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THE FEDERAL RESERVE
       SYSTEM:
     HISTORY AND
     STRUCTURE
       Module 26
INTRODUCTION TO MONETARY
            POLICY

The Fed’s         The fundamental objective of
 Board of          monetary policy is to aid the
Governors
formulates         economy         in       achieving
policy, and        full-employment output with stable
  twelve
  Federal          prices.
 Reserve
   Banks
              1.    To do this, the Fed changes the
implement           nation’s money supply.
   policy.
              2.    To change money supply, the Fed
                    manipulates size of excess
                    reserves held by banks.
INTRODUCTION TO MONETARY
                      POLICY

                                 Monetary policy has a very powerful
                Lette
Bank                    #
                r
                             
Boston,


New York,
                A


                B
                        1


                        2
                                 impact on the economy, and the
Philadelphia,   C       3
                                 Chairman of the Fed’s Board of
Cleveland,      D       4        Governors, Ben Bernanke, is
Richmond,

Atlanta,
                E

                F
                        5

                        6
                                 sometimes called the second most
Chicago,        G       7        powerful person in the U.S.
St. Louis,      H       8


Minneapolis,    I       9


Kansas City,    J       10


Dallas,         K       11

San
                L       12
Francisco,
Consolidated Balance Sheet of the
    Federal Reserve Banks
A.        The assets on the Fed’s balance sheet contains two
          major items.
     1.     Securities which are federal government bonds purchased
            by Fed
     2.     Loans to commercial banks (Note: again commercial banks
            term is used even though the analysis also applies to other
            thrift institutions.)
B.        The liability side of the balance sheet contains three
          major items.
     1.     Reserves of banks held as deposits at Federal Reserve
            Banks,
     2.     U.S. Treasury deposits of tax receipts and borrowed funds,
     3.     Federal Reserve Notes outstanding, our paper currency.
The Fed has Three Major “Tools” of
        Monetary Policy
A.    Open market operations refer to the Fed’s
      buying and selling of government bonds.
1.    Buying securities will increase bank reserves
      and the money supply.
     a.   If the Fed buys directly from banks, then bank
          reserves go up by the value of the securities sold to
          the Fed. See impact on balance sheets using text
          example.
The Fed has Three Major “Tools” of
        Monetary Policy
 b.   If the Fed buys from the general public,
      people receive checks from the Fed and then
      deposit the checks at their bank. Bank
      customer deposits rise and therefore bank
      reserves rise by the same amount. Follow
      text example to see the impact.
       i.    Banks’ lending ability rises with new excess
             reserves.
       ii.   Money supply rises directly with increased
             deposits by the public.
The Fed has Three Major “Tools” of
        Monetary Policy
c.   When Fed buys bonds from bankers, reserves
     rise and excess reserves rise by same amount
     since no checkable deposit was created.
d.   When Fed buys from public, some of the new
     reserves are required reserves for the new
     checkable deposits.
e.   Conclusion:        When     the     Fed   buys
     securities, bank reserves will increase and the
     money supply potentially can rise by a multiple
     of these reserves.
The Fed has Three Major “Tools” of
        Monetary Policy
f.         Note: When the Fed sells securities, points a e above
           will be reversed. Bank reserves will go down, and
           eventually the money supply will go down by a multiple
           of the banks’ decrease in reserves.
g.         How the Fed attracts buyers or sellers:
     i.      When Fed buys, it raises demand and price of bonds which in
             turn lowers effective interest rate on bonds. The higher price
             and lower interest rates make selling bonds to Fed attractive.
     ii.     When Fed sells, the bond supply increases and bond prices
             fall, which raises the effective interest rate yield on bonds. The
             lower price and higher interest rates make buying bonds from
             Fed attractive.
The Fed has Three Major “Tools” of
        Monetary Policy
B.    The reserve ratio is another “tool” of monetary
      policy. It is the fraction of reserves required
      relative to their customer deposits.
     1.   Raising the reserve ratio increases required reserves
          and shrinks excess reserves. Any loss of excess
          reserves shrinks banks’ lending ability and, therefore,
          the potential money supply by a multiple amount of
          the change in excess reserves.
     2.   Lowering the reserve ratio decreases the required
          reserves and expands excess reserves. Gain in
          excess reserves increases banks’ lending ability and,
          therefore, the potential money supply by a multiple
          amount of the increase in excess reserves.
The Fed has Three Major “Tools” of
        Monetary Policy
3.    Changing the reserve ratio has two effects.
     a.   It affects the size of excess reserves.
     b.   It changes the size of the monetary multiplier. For
          example, if ratio is raised from 10 percent to 20
          percent, the multiplier falls from 10 to 5.
     c.   Changing the reserve ratio is very powerful since it
          affects banks’ lending ability immediately. It could
          create instability, so Fed rarely changes it.
The Fed has Three Major “Tools” of
        Monetary Policy
C.        The third “tool” is the discount rate which is the
          interest rate that the Fed charges to
          commercial banks that borrow from the Fed.
     1.     An increase in the discount rate signals that
            borrowing reserves is more difficult and will tend to
            shrink excess reserves.
     2.     A decrease in the discount rate signals that
            borrowing reserves will be easier and will tend to
            expand excess reserves.
“Easy” Monetary Policy
C.        “Easy” monetary policy occurs when the Fed
          tries to increase money supply by expanding
          excess reserves in order to stimulate the
          economy. The Fed will enact one or more of
          the following measures.
     1.    The Fed will buy securities.
     2.    The Fed may reduce reserve ratio, although this is
           rarely changed because of its powerful impact.
     3.    The Fed could reduce the discount rate, although
           this has little direct impact on the money supply.
“Tight” Monetary Policy
C.        “Tight” monetary policy occurs when Fed tries
          to decrease money supply by decreasing
          excess reserves in order to slow spending in
          the economy during an inflationary period. The
          Fed will enact one or more of the following
          policies:
     1.    The Fed will sell securities.
     2.    The Fed may raise the reserve ratio, although this
           is rarely changed because of its powerful impact.
     3.    The Fed could raise the discount rate, although it
           has little direct impact on money supply.
Open Market Operations
F.        For several reasons, open market operations
          give the Fed most control of the three “tools.”
     1.     Open market operations are most important. This
            decision is flexible because securities can be
            bought or sold quickly and in great quantities.
            Reserves change quickly in response.
     2.     The reserve ratio is rarely changed since this
            could destabilize bank’s lending and profit
            positions.
     3.     Changing the discount rate has little direct
            effect, since only 2 3 percent of bank reserves are
            borrowed from Fed.          At best it has an
            “announcement effect” that signals direction of
Monetary Policy, Real GDP, and the
     Price Level: How Policy Affects the
                  Economy
A.        Cause effect chain:
     1. Money market impact:
     a. Demand for money is comprised of two parts
          i.     Transactions demand is directly related to GDP.
          ii.    Asset demand is inversely related to interest rates,
                 so total money demands is inversely related to
                 interest rates.
     b.         Supply of money is assumed to be set by the
                Fed.
     c.         Interaction of supply and demand determines
                the market rate of interest.
Monetary Policy, Real GDP, and the
Price Level: How Policy Affects the
             Economy
d.   Interest rate determines amount of
     investment businesses will be willing to
     make.      Investment demand is inversely
     related to interest rates.
e.   Effect of interest rate changes on level of
     investment is great because interest cost of
     large, long-term investment is sizable part of
     investment cost.
f.   As investment rises or falls, equilibrium GDP rises
     or falls by a multiple amount
Monetary Policy, Real GDP, and the
Price Level: How Policy Affects the
             Economy
2.   Expansionary or easy money policy: The Fed
     takes steps to increase excess reserves, which
     lowers the interest rate and increases investment
     which, in turn, increases GDP by a multiple
     amount.
3.   Contractionary or tight money policy is the reverse
     of an easy policy: Excess reserves fall, which
     raises interest rate, which decreases investment,
     which, in turn, decreases GDP by a multiple
     amount of the change in investment.
Monetary Policy, Real GDP, and the
Price Level: How Policy Affects the
             Economy
4.   Aggregate supply and monetary policy:
a.   Easy monetary policy may be inflationary if initial
     equilibrium is at or near full-employment.
b.   If economy is below full-employment, easy
     monetary policy can shift aggregate demand and
     GDP toward full-employment equilibrium.
c.   Likewise a tight monetary policy can reduce
     inflation if economy is near full-employment, but
     can make unemployment worse in a recession.
Effectiveness of Monetary Policy

A.   Strengths of monetary policy:
1.   It is speedier and more flexible than fiscal policy
     since the Fed can buy and sell securities daily.
2.   It is less political. Fed Board members are isolated
     from political pressure, since they serve 14 year
     terms, and policy changes are more subtle and not
     noticed as much as fiscal policy changes. It is
     easier to make good, but unpopular decisions.
3.   In the 1980s and 1990s Fed policy is given much
     credit for achieving a prosperous economy with
     low inflation and high employment.
Effectiveness of Monetary Policy

B.   Shortcomings of monetary policy:
1.   Control is weakening as technology makes it
     possible to shift from money assets to other types;
     also global finance gives nations less power.
2.   Cyclical asymmetry may exist: a tight monetary
     policy works effectively to brake inflation, but an
     easy monetary policy is not always as effective in
     stimulating the economy from recession.
Effectiveness of Monetary Policy

B.   Shortcomings of monetary policy (cont):
3.   The velocity of money (number of times the
     average dollar is spent in a year) may be
     unpredictable, especially in the short run and can
     offset the desired impact of changes in money
     supply. Tight money policy may cause people to
     spend faster; velocity rises.
4.   The impact on investment may be less than
     traditionally thought.     Japan provides a case
     example.       Despite interest rates of zero,
     investment spending remained low during the
     recession.
Effectiveness of Monetary Policy

C.   Currently the Fed communicates changes in
     monetary policy through changes in its target for
     the Federal funds rate.
1.   The Fed does not set either the Federal funds rate
     or the prime rate; each is established by the
     interaction of lenders and borrowers, but rates
     generally follow the Fed funds rate.
2.   The Fed acts through open market operations,
     selling bonds to raise interest rates and buying
     bonds to lower interest rates.
Effectiveness of Monetary Policy

D.   Links between monetary policy and the
     international economy:
1.   Net export effect occurs when foreign financial
     investors respond to a change in interest rates.
a.   Tight monetary policy and higher interest rates
     lead to appreciation of dollar value in foreign
     exchange markets; lower interest rates from an
     easy monetary policy will lead to dollar
     depreciation in foreign exchange markets.
Effectiveness of Monetary Policy

b.   When dollar appreciates, American goods become
     more costly to foreigners, and this lowers demand
     for U.S. exports, which tends to lower GDP. This is
     the desired effect of a tight money policy.
     Conversely, an easy money policy leads to
     depreciation of dollar, greater demand for U.S.
     exports and higher GDP. This policy has the
     desired outcome for expanding GDP.
Effectiveness of Monetary Policy

2.   Monetary policy works to correct both trade
     balance and GDP problems together. An easy
     monetary policy leads to increased domestic
     spending and increased GDP, but it also leads to
     depreciated dollar and higher U.S. export demand,
     which enhances GDP and erases a trade deficit.
     The reverse is true for a tight monetary policy,
     which would tend to reduce net exports and
     worsen a trade deficit.
The Big Picture Shows Many
           Interrelationships
A.   Fiscal and monetary policy are interrelated. The
     impact of an increase in government spending will
     depend on whether it is accommodated by
     monetary policy. For example, if government
     spending comes from money borrowed from the
     general public, it may be offset by a decline in
     private spending, but if the government borrows
     from the Fed or if the Fed increases the money
     supply, then the initial increase in government
     spending may not be counteracted by a decline in
     private spending.

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Module 26 the federal reserve system history and structure

  • 1. THE FEDERAL RESERVE SYSTEM: HISTORY AND STRUCTURE Module 26
  • 2. INTRODUCTION TO MONETARY POLICY The Fed’s  The fundamental objective of Board of monetary policy is to aid the Governors formulates economy in achieving policy, and full-employment output with stable twelve Federal prices. Reserve Banks 1. To do this, the Fed changes the implement nation’s money supply. policy. 2. To change money supply, the Fed manipulates size of excess reserves held by banks.
  • 3. INTRODUCTION TO MONETARY POLICY Monetary policy has a very powerful Lette Bank # r  Boston, New York, A B 1 2 impact on the economy, and the Philadelphia, C 3 Chairman of the Fed’s Board of Cleveland, D 4 Governors, Ben Bernanke, is Richmond, Atlanta, E F 5 6 sometimes called the second most Chicago, G 7 powerful person in the U.S. St. Louis, H 8 Minneapolis, I 9 Kansas City, J 10 Dallas, K 11 San L 12 Francisco,
  • 4. Consolidated Balance Sheet of the Federal Reserve Banks A. The assets on the Fed’s balance sheet contains two major items. 1. Securities which are federal government bonds purchased by Fed 2. Loans to commercial banks (Note: again commercial banks term is used even though the analysis also applies to other thrift institutions.) B. The liability side of the balance sheet contains three major items. 1. Reserves of banks held as deposits at Federal Reserve Banks, 2. U.S. Treasury deposits of tax receipts and borrowed funds, 3. Federal Reserve Notes outstanding, our paper currency.
  • 5. The Fed has Three Major “Tools” of Monetary Policy A. Open market operations refer to the Fed’s buying and selling of government bonds. 1. Buying securities will increase bank reserves and the money supply. a. If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed. See impact on balance sheets using text example.
  • 6. The Fed has Three Major “Tools” of Monetary Policy b. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact. i. Banks’ lending ability rises with new excess reserves. ii. Money supply rises directly with increased deposits by the public.
  • 7. The Fed has Three Major “Tools” of Monetary Policy c. When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created. d. When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits. e. Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.
  • 8. The Fed has Three Major “Tools” of Monetary Policy f. Note: When the Fed sells securities, points a e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves. g. How the Fed attracts buyers or sellers: i. When Fed buys, it raises demand and price of bonds which in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive. ii. When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive.
  • 9. The Fed has Three Major “Tools” of Monetary Policy B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required relative to their customer deposits. 1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves. 2. Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.
  • 10. The Fed has Three Major “Tools” of Monetary Policy 3. Changing the reserve ratio has two effects. a. It affects the size of excess reserves. b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5. c. Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so Fed rarely changes it.
  • 11. The Fed has Three Major “Tools” of Monetary Policy C. The third “tool” is the discount rate which is the interest rate that the Fed charges to commercial banks that borrow from the Fed. 1. An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. 2. A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.
  • 12. “Easy” Monetary Policy C. “Easy” monetary policy occurs when the Fed tries to increase money supply by expanding excess reserves in order to stimulate the economy. The Fed will enact one or more of the following measures. 1. The Fed will buy securities. 2. The Fed may reduce reserve ratio, although this is rarely changed because of its powerful impact. 3. The Fed could reduce the discount rate, although this has little direct impact on the money supply.
  • 13. “Tight” Monetary Policy C. “Tight” monetary policy occurs when Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period. The Fed will enact one or more of the following policies: 1. The Fed will sell securities. 2. The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact. 3. The Fed could raise the discount rate, although it has little direct impact on money supply.
  • 14. Open Market Operations F. For several reasons, open market operations give the Fed most control of the three “tools.” 1. Open market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response. 2. The reserve ratio is rarely changed since this could destabilize bank’s lending and profit positions. 3. Changing the discount rate has little direct effect, since only 2 3 percent of bank reserves are borrowed from Fed. At best it has an “announcement effect” that signals direction of
  • 15. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy A. Cause effect chain: 1. Money market impact: a. Demand for money is comprised of two parts i. Transactions demand is directly related to GDP. ii. Asset demand is inversely related to interest rates, so total money demands is inversely related to interest rates. b. Supply of money is assumed to be set by the Fed. c. Interaction of supply and demand determines the market rate of interest.
  • 16. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy d. Interest rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rates. e. Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is sizable part of investment cost. f. As investment rises or falls, equilibrium GDP rises or falls by a multiple amount
  • 17. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy 2. Expansionary or easy money policy: The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount. 3. Contractionary or tight money policy is the reverse of an easy policy: Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment.
  • 18. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy 4. Aggregate supply and monetary policy: a. Easy monetary policy may be inflationary if initial equilibrium is at or near full-employment. b. If economy is below full-employment, easy monetary policy can shift aggregate demand and GDP toward full-employment equilibrium. c. Likewise a tight monetary policy can reduce inflation if economy is near full-employment, but can make unemployment worse in a recession.
  • 19. Effectiveness of Monetary Policy A. Strengths of monetary policy: 1. It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily. 2. It is less political. Fed Board members are isolated from political pressure, since they serve 14 year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes. It is easier to make good, but unpopular decisions. 3. In the 1980s and 1990s Fed policy is given much credit for achieving a prosperous economy with low inflation and high employment.
  • 20. Effectiveness of Monetary Policy B. Shortcomings of monetary policy: 1. Control is weakening as technology makes it possible to shift from money assets to other types; also global finance gives nations less power. 2. Cyclical asymmetry may exist: a tight monetary policy works effectively to brake inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession.
  • 21. Effectiveness of Monetary Policy B. Shortcomings of monetary policy (cont): 3. The velocity of money (number of times the average dollar is spent in a year) may be unpredictable, especially in the short run and can offset the desired impact of changes in money supply. Tight money policy may cause people to spend faster; velocity rises. 4. The impact on investment may be less than traditionally thought. Japan provides a case example. Despite interest rates of zero, investment spending remained low during the recession.
  • 22. Effectiveness of Monetary Policy C. Currently the Fed communicates changes in monetary policy through changes in its target for the Federal funds rate. 1. The Fed does not set either the Federal funds rate or the prime rate; each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate. 2. The Fed acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.
  • 23. Effectiveness of Monetary Policy D. Links between monetary policy and the international economy: 1. Net export effect occurs when foreign financial investors respond to a change in interest rates. a. Tight monetary policy and higher interest rates lead to appreciation of dollar value in foreign exchange markets; lower interest rates from an easy monetary policy will lead to dollar depreciation in foreign exchange markets.
  • 24. Effectiveness of Monetary Policy b. When dollar appreciates, American goods become more costly to foreigners, and this lowers demand for U.S. exports, which tends to lower GDP. This is the desired effect of a tight money policy. Conversely, an easy money policy leads to depreciation of dollar, greater demand for U.S. exports and higher GDP. This policy has the desired outcome for expanding GDP.
  • 25. Effectiveness of Monetary Policy 2. Monetary policy works to correct both trade balance and GDP problems together. An easy monetary policy leads to increased domestic spending and increased GDP, but it also leads to depreciated dollar and higher U.S. export demand, which enhances GDP and erases a trade deficit. The reverse is true for a tight monetary policy, which would tend to reduce net exports and worsen a trade deficit.
  • 26. The Big Picture Shows Many Interrelationships A. Fiscal and monetary policy are interrelated. The impact of an increase in government spending will depend on whether it is accommodated by monetary policy. For example, if government spending comes from money borrowed from the general public, it may be offset by a decline in private spending, but if the government borrows from the Fed or if the Fed increases the money supply, then the initial increase in government spending may not be counteracted by a decline in private spending.