Transcript The Federal Reserve System

The Federal Reserve System
1. Functions of the Fed
2. Fed Policy Levers
3. Interest Rates
4. Inflation Implications
5. Money Definitions
6. Banking
7. Money Creation
8. Fed Policy
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1. Functions of the Fed
http://www.federalreserve.gov : about the Federal Reserve
System
Conducting the nation's monetary policy by
influencing the money and credit conditions in the
economy in pursuit of full employment and stable
prices
Supervising and regulating banking institutions
• Maintaining the stability of the financial system and
containing systemic risk that may arise in financial
markets
• Providing certain financial services
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2. Fed Policy Levers
Influence Bank Reserves to change
Money Supply and Federal Funds Rate
Discuss later in which ways bank
reserves may be changed.
Short-run and Long-run implications of
changing Bank Reserves:
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Market for Bank Reserves
Supply of Reserves
Federal
Funds
Rate
c
a
b
Demand for
Reserves
Bank Reserves
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Implications
Bank Reserves up -> Money Supply up,
Fed Funds Rate down -> Market Rates
down ->
1. stock prices increase,
2. dollar (exchange rate) depreciates,
3. investment and consumer durables
demand increase.
4. first production increases, then the
price level.
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Market for Bank Reserves
Supply of Reserves
Federal
Funds
Rate
c
a
b
Demand for
Reserves
Bank Reserves
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Interest Rates over Time
Market
Rates
Time of temporary increase in
growth rate of bank reserves
Time
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Interest Rates over Time
Market
Rates
Time of permanent increase in
growth rate of bank reserves
Rate end up permanently
higher due to higher inflation
Time
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3. Nominal and Real Interest
Rates (or returns)
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•
•
•
Observed market rates are Nominal
Taxes are based on market rates.
Real returns take inflation into account.
Due to x% inflation, a loan is worth x%
less in real terms after one year.
• For the lender the return per $ of the
loan is the nominal interest % - x%.
Same for the cost of the borrower.
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Nominal and Real rates
(continued)
• Thus: real Interest % = nominal
interest % - inflation %.
• After-tax real interest % = (1 - tax rate)
x (nominal interest %) - inflation %.
• “Fischer Effect”: fully anticipated 1%
higher inflation should raise nominal
interest rates by 1% (by more if taxes
are considered; less in reality).
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4. Inflation Implications
• Eliminate our current 2% inflation rate?
• Inflation = % change in level of all prices
(includes wages in principle).
• Anticipated versus Unanticipated.
• Anticipated inflation: Misconceptions
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Misconceptions Costs of
Anticipated Inflation
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•
•
•
•
•
Real wages decrease systematically.
Costs increase.
Galloping inflation imminent.
Taxes increase [bracket creep].
Loss to society.
Redistribution of wealth (lenders lose,
borrowers gain).
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True costs of anticipated inflation
• Menu costs, Shoe leather costs
• People on fixed incomes suffer.
• Even if income tax brackets adjust:
capital gains tax due to inflation,
depreciation at original cost.
• High inflation implies variable inflation,
larger Unanticipated inflation changes.
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Costs of Unanticipated
Inflation
• Arbitrary redistribution:
– Real wages affected if labor contracts
Firms affected in opposite direction.
– Borrowers and lenders affected in
opposite ways.
• Confused Market signals:
– Firms do not know if their price went up
due to inflation or increased popularity.
– Relative prices change
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Price Stability
• Should we strive for 0% inflation?
– Unknown risks of deflation.
– Temporarily higher unemployment.
– People on fixed incomes benefit.
– Underground economy and our
foreign creditors benefits.
– Harder to cut salaries.
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5. What Counts as Money?
M1 = Currency in hands of the public
(coins + paper money), Checkable
Deposits, Traveler’s Checks.
M2 = M1 + Savings Deposits, MMDA’s,
MMMF’s (retail), Small Time
Deposits.
M3 = M2 + Large Time Deposits,
MMMF’s (institutional), Repurchase
Agreements, Eurodollars.
Credit Cards??
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6. The Banking System
Fractional Reserve Banking: only part of
the checking deposits is backed by Bank
Reserves.
Bank Reserves = Currency in Vault +
Accounts at the Fed.
= Required Reserves +
Excess Reserves
Profitability, Solvability, Liquidity
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Bank Balance Sheet
Assets
Typical Bank
Liabilities
Currency
Checking Deposits
Accounts at Fed
Savings and Time
Loans and
Securities
$x
Deposits
Capital
$x
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7. Money Creation
Money Multiplier: relation between money
created by Fed and total Money Supply
Monetary Base: money created by Fed =
All Currency + Bank Accounts at Fed
=
Bank Reserves + Currency in Circulation.
Why is Money Multiplier greater than 1?:
$1 in new bank reserves -> banks lend out
-> part comes back to banks in form of
checking accounts -> hold 10% to back up
checking acounts (fractional reserve
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banking) -> lend out the rest.
Money Supply = (Money Multiplier) x
( Monetary Base)
Money multiplier gives the increase in money
per unit of base money created by Fed.
In practice about 2.2 for M1.
Realistic?
--banks always get rid of excess reserves fast
--people hold cash about 50c per $
--banks hold excess reserves voluntarily.
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8. Federal Reserve Policy
Origin of Fed: Bank Panics (last in 1907)
-> need for “Lender of Last Resort.” (1913)
Board of Governors
12 Fed Reserve District Banks (24 branch banks)
Federal Open Market Committee (FOMC)
Member Banks (mostly National Banks)
Bank Runs during depression led to Federal
Depository Insurance Corporation (FDIC)
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Tools for affecting Money
1. Open Market Operations (NY Fed)
2. Discount Loans to Banks
3. Changes in Reserve Requirements
OMO’s most common, First two affect
Bank Reserves, Third affects money
multiplier.
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Policy Question
Should Greenspan further lower FFR?
Yes: Economy slowing down, World needs
a boost, Exchange rate too high, Liquidity
needs (LTCM), Good for Banks, Avoids
Deflation.
No: “Irrational exuberance”, Inflationary
(due to both lower exchange rate and
lower interest), Don’t let inflation genie out.
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