Chapter 4 the u.s. federal reserve and the creation of money Foundations of Financial Markets and Institutions 4th edition 2009 Frank J. Fabozzi Franco Modigliani Frank J. Jones

1. The U.S. Federal
Reserve and the
Creation of Money
Chapter 4

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Central Banks and Their Purpose
Monetary authority
Reserve banks
Many countries have central banks
European Central Bank

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Functions of Central Banks
Risk assessment
Risks reduction
Oversight of payment systems
Crisis management

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The Federal Reserve System
Board of Governors
Federal Reserve Banks
Member Banks
Federal Open Market Committee

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Instruments of Monetary Policy
Reserve Requirements
Open Market Operations
Open Market Repurchase Agreements
Discount Rate

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Reserve Requirements
Fractional Reserve Banking System
Required reserve ratio
Demand deposits
Time deposits
Total reserves
Required reserves
Excess reserves

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Open Market Operations
Fed purchases and sales of government securities
Fed purchases
Increase excess reserves
Increase new loans
Increase money supply
Fed sales
Decrease excess reserves
Decrease loans
Decrease money supply

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Open Market Repurchase Agreements
Repurchase Agreement
Fed buys securities from a seller who agrees to
repurchase them at a higher price
Reverse Repurchase Agreement
Fed sells securities and agrees to repurchase them at a
higher price

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Discount Rate
Rate charged on loans from the Fed’s discount
window.
Administratively set by Board of Governors
An increase in the discount rate discourages
banks from borrowing from the Fed
A decrease in the discount rate encourages banks
to borrow from the Fed

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Different Uses of Money
Unit of Account
Numeraire
Medium of Exchange
Currency and demand deposits
Store of Value
Time deposits

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Monetary Aggregates
Monetary Base: Currency in circulation
Currency and coins plus total reserves
M1 Money Supply
Currency plus demand deposits
M2 Money Supply
M1 plus short-term time deposits
M3 Money Supply
M2 plus long-term time deposits

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Money Multiplier
Process by which changes in bank reserves
generate larger changes in the money supply.
Size of Multiplier Influenced by:
Reserve requirement ratio
Public’s demand for cash
Banks’ willingness to make loans
Level of interest Rates

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Annual Rates of Growth of Monetary Aggregates

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The Money Supply Process in an Open
Economy
Foreign Exchange Market Intervention
The Fed’s purchase and sale of foreign
currencies
Purchase of foreign currencies
Increases monetary base
Reduces value of the U.S. currency
Sale of foreign currencies
Decreases monetary base
Increases value of the U.S. currency

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