Chapter 13: The Federal Reserve System

The Federal Open Market Committee (FOMC) 1. How many members is it made up of? 2. How many member boards of governors? 3. The president of the federal reserve bank of new york has what kind of seat? 4. 4 from the remaining 11 reserve bank presidents, serve what kind of terms?

1. Made up of 12 members: 2. 7 member board of governors 3. A permanent seat 4. 4 from the remaining 11 serve a two-year terms on a rotating basis.

What can a bank use its excess reserves for?

A bank can use its excess reserves to create new loans in the form of new checkable deposits

The Money Supply Expansion Process: 1. What happens when the Fed conducts an open market purchase? 2. How can an open market purchase result in the expansion of the money supply?

1. An open market purchase is a type of open market operations in which the Fed buys bonds to increase the money supply. - Ex: The Fed buys $500 worth of bonds from Bank A. Bank A turns over the bonds to the Fed, and, in return, the Fed must pay Bank A $500. Bank A currently has a reserve account (bank deposits at the Fed) of $1000. The Fed simply changes the balance in this account from $1,000 to $1,500 ==> With there being more reserves, the more excess reserves help to create new checkable deposits and thus loans, which causes the money supply to increase. 2. Bank A shows $1,500 in reserves and $10,000 in checkable deposits. If the required reserve ratio is 10%, Bank A is required to hold only $1,000 in reserves. SO bank A has $500 in excess reserves. Suppose Bank A takes the entire $500 in excess reserves and creates a loan. Specifically, it grants the loan in the form of a new checkable deposit with a balance of $5000. Checkable deposits started off at $10,000 in Bank A, but are now $10,500. The extra $500 checkable deposit is the new deposit that the bank creates. The money supply is now $10,500. (The more reserves that a bank has, the more it can create more loans in the form of new checkable deposits, which causes the money supply to increase.) ==> The process continues: Individual takes the $500 loan from Bank A (in the form of a new checkable deposit) and spends it. Specifically, the individual writes a check for $500 to another individual. The 2nd individual takes the $500 check and deposits the full amount into his checking account at Bank B. When the check that the 1st individual wrote to the 2nd individual clears, bank A instructs the Fed to move $500 out of its reserve account and deposit the amount into Bank B's reserve account. Bank B now has $500 in reserves and $500 in checkable deposits. But if the required reserve ratio is 10%, Bank B is required to hold only $50 in reserves. Bank B has $450 in excess reserves as a result. Bank B uses the entire $450 in excess reserves to create a loan of $450 for a 3rd individual in the form of a checkable deposit. In other words, Bank B creates a new checkable deposit of $450. What is the money supply now? - The money supply of $10,000 went up to $10,500 because Bank A extended a loan (created a new checkable deposit for the 1st individual). Bank B then extended a loan (created a new checkable deposit) of $450 for the 2nd individual, so the money supply is now $10,950. - The change in checkable deposits (or the money supply) is $5,000; thus, the Fed's open market purchase resulted in the money supply rising from $10,000 to $15,000.

The Money Supply Contraction Process: 1. What is an open market sale? 2. How the money supply contraction process works

1. An open market sale is when the Fed sells bonds to decrease the money supply 2. Assume that the initial money supply is $10,000. The Fed undertakes an open market sale by means of selling bonds to banks. The Fed sells $400 worth of bonds to Bank A. The Fed turns the bonds over to Bank A and then subtracts $400 from Bank A's reserve account. Reserves for Bank A have gone from $1,000 to $600. Given that checkable depostis are $10,000, Bank A is reserve deficient. If the required ratio is 10%, Bank A is required to hold $1,000 in reserves. But after the open market sale, Bank A is holding only $600 in reserves, so it is reserve deficient by $400. - When a bank is reserve deficient, one of three things it can do is to apply some of its loan repayments to the reserve deficiency position. ==> Suppose an individual walks into the bank and pays bak a $400 loan he took out months ago. If Bank A weren't reserve deficient, it would probably create a $400 loan (new checkable deposit) for someone else. The creation of the loan by the bank would keep the money supply constant (one's checkable deposit balance goes 0, while another would rise by $400). But because the bank is reserve deficient, it keeps the 4400 as reserves. As a result, checkable deposits decline by $400. Consequently, the money supply declines by $400 to $9,600. ==> The contraction of the money supply does not stop with Bank A: It moves on to other banks. To illustrate, suppose the loan repayment that the individual made to Bank A was written on a check issued by Bank B. Then, when the check clears, the reserves of Bank B decline, and Bank B finds itself reserve deficient. It then applies loan repayments to its reserve deficiency position. The effect continues with banks C, D, and so on (the more loans they receive from other banks to put in their reserves, the less the reserve balance of other banks will decline, and thus the reserves will be held and thus no new checkable deposits, causing the money supply to decrease). ==> Can also use the formula for the change in money supply of checkable deposits to determine how much the money supply has declined.==>Justaddanegativesigntotheinitialcheckabledeposit

What are the 6 functions of the federal reserve banking system?

1. Conduct monetary policy: change in quantity of money in circulation designed to alter interest rate and affect the level of overall spending (controlling the money supply) 2. Supervise and regulate financial institutions 3. Clear checks among banks 4. Holding depository institutions reserves (bank of banks) 5. Serving as Government's Banker: Holds government's checking account 6. Lender of last resort to those banks that suffer from cash management, or liquidity, problems

The Federal Reserve System 1. When was the Fed created and when did it start operating? 2.What kind of agency is the Fed? 3. The Fed consists of how many branches? 4. Where are the branches located?

1. Created in 1913, started operating in 1914 2. The Fed is an independent agency 3. The Fed consists of 12 branches across the U.S 4. 12 branches: new york, san francisco, boston, philadelphia, celveland, richmond, dallas, chicago, minneapolis, atlanta, st. louis, kansas city

Formula to determine the change in checkable deposits (or money supply) ==> change in reserves (R)

1. First find the money multiplier ==> 1/required reserve ratio (r) 2. multiply the money multiplier by the initial injection of funds (the initial deposit at the bank)

What are the 3 tools of monetary policy?

1. Required reserve ratio (r) 2. The discount rate 3. Open market operations. The three mentioned can be used to increase or decrease the money supply.

1. The discount rate is another tool that the Fed can use to do what? 2. Using the discount rate. how can the Fed increase the money supply? Provide an example 3. Using the discount rate, how might the Fed want to contract the money supply?

1. The discount rate is another tool that the Fed can use to regulate the money supply 2. If the Fed wants to increase the money supply, it can drop the discount rate below the federal funds rate - Ex: Suppose the federal funds rate is 5%. All the Fed has to do is set the discount rate to 3%. Now, Bank A has an incentive to go to the Fed instead of to another bank for the $1 million it wants. The Fed gives the bank the $1 million discount loan by increasing the balance in the bank's reserve account by $1 million. With more reserves, the bank can create more loans (more checkable deposits, due to there being more excess reserves), and as a result, the money supply rises. 3. If the Fed wants to contract. the money supply, it can set the discount rate above the federal funds rate. Now, banks will not go to the Fed for loans, and as the banks repay discount loans taken out in the past, reserves in the banking system decline. When a bank repays a discount loan, the Fed subtracts the repayment from the banks reserve account, which causes the money supply to decline (less excess reserves).

delete ==> Slide 1: 1. The initial deposit at the bank can become a ...? 2. Multiplier formula 3. Total change in money supply (or checkable deposits) formula ==> The more new checkable deposits, the more that the money supply increases

1. The initial deposit can become a required reserve or an excess reserve 2. 1/r 3. multiplier (1/r) x initial money deposit = change in R

1. The loan that a bank might get from another bank is called what? 2. The market in which banks lend reserves to one another, usually for short periods, is called what? 3. The interest rate that one bank pays for an overnight loan is called what? And in which market is it determined in? 4. What determines the federal funds rate?

1. The loan that a bank might get from another bank is called an overnight loan since it is typically a loan of short duration. 2. The market in which banks lend reserves to one another, usually for short periods, is called the market for reserves or the federal funds market. 3. The interest rate that one bank pays for an overnight loan is called the federal funds rate, which is determined in the federal funds market. 4. The demand for and the supply of reserves determines the federal funds rate

Delete ==> How does the Fed serve as the lender of last resort to those banks that suffer from cash management, or liquidity, problems

A traditional function of a central bank is to serve as the lender of last resort for banks suffering cash management, or liquidity, problems

As each bank creates some new loans (new checkable deposits), each time, the amount created is smaller or larger than the amount that the previous bank created?

As each bank creates some new loans (new checkable deposits), each time, the amount created is smaller than the amount that the previous bank created.

Formula to determine a bank's excess reserves

Bank's reserves - Required Reserve Ratio

Define bank's reserves

Bank's reserves: bank deposits at the Fed (the balance in its reserve account at the Fed) + bank's vault cash

Delete ==> What does it mean to hold depository institutions' reserves?

Banks are required to keep reserves against customer deposits either in their vaults of in reserve accounts at the Fed.

How come banks do not hold and excess reserves?

Banks do not hold any excess reserves as that would affect the money supply because the more excess reserves banks hold, the smaller the increase will be in the money supply (which increases when more loans are made in the form of new checkable deposits)

Formula for M1 money supply

currency and coins held outside banks + checkable deposits + traveler's checks

3. Open market operations - By using the monetary tool of open market operations, how can the Fed increase and decrease the money supply? ==> a. & b.

Most often used tool by the Fed a. To increase the money supply, the Fed buys bonds (money added to the banks) ==> An open market purchase b. To decrease the money supply, the Fed sells bonds (money removed from the banks) ==> An open market sale

How does the Fed provide check-clearing services?

Only talking about 2 banks here: When a bank receives a check (from a depositor) drawn on another bank (i.e., a check to be deposited at another bank), it may send the check for collection and clearing directly to the other bank, deliver the check to the other bank through a local clearing house, or use the check-collection and -clearing services of the federal reserve bank. If it uses the services of a federal reserve bank, the account of the bank collecting the value of the check is credited and the account of the bank that is paying is debited. Most checks are collected and settled within one business day. - When your bank account is debited, money is taken out of the account. The opposite of a debit is a credit, in which case money is added to your account. Your account is debited in many instances.

Formula for a bank's required reserves

Required reserve ratio (r) x bank's checkable deposits

Delete ==> How does the Fed serve as the government's banker?

The Fed holds the government's checking account. The federal government collects and spends large sums of money. As a result, it needs a checking account for many of the same reasons an individual does. The primary checking account of the federal government is with the Fed, which is the government's banker.

2. Define the discount rate - What is the "Federal Funds Rate"? - In relation to the discount rate and the federal funds rate, how can the Fed decrease and increase the money supply? ==> a.& b.

The discount rate: interest rate the Fed charges banks when they borrow from the Fed - The "Federal Funds Rate" is the interest rate that banks charge when they borrow from each other a. The Fed decreases the discount rate below the federal funds rate to increase the money supply (the more that banks will want to borrow from the Fed) - Banks will borrow from the Fed and increase their deposit and their ability to lend. This can potentially increase the money supply. (by increasing their ability to lend, the money supply increases) b. The Fed increases the discount rate above the federal funds rate to decrease the money supply (the less that banks will want to borrow from the Fed) - Banks will be discouraged to borrow from the Fed and their deposit and their ability to lend will be limited to the existing amount of money supply in the economy - since there is no added amount being added to the money supply) (by decreasing their ability to lend, the less new loans and thus checkable deposits, so the less that is added to the money supply)

The loan the bank gets from the Fed is called what? The interest rate the bank pays for a discount loan is called what? Who is the discount rate set by?

The loan the bank gets from the Fed is called a discount loan, and the interest rate the bank pays for a discount loan is called the discount rate. The discount rate is set by the Fed.

The money supply process shows how the Fed can do what to the money supply?

The money supply process shows how the Fed can increase and decrease the money supply

1. By changing the required reserve ratio (r), what can it cause to change? Also provide examples ==> How can changing the required reserve ratio affect the money supply? Practice questions: Slide 5 1. r = 20%. What is the multiplier? So, each $1 deposited in a bank,... 2. r = 40%. What is the multiplier? So, each $1 deposited in a bank will multiply to what of the money supply?

The required reserve ratio (r) can be changed to change the money multiplier: - Increase "r" to decrease money supply (the less excess reserves - because the more reserves that are held) - Decrease "r" to increase the money supply (the more excess reserves - because the less reserves that are held) - Changing "r" affects the money multiplier Practice questions: 1. Money multiplier = (1/0.2) = 5. So, each $1 deposited in a bank (a $1 change in reserves), once loaned out, will multiply to $5 of M2 (the change in checkable deposits or the money supply). Increasing the money supply. ==> How much the money supply has changed ==> the excess reserves will help generate this increase in the money supply) - Textbook: r = 10%, then for a $1 change in reserves, the change in checkable deposits (money supply) is $10. 2. Money multiplier = 1/0.4 = 2.5. So, each $1 deposit in a bank, once loaned out, will multiply to only $2.5 of M2 - decreasing the money supply