Transcript The Federal Reserve System and Its Tools

The Federal Reserve System
and Its Tools
Unit 4 Lesson 4
Activity 38
Graboyes, Rover. University of Richmond.
Advanced Placement Economics Teacher Resource Manual.
National Council on Economic Education, New York, N.Y
Objectives
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Describe the structure of the Federal Reserve
System
Identify each of the tolls of the Fed and
explain
Explain basic balance sheets
Introduction
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The focus of this lesson is the Federal Reserve
System; how its actions relate to the money creation
process introduced in the last lesson and how its
tools affect the money supply.
The Federal Reserve System is the central bank for
the United States created in 1913.
It has regulatory authority for many financial
institutions that hold checkable deposits.
It has the responsibility to control the money supply
to promote the economic goals of full employment,
price stability and stable economic growth.
Federal Reserve System: (Fed)
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Provides Resilient National Currency
Nation’s Financial Agent
Regulating Private Banking System
National Check-Clearing Mechanism
Banking Institution for the Nation’s Banks
(Carter, 147)
Operate the nation’s payments system:
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The 12 Federal Reserve Banks provide:
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“banking services to depository institutions;
 they maintain reserve and clearing accounts to
provide various payment services, including
collecting checks, electronically transferring funds,
and storing, distributing, receiving, and processing
currency and coin.
For the federal government:
 the Reserve Banks maintain the Treasury
Department’s transaction account,
 pay Treasury checks,
 process electronic payments,
 issue, transfer, and redeem U.S. government
securities.”
(Hill)
Federal Reserve Bank
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Income
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Interest earned on government. securities
Priced services to depository institutions
NOT OPERATED FOR PROFIT!
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End of fiscal year money is turned over
to the U.S. Treasury Department.
(“Federal Reserve Board”)
The Federal Open Market Committee [FOMC]
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“The Fed’s chief body for monetary
policymaking.
The FOMC’s decisions ultimately affect
interest rates.
The FOMC meets in Washington, usually
eight times a year.”
(Emery)
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“The Federal Reserve controls the three tools of monetary
policy—
 open market operations,
 the discount rate,
 reserve requirements.
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The Board of Governors of the Federal Reserve System is
responsible for the discount rate and reserve requirements, and
the Federal Open Market Committee is responsible for open
market operations.
Using the three tools, the Federal Reserve influences the
demand for, and supply of, balances that depository institutions
hold at Federal Reserve Banks and in this way alters the federal
funds rate.
The federal funds rate is the interest rate at which depository
institutions lend balances at the Federal Reserve to other
depository institutions overnight.”
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(“Federal Reserve Board”)
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“Changes in the federal funds rate trigger a
chain of events that affect other short-term
interest rates, foreign exchange rates, longterm interest rates, the amount of money and
credit, and, ultimately, a range of economic
variables, including employment, output, and
prices of goods and services.”
(“Federal Reserve Board”)
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Primary Responsibility:
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“Among the Fed's duties are managing the growth
of the money supply, providing liquidity in times of
crisis, and ensuring the integrity of the financial
system.
The FOMC's decisions to change the growth of
the nation's money supply affect the availability of
credit and the level of interest rates that
businesses and consumers pay.
Those changes in money supply and interest
rates, in turn, influence the nation's economic
growth and employment in the short run and the
general level of prices in the long run.”
(“Federal Reserve Board”)
The Mechanics of Monetary Policy
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To manage the money supply, the Federal Reserve
uses the tools of monetary policy to influence the
quantity of reserves in the banking system.
Increasing (decreasing) reserves tend to expand
(contract) a bank’s ability to make loans.
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Thus, reserve management gives the Fed powerful
influences over the money supply and, in turn, over the
general price level.
The primary tool for reserve management today is
open market operations (OMO).
Discount rate changes serve primarily as signals;
reserve requirements are rarely changed.
Using T-accounts show how the Fed could use open
market operations to increase money supply.
Balance Sheets
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“The Federal Reserve operates with a sizable balance sheet that
includes a large number of distinct assets and liabilities. Left side
of a balance sheet shows the assets, and the right side shows
the liabilities.”
 Net worth = assets - liabilities
 Liabilities:
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Treasury Securities
Federal Reserve notes (U.S. paper currency) and the deposits that
thousands of depository institutions, the U.S. Treasury, and others
hold in accounts at the Federal Reserve Banks.
Assets:
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holdings of Treasury, agency, mortgage-backed securities; discount
window lending; lending to other institutions; foreign currency
(“Federal Reserve Board”)
Example: Baseline case
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Figure 38.1 shows a baseline T-account. The
required reserve ratio is 10% of checking
deposits. With $26 in reserve accounts and
$4 to Federal Reserve notes (vault cash),
total bank reserves = $30, exactly 10% of
checkable deposits (in other words, no
excess reserves).
Net worth = assets - liabilities
Figure 38.1 Baseline Case
Assets
Treasury securities
Reserve accounts
Federal Reserve notes
Liabilities
The Fed
$83
$26
$57
Banks
$26
$300
$4
$405
$135
Reserve accounts of banks
Federal Reserve notes
Checkable deposits
Net worth (to stockholders)
Bank Customers
Checkable deposits
$300
$405
Loans
Federal Reserve notes
$53
Treasury securities
$52
Money supply = $353 (300 +53)
Example: Expansionary policy via open market purchases
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Suppose the Fed believes the economy is heading
into a recession and wishes to increase the money
supply by $100.
Using open market operations, the Fed purchases
$10 worth of Treasury securities from the public.
Fig. 38.2 shows the consolidated accounts after the
changes of this Fed action works it way through the
economy. Changes are shown in boldface. Be sure
to compare Fig 38.1 with Fig. 38.2 to see the
changes.
The Fed’s $10 increase in reserve accounts yields a
$100 increase in the money supply.
Figure 38.2 After $10 Open Market Purchase
Assets
Treasury securities (+10)
Reserve accounts (+10)
Federal Reserve notes
Loans (+90)
Checkable deposits (+100)
Federal Reserve notes
Treasury securities (-10)
Liabilities
The Fed
$93
$36
$57
Banks
$36
$400
$4
$495
$135
Bank Customers
$400
$495
$53
$42
Reserve accounts of banks (+10)
Federal Reserve notes
Checkable deposits (+100)
Net worth (to stockholders)
Loans (+90)
Money supply = $453 (400 +53)
Activity 38
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1.
2.
For Questions 1 thru 4 start with the
baseline case in Fig. 38.1. The Fed wishes
to decrease the money supply from $353 to
$303 by market operations. The reserve
requirement is 10%.
Will the Fed want to by or sell existing
Treasury securities? _____________
Sell
What is the money multiplier? ______
10
(1/0.10 = 10)
3.
What is the value of Treasury securities that
(50/10 = 5)
need to be bought or sold? _____________
Figure 38.3
Assets
Liabilities
The Fed
Treasury securities (-$5)
$78
$21
$57
Reserve accounts of banks (-$5)
Federal Reserve notes
Banks
Reserve accounts (-$5)
Federal Reserve notes
Loans
$21
$4
$250
Checkable deposits (-$50)
$360
$135
Net worth (to stockholders)
Bank Customers
Checkable deposits (-$5)
Federal Reserve notes
Treasury securities (+$5)
$250
$53
$57
$360
Loans (-$45)
Money supply = $303 ($250 + $53)
For Q 5 thru 7, suppose banks keep zero excess reserve
and the reserve requirement is 15%.
5.
6.
What is the deposit expansion multiplier?
(1/0.15 = 6.67)
_____________
A customer deposits $100,000 in his
checking account.
A.
B.
C.
How much of this can the bank lend to new
85% of 100,000 = $85,000
customers? ___________________
How much must the bank add to its
15% of 100,000 = $15,000
reserves? ___________________
In what two forms can a bank hold the new
required reserves?
Vault cash or in the reserve account (Fed Res.)
7.
8.
Suppose that the $100,000 had previously
been held in Federal Reserve notes under the
customer’s mattress and that banks continue to
hold no excess reserves. By how much will the
customer’s deposit cause the money supply to
$85,000 x 6.67 = $566,950
grow? ______________________
A very low discount rate may (encourage /
discourage banks from borrowing) from the
federal Reserve. Underline the correct answer
and explain why.
If banks are able to borrow from the federal
Reserve at a low interest rate and make loans at
a high rate, this will earn a profit and, hence,
have an incentive to use the discount window.
9.
The federal funds rate is the interest rate at
which financial institutions can borrow from
other financial institutions. Suppose the
federal funds rate is 5% and the discount
rate is 4.5 percent. Why is it that a bank
might choose to borrow in the federal funds
market, rather than getting the lower interest
rate available through the discount window?
Borrowing from another financial institution will
have fewer transaction costs, plus the bank will
not have the added scrutiny of its business
practices that borrowing from the Federal
Reserve will generate.
10.
11.
In a foreign country, the reserve
requirement is 100%. What will be the
(1/1 = 1)
deposit expansion multiplier? ___________
If the fed decided to implement a policy
action designed to increase the money
supply in which direction would bank
reserves and the federal funds rate change
and why?
If the Fed wants to increase the money supply it
will institute a policy to increase reserves (giving
banks an increased ability to make loans).
Banks have more money to loan to other banks,
businesses and consumers, so the federal funds
rate is likely to decrease.
12. Circle the correct symbol (↑ for increase, ↓ for decrease)
Fed Actions and Their Effects
Federal Reserve action
A. Sold Treasury
securities on the
open market
B. Bought Treasury
securities on the
open market
C. Raised the discount
rate
D Lowered the
discount rate
E. Raised the reserve
requirement
F. Lowered the
reserve requirement
Bank
Reserves
Money
Supply
Fed Funds
Rate
13. Indicate in the table in Fig. 38.5 how the Federal Reserve
could use each of the three monetary policy tolls to pursue
an expansionary policy and a contractionary policy.
Fig. 38.5 Tools of Monetary Policy
Monetary Policy
Expansionary
Policy
Contractionary
Policy
A. Open market
operations
Buy Treasury
securities
Sell Treasury
securities
B. Discount rate
Lower discount
rate
Raise discount
rate
C. Reserve
requirements
Lower required
reserve ratio
Raiser required
reserve ratio
14.
Why do banks hold excess reserves, which
pay no interest?
(1) required by law to hold required reserves
(2) as a precaution in case of sudden withdrawals or
changes in economic conditions.
15.
Why does the Fed rarely use the reserve
requirement as an instrument of monetary
policy?
Changes in the required reserve ratio cause radical or
strong changes in the monetary system. It is difficult
for financial institutions to adjust to changes in the
required reserve ratio. In general, the Fed uses the
tools of monetary policy to adjust the economy in
smaller increments.
16.
What does it mean to say that the Fed
changes the discount rate mostly as a
signal to markets?
It signals to the banks and others how the Fed would like the
money supply to change. (The discount rate has no impact if
banks do not borrow from the Federal Reserve; banks do not
have to borrow because if they need funds, they can always
go to the federal funds market.)
17.
Why does the fed currently target the
federal funds rate rather than the money
supply?
It targets the federal funds rate because the Fed
believes that this rate is closely tied to economic
activity. (The Fed uses changes in reserves to
affect the federal funds rate.)
Works Cited
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Emery, Barbara. “Monetary Policy”. Federal Reserve
Bank of Philadelphia. 18 Feb 2009
http://www.philadelphiafed.org/
education/teachers/lesson-plans/index.cfm?tab=
3&CFID=1604898&CFTOKEN=97766325&jsess
ionid=383079bdcb242df693e17a7e4b313a554b
54>
“Federal Reserve Board”. Federalreserve.gov. 1 March
2006. 14 March 2006. http://www.federal
reserve.gov/general.htm
Hill, Andrew T. “What Does the Fred Do? Federal
Reserve Bank of Philadelphia. 18 Feb 2009.
<http://www.philadelphiafed.org/education/teach
ers/lesson-plans/index.cfm?tab=3&CFID=
1604898&CFTOKEN=97766325&jsessionid=38
3079bdcb242df693e17a7e4b313a554b54>