Chapter 13

The Fed has announced a new, lower target for the federal funds rate; in other words the Fed wants to lower the federal funds rate from its present level. What does setting a lower target for the federal funds rate have to do with open market operations?

Setting a lower target for the federal funds rate means that the Fed will have to buy securities in an open market operation. This increases the supply of reserves in the banking system, causing the federal funds rate to fall (towards the lower target rate).

Explain what might limit the banking system's ability to create money.

If not all funds are deposited into bank checking accounts or if banks voluntarily hold excess reserves, then the banking system's ability to create money will be limited.

The Fed can change the discount rate directly and the federal funds rate indirectly. Explain.

The Fed can change the discount rate directly, since it is the rate that it uses to loan money to the banks. The Fed controls the federal funds rate indirectly through open market operations.

Explain how the Fed uses the required reserve ratio to increase the money supply.

The Fed lowers the required reserve ratio to increase the money supply. This frees up excess reserves that banks will most likely use to create new loans (which is money creation).

Dealing with a financial crisis

The Fed might take different actions when it is dealing with a financial crisis. The Fed did three things to deal with the 2007-2009 financial crisis:

Write the formula used to calculate the maximum amount of new money that may be created from any new money.

The maximum change in checkable deposits from an initial injection of funds into the banking system = 1/r × ΔR, where r = the required-reserve ratio and ΔR = the change in total reserves resulting from the initial injection of funds.

Explain how banks create money under a fractional reserve banking system.

Under a fractional reserve banking system, banks create money by holding on reserve only a fraction of the money deposited with them and lending the remainder. Banks create money (in the form of checkable deposits) when they create loans.

Explain how the Fed uses open market operations to increase the money supply.

When the Fed buys a security, it pays for it by increasing the balance in a bank's reserve account. This is newly created money. The multiplier effect will lead to even more money being created.

5. If reserves decrease by $3 million and the required reserve ratio is 8 percent, what is the change in the money supply? What does the simple deposit multiplier equal?

Change in the money supply = (1/0.08) × -$3 million = 12.5 × -$3 million = -$37.5 million Simple deposit multiplier = (1/0.08) = 12.5

If reserves decrease by $4 million and the required reserve ratio is 10 percent, what is the change in the money supply?

Change in the money supply = (1/0.10) × -$4 million = 10 × -$4 million = -$40 million

Reserves change by $10 million and the money supply changes by $50 million. What does the simple deposit multiplier equal? What does the required reserve ratio equal?

Change in the money supply = (1/r) × change in reserves $50 million = (1/r) × $10 million r = $10 million/$50 million r = 0.2 or 20% Simple deposit multiplier = (1/0.2) = 5

The Money Supply Expansion Process Steps

Step One: (Assume that the money supply initially consists of checkable deposits worth $10,000.) Suppose the Fed conducts an open market purchase of $500 from Bank A, and increases Bank A's reserve account by $500. Step Two: Bank A now has $500 of excess reserves, which it lends to Jill in the form of a new checkable deposit. The money supply has now increased from $10,000 to $10,500. Step Three: Jill spends the $500 by writing a $500 check to Joe. Joe deposits the $500 at Bank B. Step Four: Joe's Bank B sets aside 10 percent of his $500—that is, $50—as required reserves. The remaining $450 becomes excess reserves. Step Five: Joe's Bank B now has $450 that may be lent—an action that will increase the money supply again. Exhibit 2 traces out the multiplier process to its end. The process continues until no new excess reserves can be created. The maximum amount of new money that may be created from any new money can be derived using the formula: Change in checkable deposits (or money supply) = 1/r × ΔR where r = the required-reserve ratio and ΔR = the change in total reserves resulting from the initial injection of funds. The expression (1/r) in the formula above is known as the simple deposit multiplier. This assumes that banks always use all their excess reserves to create loans and that there were no cash leakages: situations where funds are held as currency instead of deposited into a checking account.

Explain how the Fed uses open market operations to decrease the money supply.

When the Fed sells a security, it collects the amount that is due by reducing the balance in a bank's reserve account. This action removes money from the economy. The multiplier effect will lead to even more money being destroyed.

Federal Open Market Committee(FOMC)

The major policy-making group within the Fed, the FOMC, is made up of the seven governors plus five presidents of Federal Reserve District Banks (the president of the New York Fed has a permanent seat; the other four places rotate among the remaining 11 Federal Reserve District Bank presidents). The FOMC has the authority to conduct open market operations. It is the responsibility of the New York Fed to carry out FOMC orders.

Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed is trying to do?

By conducting a policy in which it persistently bought securities and lowered the discount rate, the Fed appears to be trying to boost the money supply. A more discerning eye will also notice that, while taking expansionary measures with both the discount rate and open market operations, the Fed did not reduce the reserve requirement. This would suggest that the Fed is comfortable with the size of the simple deposit multiplier and does not want the banking system to be any more or less able to multiply the effects of the other policy changes.

Explain how a decrease in the required reserve ratio increases the money supply.

If the required reserve ratio decreases, then banks will have more reserves than they are required to have, which means that some formerly required reserves are now excess reserves. These excess reserves can then be used to make new loans that cause an increase in checkable deposits and hence an increase in the money supply.

Term Auction Facility (TAF) Program

In late 2007, the Fed created the term auction facility (TAF) program, whereby the Fed states the amount of credit it wants to extend then allows banks to bid on the funds, thereby determining the interest rate for the loans. This allows banks to avoid the stigma attached to discount loans. Banks found that borrowing through the term auction facility was cheaper than with discount loans.

What does it mean to say that a bank is reserve deficient?

It means the bank is not holding enough reserves against its checkable deposits. A reserve-deficient bank holds fewer reserves than it should, given the required reserve ratio.

APPENDIX C: THE MARKET FOR RESERVES (OR THE FEDERAL FUNDS MARKET)

Monetary policy can be conducted in various ways. One is to target a specific money supply, such as M1 or M2. The Fed then uses open market operations to achieve its target. Today, the Fed usually tries to target a set federal funds rate. This appendix describes how this works.

Explain how the Fed uses the discount rate to increase the money supply.

The Fed lowers the discount rate to increase the money supply. Lower discount rates increase the likelihood that banks will borrow from the Fed, thus increasing their excess reserves, which they will use to create new loans (which is money creation).

Describe how the Fed pays for the government securities that it buys

The Fed pays for the government securities that it buys by creating M1 money (in the form of an addition to the reserve deposits in the bank involved in the transaction).

Explain how the Temporary Auction Facility (TAF) works.

The TAF program works as follows: the Fed states the amount of credit it wants to extend then allows banks to bid on the funds, thereby determining the interest rate for the loans.

What is the difference between the discount rate and the federal funds rate?

The discount rate is the interest rate that a commercial bank pays on a loan that it receives from the Federal Reserve. The federal funds rate is the interest rate that a commercial bank pays on a loan that it receives from another bank.

What Is Free Banking?

Under the system of free banking, banks would not be subject to any special regulations. Banks would have the right to issue their own paper currency based on, perhaps, commodity reserves. The money supply would be determined by market forces.

Board of Governors—The Board of Governors

controls and coordinates the activities of the Federal Reserve System. The seven governors are appointed by the president and confirmed by the Senate to staggered 14-year (non-renewable) terms. The president designates one member of the board as the chair for a four-year, renewable term

THE MONEY SUPPLY EXPANSION PROCESS: A Quick Review of Reserves, Required Reserves, and Excess Reserves

As discussed in the previous chapter, a bank's reserves equal its bank deposits at the Fed (the balance in its reserve account at the Fed) plus its vault cash, a bank's required reserves are equal to the required reserve ratio (r) times its checkable deposits, a bank's excess reserves equal its reserves minus its required reserves, and a bank can use its excess reserves to create new loans.

Quantitative Easing

The Fed can inject resources into the economy through both open market purchases and quantitative easing. Under quantitative easing, the Fed buys long-term government securities from banks and private sector bonds and securities from other private institutions. It affects the long-term interest rates.

The money supply expansion process definition

The Fed conducts open market purchases (the buying of government securities by the Fed) and pays for those purchases by simply changing the balance in the reserve account of the bank from whom it buys the government security. This increases excess reserves for the bank in question, allowing it to create a loan in that amount. For example:

List three steps the Fed took to deal with the 2007-2009 financial crisis.

The Fed created the term auction facility (TAF) program, it extended its lender-of-last-resort function to non-bank institutions, and it bought securities from nonbank institutions, including securities that were not Treasury issues.

Explain where the supply of reserves comes from.

The supply of reserves comes from the Fed through open market purchases and from banks taking out discount loans from the Fed.

Explain what actions the Fed can take to move the federal funds rate to its target

To move the federal funds rate to its target, the Fed can conduct an open market operation, change the discount rate, or change the interest rate it pays on reserves

Define the term open market operation.

An open market operation is the buying or selling U.S. government securities by the Fed (acting on its own behalf, not as a fiscal agent for the U.S. Treasury)

If reserves increase by $2 million and the required reserve ratio is 8 percent, what is the change in the money supply?

Change in money supply = (1/0.08) × $2 million = 12.5 × $2 million = $25 million

If reserves increase by $2 million and the required reserve ratio is 10 percent, what is the change in the money supply?

Change in money supply = (1/0.10) × $2 million = 10 × $2 million = $20 million

Extending the Lender of Last Resort Function Beyond Banks

During the financial crisis, the Fed extended its lender-of-last-resort function to other institutions.

Buying Securities from Institutions Other than Banks

During the financial crisis, the Fed not only bought securities from nonbank institutions, but often bought securities that were not Treasury issues. Often they were mortgage-backed securities that were declining in value.

The Corridor and Changing the Federal Funds Rate

Exhibit 2(b) in the appendix shows a supply curve (of reserves) with two kinks: one at the interest rate that the Fed pays on reserves and another at the discount rate. The vertical section between the kinks is called the corridor. The federal funds rate moves within this corridor. If the current federal funds rate is higher than the Fed's target, the Fed can undertake an open market purchase to increase reserve, lower the discount rate, and lower the interest rate it pays on reserves. This shifts the supply curve as shown in Exhibit 3 in the appendix.

Explain how the Fed uses open market operations to achieve its federal funds rate target.

If the current federal funds rate is higher than the Fed's target, the Fed will conduct an open market purchase to inject reserves into the banking system. This increases the supply of reserves in the market for reserves and the price of those reserves—the federal funds rate—falls. Conversely, if the current federal funds rate is lower than the Fed's target, the Fed will conduct an open market sale to pull reserves from the banking system. This decreases the supply of reserves in the market for reserves and the price of those reserves—the federal funds rate—rises.

Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

It prevents the money supply from contracting as much and as fast as it would have contracted if the banks had not gone to the Fed for loans. However, this is only a short-run phenomenon. Once the banks repay the Fed loans (probably within the next two to four weeks), reserves will leave the banking system, and the money supply will decline as predicted. The loans the Fed makes to banks create a lag between the increase in the required reserve ratio and the full contractionary effect on bank reserves and the money supply.

A person takes $4,000 and places it into a checking account in a bank. Does the composition of the money supply change? Does the size of the money supply change? Explain your answers.

M1 = currency held outside banks + checkable deposits + travelers checks. There is an increase in checkable deposits by $4,000 and a decrease in currency held outside bank by $4,000. This changes the composition of money supply. Since checkable deposits increase, the bank has more excess reserves and can lend more money in the form of loans. Therefore, the size of the money supply also changes.

Suppose bank A borrows reserves from bank B. Now that bank A has more reserves than previously, will the money supply increase? Explain your answer

No, the money supply will not increase because there are no new reserves in the banking system. Though bank A has more reserves and bank B has fewer reserves, the banking system as a whole has the same volume of reserves.

The Fed and the Federal Funds Rate Target

Normally, if the Fed wants to change the money supply, it sets a federal funds rate target and then uses open market operations to hit the target. For example, if the current federal funds rate is higher than the Fed's target, the Fed will conduct an open market purchase to inject reserves into the banking system. As a result, the supply of reserves in the market for reserves rises and the price of those reserves—the federal funds rate—falls.

Explain how an open market sale decreases the money supply.

Suppose that the Fed sells one million dollars' worth of its government securities to a bank. The bank pays by giving the Fed one million dollars from its reserve account at the Fed so that the bank can meet its reserve requirement. With a reduction in its Fed reserves, the bank must reduce its total outstanding loans, which then reduces checkable deposits and money in the economy.

Describe the membership and functions of the Board of Governors.

The Board of Governors is made up of seven members appointed by the President and confirmed by Congress to staggered 14-year terms. One member is designated as the chair for a four-year, renewable term. The Board of Governors controls and coordinates the activities of the Federal Reserve System.

Identify the major responsibilities of the Federal Reserve System

The Federal Reserve System is responsible for conducting the nation's monetary policy. Its major responsibilities include (1) controlling the money supply, (2) supplying the economy with paper money (Federal Reserve Notes), (3) providing check-clearing services, (4) holding depository institutions' reserves, (5) supervising member banks, (6) serving as the government's banker, (7) serving as a lender of last resort, and (8) handling the sale of U.S. Treasury securities (auctions).

Explain why the demand for reserves curve is downward sloping.

The demand for reserves curve is downward sloping because as the federal funds rate moves down, banks will buy more "insurance" to guard against checkable deposit withdrawals, and vice versa.

The money supply contraction process

The process described above works equally well in reverse. In this case, the Fed conducts an open market sale (the selling of government securities by the Fed) which removes $400 from the banking system, creating a shortage of reserves. To remedy that shortage, banks reduce their outstanding loans, thereby reducing the money supply.

What is the relationship between the required reserve ratio and the money supply? What is the relationship between the simple deposit multiplier and the money supply?

The required reserve ratio is inversely related to the money supply. The simple deposit multiplier is directly related to the money supply.

The Supply of Reserves

The supply of reserves comes from the Fed (increases when the Fed makes open market purchases and decreases when the Fed makes open market sales) and from banks taking out discount loans from the Fed (increases when a bank borrows from the Fed and decreases when a bank pays back a discount loan to the Fed).

Two Different Supply curves for Reserves

The supply of reserves curve has a kink in it at the discount rate and does not extend vertically above this point. This is because banks would prefer to borrow from the Fed at the discount rate rather than in the federal funds market at any interest rate above the discount rate. The Fed sets its discount rate slightly above the target federal funds rate so that it serves as a ceiling for the federal funds rate. Just as the Fed can set a ceiling, it can also set a floor. In late 2008, the Fed started to pay an interest rate on reserves that banks held. Since no bank would prefer to lend reserves to another bank at a federal funds rate lower than the interest rate paid by the Fed, the federal funds rate is unlikely to fall below the interest rate on reserves paid by the Fed.

Explain why the supply of reserves curve is kinked.

The supply of reserves curve is kinked because the Fed sets a ceiling on the federal funds rate by setting a discount rate and the Fed sets a floor on the federal funds rate by paying an interest rate on reserves that banks hold.

What does it mean to say the Fed serves as the lender of last resort?

The term lender of last resort means that the Fed provides loans to banks that are suffering from cash management, or liquidity, problems.

Explain how market forces would determine the money supply under free banking.

Under a free-banking monetary arrangement, banks issue their own bank notes based on, perhaps, commodity reserves. Suppose the demand for money increases; specifically, people want to hold more money. Since people want to hold more money, they cut back on spending. In a free banking system, this means not as many of a given bank's notes (its currency) are flowing from one person to another person. It follows that any given bank will not be asked as often by another bank to redeem its bank notes for gold reserves, which then leaves each bank with more reserves to create money. Under free banking, the money supply would adjust (up or down) in response to changes in the public's demand for money.

The Structure of the Fed

The Federal Reserve System was created by the Federal Reserve Act of 1913. The act divided the country into Federal Reserve Districts; each has a Federal Reserve Bank with its own president. The boundaries of the twelve Federal Reserve Districts are shown in Exhibit 1. The most important responsibility of the Fed is to conduct monetary policy, or control the money supply in order to achieve stated macroeconomic goals.

Functions of the Fed: Controlling the money supply supplying the economy with paper money (Federal Reserve Notes) Providing check clearing services holding depository institutions reserves Supervising member banks serving as the government's baker Serving as the lender of last resort Handling the sale of US Treasury securities (auctions)

Controlling the money supply—This will be explained in detail later in the chapter. 2. Supplying the economy with paper money (Federal Reserve notes)—The Federal Reserve banks have Federal Reserve Notes on hand to meet the needs of banks and the public. 3. Providing check-clearing services—The check-clearing process is the process by which funds change hands when checks are written. The Fed provides these services. 4. Holding depository institutions' reserves—Banks are required to keep reserves against customer deposits either in their vaults or in reserve accounts at the Fed. The Federal Reserve banks maintain these accounts for member banks in their respective districts. 5. Supervising member banks—The Fed can examine the books of member commercial banks to see whether they are maintaining established banking standards, and can pressurize them to do so. 6. Serving as the government's banker—The Fed holds the government's primary checking account. 7. Serving as the lender of last resort—The Fed serves as the lender of last resort for banks suffering liquidity problems. 8. Handling the sale of U.S. Treasury securities (auctions)—The U.S. Treasury often auctions Treasury securities to help pay the government's bills. The Fed aids the Treasury in conducting the weekly auctions. There is a difference between the U.S. Treasury and the Fed. The U.S. Treasury manages the financial affairs of the government, but, except for coins, does not issue money; the Fed's job is to provide a stable monetary framework for the economy.

The Discount Window and the Federal Funds Market

If a bank wants a loan it can go to the Fed or to another bank. A loan from the Fed is called a discount loan, and the interest rate a bank pays for a discount loan is called the discount rate. The discount rate is set by the Fed. The loan that a bank gets from another bank is usually called an overnight loan. The market where banks lend reserves to one another is called the federal funds market, and the interest rate in the federal funds market is called the federal funds rate. If the Fed wants to increase the money supply, it can drop the discount rate below the federal funds rate, giving banks an incentive to borrow from the Fed instead of from another bank. Borrowing from the Fed increases excess reserves, allowing banks to create more loans (more checkable deposits) which increases the money supply. Alternatively, if the Fed wants to contract the money supply, it can set the discount rate above the federal funds rate. As banks repay discount loans taken out in the past, reserves in the banking system decline.

Explain how an open market purchase increases the money supply.

Suppose the Fed buys government securities from a commercial bank. At the end of the transaction, the Fed has more government securities than before, and the commercial bank has fewer. However, the commercial bank has a higher balance in its account at the Fed. Since deposits at the Fed are part of reserves (reserves = deposits at the Fed + vault cash), the reserves in the banking system have risen. Since the United States has a fractional reserve banking system, only a fraction of the increased amount of reserves has to be placed in required reserves. The remainder, or the positive excess reserves, can be used to extend more loans, create more demand deposits, and increase the money supply.

Describe the membership and functions of the FOMC.

The FOMC is made up of the seven governors plus the president of the New York Fed, plus four other members who are the chosen on a rotating basis from the other 11 District Bank presidents. The FOMC is the major policy-making group within the Fed, and has the authority to conduct open market operations.

The Required Reserve Ratio

The Fed can also influence the money supply by changing the required reserve ratio. If the Fed increases the reserve ratio, the simple deposit multiplier will be smaller, thereby further limiting the amount by which banks may expand the money supply. If the Fed decreases the reserve ratio, the simple deposit multiplier will be larger, thereby enabling banks to expand the money supply by a greater amount.

List the Fed's eight major functions.

The Fed's eight major functions include (1) controlling the money supply, (2) supplying the economy with paper money, (3) providing check-clearing services, (4) holding depository institutions' reserves, (5) supervising member banks, (6) serving as the government's banker, (7) serving as a lender of last resort, and (8) handling the sale of U.S. Treasury securities (auctions).

What are the differences between the Fed and the U.S. Treasury?

The Fed's job is to manage the availability of money and credit for the entire economy in order to provide a stable monetary framework for the economy. The Treasury, on the other hand, is a budgetary agency that manages the finances of the federal government. It issues government bonds, collects taxes and makes the payments for government expenditures

The Demand for Reserves

The demand for reserves curve is downward sloping: the federal funds rate and the quantity demanded of reserves are inversely related. As the federal funds rate moves down, banks will buy more "insurance" to guard against checkable deposit withdrawals, and vice versa. A change in expected deposit outflows and the required reserve ratio can lead to a shift in the demand for reserves.

Define discount rate and federal funds rate.

The discount rate is the interest rate that the Fed charges when it makes loans to financial institutions. The federal funds rate is the interest rates that financial institutions charge when they provide loans to other financial institutions.

Common Misconceptions About the U.S. Treasury and the Fed

There are major differences between the Treasury and the Fed. The U.S. Treasury is a budgetary agency; its obligation is to manage the financial affairs of the federal government. Except for coins, the Treasury does not issue money. It cannot create money out of thin air as the Fed can. The Fed is a monetary agency. The Fed is principally concerned with the availability of money and credit for the entire economy. It does not issue Treasury securities. It does not have an obligation to meet the financial needs of the federal government. Its responsibility is to provide a stable monetary framework for the economy.

Suppose the Fed lowers the federal funds rate target. How will this action likely affect both the federal funds rate and the money supply?

When the Fed lowers the federal funds rate target, it will undertake open market purchases to lower the actual federal funds rate. This injects reserves in the banking system and the federal funds rate decreases. As a result, banks have more excess reserves that they then lend out. Checkable deposits increase, which ultimately increases the money supply.

If the federal funds rate is 6 percent and the discount rate is 5.1 percent, to whom will a bank be more likely to go for a loan, another bank or the Fed? Explain your answer.

Ceteris paribus, the bank will probably borrow from another bank via the federal funds market. Although it will cost 0.9 percent more, the bank knows that the Fed is hesitant to extend loans to banks that want to take advantage of profit-making opportunities. Second, borrowing from the Fed may cause the Fed to suspect that the bank is in trouble. Banks do not like to borrow from the Fed, as it may decrease their future opportunities to borrow from the Fed. If the bank does not have any other choice, then it will borrow from the Fed, but otherwise it will want to save that privilege for a potential future rainy day.

Explain the similarities and differences between an open market purchase and quantitative easing.

Both open market purchase and quantitative easing help in increasing the reserves in the banking system and increases the money supply in the economy. Both involve the Fed buying securities from someone and both affect the interest rates. These are the similarities between an open market purchase and quantitative easing. An open market purchase entails the Fed buying short-term government securities from banks, while quantitative easing involves purchasing long-term government securities from banks and private sector securities from other private institutions. An open market purchase affects the short-term interest rates, while quantitative easing affects the long-term interest rates.