Macro Chapter 13
Monetary Policy
Changes in the money supply or in the rate of change of the money supply, intended to achieve stated macroeconomic goals.
Now here's the part I am unsure of: When a bank gives out a loan of $90, does it actually lend out the $90 of currency (let's say, nine $10 bills) or simply create a new checkable deposit of $90 for someone?
It creates a new checkable deposit of $90.
"The Fed acts as lender of last resort." What does that statement mean?
It means that the Fed stands ready to lend funds to banks that are suffering cash management, or liquidity, problems.
Open Market Operations
The buying and selling of government securities by the Fed.
open market purchase
The buying of government securities by the Fed.
Federal Funds Rate Target
The interest rate that the Fed wants the federal funds market rate to be.
The Federal Reserve's organization
There are 7 members of the Federal Reserve Board of Governors.
The Federal Reserve's organization
While all members of the Federal Reserve Board of Governors vote at Federal Open Market Committee (FOMC) meetings, only5 of the regional bank presidents are members of the FOMC.
Let me see if I have this right: if I put $100 in my checking account at a bank, the bank then takes that $100 and adds it to vault cash, so that $100 becomes part of the bank's reserves, right?
Yes, that's right.
three tools the Fed has at its disposal to change the money supply:
conducting open market operations, changing the required reserve ratio, and changing the discount rate relative to the federal funds rate.
contractionary monetary policy
aims to decrease it
expansionary monetary policy
aims to increase the money supply
When a bank is reserve deficient, it can do a number of things: It can
try to get a loan from another bank; try to get a loan from the Fed; or apply some of its loan repayments to the reserve deficiency position.
So, in the end, some portion of the $100 that I deposited into the bank ends up creating loans for a lot of people. Is that correct?
That is correct.
The second way to deal with a shortage of money is to increase the supply of money so that there is no longer a shortage
That is what would happen under free banking.
And then the bank holds a percentage of that $100 in reserve form and lends out the rest. So, if the required reserve ratio is 10 percent, the bank may lend out $90 of my $100.
That's correct.
In sum,
Alternatively, if the Fed wants to contract the money supply, it can set the discount rate above the federal funds rate. Now banks will not go to the Fed for loans, and as the banks repay discount loans taken out in the past, reserves in the banking system decline. (When a bank repays a discount loan, the Fed subtracts the repayment from the bank's reserve account.)
How does the money supply change as a result of an increase in the discount rate,
Money supply falls.
How does the money supply change as a result of an increase in the required reserve ratio?
Money supply falls.
The Fed can change the discount rate directly, since it is the rate that it uses to loan money to banks. The Fed controls the federal funds rate indirectly through open market operations.
The Fed can change the discount rate directly, since it is the rate that it uses to loan money to banks. The Fed controls the federal funds rate indirectly through open market operations.
The Federal Funds Rate Target
The Fed sets a federal funds rate target. Then it uses open market operations to change the federal funds rate so as to hit the target. For example, if the current federal funds rate is 4 percent and the target is 3 percent, the Fed can conduct an open market purchase, which results in reserves being injected into the banking system. As the supply of reserves rises, the federal funds rate declines.
simple deposit multiplier
The reciprocal of the required reserve ratio r :1/ r.
The Federal Reserve System
There are 12 Federal Reserve Districts. The Board of Governors controls and coordinates the activities of the Federal Reserve System. The Board is made up of seven members, each appointed to a 14-year term. The major policy-making group in the Fed is the Federal Open Market Committee (FOMC), a 12-member group made up of the seven members of the Board of Governors and five Federal Reserve District Bank presidents.
If reserves increase by $4 million, and the required reserve ratio is 5%, what is the change in the money supply?
You should have used the following equation to compute the change in the money supply: Change in the Money SupplyChange in the Money Supply = = 1Required Reserve Ratio×Change in Reserves1Required Reserve Ratio×Change in Reserves = = 10.05×$4 million10.05×$4 million = = $80 million
Simple Deposit Multiplier
the ratio of the amount of deposits created by banks to the amount of new reserves
To summarize,
under a free-banking monetary arrangement, banks would issue their own currency (their own banknotes) based on, perhaps, commodity reserves and the money supply would be determined by market forces. Specifically, the money supply would adjust (up or down) in response to changes in the public's demand for money.
The president of which Federal Reserve District Bank holds a permanent seat on the FOMC?
Federal Reserve Bank of New York.
Board of Governors
the seven-member board that oversees the Federal Reserve System
What is the most important responsibility of the Fed?
To control the money supply.
federal funds market
A market in which banks lend reserves to one another, usually for short periods.
remember 1
An individual (any member of the public) can change the composition of the money supply.
federal funds rate
The interest rate in the federal funds market; the interest rate banks charge one another to borrow reserves.
Discount Rate
The interest rate on the loans that the Fed makes to banks
As a result of people wanting to hold more money, they cut back on their spending.
As they cut back on their spending, demand curves (for goods and services) shift leftward and prices fall.
The U.S. Treasury is a budgetary agency;
the Fed is a monetary agency.
The Federal Reserve System
the central bank of the United States.
Reserve Deficient
the situation that exists when a bank holds fewer reserves than specified by the required reserve ratio
under free banking,
banks would not be subject to any special regulations beyond those which apply to other businesses. Also, under free banking, banks would have the right to issue their own paper currency and market forces would largely control the money supply.
The major responsibilities of the Fed are to
control the money supply, supply the economy with paper money (Federal Reserve notes), provide check-clearing services, hold depository institutions' reserves, supervise member banks, serve as the government's banker, serve as the lender of last resort, and serve as a fiscal agent for the Treasury.
federal funds rate
the interest rate at which banks make overnight loans to one another
Discount Loans and Overnight Loans
A bank obtains discount loans from the Fed and overnight loans from other banks. The interest rate it pays for a discount loan is called the discount rate. The interest rate a bank pays another bank for a loan is called the federal funds rate. The discount rate is set by the Fed. The federal funds rate is determined by market forces in the market for reserves (federal funds market). If the Fed sets the discount rate below the federal funds rate, banks will borrow from the Fed and will end up with more reserves. These reserves can be used to create more loans and checkable deposits, thus increasing the money supply. If the Fed sets the discount rate above the federal funds rate, banks will choose not to borrow from the Fed. Then, as the banks repay past discount loans, they retain fewer reserves, thus decreasing the money supply.
The Required Reserve Ratio
An increase in the required reserve ratio leads to a decrease in the money supply. A decrease in the required reserve ratio leads to an increase in the money supply.
Open Market Operations
An open market purchase by the Fed increases the money supply. An open market sale by the Fed decreases the money supply.
U.S. Treasury Securities
Bonds and bond-like securities issued by the U.S. Treasury when it borrows.
Monetary policy
Changes in the money supply or in the rate of change of the money supply, intended to achieve stated macroeconomic goals.
But money is more than currency.
For example, the M1 money supply is the sum of currency held outside banks, checkable deposits, and traveler's checks.
If the federal funds rate is 5.9%, and the discount rate is 5.5%, a bank will be more likely to go tothe Fed to get a loan because:
If a bank needs a loan, it can go to the Fed or to another bank for it. The loan the bank gets from the Fed is called a discount loan, and the interest rate the bank pays for a discount loan is called the discount rate. The loan that a bank might get from another bank is usually called an overnight loan (because it is typically a loan of short duration, such as overnight). The interest rate that the bank pays for an overnight loan is called the federal funds rate. This rate is targeted by the Fed and determined through the Fed's open market operations in the federal funds market. In this case, because the Fed set the discount rate below the federal funds rate, the bank should borrow from the Fed. See Section: The Discount Window and the Federal Funds Market.
Normally, if the Fed wants to change the money supply, it takes two measures:
It sets a federal funds rate target, and then it uses open market operations to change the federal funds rate so as to "hit" the target.
But then it sounds like I can change the money supply simply by deciding to put $100 worth of currency into a bank instead of keeping that $100 in my wallet. Is that true?
Let's put it this way: By putting $100 of currency into a bank, you change the composition of the money supply. Specifically, $100 less in currency is held outside banks and $100 more in checkable deposits. Then the banking system can take the $100 and create a multiple of it in terms of new checkable deposits, thereby raising the money supply.
Which of the following is a responsibility of the Federal Open Market Committee (FOMC)?
Making decisions regarding monetary policy
Which of the following contributes to making the Federal Reserve an independent policy making body?
Members of the Board of Governors are appointed for 14-year terms.
How does the money supply change as a result of an increase in the discount rate,
Money supply rises.
How does the money supply change as a result of an open market purchase,
Money supply rises.
Cash Leakage
Occurs when funds are held as currency instead of deposited into a checking account.
cash leakage
Occurs when funds are held as currency instead of deposited into a checking account.
Lowering the required reserve ratio will increase the money supply.
Raising the required reserve ratio will decrease the money supply.
If Bank A borrows $10 million from Bank B, what happens to the reserves in Bank A? What happens in the banking system?
Reserves in bank A rise; reserves in the banking system remain the same (bank B loses the reserves that bank A borrowed).
If Bank A borrows $10 million from the Fed, what happens to the reserves in Bank A? What happens in the banking system?
Reserves in bank A rise; reserves in the banking system rise because there is no offset in reserves for any other bank.
Federal Open Market Committee (FOMC)
The Fed's 12-member policy-making group. The committee has the authority to conduct open market operations.
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The Federal Reserve's primary tool for changing the money supply isopen market operations . In order to decrease the number of dollars in the U.S. economy (the money supply), the Federal Reserve willsell government bonds.
Board of Governors
The board members serve 14-year terms and are appointed by the president with U.S. Senate approval. To limit political influence on Fed policy, the terms of the governors are staggered—with one new appointment every other year—so that a president cannot "pack" the board. The president also designates one member as chairman of the board for a four-year term.
What does it mean to say the Fed serves as the lender of last resort?
The correct answer is A traditional function of the central bank is to lend money to banks suffering cash management, or liquidity, problems. Banks may sometimes find themselves in situations where they do not have enough cash or assets that can easily be turned into cash. These banks can then turn to the Fed itself to borrow short-term cash. See Section: Functions of the Fed.
Controlling the Money Supply
The following Fed actions increase the money supply: lowering the required reserve ratio, purchasing government securities on the open market, and lowering the discount rate relative to the federal funds rate. The following Fed actions decrease the money supply: raising the required reserve ratio, selling government securities on the open market, and raising the discount rate relative to the federal funds rate.
Board of Governors
The governing body of the Federal Reserve System.
Notice what has happened under free banking:
The money supply is determined by market forces. When people increased their demand for money, a process was started that ended with the supply of money rising. It would also follow that, had people decreased their demand for money, the supply of money would have contracted under free banking.
open market sale
The selling of government securities by the Fed.
reserve deficient
The situation that exists when a bank holds fewer reserves than specified by the required reserve ratio.
federal funds market
allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves
discount loans
loans the federal reserve makes to banks
open market sale
the sale of US government bonds by the FED to reduce the money supply
An open market sale by the Fed can decrease reserves in a bank's reserve account and lead to a decrease in the money supply.
The correct answers are decrease and a decrease, respectively. Suppose that the Fed sells $1 million worth of securities to a commercial bank. The Fed then deducts $1 million from the bank's reserve account at the Fed. If the bank had held only required reserves, this would leave the bank reserve deficient. To meet its reserve requirement, the bank now makes fewer loans, which then reduces checkable deposits and money in the economy. See Section: The Money Supply Contraction Process.
What is the difference between the federal funds rate and the discount rate?
The federal funds rate is the interest rate one bank charges another bank for a loan. The discount rate is the interest rate the Fed charges a bank for a loan.
Open Market Purchase
The purchase of U.S. government bonds by the FED to increase the money supply
discount rate
The interest rate the Fed charges depository institutions that borrow reserves from it; the interest rate charged on a discount loan.
What are the differences between the Fed and the U.S. Treasury? Check all that apply.
•The Fed is concerned with the availability of money and credit for the entire economy; the Treasury collects the taxes and borrows funds, essentially managing the financial affairs of the federal government.•The Fed is a monetary agency; the Treasury is a budgetary agency.•The Fed's fractional reserve system allows the Fed to "create money out of thin air"; the Treasury can only issue coins. The U.S. Treasury should not be confused with the Fed. The U.S. Treasury is a budgetary agency, whereas the Fed is a monetary agency. The Treasury's job is to collect taxes and borrow funds as needed by the government. Thus, the Treasury manages the federal government's finances. The Treasury issues coins, but does not issue other money. The Fed is concerned principally with the availability of money and credit for the entire economy. It does not have an obligation to meet the financial needs of the federal government. Instead, its responsibility is to provide a stable monetary framework for the entire economy. See Section: Common Misconceptions About the U.S. Treasury and the Fed.
The Fed has eight major responsibilities, or functions:
Controlling the money supply. A full explanation of how the Fed plays this role comes later in the chapter. Supplying the economy with paper money (Federal Reserve notes). The Federal Reserve Banks have Federal Reserve notes on hand to meet the demands of the banks and the public. At certain times of the year (during holidays, when people are planning vacations, etc.) for example, more people may withdraw larger-than-usual amounts of $1, $5, $20, $50, and $100 notes from banks. Needing to replenish their vault cash, banks turn to their Federal Reserve Banks, which meet cash needs by issuing more paper money (acting as passive suppliers of paper money). The money is actually printed at the Bureau of Engraving and Printing in Washington, D.C., but it is issued to commercial banks by the 12 Federal Reserve Banks. Providing check-clearing services. When a bank receives a check (from a depositor) drawn on another bank, it may send the check for collection and clearing directly to the other bank, deliver the check to the other bank through a local clearinghouse, or use the check-collection and -clearing services of a Federal Reserve Bank. If it uses the services of a Federal Reserve Bank, the account of the bank collecting the value of the check is credited and the account of the bank that is paying is debited. Most checks are collected and settled within one business day. Holding depository institutions' reserves. As explained in the previous chapter, banks are required to keep reserves against customer deposits either in their vaults or in reserve accounts at the Fed. These accounts are maintained by the 12 Federal Reserve Banks for member banks in their respective districts. Supervising member banks. Without notice, the Fed can examine the books of member commercial banks to assess the nature of the loans the banks have made, monitor compliance with bank regulations, check the accuracy of bank records, and so on. If the Fed finds that a bank has not been maintaining established banking standards, it can pressure the institution to do so. Serving as the government's banker. The federal government collects and spends large sums of money. As a result, it needs a checking account for many of the same reasons an individual does. The primary checking account of the federal government is with the Fed, which is the government's banker. Serving as the lender of last resort. A traditional function of a central bank is to serve as the lender of last resort for banks suffering cash management, or liquidity, problems. Handling the sale of U.S. Treasury securities (auctions). U.S. Treasury securities (bills, notes, and bonds) are sold to raise funds to pay the government's bills. The Federal Reserve District Banks receive the bids for these securities and process them in time for weekly auctions.
Which of the following are major responsibilities of the Fed?
The Fed has eight major responsibilities: (1) controlling the money supply; (2) supplying the economy with paper money (printed at the Bureau of Engraving and Printing in Washington, D.C.), which is issued to commercial banks by the 12 Federal Reserve Banks; (3) providing check-clearing services; (4) holding depository institutions' reserves (through the 12 Federal Reserve Banks); (5) supervising member banks, examining member bank accounts, and monitoring compliance with bank regulations; (6) serving as the government's banker (the primary checking account of the federal government is with the Fed; (7) serving as the lender of last resort for banks with liquidity problems; and (8) handling the sale of U.S. Treasury securities (through auctions) in order to raise money to pay the government's bills. See Section: Functions of the Fed.
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The Fed has three tools at its disposal to change the money supply: conducting open market operations, changing the required reserve ratio, and changing the discount rate relative to the federal funds rate. If the Fed wants to increase the money supply, it can lower the discount rate below the federal funds rate. This incentivizes banks to borrow from the Fed rather than from other banks, which increases the volume of reserves in the banking system. Banks are thus able to create more loans (more checkable deposits), and as a result, the money supply rises. Alternatively, if the Fed wants to contract the money supply, it can set the discount rate above the federal funds rate. Since banks will now be incentivized to borrow from other banks rather than the Fed, fewer reserves will be added to the banking system, constraining the overall volume of bank lending and reducing the money supply. See Section: The Discount Window and the Federal Funds Market.
When the federal government spends funds, the Treasury collects the taxes and borrows the funds needed to pay suppliers and others. In short, the Treasury has an obligation 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. (We will soon explain exactly how the Fed does this.)
The Fed is concerned principally 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.
How does a decrease in the required reserve ratio affect the money supply?
The correct answer is If the required reserve ratio is decreased, banks will have more reserves than are required. Some former required reserves are now excess reserves and available to lend out. New loans mean greater checkable deposits, which will increase the money supply. Required reserves are the portion of deposits that banks are required to hold as reserves. If the required reserve ratio is reduced, some required reserves will become excess reserves. And since banks seek to maximize their profits, they will likely lend out their newly created excess reserves, leading to an increase in the money supply. There is, in general, an inverse relationship between the required reserve ratio and the money supply—the higher the required reserve ratio, the lower the money supply, and the lower the required reserve ratio, the higher the money supply. See Section: The Required Reserve Ratio.
Suppose Bank A borrows reserves from Bank B. Now that Bank A has more reserves than it previously had, will the money supply change?
The correct answer is No, because there are no new reserves in the banking system. One bank now has more reserves and another has fewer, but there has not been an injection of new reserves to increase the money supply. Lending between banks does not affect overall amount of reserves in the banking system, because the Fed has not actually injected any new reserves. See Section: The Discount Window and the Federal Funds Market.
remember 2
A change in the composition of the money supply can lead to a dollar change in the money supply.
discount loan
A loan the Fed makes to a commercial bank.
But then the full $100 currency is still in the bank's vault, right? When does $90 of the $100 leave the vault?
Suppose the person who received the $90 loan (or new checkable deposit) writes a check to Marie. Marie then deposits the $90 check in another bank. When the check clears, the $90 is transferred from the first bank (in which you deposited your money) to Marie's bank. And then Marie's bank takes a fraction of that $90 and creates a loan with it, and the process continues.
The Fed has announced a new, lower federal funds target rate. Using open market operations, how will the Fed help to move the (actual) federal funds rate closer to the new (lower) federal funds target rate?
The correct answer is The Fed will have to purchase securities in the open market to increase the supply of reserves and lower the federal funds rate. Assume that the current federal funds rate is 2%. Now suppose that the Fed wants the federal funds rate to go to 1%. In order to effect this change, the Fed will carry out an open market purchase. As a result of the open market purchase, the supply of reserves in the federal funds market will rise, and the price of those reserves—the federal funds rate—will fall. The Fed will continue open market purchases until the federal funds rate falls from 2% to 1%. At that time, the federal funds rate will reach its new target. See Section: The Fed and the Federal Funds Rate Target.
How would market forces determine the money supply under free banking?
The correct answer is Under a free-banking monetary arrangement, banks would issue their own currency based on reserves they held. The money supply would be determined by changes in the public's demand for money. Under a free-banking system, there would be no Fed. Banks would not be subject to any special regulations over and above those applied to other businesses, and banks would also be free to issue their own paper currency based on the reserves they hold. Under free banking, the money supply would be determined by market forces. Suppose that people want to hold $1.1 trillion instead of $1 trillion. To increase their money holdings, they cut back on spending. In a free-banking system, this cutback means that a smaller number of the notes of a given bank (its currency) will flow from one person to another. But if the flow of notes drops, it follows that any given bank will not be asked as often by another bank to redeem its bank notes for gold reserves. Bank A will not see as much of its gold reserves flowing out the door and going to banks B, C, and D, so Bank A will be left with more reserves on which it can create more money. The creation of additional money is likely to stop when the public's increased demand for money has been satisfied, that is, when the quantity supplied of money is equal to the quantity demanded of money, $1.1 trillion. See Section: What Is Free Banking?
Which of the following choices correctly explains how an open market purchase changes the money supply?
The correct answer is: The Fed buys securities from banks; the Fed increases the value of the banks' reserve accounts by the amount of the purchase; the banks end up with excess reserves that they lend out (creating new checkable deposits); and because new checkable deposits are part of the money supply, the money supply rises. Suppose that the Fed buys securities from a commercial bank. At the end of the transaction, the Fed has more securities than before, and the bank has fewer securities than before. 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. The United States has a fractional banking reserve system, so only a fraction of the increased amount of reserves must 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. See Section: The Money Supply Expansion Process.
Which of the following are functions of the Federal Reserve System? Check all that apply.
The primary role of the Fed is to control the money supply in the economy. The Fed also issues paper money and facilitates the exchange of payments between financial institutions by clearing checks. Other functions of the Fed are to supervise and regulate member banks, hold depository institutions' reserves, serve as the lender of last resort, and handle the sale of the U.S. Treasury securities. Finally, the Fed also serves as the government's bank by handling its checking account.