN’S ACCOUNTS AFTER MARIA SELLS $10 MILLION OF SECURITIES ($ MILLIONS)

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Exhibit 14: Change in PFN’s Exhibit 14: Change in PFN’s Accounts After Maria Sells $10 Accounts After Maria Sells $10

Million of Securities ($ Million of Securities ($ millions)millions)

Suppose that the Fed bought $10 million of securities from a private individual (Maria) rather than from PFN. Would this still increase the money supply?• Yes, but not by as much. If she deposits the check at the bank, the bank can loan out only $8 million of the new demand deposit. The other $2 million are required reserves.

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EXHIBIT 15 CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM MARIA ($ MILLIONS)

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Securities from Maria ($ Securities from Maria ($ millions)millions)If the Fed bought $10 million of securities

from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?• The Fed’s assets increase by $10 million because it owns more securities.

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Securities from Maria ($ Securities from Maria ($ millions)millions)If the Fed bought $10 million of securities

from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts?• The Fed’s assets increase by $10 million because it owns more securities.

• The Fed’s liabilities increase by $10 million from clearing the check for PFN.

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EXHIBIT 16 CHANGE IN PFN’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES ($ MILLIONS)

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Exhibit 16: Change in PFN’s Exhibit 16: Change in PFN’s Accounts After Buying $10 Accounts After Buying $10

Million of Securities ($ Million of Securities ($ millions)millions)

What happens to the money supply as a consequence of the transaction shown in Exhibit 16?• By selling securities to PFN, the Fed reduces PFN’s reserves by $10 million. PFN is no longer in a position to loan that $10 million, which reduces the money supply.

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EXHIBIT 17 THE FED’S TARGET OPTIONS

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Exhibit 17: The Fed’s Exhibit 17: The Fed’s Target OptionsTarget Options

If Fed targets the money supply, as in Panel a, what countercyclical policy is no longer available to the Fed?• The Fed can no longer control the interest rate, since the interest rate depends on the positioning of the demand for money.

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Controlling the Interest Controlling the Interest Rate: The Fed’s Rate: The Fed’s

Alternative Target Alternative Target OptionOption

• If the Fed targets the money supply, it cannot at the same time control the interest rate.

• Likewise by choosing to target the interest rate, the Fed loses control over the money supply.

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The Fed’s countercyclical monetary policy works either way, by changing interest rates or by changing the money supply.

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Past Fed Governor Past Fed Governor Martha Seger Describes Martha Seger Describes How the FOMC WorksHow the FOMC Works

According the Honorable Martha Seeger, what is the biggest difference between the Fed as textbook writers describe it, and how it really is?• It is much more difficult for the Fed to make decisions than the process described by textbook writers.

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Margin requirements

• The maximum percentage of the cost of a stock that can be borrowed from a bank or any other financial institution, with the stock offered as collateral.

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EXHIBIT 18 FEDERAL RESERVE’S MARGIN REQUIREMENTS: 1940–94 (PERCENTAGE)

Source: Banking and Monetary Statistics, 1940–1970 (Washington, D.C.: Board of Governors of the Federal Reserve System, 1975), p. 799; and Federal Reserve Bulletin, July 1994, p. A27.

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Exhibit 18: Federal Exhibit 18: Federal Reserve’s Margin Reserve’s Margin

Requirements: 1940-94 Requirements: 1940-94 (Percentage)(Percentage)

Why were margin requirements so high during World War II?

• The fiscal stimulus from huge wartime government expenditures generated inflationary pressure, and the Fed raised margin requirements to discourage speculative bank loans.

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EXHIBIT 19 THE FED’S COUNTERCYCLICAL OPERATIONS

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Exhibit 19: The Fed’s Exhibit 19: The Fed’s Countercyclical Countercyclical

OperationsOperationsWhat countercyclical Fed policies are used during the recovery and prosperity phase of the business cycle?

• Containment of the money supply by raising reserve requirements, raising the discount rate, or selling bonds on the open market.

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© 2005 Thomson C hapter 27 The Federal Reserve System and Monetary Policy