Money and Banking Econ 315 Final

Bretton Woods system

1.Fixed Rate 2. U.S. $ converts to Gold a. only to central banks 3.other currencies pegged to $ An exchange rate system under which countries pledged to buy and sell their currencies at fixed rates against the dollar and the United States pledged to convert dollars into gold if foreign central banks requested it to. The Bretton Woods system lasted from 1945 until 1971. The United States agreed to convert U.S. dollars into gold at a price of $35 per ounce—but only in dealing with foreign central banks. The central banks of all other members pledged to buy and sell their currencies at fixed rates against the dollar. By fixing their exchange rates against the dollar, these countries were fixing the exchange rates among their currencies as well. Because central banks used dollar assets and gold as international reserves, the dollar was known as the international reserve currency.

Balance-of-payments account

A measure of all flows of private and government funds between a domestic economy and all foreign countries Current Account + Financial Account=0

Fixed Exchange Rates in Europe

Fixed exchange rates reduce the costs of uncertainty about exchange rates. They have also been used to constrain inflationary monetary policy. When a government commits to a fixed exchange rate, it is also implicitly committing to restraining inflation.

The Exchange Rate Mechanism and European Monetary Union

Members of the European Monetary System agreed to participate in an exchange rate mechanism (ERM) to limit fluctuations in the value of their currencies against each other. Specifically, the member countries promised to maintain the values of their currencies within a fixed range set in terms of the ecu, which was a composite European currency unit. As part of the 1992 single European market initiative, European Community (EC) countries drafted plans for the European Monetary Union, in which exchange rates would be fixed by using a common currency, the euro.

Dual Mandate of FED

1. Price Stability (Hawkish) 2.Employment (Dovish)

Activities Investment Banks engage in

1. Providing advice on new security issues 2. Underwriting new security issues 3. Providing advice and financing for mergers and acquisitions 4. Financial engineering, including risk management 5. Research 6. Proprietary trading

Opponents of inflation targets

1. Rigid numerical targets for inflation diminish flexibility. 2. Reliance on uncertain forecasts of future inflation can create problems. 3. The focus on inflation may make it more difficult for elected officials to monitor the Fed's support for good economic policy overall. 4. Uncertainty about future levels of output and employment can impede economic decision making in the presence of an inflation target

Agents involved in Money Supply

1. The Federal Reserve, which is responsible for controlling the money supply and regulating the banking system. 2. The banking system, which creates the checking accounts that are the most important component of the M1 measure of the money supply. 3. The nonbank public, which refers to all households and firms. The nonbank public decides the form in which they wish to hold money—for instance, as currency or as checking account balances

Notes on expression above linking the money supply to the monetary base:

1. The money supply will change in the same direction of a change in either the monetary base or the money multiplier. 2. An increase in the currency-to-deposit ratio (C/D) causes the value of the money multiplier and the money supply to decline. 3. An increase in the required reserve ratio, rrD, causes the value of the money multiplier and the money supply to decline. 4. An increase in the excess reserves-to-deposit ratio (ER/D) causes the value of the money multiplier and the money supply to decline.

M2 multiplier

=[1+(C/D)+(N/D)+(MM/D)]/[(C/D)+rrD+(ER/D)]

Foreign exchange market intervention

A deliberate action by a central bank to influence the exchange rate.

Gold standard

A fixed exchange rate system under which currencies of participating countries are convertible into an agreed-upon amount of gold

Roles of B.O.G.

Administers monetary policy: determines reserve requirements and sets the discount rate charged on loans to banks Influences the setting of guidelines for open market operations Informally influences national and international economic policy decisions Advises the president and testifies before Congress on economic matters Is responsible for some financial regulation, e.g., setting margin requirements and determining permissible activities for bank holding companies Exercises administrative controls over individual Federal Reserve banks

Managed float regime

An exchange rate system in which central banks occasionally intervene to affect foreign exchange values; also called a dirty float regime. International efforts to maintain exchange rates continue to affect domestic monetary policy.

Balance Sheet showing Open Market Sale

Because reserves have fallen by $1 million, so has the monetary base. We can conclude that the monetary base decreases by the dollar amount of an open market sale. BOA B.S.: Assets= +$1m Securities, -$1m Reserves Fed B.S.: Assets= -$1 Securities, -$1m Reserves

Inflation Targeting

Before the financial crisis, many economists and central bankers expressed significant interest in using inflation targeting as a framework for monetary policy. With inflation targeting, a central bank publically sets an explicit target for the inflation rate over a period of time, and the government and the public then judge the performance of the central bank on the basis of its success in hitting the target. While the Fed has never gone beyond using an unannounced and informal target for the inflation rate, several countries have adopted formal inflation targets.

Board of Governnors

Board of Governors is the governing board of the Federal Reserve System, consisting of seven members appointed by the president of the United States. The Board of Governors is headquartered in Washington, DC. Members are confirmed by U.S. Senate, and serve 14-year, nonrenewable terms. The terms are staggered so it is unlikely that one U.S. president will be able to appoint a full Board of Governors. The president chooses one member of the Board of Governors to serve as chairman. Chairmen serve four-year terms and may be reappointed. Board members are professional economists from business, government, and academia.

Intermediate Targets

By using prospective intermediate targets, typically either monetary aggregates or interest rates, the Fed can try to achieve a goal outside of its direct control better than it would if it had focused solely on the goal. Using intermediate targets can also provide helpful feedback about the Fed's policy actions.

Capital Controls

Capital controls: Government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets Some currency crises in emerging market countries have been fueled in part by sharp inflows and outflows of financial investments, or capital inflows and capital outflows, leading some economists and policymakers to advocate restrictions on capital mobility.

International reserves

Central bank assets that are denominated in a foreign currency and used in international transactions. If the Fed wants the foreign exchange value of the dollar to rise (fall), it can increase (decrease) the supply of dollars by selling (buying) dollars and foreign assets. Such transactions affect not only the value of the dollar but also the domestic monetary base.

Fixed Exchange Rates under Bretton Woods

Central bank interventions in the foreign exchange market maintained the fixed exchange rates of the Bretton Woods system. A central bank can maintain a fixed exchange rate as long as it is able and willing to buy and sell the amounts of its own currency that are necessary for exchange rate stabilization. A country with a balance-of-payments deficit has its ability to buy its own currency (to raise its value relative to the dollar) limited by the country's stock of international reserves. When a country's stock of international reserves was exhausted, the central bank and the government would have to implement restrictive economic policies, such as increasing interest rates, to reduce imports and the trade deficit or abandon the policy of stabilizing the exchange rate against the dollar

Policy Trade-offs

Central banks generally lose some control over the domestic money supply when they intervene in the foreign exchange market. To increase the exchange rate—that is, to make the domestic currency appreciate—a central bank must sell international reserves and buy the domestic currency, thereby reducing the domestic monetary base and money supply. To decrease the exchange rate, or make the domestic currency depreciate, a central bank must buy international reserves and sell the domestic currency, thereby increasing the domestic monetary base and money supply. So, a central bank often must decide between actions to achieve its goal for the domestic monetary base and interest rates and actions to achieve its goal for the exchange rate.

Changes to the Fed Under the Dodd-Frank Act

Dodd-Frank Wall Street Reform and Consumer Protection Act is legislation passed during 2010 that was intended to reform regulation of the financial system. The Fed was made a member of the new Financial Stability Oversight Council, which was charged with preventing the failure of large financial firms. One member of the Board of Governors will coordinate the Fed's regulatory actions. The Government Accountability Office (GAO) was ordered to perform an audit of the Fed's emergency lending programs. Class A directors will no longer participate in elections of the bank presidents. The Fed was ordered to disclose the names of financial institutions to which it makes loans and with which it buys and sells securities. A new Consumer Financial Protection Bureau was established at the Fed to write rules concerning consumer protection from financial firms.

Power and Authority within the Fed

During its first 20 years, the decentralized District Bank system could not adequately respond to national economic and financial disturbances. The Banking Acts of 1933 and 1935 centralized the Board of Governors' control of the system, giving it a majority of seats (7 of 12) on the FOMC. The secretary of the Treasury and the comptroller of the currency were also removed from the Board of Governors, thereby increasing the Fed's independence. The informal power structure within the Fed is more concentrated than the formal power structure. The Fed chairman is most powerful in the system. The distinction between ownership and control is clear: Member banks own shares of stock, but this ownership confers none of the rights that are typically granted to shareholders of private corporations.

Proprietary Trading

Proprietary trading is buying and selling securities for the bank's own account rather than for clients

Monetary base (or high-powered money) The sum of bank reserves and currency in circulation.

The sum of bank reserves and currency in circulation. Monetary base = Currency in circulation + Reserves. The money multiplier links the monetary base to the money supply. As long as the value of the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. M=B+m

Pension fund

a financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide for pension benefit payments during workers' retirements

Contractual saving institution

a financial intermediary that receives payments from individuals as a result of a contract and uses the funds to make investments. (pension fund or an insurance company)

Insurance company

a financial intermediary that specializes in writing contracts to protect policyholders from the risk of financial loss associated with particular events. -Insurers obtain funds by charging premiums to policyholders and use these funds to make investments and direct loans to firms known as private placements.

Final Form of realistic Multiplier

m=[(C/D)+1]/[(C/D)+rrD+(ER/D)]

excess reserves-to-deposit ratio (ER/D)

measure banks' holdings of excess reserves relative to their checkable deposits. We can introduce the deposit ratios into our expression for the money multiplier this way

The monetary base has two components

the nonborrowed monetary base, Bnon, and borrowed reserves, BR, which is another name for discount loans. We can express the monetary base, B, as B = Bnon + BR. The Fed has control over the nonborrowed monetary base.

Effects of Open Market Purchase on the Federal Funds Market

x-axis= Reserves T-axis= Fed Fund Rate an open market purchase of securities by the Fed increases reserves in the banking system, shifting the supply curve to the right, increasing the level of reserves and decreasing the federal fund rate

Current Account

+ exports - Imports If the United States has a current account surplus (a positive number), this means that U.S. citizens are selling more goods and services to foreigners than they are buying imports from foreigners. Therefore, U.S. citizens have funds to lend to foreigners. A current account surplus or deficit must be balanced by international lending or borrowing or by changes in official reserve transactions. Large U.S. current account deficits have caused the United States to rely heavily on savings from abroad—international borrowing—to finance domestic consumption, investment, and the federal budget deficit. One reason for the U.S. current account deficits in the 2000s may have been the global "saving glut" that we discussed in Chapter 4. The saving glut was partly the result of high rates of saving abroad. With high savings rates and relatively limited opportunities for investment, funds from other countries flowed into the United States, bidding up the value of the dollar. The high value of the dollar reduced U.S. exports and increased imports, contributing to the current account deficit.

Financial Account

+Inflows -Outflows The financial account measures trade in existing financial or real assets among countries. The sale of an asset is recorded as a capital inflow. When someone in a country buys an asset abroad, the transaction is recorded as a capital outflow because funds flow from the country to buy the asset. The financial account balance is the amount of capital inflows minus capital outflows—plus the net value of capital account transactions, which consist mainly of debt forgiveness and transfers of financial assets by migrants when they enter the United States. The financial account balance is a surplus if the citizens of the country sell more assets to foreigners than they buy from foreigners. The financial account balance is a deficit if the citizens of the country buy more assets from foreigners than they sell to foreigners.

how when the Fed purchases or sells foreign currency it affect the base

, the Fed attempts to reduce the foreign exchange value of the dollar by buying foreign securities. The Fed pays with a check for $1 billion, adding to the bank's reserve deposits. If the Fed pays with currency, its liabilities still rise by $1 billion: Because the monetary base equals the sum of currency in circulation and bank reserves, either transaction causes the monetary base to rise by the amount of the foreign assets (international reserves) purchased.

"Repo Financing" and Rising Leverage in Investment Banking

-Among the sources of funds for investment banks are the bank's capital and short-term borrowing. -During the 1990s and 2000s, most large investment banks converted from partnerships to publicly traded corporations. Proprietary trading became a more important source of profits. -Financing investments by borrowing rather than by using capital increases leverage.

Types of Mutual Funds

-Closed-end mutual funds: a fixed number of nonredeemable shares is issued, with the share price fluctuating with the market value of the assets. -Open-end mutual fund: investors can redeem shares after the markets close for a price tied to the value of the assets in the fund. -Exchange-traded funds (ETFs): market prices track the prices of the assets. -No-load funds: funds do not charge a commission, or "load." -Load funds: funds charge buyers a "load" to both buy and sell shares. -Index fund: consists of a fixed-market basket of securities, such as the stocks in the S&P 500 stock index.

types of pension funds

-Defined contribution plan: the firm invests contributions for the employees who own the value of the funds in the plan. These are the most common plans today. -Defined benefit plan: the firm promises employees a particular dollar benefit payment, based on each employee's earnings and years of service. -401(k) plan: one particular defined contribution plan in which an employee makes tax-deductible contributions through regular payroll deductions.

Providing Advice and Financing for Mergers and Acquisitions

-Find an acquiring firm willing to pay more than the market value of the firm. -Provide a fairness opinion about a fair proposed offer. -Advise firms on their capital structure (mix of stocks and bonds) used to raise funds -Advising on M&As is particularly profitable for investment banks because the bank does not have to invest its own capital.

Hedge Fund

-Hedge fund is a partnership of wealthy investors that make relatively high-risk, speculative investments. -Hedge funds are typically organized as partnerships of 99 investors or fewer, either wealthy individuals or institutional investors. -They are largely unregulated and free to make risky investments. -Modern hedge funds typically are involved in speculation rather than hedging, so their name is no longer an accurate description of their strategies. -In 2012, there were as many as 10,000 operating in the United States, managing more than $2 trillion in assets.

Hedge Fund drawbacks

-Hedge fund managers charge not only a management fee but also get a share of fund profits. -Investments in hedge funds are illiquid as investors are often not allowed to withdraw their funds for one to three years. -Some hedge funds have experienced substantial losses that led to potential risk to the financial system, e.g., Long-Term Capital Management in 1998. -Hedge funds' use of short selling can cause security prices to fall by increasing the volume of securities being sold.

types of insurance companies

-Life insurance companies: sell policies to protect households against a loss of earnings from the disability, retirement, or death of the insured person. -Property and casualty companies: sell policies to protect households and firms from the risks of illness, theft, fire, accidents, or natural disasters.

Mutual funds

-Mutual fund is a financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks, bonds, mortgages, and money market securities. -Mutual funds help to reduce transaction costs, provide risk-sharing benefits, and gather information about different investments. -The industry in the United States dates back to 1924, with the creation of the Massachusetts Investors Trust, State Street Investment Corporation, and Putnam Management Company.

Process of an IPO

1. Choose Investment banks; more than one (syndicate) - one lead underwriter. 2. Develop prospectus - info about the firm 3. Find firm value 4.find buyers (institutions) 5. bookbuilding -determines price 6. collect fee a. spread (buy - sell price) b. % of value

Arguments in favor of an explicit inflation target

1. It would draw attention to what the Fed can actually achieve in practice. 2. It would provide an anchor for inflationary expectations. 3. It would help institutionalize effective U.S. monetary policy. 4. It would promote accountability.

criteria for any policy target

1. Measurable. The variable must be measurable in a short time frame to overcome information lags. Both reserve aggregates and the federal funds rate are easily measurable. 2. Controllable. Open market operations can keep both variables close to whatever target the Fed selects. 3. Predictable. The complexity of the impact a change in either reserves or the federal funds rate has on goals such as economic growth or price stability compromises predictability. Thus, economists continue to discuss which policy instrument is best.

The Fed's three traditional policy tools

1. Open market operations. Open market operations The Federal Reserve's purchases and sales of securities, usually U.S. Treasury securities, in financial markets. 2. Discount policy. Discount policy The policy tool of setting the discount rate and the terms of discount lending. Discount window The means by which the Fed makes discount loans to banks, serving as the channel for meeting the liquidity needs of banks. 3. Reserve requirements. Reserve requirement The regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

six goals of monetary policy

1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign-exchange market stability

Discount Loans

A loan made by the Federal Reserve, typically to a commercial bank. Discount loans alter bank reserves and cause a change in the monetary base. An increase in discount loans affects both sides of the Fed's balance sheet: Assets=+$1m Discount loans, Liabilities= +$1m Reserves As a result of the Fed's making $1 million of discount loans, bank reserves and the monetary base increase by $1 million.

International Monetary Fund (IMF)

A multinational organization established by the Bretton Woods agreement to administer a system of fixed exchange rates and to serve as a lender of last resort to countries undergoing balance-of-payments problems. Headquartered in Washington, DC, this multinational organization grew from 30 member countries in 1945 to 187 in 2010. The IMF encourages domestic economic policies that are consistent with exchange rate stability, and gathers and standardizes international economic and financial data to use in monitoring member countries. The IMF no longer attempts to foster fixed exchange rates, but its activities as an international lender of last resort have grown.

European Monetary Union

A plan drafted as part of the 1992 single European market initiative, in which exchange rates were fixed and eventually a common currency was adopted. euro The common currency of 16 European countries. With a single currency, transactions costs of currency conversion and bearing exchange rate risks would be eliminated. In addition, the removal of high transactions costs in cross-border trades would increase efficiency in production by offering the advantages of economies of scale.

Exchange-rate regime

A system for adjusting exchange rates and flows of goods and capital among countries.

Flexible exchange rate system

A system in which the foreign exchange value of a currency is determined in the foreign exchange market. When the Fed and foreign central banks believe their currency is significantly

The Taylor Rule: A Summary Measure of Fed Policy

Actual Fed deliberations are complex and incorporate many factors about the economy. John Taylor of Stanford University has summarized these factors in the Taylor rule. Taylor rule: A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate. The Taylor rule begins with an estimate of the value of the real federal funds rate, which is the federal funds rate—adjusted for inflation—that would be consistent with real GDP being equal to potential real GDP in the long run. With real GDP equal to potential real GDP, cyclical unemployment should be zero, and the Fed will have attained its policy goal of high employment According to the Taylor rule, the Fed should set its current federal funds rate target equal to the current inflation rate, the equilibrium real federal funds rate, and two additional terms. The first of these terms is the inflation gap—the difference between current inflation and a target rate; the second is the output gap—the percentage difference of real GDP from potential real GDP. The inflation gap and the output gap are each given "weights" that reflect their influence on the federal funds rate target. With weights of one half for both gaps, we have the following Taylor rule: "Federal funds target"="Current inflation rate"+"Equilibrium real"" federal funds rate" +(1/2" "×" Inflation gap) " "+ (1/2 "×" Output gap)."

The Bank of Japan

Adopted explicit money growth targets and reduced money growth after the oil shock of 1973, when the inflation rate was in excess of 20%. Having fulfilled its promises, the bank gained the public's belief in its commitment to lower money growth and lower inflation. Used a short-term interest rate in the Japanese interbank market—similar to the U.S. federal funds market—as its operating target. Relied less on its M2 aggregate after deregulation in the 1980s. Does not have formal inflation targets, although emphasizes price stability. Adopted deflationary monetary policy in the late 1990s and 2000s, which played a significant role in the weakness of the economy. Began to stimulate both economic growth and inflation in the mid-2000s. Intervened to reverse the soaring value of the yen against the U.S. dollar, which was hampering exports and impeding an economic recovery.

Fedspeak vs. Transparency

Alan Greenspan, former chairman of the Federal Reserve Board, earned a reputation of "Fedspeak" as he often used ambiguous and vague language that confused securities traders. By contrast, Ben Bernanke has been committed to greater transparency about the Fed's monetary policy intentions. Economists generally welcome more transparency, which can help households and firms make better economic decisions. Critics argue that more transparency about policy commitment would give the Fed less leeway to respond to changes in the economy. Still, some critics argue that the Fed is providing more information than anyone can interpret.

The Bank of England

Announced money supply targets in late 1973 in response to inflationary pressures, but the targets were not pursued aggressively. In response to accelerating inflation in the late 1970s, the government introduced in 1980 a strategy for gradual deceleration of M3 growth, but had difficulty achieving M3 targets. Shifted its emphasis toward targeting growth in the monetary base beginning in 1983. Adopted inflation targets in 1992, and used short-term interest rates as the primary instrument of monetary policy. Was led to take several dramatic policy actions during the financial crisis, cutting its overnight base rate. Rapidly lowered the interest rate it paid banks on reserves, and engaged in quantitative easing.

International Comparisons of Monetary Policy

Central banks in industrial countries have increasingly used short-term interest rates as the policy instrument, or operating target, through which goals are pursued. Many central banks are focusing more on ultimate goals such as low inflation than on particular intermediate targets.

The Effect of Changes in the Discount Rate and in Reserve Requirements

Changes in the Discount Rate Since 2003, the Fed has kept the discount rate higher than the target for the federal funds rate. This makes the discount rate a penalty rate, which means that banks pay a penalty by borrowing from the Fed rather than from other banks in the federal funds market. Changes in the Required Reserve Ratio The Fed rarely changes the required reserve ratio. Changing the required reserve ratio without also engaging in open market operations would cause a change in the equilibrium federal funds rate. If the Fed changes the required reserve ratio, it will likely carry out offsetting open market operations to keep the target for the federal funds rate unchanged (see figure 15-3).

The Monetary Base

Currency in circulation: Paper money and coins held by the nonbank public. Vault cash: Currency held by banks. Currency in circulation = Currency outstanding - Vault cash. Bank reserves: Bank deposits with the Fed plus vault cash. Reserves = Bank deposits with the Fed + Vault cash. Reserve deposits are assets for banks, but they are liabilities for the Fed because banks can request that the Fed repay the deposits on demand with Federal Reserve Notes. Reserves = Required reserves + Excess reserves. Required reserves: Reserves that the Fed compels banks to hold. Excess reserves: Reserves that banks hold over and above those the Fed requires them to hold. Required reserve ratio: The percentage of checkable deposits that the Fed specifies that banks must hold as reserves.

Member Banks

Currently, only about 16% of state banks and about one-third of all banks are members of the Federal Reserve System. Historically, state banks often chose not to join because they saw membership as costly. Banks could also avoid the Fed's reserve requirements. The opportunity cost of being a member of the Fed increased during the 1960s and 1970s as nominal interest rates rose, and fewer state banks elected to become or remain members. The Fed argued that declining bank membership eroded its ability to control the money supply and urged Congress to compel all commercial banks to join the Federal Reserve System. Congress has not yet legislated such a requirement, but DIDMCA of 1980 required that all banks maintain reserve deposits with the Fed on the same terms.

Economic Growth

Economic growth provides the only source of sustained real increases in household incomes. Economic growth depends on high employment. With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements. Stable economic growth allows firms and households to plan accurately and encourages the long-term investment that is needed to sustain growth.

the roles of the Fed branches as well as the Federal reserve system itself

Economic power within the Federal Reserve System is divided in 3 ways: 1. Among bankers and business interests 2. Among states and regions 3. Between government and the private sector Four groups within the system were empowered to perform separate duties: 1. The Federal Reserve Banks (12 districts) 2. Private commercial member banks 3. The Board of Governors 4. The Federal Open Market Committee (FOMC) All national banks (chartered by the federal government) were required to join the system. State banks (chartered by state governments) were given the option to join.

Treasury Vs Fed

Elected officials lack formal control of monetary policy, which has occasionally resulted in conflicts between the Fed and the president. During World War II, the Roosevelt administration increased its control over the Fed. The Fed agreed to hold interest rates on Treasury securities at low levels in order to help finance wartime budget deficits,. When the war ended in 1945, the Treasury wanted to continue this policy, but the Fed didn't agree for fear of inflation. On March 4, 1951, the federal government formally abandoned the wartime policy of fixing the interest rates on Treasury securities with the Treasury-Federal Reserve Accord. The Federal Reserve Accord was important in reestablishing the ability of the Fed to operate independently of the Treasury. President Ronald Reagan and Fed Chairman Paul Volcker argued over who was at fault for the economic recession of the early 1980s. Similar conflicts occurred during the administrations of George H. W. Bush and Bill Clinton, with the Treasury frequently pushing for lower short-term interest rates than the Fed considered advisable. During the financial crisis of 2007-2009, the Fed worked closely with the Treasury. If such close collaboration were to continue, it would raise the question of whether the Fed would be able to pursue policies independently. A proposal in early 2010 that the U.S. president appoint the presidents of the District Banks raised further concerns about Fed independence. The provisions of the Dodd-Frank Act did little to undermine Fed independence.

The German Central Bank

Experimented with monetary targets in the late 1970s to combat inflation. Used an aggregate called central bank money, or M3, which is a weighted sum of currency, checkable deposits, and time and savings deposits. Succeeded in maintaining its target ranges for M3 growth in the early 1980s, but in the late 1980s, in an effort to devaluate its currency relative to the U.S. dollar, the Bundesbank increased money growth faster than its announced targets. Confronted problems with reunification, as differences between West and East German currencies brought inflationary pressures. Used changes in the lombard rate (a short-term repurchase agreement rate) to achieve its M3 target. Relinquished its control of monetary policy to the European Central Bank after introduction of the euro in 2002.

Quantitative Easing

Fed Bond Purchases during the Financial Crisis of 2007-2009 The policy of a central bank attempting to stimulate the economy by buying long-term securities is called quantitative easing. The Fed took the unusual step of buying more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities during 2009 and early 2010. In November 2010, the Fed announced a second round of quantitative easing (dubbed QE2). With QE2 the Fed would buy an additional $600 billion in long-term Treasury securities through June 2011. Some economists and policymakers worried that they would eventually lead to higher inflation.

The Federal Open Market Committee

Federal Open Market Committee (FOMC) is the 12-member Federal Reserve committee that directs open market operations. FOMC consists of the chairman of the Board of Governors, the other Fed governors, the president of the Federal Reserve Bank of New York, and the presidents of four of the other 11 Federal Reserve Banks (on a rotating basis). The chairman of the Board of Governors serves as chairman of the FOMC. Only five Federal Reserve bank presidents are voting members of the FOMC, but all 12 attend meetings and participate in discussions. The president of the Federal Reserve Bank of New York is always a voting member. The committee meets in Washington, DC, eight times each year. Prior to each meeting, FOMC members access data from three books: 1. Green Book: national economic forecast for the next two years 2. Blue Book: projections for monetary aggregates 3. Beige Book: summaries of economic conditions in each district. The FOMC sets a target for the federal funds rate by buying and selling Treasury securities to adjust the level of bank reserves. The FOMC doesn't itself buy or sell securities for the Fed's account. Instead, it issues a directive to the Fed's trading desk at the New York Fed. The manager for domestic open market operations carries out the directive by buying and selling Treasury securities with primary dealers (private financial firms that deal in these securities).

The Federal Funds Market and the Fed's Target Federal Funds Rate

Federal funds rate: The interest rate that banks charge each other on very short-term loans; determined by the demand and supply for reserves in the federal funds market. The target for the federal funds rate is set at meetings of the Federal Open Market Committee (FOMC). We use a graph of the banking system's demand for and the Fed's supply of reserves to see how the Fed uses its policy tools to influence the federal funds rate and the money supply.

Problems With Capital Controls

First, government corruption is often a result of investors having to receive permission from the government to exchange domestic currency for foreign currency. Second, multinational firms will have difficulty returning any profits they earn to their home countries if they can't exchange domestic currency for foreign currency. Finally, in practice, individuals and firms resort to a black market where currency traders are willing to illegally exchange domestic currency for foreign currency.

Fixed exchange rate system

Fixed exchange rate system

The Bank of Canada

Gradually reduced the growth rate of M1 in the early 1970s as inflation became a concern. Shifted its policy toward an exchange rate target in the late 1970s. Reinstated its commitment to price stability in 1988 through declining inflation targets and operational target bands for the overnight rate. Focused on exchange rates, reflecting the importance of exports to the Canadian economy. Received praise for helping the Canadian financial system avoid the heavy losses suffered by many banks during the 2007-2009 financial crisis.

Hedge Vs Mutual funds (differences)

Hedge funds: -managed more aggressively. -able to take speculative positions in derivative securities (options, short sell stocks). This will typically increase the leverage - and thus the risk - of the fund. -it's possible for hedge funds to make money when the market is falling. -only available to a specific group of sophisticated investors with high net worth Mutual funds: - not permitted to take these highly leveraged positions and are typically safer as a result. -very easy to purchase with minimal amounts of money.

Example of Gold Standard Operation

Here is how the gold standard operated. In the case between the U.S. and France, if the relative demand for U.S. goods rises, market forces put upward pressure on the exchange rate. Gold then flows from France to the United States, reducing the French monetary base and increasing the U.S. monetary base. The accompanying increase in the U.S. price level relative to the French price level makes French goods more attractive, restoring the trade balance. The exchange rate moves back toward the fixed rate. So, we can conclude that the gold standard had an automatic mechanism that would cause exchange rates to reflect the underlying gold content of countries' currencies. This automatic mechanism was called the price-specie-flow mechanism. Under the gold standard, periods of unexpected and pronounced deflation caused recessions. A falling price level raised the real value of households' and firms' nominal debts, leading to financial distress for many sectors of the economy. With fixed exchange rates, countries had little control over their domestic monetary policies. Gold flows from international trade caused changes in the monetary base, and unexpected inflation or deflation. Moreover, gold discoveries and production strongly influenced changes in the world money supply, making the situation worse.

High Employment

High employment, or a low rate of unemployment, is another key monetary policy goal. Unemployment reduces output and causes financial and personal distress. Congress and the president share responsibility for the goal of high employment. Even under the best economic conditions, some frictional and structural unemployment always remains. The tools of monetary policy are ineffective in reducing these types of unemployment. Instead, the Fed attempts to reduce levels of cyclical unemployment, which is unemployment associated with business cycle recessions. Most economists estimate that the natural rate of unemployment is between 5% and 6%.

Open Market Operations Specifics

In 1935, Congress established the FOMC to guide open market operations. An open market purchase of Treasury securities causes the prices to increase, thereby decreasing their yield. Because the purchase will increase the monetary base, the money supply will expand. An open market sale has the opposite effects. Because open market purchases reduce interest rates, they are considered an expansionary policy. Open market sales increase interest rates and are considered a contractionary policy.

The European Monetary Union in Practice

In 1989, a common central bank, the European Central Bank (ECB), was established to conduct monetary policy and, eventually, to control a single currency. The ECB is structured along the lines of the Federal Reserve System in the United States. The ECB's charter states that the ECB's main objective is price stability. By the time monetary union began in 1999, 11 countries met the conditions for participation with respect to inflation rates, interest rates, and budget deficits. The United Kingdom declined to participate.

The Effect of Increases in Currency Holdings and Increases inExcess Reserves

In deriving the money multiplier, we made two key assumptions: 1. Banks hold no excess reserves. 2. The nonbank public does not increase its holdings of currency. In order to build a complete account of the money supply process, we change the simple deposit multiplier in three ways: 1. Rather than a link between reserves and deposits, we need a link between the monetary base and the money supply. 2. We need to include the effects on the money supply process of changes in the nonbank public's desire to hold currency relative to checkable deposits. 3. We need to include the effects of changes in banks' desire to hold excess reserves relative to deposits.

Foreign-Exchange Market Stability

In the global economy, foreign-exchange market stability, or limited fluctuations in the foreign-exchange value of the dollar, is an important monetary policy goal of the Fed. A stable dollar simplifies planning for commercial and financial transactions. Fluctuations in the dollar's value change the international competitiveness of U.S. industry: A rising dollar makes U.S. goods more expensive abroad, reducing exports, and a falling dollar makes foreign goods more expensive in the United States. In practice, the U.S. Treasury often originates changes in foreign-exchange policy, although the Fed implements these policy changes.

China and the Dollar Peg

In the late 2000s, there was considerable controversy over the policy of the Chinese government pegging its currency, the yuan, against the U.S. dollar. In 1994, the Chinese pegged the value of the yuan to the dollar at a fixed rate of 8.28 yuan to the dollar. By the early 2000s, many economists argued that the yuan was undervalued, and some U.S. firms claimed that the undervaluation of the yuan gave Chinese firms an unfair advantage in competing with U.S. firms. In mid-2010, President Barack Obama argued that "market-determined exchange rates are essential to global economic activity." The Chinese central bank responded a few days later that it would return to allowing the value of the yuan to change based on movements in other currencies. By late 2010, however, the exchange rate between the yuan and the dollar had changed relatively little.

Price Stability

Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and as a unit of account. Most industrial economies have set price stability as a policy goal. Inflation makes prices less useful as signals for resource allocation. Uncertain future prices complicate decisions households and firms have to make. Inflation can also arbitrarily redistribute income. Rates of inflation in the hundreds or thousands of percent per year—known as hyperinflation—can severely damage an economy's productive capacity. The range of problems caused by inflation—from uncertainty to economic devastation—make price stability a key monetary policy goal.

Risk Pooling for Insurance Companies

Insurance companies use the law of large numbers (average occurrences of events for large numbers of people) to make predictions. By issuing a sufficient number of policies, insurance companies take advantage of risk pooling and diversification. Statisticians known as actuaries compile probability tables to help predict the risk of an event occurring in the population.

Interest Rate Stability

Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms. The Fed's goal of interest rate stability is motivated by political pressure as well as by a desire for a stable saving and investment environment. Sharp interest rate fluctuations cause problems for banks and other financial firms. So, stabilizing interest rates can help to stabilize the financial system.

Functions of District Banks

Manage check clearing in the payments system Manage currency in circulation by issuing new Federal Reserve notes and withdrawing damaged notes from circulation Conduct discount lending by making and administering discount loans to banks within the district Perform supervisory and regulatory functions such as examining state member banks and evaluating merger applications Collecting and making available data on district business activities and publishing articles on monetary and banking topics Serve on the FOMC, the Federal Reserve System's chief monetary policy body The Federal Reserve District Banks engage in monetary policy both directly (by making discount loans) and indirectly (through membership on Federal Reserve committees). In recent decades, the discount rate has been set by the Board of Governors in Washington, DC, not by the District Banks. The District Banks also influence policy through their representatives on the FOMC and on the Federal Advisory Council, a consultative body composed of district bankers.

how problems in the shadow banking sector can spread to other areas of the financial system

Many firms in the shadow banking system were borrowing short term and lending long term. Investors providing funds to investment banks were not protected by deposit insurance, making them more susceptible to runs. Due in part to lack of regulation, investment banks could invest in risky assets and became highly leveraged. Many investment banks suffered heavy losses due to investments in mortgage-backed securities.

Applying types of Reserves to the relationship between money supply to the monetary base:

Money Supply =[(C/D)+1]/[(C/D)+rrD+(ER/D)] X (Bnon+BR)

New Money supply equation

Money Supply =[(C/D)+1]/[(C/D)+rrD+(ER/D)] X B

Money Market Mutual Funds

Money market mutual fund is a mutual fund that invests exclusively in short-term assets, such as Treasury bills, negotiable certificates of deposit, and commercial paper.

Official Settlements

Official reserve assets are assets that central banks hold and that they use in making international payments to settle the balance of payments and to conduct international monetary policy. Historically, gold was the leading official reserve asset. Official reserves now are primarily government securities, foreign bank deposits, and special assets called Special Drawing Rights. Official settlements equal the net increase (domestic holdings minus foreign holdings) in a country's official reserve assets. A U.S. balance-of-payments deficit can be financed by a reduction in U.S. international reserves and an increase in dollar assets held by foreign central banks. Similarly, a combination of an increase in U.S. international reserves and a decrease in dollar assets held by foreign central banks can offset a U.S. balance-of-payments surplus.

Currency Pegging

Pegging The decision by a country to keep the exchange rate fixed between its currency and another country's currency. It is not necessary for both countries in a currency peg to agree to it. Countries peg their currencies to gain the advantages of a fixed exchange rate: reduced exchange rate risk, a check against inflation, and protection for firms that have taken out loans in foreign currencies. A peg can run into problems if the equilibrium exchange rate, as determined by demand and supply, is significantly different than the pegged exchange rate. The currency may become over or undervalued with respect to the dollar. In the 1990s, a number of Asian countries with overvalued currencies were subject to speculative attacks. During the resulting East Asian currency crisis, these countries attempted unsuccessfully to defend their pegs.

Policy Instruments, or Operating Targets

Policy instruments, or operating targets, are variables that the Fed controls directly with its monetary policy tools and that are closely related to intermediate targets. Examples of policy instruments include the federal funds rate and nonborrowed reserves. Most major central banks use interest rates as policy instruments.

The Principal-Agent View

Principal-agent view is a theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public. This view predicts that the Fed acts to increase its power, influence, and prestige as an organization, subject to constraints placed by principals (the president and Congress). The principal-agent view also suggests that the Fed would fight to maintain its autonomy. Indeed the Fed has frequently resisted congressional attempts to control its budget. The Fed successfully lobbied Congress to strip most of the provisions in the Dodd-Frank Act that would have reduced its independence. According to the principal-agent view, the Fed could manage monetary policy to assist the reelection efforts of presidential incumbents who are unlikely to limit its power. The result would be a political business cycle: The Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection. The facts for the United States don't support the political business cycle theory, but the president's desires may subtly influence Fed policy. One study found a close correlation between changes in monetary policy and signals from the administration that they desired a policy change.

The Public Interest View

Public interest view is a theory of central bank decision making that holds that officials act in the best interest of the public. The Fed seeks to achieve economic goals that are in the public interest (e.g., price stability, high employment and economic growth). Does the evidence support the public interest view of the Fed? Some economists argue that it doesn't appear to with regard to price stability (e.g., persistent inflation since World War II). Other economists argue otherwise. There are similar debates over the Fed's contributions to the stability of other economic indicators.

Discount Policy

Since 1980, all depository institutions have had access to the discount window. Each Federal Reserve Bank maintains its own discount window, although all Reserve Banks charge the same discount rate.

multiple deposit creation

Suppose that the Fed purchases $100,000 in Treasury bills (or T-bills) from Bank of America, increasing its reserves that much. Here is how a T-account can reflect these transactions: Since required reserves are determined as a percentage of the bank's checkable deposits, The Fed's purchase of T-bills from Bank of America increases the bank's excess reserves but not its required reserves. Next, Bank of America extends a loan to Rosie's Bakery by creating a checking account and depositing the $100,000 principal of the loan in it. Both the asset and liability sides of Bank of America's balance sheet increase by $100,000: If Rosie's spends the loan proceeds by writing a check for $100,000 to buy ovens from Bob's Bakery Equipment and Bob's deposits the check in its account with PNC Bank, Bank of America will have lost $100,000 of reserves and checkable deposits: After PNC has cleared the check and collected the funds from Bank of America, PNC's balance sheet changes as follows: Suppose that PNC makes a $90,000 loan to Jerome's Printing who writes a check in that amount for equipment from Computer Universe who has an account at SunTrust Bank. The balance sheets change as follows: Suppose that SunTrust lends its new excess reserves of $81,000 to Howard's Barber Shop to use for remodeling. When Howard's spends the loan proceeds and a check for $81,000 clears against it, the changes in SunTrust's balance sheet will be as follows: If the proceeds of the loan to Howard's Barber Shop are deposited in another bank, checkable deposits in the banking system will rise by another $81,000. To this point, the $100,000 increase in reserves supplied by the Fed has increased the level of checkable deposits by $100,000 + $90,000 + $81,000 = $271,000.

Systemic Risk and the Shadow Banking System

Systemic risk is risk to the entire financial system rather than to individual firms or investors. The "shadow banking system" consists of investment banks, hedge funds, and money market mutual funds (i.e., nonbank financial institutions). On the eve of the financial crisis, the size of the shadow banking system was greater than the size of the commercial banking system. The FDIC and the SEC were created with the goal to protect depositors from the likelihood that the failure of one bank would lead depositors to withdraw their money from other banks—contagion. Congress was less concerned with the risk to individual depositors than with systemic risk to the entire financial system.

Using Targets to Meet Goals

Targets are variables that the Fed can influence directly and that help achieve monetary policy goals. Traditionally, the Fed has relied on two types of targets: policy instruments—sometimes called operating targets—and intermediate targets. Although using policy instruments and intermediate targets is no longer the favored approach at the Fed, reviewing how they work can provide some insight into the difficulties the Fed faces in executing monetary policy.

The European Central Bank and the 2010 Sovereign Debt Crisis

The 2007-2009 financial crisis affected the countries of the European Union, but the individual countries were not able to pursue independent policies in response. During the crisis, these countries also suffered from large government budget deficits. To finance the deficits, they issued bonds (sovereign debt). A sovereign debt crisis ensued when the debt issued by Greece, Ireland, Spain, and Portugal came into question. On May 10, 2010, the ECB intervened by buying bonds. ECB President Jean-Claude Trichet argued that the intervention was necessary to ensure that the affected governments would still be able to raise funds and to protect the solvency of European banks.

balance of power issues that lead to the structure of the Fed

The Bank of the United States was created to function as a central bank. Local banks resented the Bank's supervision of their operations. Congress granted the Bank a 20-year charter in 1791, but it ceased operations in 1811 due to a lack of support to renew its charter. In 1816, Congress established the Second Bank of the United States. The Bank encountered the same controversies as the First Bank and its charter expired in 1836. The Federal Reserve Act of 1913 created the Federal Reserve System after severe nationwide financial panics in the late 1800's, which raised fears that the U.S. financial system was unstable without a central bank.

The Speculative Attack on the Deutsche Mark and the Collapse of Bretton Woods

The Bundesbank was trying to maintain a low inflation rate. The German deutsche mark was undervalued against the dollar. Defending the fixed exchange rate was inflationary. It required buying dollars and acquiring international reserves, thus increasing the monetary base. Revaluation would avoid inflationary pressures but would undermine the Bretton Woods system, upsetting German exporters. Speculators bought marks with dollars, expecting the mark to rise in value. On May 5, 1971, the Bundesbank purchased more than 1 billion U.S. dollars. Afraid that continued increases in the monetary base would spark inflation, the Bundesbank halted its intervention later that day. The mark began to float against the dollar, with its value being determined solely by the forces of demand and supply in the foreign exchange market In the late 1960s, foreign central banks acquired large amounts of dollar-denominated assets that totaled more than three times the official U.S. gold holdings at the rate of $35 per ounce of gold. On August 15, 1971, the Nixon administration attempted to force revaluations but eventually suspended the convertibility of dollars into gold, effectively putting an end to the Bretton Woods era. Many currencies began to float, although central banks intervened to prevent large fluctuations in exchange rates. In 1976, the IMF formally agreed to allow currencies to float, and to eliminate gold's official role in the international monetary system. In 1970, the IMF had begun issuing a paper substitute for gold. The IMF created these international reserves, known as Special Drawing Rights (SDRs), in its role as lender of last resort. The price of gold is now determined the same way that the prices of other commodities are determined—by the forces of demand and supply in the market

The European System of Central Banks

The ESCB consists of the European Central Bank (ECB) and the national central banks of all member states of the European Union. In operation since 1999 following the Treaty of Maastricht, the bank was modeled after the German Bundesbank, with price stability as its primary goal. Has secondary objective to support the general economic policies of the European Union. Attaches significant role to monetary aggregates—in particular, the growth rate of the M3 aggregate. Despite emphasis on price stability, has not committed to either a monetary-targeting or an inflation-targeting approach. Struggled to forge a monetary policy appropriate to the very different needs of the member countries during the financial crisis and its aftermath. Received furthere strains in 2010 by intervening in Greece's sovereign debt crisis.

The European Central Bank

The European Central Bank (ECB) is charged with conducting monetary policy for the 16 countries that participate in the European Monetary Union, and use the euro as their common currency. The ECB's organization is similar to that of the U.S. Fed. The ECB's executive board has six members who work exclusively for the bank. Board members are appointed by the heads of state and government, after consulting the European Parliament and the Governing Council of the ECB. Executive board members serve nonrenewable eight-year terms. The governors of each of the member national central banks serve a term of at least five years. The long terms board members and governors of are designed to increase the political independence of the ECB. In principle, the ECB has a high degree of overall independence, with a clear mandate to emphasize price stability. Whether legal independence is enough to guarantee actual independence is another matter. National central banks have considerable power in the ECB. The governors of the European System of Central Banks (ESCB) hold a majority of votes in the ECB's governing council. While the ECB statute emphasizes price stability, countries have argued over the merits of monetary policy actions. This conflict became evident during the financial crisis of 2007-2009. Countries such as Greece, Spain, and Ireland urged that the ECB follow a more expansionary policy, while countries such as Germany that had fared better were reluctant to see the ECB abandon its inflation target.

Implementing Open Market Operations

The FOMC issues a policy directive to the Federal Reserve System's account manager, who is a vice president of the Federal Reserve Bank of New York and who has the responsibility of implementing open market operations and hitting the FOMC's target for the federal funds rate. The Open Market Trading Desk is linked electronically through the Trading Room Automated Processing System (TRAPS) to about 18 primary dealers. Each morning, the trading desk notifies the primary dealers of the size of the open market purchase or sale being conducted and asks them to submit offers to buy or sell Treasury securities.

why the Fed cannot target both reserves and the federal funds rate

The Fed faces a trade-off. It can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate, but it cannot choose both. Using reserves as the Fed's policy instrument will cause the federal funds rate to fluctuate in response to changes in the demand for reserves. Using the federal funds rate as the policy instrument will cause the level of reserves to fluctuate in response to changes in the demand for reserves. By the 1980s, the Fed had concluded that the link between the federal funds rate and its policy goals was closer than the link between the level of reserves and its policy goals. So, for the past 30 years, the Fed has used the federal funds rate as its policy instrument.

How the Fed Changes the Monetary Base

The Fed increases or decreases the monetary base by changing the levels of its assets—that is, the Fed changes the monetary base by buying and selling Treasury securities or by making discount loans to banks.

the role of monetary targeting in monetary policy.

The Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high economic growth and low inflation. In an attempt to spur economic growth, the Fed could lower the target for the federal funds rate and cause other market interest rates to fall through open market purchases, which increase the monetary base and money supply, potentially increasing the inflation rate in the longer run. With economic growth having slowed and the unemployment rate seemingly stuck well above 9%, the Fed contemplated taking further expansionary actions despite their consequences. Adding insult to injury, the Fed has no direct control over real output or the price level. The tools of monetary policy don't permit the Fed to achieve its monetary policy goals directly. The Fed also faces timing difficulties. The information lag refers to the Fed's inability to observe instantaneously changes in GDP, inflation, or other economic variables. A second timing problem is the impact lag. This is the time that is required for monetary policy changes to affect output, employment, or inflation. The Fed's actions may affect the economy at the wrong time, and the Fed might not be able to recognize its mistakes soon enough to correct them. One possible solution to the problems caused by the information lag and impact lag is for the Fed to use targets to meet its goals. Unfortunately, targets also have problems.

Categories of Discount Loans

The Fed's discount loans to banks fall into three categories: (1) primary credit, (2) secondary credit, and (3) seasonal credit. Primary credit Discount loans available to healthy banks experiencing temporary liquidity problems. Secondary credit Discount loans to banks that are not eligible for primary credit. Seasonal credit Discount loans to smaller banks in areas where agriculture or tourism is important.

FED Balance sheet showing Open market purchase

The Fed's open market purchase from Bank of America increases reserves by $1 million and, therefore, the monetary base increases by $1 million. A key point is that the monetary base increases by the dollar amount of an open market purchase. BOA Balance Sheet: Assets= -$1m Securities, +$1m Reserves FED Balance Sheet: Assets= +$1m Securities Liabilities=+$!m Reserves

Open Market Purchase

The Federal Reserve's purchase of securities, usually U.S. Treasury securities.

Open market operations

The Federal Reserve's purchases and sales of securities, usually U.S. Treasury securities, in financial markets. Open market operations are carried out by the Fed's trading desk, which buys and sells securities electronically with primary dealers. In 2010, there were 18 primary dealers, who are commercial banks, investment banks, and securities dealers. In an open market purchase, which raises the monetary base, the Fed buys Treasury securities.

Open Market Operations versus Other Policy Tools

The benefits of open market operations include control, flexibility, and ease of implementation. Discount loans depend in part on the willingness of banks to request the loans and so are not as completely under the Fed's control. The Fed can make both large and small open market operations. Often, dynamic operations require large purchases or sales whereas defensive operations call for small. Reversing open market operations is simple for the Fed. Discount loans and reserve requirement changes are more difficult to reverse quickly. This is a key reason that the Fed has left reserve requirements unchanged since 1992. The Fed can implement its open market operations rapidly, with no administrative delays. Changing the discount rate or reserve requirements requires lengthier deliberation.

Central Bank Independence Outside the United States

The degree of central bank independence varies greatly from country to country. In the United States, board members serve longer terms than in other countries, implying greater independence. In other countries, the head of the central bank serves a longer term, implying somewhat less political control. An independent central bank is free to pursue its goals without direct interference from government officials and legislators. An independent central bank can more freely focus on keeping inflation low. The European Central Bank is, in principle, extremely independent, and the Bank of Japan and the Bank of England traditionally have been less independent. By the late 1990s, both had become more independent and more focused on price stability. The Bank of England, founded in 1694 and one of the world's oldest central banks, obtained the power to set interest rates independently in 1997. The Bank of Japan Law, in force since April 1998, gives the Policy Board more autonomy to pursue price stability. The Bank of Canada has an inflation target as a goal. While the government has the final responsibility for monetary policy, the Bank of Canada has generally controlled it. The push for central bank independence to pursue a goal of low inflation has increased in recent years. In most of the industrialized world, central bank independence from the political process is gaining ground as the way to organize monetary authorities. What conclusions should we draw from differences in central bank structure? Many analysts believe that an independent central bank improves the economy's performance by lowering inflation without raising output or employment fluctuations. The most independent central banks had the lowest average rates of inflation during the 1970s and 1980s. The central bank also must be able to set goals for which it can be held accountable. The leading example of such a goal is a target for inflation. Central banks in Canada, Finland, New Zealand, Sweden, and the United Kingdom have official inflation targets, as does the European Central Bank. The U.S. Fed has only an informal inflation target.

Arguments against Fed Independence

The importance of monetary policy for the economy is also the main argument against central bank independence. In a democracy, elected officials should make public policy. The public could hold elected officials responsible for perceived monetary policy problems. If the central bank was controlled by elected officials, monetary policy could be coordinated and integrated with government taxing and spending policies. Some critics note that the Fed failed to assist the banking system during the economic contraction of the early 1930s. Also, Fed policies were too inflationary in the 1960s and 1970s. Some analysts believe that the Fed ignored the housing market bubble in the early 2000s and then moved too slowly to contain the effects of the bubble burst in 2006.

Discount Lending during the Financial Crisis of 2007-2009

The initial stages of the financial crisis involved shadow banks rather than commercial banks. When the crisis began, the Fed was handicapped in its role as a lender of last resort because it had no recent tradition of lending to anyone but banks. The Fed did, however, use its authority to set up several temporary lending facilities: Primary Dealer Credit Facility. This facility was intended to allow the investment banks and large securities firms that are primary dealers to obtain emergency loans. Term Securities Lending Facility. This facility was intended to allow financial firms to borrow against illiquid assets, such as mortgage-backed securities. It was established in March 2008 and closed in February 2010. Commercial Paper Funding Facility. Under this facility, the Fed purchased three-month commercial paper directly from corporations so they could continue normal operations. Term Asset-Backed Securities Loan Facility (TALF). Under this facility, the Federal Reserve Bank of New York extended three-year or five-year loans to help investors fund the purchase of asset-backed securities. Asset-backed securities are securitized consumer and business loans, apart from mortgages. The Fed also set up a new way for banks to receive discount loans under the Term Auction Facility. In this facility, the Fed for the first time began auctioning discount loans at an interest rate determined by banks' demand for the funds. The Fed ended these innovative discount programs in 2010, with the financial system having recovered from the worst of the crisis.

Arguments for Fed Independence

The main argument for Fed independence is that monetary policy is too important and technical to be determined by politicians. Because of the frequency of elections, politicians may be shortsighted, concerned with short-term benefits without regard for potential long-term costs. The public may well prefer that the experts at the Fed, rather than politicians, make monetary policy decisions. Another argument for Fed independence is that complete control of the Fed by elected officials increases the influence of political business cycles on the money supply.

Simple deposit multiplier

The ratio of the amount of deposits created by banks to the amount of new reserves. Simple deposit multiplier =1/rrD ∆D=∆R/rrD

Proprietary Trading Risk

The problems of investment banks worsened during the financial crisis as they used large amounts of borrowed funds to finance their proprietary trading, resulting in higher leverage—funding risk

Currency-to-deposit ratio (C/D)

The ratio of currency held by the nonbank public, C, to checkable deposits, D.

Handling External Pressure

The structure of the Fed is designed to operate largely independently of external pressures. Not only is the Fed exempt from having to ask Congress for the funds to operate, but it is also a profitable organization. Most of the Fed's earnings come from interest on the securities it holds, interest on discount loans, and fees for check-clearing and other services. But the Fed isn't completely insulated from external pressure: The president can exercise control over the membership and may appoint a new chairman every four years. The U.S. Constitution does not specifically mandate a central bank, so Congress can even abolish it entirely.

Conclusion on Interdependence Arguement

There is no universal agreement on the merits of Fed independence. Debates focus on limiting Fed independence, not eliminating its formal independence entirely. The debate over the Dodd-Frank Act gave critics the opportunity to propose changes to the existing laws, but relatively minor changes were passed by Congress in the end.

Devaluations and Revaluations under Bretton Woods

Under the Bretton Woods system, when its currency was overvalued relative to the dollar, with agreement from the IMF, the country could devalue its currency. In practice, countries didn't often pursue devaluations or revaluations. Governments changed their exchange rates only in response to severe imbalances in the foreign exchange market.

Deriving a Realistic Money Multiplier

We need to derive a money multiplier, m, that links the monetary base, B, to the money supply, M: M= m X b This equation tells us that the money multiplier is equal to the ratio of the money supply to the monetary base: m=M/B The money supply is the sum of currency in circulation, C, and checkable deposits, D. The monetary base is the sum of currency in circulation and bank reserves, R. To expand the expression for the money multiplier, we separate reserves into its components: required reserves, RR, and excess reserves: m=(C+D)/(C+RR+ER)

unsterilized foreign exchange intervention.

When a central bank allows the monetary base to respond to the sale or purchase of domestic currency in the foreign exchange market

sterilized foreign exchange intervention

When a foreign exchange intervention is accompanied by offsetting domestic open market operations that leave the monetary base unchanged

Who owns the Federal Reserve banks?

When banks join the Federal Reserve System, they are required to buy stock in their District Bank. So, the member banks own the District Bank. To prevent one constituency from exploiting the central bank's power at the expense of another, Congress restricted the composition of the boards of directors of the District Banks. The directors represent the interests of three groups: 1. Banks 2. Businesses 3. The general public Member banks elect three bankers (Class A directors) and three leaders in industry, commerce, and agriculture (Class B directors). The Fed's Board of Governors appoints three public interest directors (Class C directors).

Stability of Financial Markets and Institutions

When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources. The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The Fed responded vigorously to the financial crisis that began in 2007, but it initially underestimated its severity and was unable to head off the deep recession of 2007-2009. Some economists believe that actions to deflate asset bubbles may be counterproductive, but the severity of the 2007-2009 recession has made financial stability a more important Fed policy goal.

Speculative Attacks in the Bretton Woods System

When investors came to believe that a government was unable or unwilling to maintain its exchange rate, they attempted to profit by selling a weak currency or buying a strong currency. These actions, known as speculative attacks, could force a devaluation or revaluation of the currency. Speculative attacks can produce international financial crises. That happened in 1967, when the British pound was overvalued relative to the dollar (see Figure 16-3). Devaluations are forced by speculative attacks when a central bank is unable to defend the exchange rate, as in England's 1967 crisis. Revaluations, on the other hand, can be forced by speculative attacks when a central bank is unwilling to defend the exchange rate.

Sterilized Intervention

With a sterilized foreign exchange intervention, the central bank uses open market operations to offset the effects of the intervention on the monetary base. Because the monetary base is unaffected, domestic interest rates will not change. Therefore, the demand curve and supply curve for dollars in exchange for yen will also be unaffected, and the exchange rate will not change. To be effective, central bank interventions that are intended to change the exchange rate need to be unsterilized.