Slides by John F. Hall Animations by Anthony Zambelli INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 16 / THE BANKING SYSTEM, THE FEDERAL RESERVE,

Slides by John F. Hall

Animations by Anthony ZambelliINTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 16 / THE BANKING SYSTEM, THE FEDERAL RESERVE, …©2005, South-Western/Thomson Learning

Chapter 16

The Banking System, The Federal Reserve, and Monetary Policy

Lieberman & Hall; Introduction to Economics, 2005 2

The Banking System, the Federal Reserve, and Monetary Policy

Where does money actually come from? The government just prints it, right?

Much of our money supply is paper currency printed by our national monetary authority Most of our money supply is not paper currency and is

not printed by anyone The monetary authority in the United States—the Federal

Reserve System—is not technically a part of the government

• But a quasi-independent agency that operates along side of the government


What Is Counted as Money

Money is the means of payment in the economy The standard definition of money is cash, checking account

balances, and traveler’s checks First, only assets—things of value that people own—are

regarded as money Second, only things that are widely acceptable as a means

of payment are regarded as money The Federal Reserve keeps track of the total money supply

and reports it each week


The Components of The Money Supply

We count as money cash in the hands of the public In July, 2003 the Fed reported that cash in the

hands of the public totaled $646 billion Almost half of this cash is circulating in foreign

countries In July, 2003 the public held about $8 billion in traveler’s

checks The remaining component of the money supply is

checking account balances The U.S. public held $314 billion in demand deposits in

July, 2003


The Components of The Money Supply

Other checkable deposits is the catchall category for several types of checking accounts that work like demand deposits In July, 2003 the U.S. public held $298 billion of these types of

checkable deposits Money Supply = cash in the hands of the public + Traveler’s checks

+ demand deposits + other checkable deposits In July, 2003 this amounted to

Money Supply = $646 billion + $8 billion + $314 billion + $298 billion = $1,266 billion

It is important to understand that our measure of the money supply excludes many things that people use regularly as a means of payment


Financial Intermediaries Banks are important examples of

Financial Intermediaries• A business firm that specializes in brokering between savers and borrowers

An intermediary helps to solve problems by combining a large number of small savers’ funds into custom designed packages Then lends them to larger borrowers The intermediary can reduce the risk to savers by spreading its loans among

a number of different borrowers Four types of depository institutions

Savings and loan associations (S&Ls) Mutual savings banks Credit unions Commercial banks


Commercial Banks

A commercial bank is a private corporation, owned by its stockholders, that provides services to the public Most important service is to provide checking accounts

Banks provide checking account services in order to earn a profit Bank profits come from lending Banks do not lend out every dollar of deposits they

receive• They hold some back as reserves


Bank Reserves and The Required Reserve Ratio

Commercial bank’s reserves are funds that it has not lent out But instead keeps in a form that is readily available to its depositors

• Bank holds its reserves in two places In its vault In a special reserve account managed by the Federal Reserve

Why does the bank hold reserves? First, on any given day, some of the bank’s customers might want to

withdraw more cash than other customers are depositing Second, banks are required by law to hold reserves

• Required reserve ratio, set by the Federal Reserve Tells banks the fraction of their checking accounts that they must hold as required

reserves The relationship between a bank’s required reserves (RR), demand

deposits (DD), and the required reserve ratio (RRR) is RR = RRR × DD


The Federal Reserve System

Every large nation controls its banking system with a central bank The Bank of England was created in 1694 France waited until 1800 to establish the Banque de France Congress established the Federal Reserve System in 1913

Why did it take the United States so long to take control of its monetary system? Suspicion of central authority Large size and extreme diversity of our country These characteristics explain why our central bank is different in

form from its European counterparts One major difference is that it does not have the word

“central” or “bank” anywhere in its title


The Federal Reserve System Instead of a single central bank, the United States is divided

into 12 different Federal Reserve districts Each one served by its own Federal Reserve Bank

Another interesting feature of the Federal Reserve System is its peculiar status within the government It is not even a part of the government, but rather a corporation

whose stockholders are the private banks that it regulates But it is unlike other corporations in several ways

• Fed was created by Congress and could be eliminated by Congress if it so desired

• Both the president and Congress exert some influence on the Fed through their appointments of key officals in the system

• Fed’s mission is not to make a profit for its stockholders like an ordinary corporation, but rather to serve the general public


Figure 1: The Geography of the Federal Reserve System

District boundariesState boundariesReserve Bank citiesBoard of Governors of the Federal Reserve System

Dallas

Boston

New York

WashingtonSan Francisco Kansas City

Atlanta

12

9

10

11

8

6

5

7

4

3

2

1

St. Louis

Chicago

Richmond

Cleveland

Minneapolis

Philadelphia

Note: Both Alaska and Hawaii are in the Twelfth District


The Structure of The Fed Near the top is the Board of Governors, consisting of seven members

Who are appointed by the president and confirmed by the Senate for a 14 year term

• The most powerful person at the Fed is the chairman of the Board of Governors• To keep any president or Congress from having too much influence over the Fed,

the 4-year term of the chair is not coterminous with the 4-year term of the president

Each of the 12 Federal Reserve Banks is supervised by nine directors, three of whom are appointed by the Board of Governors The other six are elected by private commercial banks The directors of each Federal Reserve Bank choose a president of that bank

• Who manages its day-to-day operations 3,000 of the 9,000 commercial banks in the United States are members

of the Federal Reserve System They include all national banks and some state banks All of the largest banks in the United States are nationally chartered banks

and therefore member banks as well


Figure 2: The Structure of the Federal Reserve System

Senate confirms

Chair of Board of Governors

12 Federal ReserveDistrict Banks

• Lend reserves • Clear checks

• Provide currency

3,500 Member Banks

Elect 6 directorsof each

Federal ReserveBank

Appoints 3 directors of each Federal Reserve BankPresident

appoints

Federal Open MarketCommittee

(7 Governors + 5 Reserve Bank Presidents)

• Conducts open market operations to control the money supply

Board of Governors(7 members, including chair)

• Supervises and regulates member banks

• Supervises 12 Federal Reserve District Banks

• Sets reserve requirements and approves discount rate


The Federal Open Market Committee

Most economists regard FOMC as most important part of Fed

Federal Open Market Committee (FOMC) A committee of Federal Reserve officials that establishes

U.S. monetary policy After determining the current state of the economy, the

FOMC sets the general course for the nation’s money supply

Summaries of its meetings are published only after a delay of a month or more FOMC controls the nation’s money supply by buying and

selling bonds in the public (“open”) bond market


The Functions of the Federal Reserve

Federal Reserve, as overseer of the nation’s monetary system, has a variety of important responsibilities Supervising and regulating banks Acting as a “bank for banks” Issuing paper currency Check clearing Controlling the money supply


How the Fed Increases the Money Supply

To increase money supply, Fed will buy government bonds Called an open market purchase

Open Market Operations Purchases or sales of bonds by the Federal Reserve System

The demand deposit multiplier is the number by which we must multiply the injection of reserves to get the total change in demand deposits

For any value of the required reserve ratio (RRR), the formula for the demand deposit multiplier is 1/RRR

Using our general formula for the demand deposit multiplier, we can restate what happens when the Fed injects reserves into the banking system as follows ΔDD = (1/RRR) × ΔReserves


How the Fed Decreases the Money Supply

Fed can also decrease money supply by selling government bonds An open market sale

The Fed has trillions of dollars worth of government bonds from open market purchases it has conducted in the past A withdrawal of reserves is a negative change in

reserves• Can still use our demand deposit multiplier—1/(RRR)—and our

general formula

• ΔDD = (1/RRR) x ΔReserves


Some Important Provisos About the Demand Deposit Multiplier

Our formula for demand deposit multiplier—1/RRR—is oversimplified The multiplier is likely to be smaller than formula

suggests• As the money supply increases, the public typically will

want to hold part of the increase as demand deposits, and part of the increase as cash

• Banks may want to hold excess reserves—reserves beyond those legally required


Other Tools for Controlling the Money Supply

There are other tools that the Fed can use to increase or decrease the money supply Changes in the Required Reserve Ratio Changes in the Discount Ratio

Changes in either the required reserve ratio or the discount rate could change the money supply by causing banks to expand or contract their lending Neither of these policy tools is used very often

Why are these other tools used so seldom? They can have unpredictable effects

While other tools can affect the money supply, open market operations have two advantages over them Precision and secrecy

This is why open market operations remain the Fed’s primary means of changing the money supply


The Demand For Money

Don’t people always want as much money as possible? Isn’t their demand for money infinite?

Actually, no The “demand for money”

• Means how much money people would like to hold, given the constraints that they face


An Individual’s Demand for Money

Money is one of the ways that each of us, as individuals, can hold our wealth

An individual’s demand for money is the amount of wealth that the individual chooses to hold as money, rather than as other assets

When you hold money, you bear an opportunity cost Interest or other financial return you could have

earned if you held your wealth in some other form


An Individual’s Demand for Money Bond

IOU issued by a corporation or a government agency when it borrows money

Individuals choose how to divide wealth between two assets Money, which can be used as a means of payment but

earns no interest Bonds, which earn interest, but cannot be used as a

means of payment Since interest is the opportunity cost of holding

money The greater the interest rate, the less money an

Individual will want to hold


The Demand for Money by Businesses

Businesses face the same types of constraints as individuals They have only so much wealth, and they must

decide how much of it to hold in money rather than in other assets

The quantity of money demanded by businesses follows the same principles we have developed for individuals• They want to hold more money when the opportunity

cost is lower and less money when the interest rate is higher


The Economy-Wide Demand for Money

When we use the term “demand for money” without the word “individual,” we mean the total demand for money by all wealth holders in the economy

The demand for money is the amount of total wealth in the economy that all households and businesses, together, choose to hold as money Rather than as bonds

A rise in the interest rate will decrease the quantity of money demanded A drop in the interest rate will increase the quantity of

money demanded


The Money Demand Curve

This tells us the total quantity of money demanded in the economy at each interest rate The curve is downward sloping As long as the other influences on money

demanded don’t change, a drop in the interest rate will increase the quantity of money demanded• Lowers the opportunity cost of holding money


Figure 3: The Money Demand Curve

Money ($ Billions)

Interest Rate

6%E

F

800500

3%

Md

The money demand curve is drawn for a given real GDP and a given price level.

At an interest rate of 6 percent, $500 billion of money is demanded.

If the interest rate drops to 3 percent, the quantity of money demanded increases to $800 billion.


The Supply of Money Just as we did for money demand, we would like to

draw a curve showing the quantity of money supplied at each interest rate The interest rate can rise or fall, but the money supply

will remain constant unless and until the Fed decides to change it

Open market purchases of bonds inject reserves into the banking system Shift the money supply curve rightward by a multiple of

the reserve injection• Open market sales have the opposite effect

They withdraw reserves from the system and shift the money supply curve leftward by a multiple of the reserve withdrawal


Figure 4: The Supply of Money

6%E

J

700500

3%

Money ($ Billions)

Interest Rate S1M S

2M


Equilibrium in the Money Market

We want to find the equilibrium interest rate The rate at which the quantity of money

demanded and the quantity of money supplied are equal

Equilibrium in the money market occurs When the quantity of money people are actually

holding is equal to the quantity of money they want to hold


How the Money Market Achieves Equilibrium

When there is an excess supply of money in the economy, there is also an excess demand for bonds Excess Supply of Money

• The amount of money supplied exceeds the amount demanded at a particular interest rate

Excess Demand for Bonds• The amount of bonds demanded exceeds the amount supplied at

a particular interest rate

When the interest rate is higher than its equilibrium value The price of bonds will rise


Figure 5: Money Market Equilibrium

E

500300 Money ($ Billions)

Interest Rate

6%

9%

3%

Ms

800

Md

At the equilibrium interest rate of 6%, the public is content to hold the quantityof money it is actually holding.

At a higher interest rate, an excess supply of money causes the interest rate to fall.

At a lower interest rate, an excess demand for money causes the interest rate to rise.


An Important Detour: Bond Prices and Interest Rates

A bond A promise to pay back borrowed funds at a certain date or dates in

the future The interest rate that you will earn on your bond depends

entirely on the price of the bond The higher the price, the lower the interest rate

When the price of bonds rises, the interest rate falls When the price of bonds falls, the interest rate rises

The relationship between bond prices and interest rate helps explain why the government, the press, and the public are so concerned about the bond market Where bonds issued in previous periods are bought and sold


Back to the Money Market A rise in the price of bonds means a decrease in the interest

rate The complete sequence of events is

In the case of an excess demand for money and an excess supply of bonds The following would happen


How the Fed Changes the Interest Rate

To change the interest rate, the Fed must change the equilibrium interest rate in the money market, and it does this by changing the money supply The process works like this

Or this

If the Fed increases the money supply by buying government bonds, the interest rate falls If the Fed decreases the money supply by selling government bonds, the

interest rate rises By controlling the money supply through purchases and sales of bonds, the

Fed can also control the interest rate


Figure 6: An Increase in the Money Supply

E

F


Interest Rate

6%

3%

800

Md

At point E, the money market is in equilibrium at an interest rate of 6 percent. To lower the interest rate, the

Fed could increase the money supply to $800 billion.

The excess supply of money (and excess demand for bonds) would cause bond prices to rise, and the interest rate to fall until a new equilibrium is established at point F with an interest rate of 3 percent.

S1M S

2M


How the Interest Rate Affects Spending

We can summarize the impact of monetary policy as follows When the Fed increases the money supply, the

interest rate falls and spending on three categories of goods increases• Plant and equipment• New housing• Consumer durables

When the Fed decreases the money supply, the interest rate rises and these categories of spending fall


Monetary Policy and the Economy

When the Fed controls or manipulates the money supply in order to achieve any macroeconomic goal it is engaging in monetary policy

This is what happens when the Fed conducts open market purchases of bonds

Open market sales by the Fed have exactly the opposite effects


Figure 7: Monetary Policy and the Economy

6% E

F

500

3%

Money ($ Billions)

Interest Rate

800

dM

S1M S

2M

GDP↑r↓Spending on plant

and equipment, housing, and

durables↑ Total

Spending↑


Expectations and Money Demand

Why should expectations about the future interest rate affect money demand today? If you expect the interest rate to rise in the future, then you also

expect the price of bonds to fall in the future A general expectation that interest rates will rise in the

future will cause the money demand curve to shift rightward in the present

When the public as a whole expects the interest rate to rise in the future They will drive up the interest rate in the present

When the public expects the interest rate to drop in the future They will drive down the interest rate in the present


Figure 9: Interest Rate Expectations

E


Interest Rate

5%

10%

Ms

d1M

d2M


Expectations and the Fed Changes in interest rates due to changes in

expectations can have important consequences Fortunes can be won and lost depending on how people

have bet on the future Another consequence of changes in expectations is

the effect on the overall economy When a change in expectations becomes a self-fulfilling

prophecy, it causes current interest rates to change The public’s ever-changing expectations about

future interest rates make the Fed’s job more difficult


The Fed’s Response to Changes in Money Demand

Changes in the expected future interest rate can shift the money demand curveChanges in tastes for holding money and

other assets, or changes in technology, can also shift the money demand curve

Money demand shifts—if ignored—would create problems for the economy

If the Fed’s goal is to stabilize real GDP, it cannot sit by while these events occur


The Fed’s Response to Changes in Money Demand

To stabilize real GDP when money demand changes on its own (not in response to a spending shock), the Fed must change the money supply Specifically, it must increase the money supply in response to an

increase in money demand• And decrease the money supply in response to a decrease in money

demand

To prevent changes in money demand from affecting real GDP, the Fed should set a target for the interest rate And adjust the money supply as necessary to maintain that target

Since the Fed conducts open market operations each day It is able to use continuous feedback to keep the interest rate

relatively constant


Figure 9: The Fed’s Response to Changes in Money Demand

5%E'E

500

10%

1,000 Money ($ Billions)

Interest Rate S1M S

2M

d1M

d2M


The Fed’s Response to Spending Shocks

Shifts in total spending—due to changes in autonomous consumption, investment spending, taxes, or government purchases—cause changes in real GDP How can the Fed keep real GDP close to potential output when there are

direct spending shocks like these? To stabilize real GDP, the Fed must change its interest rate target in

response to a spending shock And change the money supply to hit its new target

• It must raise its interest rate target (decrease the money supply) in response to a positive spending shock and lower the interest rate target (increase the money supply) in response to a negative spending shock

Fed’s policy of stabilizing real GDP comes at a price Fluctuations in the interest rate

Fluctuations in the interest rate are costly Fluctuations in real GDP are costly too, and the Fed has concluded that it is

a good idea to adjust its interest rate targets aggressively when necessary to stabilize real GDP


Figure 10: The Fed’s Response to Spending Shocks

H

E


Interest Rate

7.5%

5%

500

Md

S1MS

2M


Using the Theory: The Fed and the Recession of 2001

Our most recent recession lasted from March to November of 2001 What did policy makers do to try to prevent the recession, and to deal

with it once it started? Why did consumption spending behave abnormally, rising as income

fell and preventing the recession from becoming a more serious downturn?

Starting in January 2001 the Fed began to worry The Fed feared that if it did nothing, the investment slowdown would

lead through the multiplier to a significant drop in real GDP The Fed decided to take action

Beginning in January, the Fed began increasing the money supply rapidly

The federal funds rate is the interest rate that banks with excess reserves charge for lending reserves to other banks

In September of 2001, during which real GDP probably hit bottom, the federal funds rate averaged about 3.1 percent


Using the Theory: The Fed and the Recession of 2001

Although the Fed’s policy did not completely prevent the recession It no doubt saved the economy from a more severe and

longer-lasting one Lower interest rates stimulate consumption

spending on consumer durables Moreover, when interest rates drop dramatically

and rapidly—as they did in 2001—a frenzy of home mortgage refinancing can occur Home refinancing and additional borrowing on homes

seemed to play a major role in boosting consumption spending during the recession of 2001


Figure 11(a): The Fed in Action: 2001

3.1%C

A

$1,093

6.4%

1,170

During 2001, the Fed repeatedly increased the money supply . . .

Money ($ Billions)

Interest Rate S1M S

2M

dbillion$9,130 YM

dbillion$9,243 YM

(a)


Figure 11(b): The Fed in Action: 2001

(b)

Money (M1) ($ Billions)

1,000

1,050

1,100

1,150

1,200

Aug.2000

Dec.2000

Apr.2001

Aug.2001

Dec.2001

During 2001, the Fed repeatedly increased the money supply . . .


Figure 11(c): The Fed in Action: 2001

which caused the interest rate to drop.

5.0

4.0

6.0

Federal Funds Rate

Percent

2.0

3.0

Aug.2000

Dec.2000

Apr.2001

Aug.2001

Dec.2001

(c)

Documents

Slides by John F. Hall Animations by Anthony Zambelli INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 16 / THE BANKING SYSTEM, THE FEDERAL RESERVE,