Money and Banking Exam 2
What caused the recession of 1937-1938
"The general fear which many people entertain that excess reserves of the present magnitude must sooner or later set in motion inflationary forces which, if not dealt with before they get strongly under way, may prove impossible to control...." - Fed memorandum
Required Reserve Ratio (rr)
% of checkable deposits that must be held in the form of required reserves
Money multiplier is equal to
(1 + c) / (rr +e +c) Where: e = [ER/D] = excess reserve ratio C = [C/D] = currency ratio rr = [RR/D] = required reserve ratio
The Simple Deposit Multiplier
(Change in)D = (1/rr) c (Change in)R Assumptions: (i) ER = 0 (ii) all loan proceeds are deposited back into the banking system
Governments have two main ways they can attempt to avoid bank panics
1. A central bank can act as a lender of last resort. In 1913, Congress passed the Federal Reserve Act so that the "Fed" would act as a lender of last resort 2. The government can insure deposits. Congress passes a Banking Act of 1933 which created the Federal Deposit Insurance Corporation (FDIC) to insure deposits
Financial regulation pattern
1. A crisis occurs in the financial system 2. The government responds with regulation 3. The financial system responds as firms try to stay competitive and maximize profits 4. Regulators react to changes in the financial system
The Board of Governors
: The 7-member (blank) is headquartered in Washington, D.C. Each member is appointed by the U.S. President and confirmed by the Senate to a 14-year nonrenewable term (terms are staggered such that expiration occurs every other year). All 7 members sit on the Federal Open Market Committee (FOMC). The U.S. President chooses a (blank) to be chair (for a 4-year, renewable term); (blank) chair is also FOMC chair. Duties: • Majority of votes on FOMC • Sets reserve requirements (within limits imposed by legislation) • Since 1935, it controls the discount rate because it can (dis)approve any rate "established" by the FRBs • Sets margin requirements (the % of securities that must be paid for with cash rather than borrowed funds) • Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank's budget • Chair of the BOG advises the U.S. President and provides Congressional testimony • Appoints 3 directors (Class C) to each FRB
What is another equation for the Monetary Base
= BR + Bnon BR = Borrowed Reserves (discount loans) Bnon = Nonborrowed reserves (the remainder of B, e.g. open market operations)
Tools of monetary policy have changed in recent years ....
A dramatic increase in reserves in the banking system have led to a change in the tools used by the Fed to conduct monetary policy. We will make the following distinction: traditional vs non-traditional tools
Ending the too-big-to-fail policy
A provision allows the Fed, FDIC, and treasury to seize and "wind down" large financial firms by selling their assets. The provision gives a third option besides allowing the firm to go bankrupt or bailing it out
Taylor Rule
A rule developed by John Taylor that links the Fed's target for the federal funds rate to economic variables
Financial Crisis
A significant disruption in the flow of funds from lenders to borrowers. Since economic activity depends on households, firms, and the government's ability to borrow, a (blank) (blank) often results in a recession Most of these in the US have involved a commercial banking system
Foreign exchange stability
A stable dollar simplifies planning for commercial and financial transactions
Member Banks
About: Approximately 38 percent of the 8,039 commercial banks in the United States are members of the Federal Reserve System. National banks must be members; state-chartered banks may join if they meet certain requirements. The member banks are stockholders of the Reserve Bank in their District and as such, are required to hold 3 percent of their capital (i.e., net worth) as stock in their Reserve Banks. In exchange, member banks receive 6% dividends, but have no traditional voting rights. Member banks do elect Class A directors (bankers) and Class B directors (business leaders) to the board in each FRB district. Membership: Historically, state banks often chose not to join the Fed because the Fed's reserve requirements were costly. In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) which resulted in all depository institutions being subject to regulations of the Fed (including reserve requirements and access to payment services). Also, the Fed began paying interest on bank reserves in October 2008.
The Federal Open Market Committee (FOMC)
About: The FOMC is the chief policy-making body of the Federal Reserve System. It meets about 8 times per year in Washington, D.C. The committee consists of 12 voting members: all 7 BOGs + NYFRB President + 4 FRB Presidents which rotate (although all FRB Presidents participate in meetings). Duties: The FOMC determines the federal funds interest rate target, and their trading desk in NY will conduct open market operations (i.e., buy/sell Treasury securities with primary dealers) to make the actual federal funds rate equal to the target. Meetings: Members review material prepared by the research staff in advance; during the meeting all members share their views, a formal vote is taken.
Monetary Policy
Actions taken by the Fed to manage the money supply and interest rates to pursue macroeconomic policy objectives, which are: - Price stability* - High Employment* - Stability of financial markets and institutions - Economic Growth - Interest rate stability - Foreign exchange stability *These are most important
Reserves
All banks have an account with the Fed where they hold deposits (plus vault cash). Banks must hold a minimum amount, called required reserves, and are free to hold additional reserves, called excess reserves, if they so choose
Stock market crash
Although only 10% of Americans were invested in the stock market, the crash in October 1929 reduced household wealth and investment, and resulted in greater uncertainty for all Americans
Expansionary Policy
An open market purchase is an [blank] [blank] because it reduces interest rates and increases the monetary base (and you will learn in chapter 17 that aggregate demand increases in the economy). An open market sale has the opposite effects, and so it is called a contractionary policy.
Overnight reserve repurchase agreements (on RRPs)
Are when the Fed sells a security to a financial firm with an agreement to repurchase that same security at a specified price at a specific time in the future. The Fed has used these to change the federal funds rate since 2015.
Simplified Balance Sheet of the Federal Reserve System
Assets: Securities and Loans Liabilities: Currency in circulation and Reserves
How does this transaction effect the monetary base? - Open Market sale
B decreases by the exact amount of the sale
How does this transaction effect the monetary base? - Discount Loan
B rises by the exact amount of the loan
How does this transaction effect the monetary base? - Open Market Purchase
B rises by the exact amount of the purchase
Supply of Reserves, R supply
BR + NBR
Feedback loop
Bank runs can cause good banks, as well as bad banks, to fail. Bank failures reduce the availability of credit to households and firms and the supply of money. Once a panic starts, failing income, employment, and asset prices can cause more bank failures. Government intervention can stop this Bad News -> Bank Run -> Contagion -> Banks React -> The Economy
The early 1930s saw waves of banking panics
Bank suspensions, during which banks are closed to the public either temporarily and permanently, soared during the bank panics of the early 1930s. On March 6, 1933, President Roosevelt attempted to restore confidence by declaring a national bank holiday that shut down the banking system for a week and by giving his first radio broadcast to the nation Although confidence seems to have improved, significant damage to the banking sector had occurred. About 37% of the commercial banks in operating in June 1929 had closed by June 1934.
Maturity Mismatch
Banks typically borrow short term from depositors and lend long term households and firms. This means that banks face a liquidity risk because they may be unable to meet their depositors' withdrawals. - As a result, banks will try to borrow or sell assets to raise funds
Bank runs in the shadow banking system
By 2007, it was clear that owners of mortgage-backed securities would suffer significant losses. But the full extent that financial firms were involved would be slowly revealed. - August 2007: French bank BNP Paribas announces that it would not allow investors to redeem their shares in three funds that had held large amounts of mortgage-backed securities. Credit conditions worsen. - March 2008: Lenders become concerned about the decline in mortgage-backed securities at Bear Stearns. With aid from the Federal Reserve, Bear is saved from bankruptcy - August 2008: The crisis deepens as nearly 25% of subprime mortgages are at least 30 days past due - September 15, 2008: Lehman Brothers files for bankruptcy protection after the Treasury and the Fed decline to help. This is a turning point The next day Reserve Primary Fund, a prominent money market mutual fund, announces that it would "break the buck" by allowing the value of shares in the fund to fall to $0.97, meaning its investors would lose principal. A "run" on money market funds resulted as investors cashed in their shares. Many parts of the financial system become frozen as trading in securitized loans largely stops
Depository Institutions
Can borrow and lend in the federal funds market and their deposits with the Fed receive interest (thus the IOER applies)
Other Financial Institutions
Can borrow and lend in the federal funds market but their deposits with the Fed do no receive interest (thus the rate on ON RRPs applies)
(Change in)R
Change in reserves in the banking system
(Change in)D
Change in total checkable deposits in the banking system
The challenge for a lender of last resort
Congress created the Fed in 1913 to act as a lender of last resort - The Fed failed at this during the Great Depression - In response, Congress restructured the Fed in the 1933 Banking Act (and created the FDIC) - Post WWII, the Fed has by-in-large successfully acted as a lender of last resort. The risk, however, is that this increases moral hazard
Weak fiscal policy
Congress minimized deficit spending; the cyclically adjusted budgeted was in surplus all but one year during the 1930s
Contagion
Depositors are unable to distinguish solvent banks from insolvent banks. A run on one bank spreads to other banks
Bad News
Depositors question the value of a bank's underlying assets
Multiple deposit expansion
Deposits increase by a multiple of an increase in reserves injected into the banking system
First Bank of the US (1791-1811)
Designed by Secretary of the Treasury Alexander Hamilton, it was modeled after the Bank of England Given a 20-year charter, it has authority to regulate the amount of notes state banks could issue, thereby regulating the money supply. It also served as the holder of Treasury deposits Opposed by state banks who resented the restrictions and competition, antifederalists who believed it to be unconstitutional, and various agrarian interests who thought the Bank of the US favored commercial and industrial interests
The Fed's Tools and Its New Approach to Managing the Federal Funds Rate
Discount Policy How the Fed currently manages the Federal Funds Rate
Why was there a failure of federal reserve policy when the Fed did not act as a lender of last resort
Due to there being a Moral Hazard, the Fed was afraid of creating this as acting as a lender of last resort
The Fed was reluctant to rescue insolvent banks
Fed Officials believed that taking actions to save them might encourage risky behavior (moral hazard) by bank managers
What can the Fed do with Discount Loans
Fed can only incentivize banks via changing the discount rate
Repurchase Agreements (repos)
Fed purchases securities with the agreement that the seller will repurchase them in a short period of time (i.e., 1-15 days).
What happens during an open market purchase in the reserves graph
Fed purchases security -> NBR rises -> R^s increases / shifts outward
matched sale-purchase transaction (reverse repo)
Fed sells securities with the agreement that it will buy them back in a short period of time (i.e., 1-15 days).
What happened in 1913
Federal Reserve Act: Following the "Panic of 1907". the Fed is created
Housing prices collapsed
Following legislation that restricted immigration, population growth declined, and spending on new houses fell. This exacerbated a bubble in the real estate market that had begun to deflate in the 1920s
Seasonal Credit
For small banks with seasonal deposits (e.g., from tourism or agriculture) Fed has questioned the need for this credit facility
Regulation Q
From the Banking Act of 1933, placed ceiling on interest rates that banks could pay depositors. The intent was to maintain back profitability by limiting competition for funds (and thereby reduce excessive risk taking) Process: Bank to Depositors: (blank) (blank) set a limit on the interest banks pay depositors Depositors to Other financial Institutions: Depositors looked elsewhere to earn higher interest. Financial Institutions developed alternatives to bank depositors (e.g., money market mutual funds in 1971) Other Financial Institutions to Borrowers: Larger firms began borrowing from other financial institutions (e.g., by selling commercial paper to money market mutual funds)
Decentralized structure of the Fed
Given the historical fear of centralized power and distrust of moneyed interests, the Federal Reserve Act attempts to diffuse power along regional lines, between the private sector and the government, and among bankers, business people, and the public. Major components: 1. Board of Governors (BOGs) 2. Twelve Federal Reserve Banks (FRBs) 3. Federal Open Market Committee (FOMC) 4. Member commercial banks
Primary Credit (standing lending facility)
Healthy banks, purpose is backup source for liquidity This is the "discount rate" Set above iff target
Open Market Operations
In 1935, Congress established the FOMC to guide open market operations. Today, the FOMC typically meets about 8 times each year. It sets a target for the federal funds rate. Its trading desk at the NY Fed works daily to keep the actual federal funds rate at its target.
Dual Mandate
In 1977, Congress gave the Fed a "(blank) (blank)" to follow price stability and high employment. "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."
Decreased international trade
In an attempt to appeal to voters by "protecting" American jobs, Congress passed the infamous Smoot-Hawley Tariff Act in 1930 which led to retaliatory tariffs
Securrities
In conducting monetary policy, the Fed typically buys/sells many Treasury and other (blank). In fact, that is precisely what the FOMC does when it conducts open market operations
The Federal Reserve was concerned about a stock market bubble in the late 1920s
In response, the Fed began to raise interest rates in 1928. By September 1929, the economy was beginning to slow and stock prices started to fall. Then in late October, stock prices plummeted. The decline in stock prices from 1929 to 1932 was the largest in US history
Price Stability (important)
Inflation erodes money's store of value and arbitrarily redistributes income between borrowers and lenders. Uncertainty of future prices also complicates financial decisions
Non-traditional policy tools (since 2008)
Interest on reserve balances Overnight reserve repurchase agreements (on RRPs) Term deposit facility
Who controls the excess reserve ratio
It is control by banks
Some countries have a pegged interest rate. What does this mean and why
It means the government has a fixed interest rate - The government is going to intervene to let its currency is fixed
Out of Bear Stearns, Lehman Bros, and AIG: Which one was not bailed out
Lehman Bros, because they were the straw that broke the camels back
Interest rate stability
Like fluctuations in price levels, fluctuations in interest rates make planning and investment decision difficult for households and firms
The supple of money is determine via the money multiplier and the monetary base
M = m x B
The Fed wanted to "purge speculative excess"
Many Fed members believed that the Depression was the result of financial speculation, so the Fed followed the "liquidationist" policy: allowing the price level to fall and weak banks and weak firms to fail before a recovery could begin
Banking panic
Many banks simultaneously experience runs a financial crisis ensues
Intermediate Targets
Monetary aggregates Interest rates (The Fed can only indirectly influence this because decisions by households, firms, and investors also influence these variables)
Economic Growth
Monetary policy cannot grow the economy in the long run. In the short run, though, the Fed can promote growth via high employment and stability of financial markets
International Comparisons of monetary policy
Monetary policy is becoming more similar across central banks (CBs). • Many CBs target a short-term interest rate. • Inflation targeting is common, often using 2%. • Many CBs undertook extraordinary policy measures, including quantitative easing, during the 2007- 09 crisis. Many seem to be doing it again with respect to COVID-19. • Some CBs, including the ECB and Bank of Japan, have used negative interest rates to try and stimulate their economies. The success of negative interest rates is debatable (see pp. 532-533 in your text).
How does this transaction effect the monetary base? - Shifting deposits to currency
No effect on M
Why did the Fed not intervene to stabilize the banking system?
No one was in charge The Fed was reluctant to rescue insolvent banks The Fed failed to understand the difference between nominal and real interest rate The Fed wanted to "Purge speculative excess"
Why did the Fed not intervene to stabilize the banking system in the early 1930s?
No one was in charge The Fed was reluctant to rescue insolvent banks The Fed failed to understand the difference between nominal and real interest rates The Fed wanted to "purge speculative excess"
Sovereign debt crises
Occurs when a country has difficulty making interest or principal payments on its government bonds. This typically occurs for either for two reasons: 1. Chronic government budget deficits and interest payments taking up an unsustainably large fraction of government spending. 2.A severe recession that increases government spending and reduces tax revenues, resulting in soaring budget deficits If a government defaults and is unable to issue bonds, it will have cut spending and/or increase taxes. Doin so can push the economy into recession
Traditional policy tools (pre-2008)
Open market operations Discount policy Reserve requirement
Goals
Output Inflation Unemployment Rate
The Economy
Output, employment, and asset prices decline, causing more bank failures
Quasi-Public Institution
Owned by private commercial banks in the district that are members of the Fed System
No one was in charge
Power within the Federal Reserve System was divided. The Fed has less independence from the executive branch, and important decisions required forming a consensus which was hard to come by
Quantity of Reserves, R demand
RR + ER = rr x D + ER
currency in ciruclation
Refers to currency in the hands of the public (i.e., the dollar bill in your wallet that says "Federal Reserve Note"). Note: If currency is held by a bank, it called value cash and is counted as part of reserves
Interest on reserve balances
Refers to interest the Fed pays on required and excess reserves (IOER). The Fed began doing this in October 2008
Term Deposit Facility
Refers to term deposits (e.g., certificates of deposits) offered by the Fed to banks
Reserve Requirements
Regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed The Required Reserve Ratio
Excess Reserves (ER)
Reserves held in excess of those required by the Fed. RR + ER = R = R - RR
What happened from 1816-1836
Second Bank of the US; charter renewal vetoed by President Andrew Jackson - War of 1812 helped reignite interest. - Functions similar to the First Bank of the U.S.; also given a 20-year charter. - President Andrew Jackson vetoed a bill to renew the charter
The federal Reserve's response to the crisis
September 2007: the Fed began lowering short-term interest rates by cutting its target for the federal funds rate, the interest rate that commercial banks charge each other for short-term loans. This would become close to zero by December 2008 - the lowest it has ever been September 2008: the Fed and the Treasury unveiled a plan for Congress to authorize $700 billion used to purchase mortgages and mortgage-backed securities from financial firms and other investors October 2008: the Fed announced it would begin lending directly to corporations by purchasing commercial paper
How does the federal funds rate relate to other interest rates
Short-term rates, like the 3-month Treasury yield, follow the federal funds rate very closely. Long-term rates, like that for 30-year mortgages, are less correlated but still rise and fall with the federal funds rate
Discount Policy
Since 1980 all depository institutions can borrow from the Fed via the discount window. There are three categories: 1. Primary Credit 2. Secondary Credit 3. Seasonal Credit Section 13(3) of the Federal Reserve Act - Under "unusual and exigent circumstances" the Fed can lend to any "individual, partnership, or corporation" that could provide acceptable collateral and can demonstrate that it cannot borrow from commercial banks During the financial crisis, lending by the Fed increased from just a few hundred million dollars to $993.5 billion in December 2008.
Exchange rate crises
Some governments kept the value of their currency fixed by pegging it against another country's currency. This can reduce the risk involved with international trade and borrowing from foreigners. However, serious problems can result if a government cannot maintain his exchange rate Pegging the value of a currency to another country's currency become problematic if it is substantially above the equilibrium rate that would prevail in the absence of the peg
Stability of Financial Markets and Institutions
Stable financial markets and facilitate more savings and investment, a key ingredient to long run economic growth. Economists debate how active the Fed should be in deflating asset bubbles
Multiple factors explain the severity in the US
Stock Market Crash Decreased international trade Housing prices collapsed Weak fiscal policy Bank Panics Failure of Federal Reserve policy
Using Targets to meet goals
Targets partially solve the Fed's inability to directly control its goal variable, and targets can help reduce the lag in observing and reacting to changes in the economy. Traditionally, the Fed relied on policy instruments and intermediate targets to conduct policy Policy Tools --> Targets --> Goals
What happened from 1791-1811
The (First) Bank of the US: Designed by Alexander Hamilton, modeled after Bank of England Designed by Secretary of the Treasury Alexander Hamilton, it was modeled after the Bank of England. - Given a 20-year charter, it had authority to regulate the amount of notes state banks could issue, thereby regulating the money supply. It also served as the holder of Treasury deposits. - Opposed by state banks who resented the restrictions and competition, antifederalists who believed it to be unconstitutional, and various agrarian interests who thought the Bank of the U.S. favored commercial and industrial interests.
What can the Fed do during open market operations
The Fed controls perfectly
Interpreting the dual mandate
The Fed interprets price stability as occurring when inflation rate is 2%, based on the core Personal Consumption Expenditures price index. The Fed interprets high employment" as occurring when the unemployment rate is at its natural rate
How does the Fed go about achieving it goals
The Fed uses monetary policy tools to target an interest rate called the federal funds rate
political business cycle theory
The Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party for reelection Expansionary fiscal policy before election, more restrictive fiscal policy after election
Open market operations
The Fed's purchase and sales of securities, usually US Treasury securities, in financial markets
Who controls the supply of money?
The Fed, banks, and public
Who controls the monetary base
The Federal Reserve
Who controls the required reserve ratio
The Federal Reserve controls this
Advance Warning System
The Financial Stability Oversight Council (FSOC) was created to, among other things, identify systematically important financial institutions and subject these institutions to close regulatory supervision
What happened from 1836-1914
The US had no central bank
What happened prior to 1933
The US had no deposit insurance
Sever financial crises were common during the latter 19th cetury
The US has a fractional reserve banking system (i.e., banks keep only a fraction of their deposits as reserves). This exposes the industry to bank runs and panics. Central banks, like the Federal Reserve, can help to prevent bank runs and panics by acting as a lender of last resort, promising to make loans to banks in order to pay off depositors. This assurance can break the negative feedback loop.
What does the stability of the banking system depends on?
The confidence of depositors Bank run --> Contagion --> Banking Panic
The Fed targets inflations as measured by ....
The core PCE (personal consumer expenditures) index. It is similar to the GDP deflator, but pertains to consumption category of GDP "Core" refers to the fact that prices of food and energy are excluded
The Twelve Federal Reserve Banks (FRBs)
The country is composed of 12 districts to decentralize power. FRBs are quasi-public institutions because commercial banks in a district "own" the FRB - they receive 6% dividends but have no voting rights typically associated with ownership. Each FRB has 3 board of directors from each class: Class A represent bankers; Class B represent general business; and Class C represent the general public. Class B and C directors elect the president of each FRB subject to the approval of the BOGs. Duties: • Manage check clearing in the payments system and replacing damaged notes from circulation. • Perform supervisory and regulatory functions such as examining state member banks and evaluating merger applications. • Collect and make available data on district business activities and publish articles on monetary and banking topics. • Serve on the FOMC, the Federal Reserve System's chief monetary policy body and select a representative banker to serve on the Financial Advisory Council.
A housing market bubble formed in the mid 2000s
The divergence between housing prices and housing rents is evidence of a bubble In 2006, homebuyers started to default, which led to foreclosures A vicious cycle ensued: home foreclosures led to lower home prices, banks tightened their requirements for borrowers, home prices dropped further which led to more foreclosures, and so on
Federal funds rate
The interest rate that banks charge each other for short-term (e.g., overnight) loans
The Required Reserve Ratio
The minimum fraction of deposits banks are required by law to keep as reserves Applies to all depository institutions - Depository institutions Deregulation and Monetary Control Act of 1980 Historically, based on a sliding scale (2014 figures) - 0% for checkable deposits between $0 and $13.3 million - 3% for checkable deposits between $13.3 and $89 million - 10% for checkable deposits over $89 million Rarely used - March 2020 the Fed announced the required reserve ratio would be 0% for all deposit institutions. Before this, the Fed rarely changed it (the previous change was April 1992)
Discount policy
The policy tool of setting the discount rate and the terms of discount lending. Discount window is the means by which the Fed makes discount loans to banks. This serves as the channel for meeting the liquidity needs of banks
Who controls the Currency Ratio
The public controls it
(1/rr)
The reciprocal of the required reserve ratio is also called the simple deposit multiplier
How the Fed currently manages the federal funds rate
There are two groups in the federal funds market: Depository Institutions Other Financial Institutions Summary: - The current federal funds market has ample reserves - The Fed sets the IOER rate which ensures banks will never lend funds below this rate - However, some financial institutions in the federal funds market are not eligible for IOER, thus the FFR could drop below IOER - The Fed sets the rate it pays on ON RRP transactions which ensures these institutions will never loan funds below this rate. The ON RRP acts as a floor for the FFR
Why must a central banks have sufficiently enough excess reserves in its currency
To avoid a financial crisis and maintain a pegged exchange rate
1907 Financial Crisis
Two unscrupulous bankers, Augustus Heinz and Charles Morse, tried to corner the stock of United Copper. However, commodity prices started to fall in 1907, which resulted in major losses for Heinze and Morse, as well as their lenders. This set off a bank panic across the country and a major recession. National output declined by 11% between 1907 and 1908
High employment (Important)
Unemployment reduces output and causes obvious hardship for American households. The Fed uses policy to eliminate cyclical unemployment is at its natural rate
Secondary Credit
Unhealthy banks, with severe liquidity problems Typically 50 bp above the primary credit rate
Total Reserves (R) =
Vault cash + deposits with Fed
Second Bank of the US (1816-1836)
War of 1812 helped reignite interest Functions similar to the First Bank of the US; also given a 20-year charter President Andrew Jackson vetoed a bill to renew the charter
Loans
When the Fed extends a (blank) to a bank, the (blank) appears as an asset to the Fed. This includes (blanks) when the Fed is acting as a lender of last resort (called discount [blank])
The Fed failed to understand the difference between nominal and real interest rates
With the price level failing, real interest rates were much higher in the early 1930s than policymakers at the Fed believed them to be
Have bank panics decrease in severity and frequency as a result of the FDIC's deposit insurance and the Fed's lender of last resort capability?
Yes. Economists believe this is one reason the post-1950 business cycle for the US has become more moderate
Debt-deflation process
a cycle of falling asset prices and falling prices of goods and services that can increase the severity of an economic downturn As the economic downturn worsened, the price level would fall with two negative effects: - Real interests rates would rise, and the real value of debts would increase - This process of falling asset prices, falling prices of goods and services, and increasing bankruptcies and defaults can increase the severity of an economic downturn
Contractionary policy
a fiscal policy used to reduce economic growth, often through decreased spending or higher taxes
Defensive OMOs
are intended to offset movements in other factors that affect R and the MB (e.g., the terrorist attacks on 9/11). These transactions are common and conducted through repurchase agreements.
Banks React
banks sell assets and reduce loans to households and firms
Bank Run
depositors lose confidence in a bank and simultaneously withdraw enough funds to force the bank to close
Dynamic OMOs
entended to change the level of R and the MB (e.g., when the FOMC announces a lower target). These transactions are often described as being outright.
monetary base (or high-powered money)
equals the sum of currency in circulation and reserves B = C + R The Fed can easily change this quantity by buying/selling securities and by extending discount loans. To show how, we'll use a T-account which records changes in the balance sheet...
Fed Lending Restrictions
in 1932 section 13(3) of the Federal Reserve Act was amended to allow the Fed to lend to "any individual, partnership, or corporation". Dodd-Frank changed this to a "participant in any program or facility with broad-based eligibility" and subjects lending to the approval of the Treasury. This prevents the Fed to giving a loan to assist and single and specific company.
Open Market Operation
involve trading short-term securities. However, in December 2008, the Fed had lowered the federal funds rate target to zero and yet the crisis continued. Therefore, the Fed started buying long-term securities as an alternative means to stimulate the economy. This is called quantitative easing.
The money supply process is determined by
m x B m = Multiplier B = Monetary Base
Policy Tools
methods that can be used to enforce or implement regulations or achieve desired outcomes Open Market Operations Discount Policy Reserve requirements Interest rate on reserves Interest rate on overnight reverse repos
Inflation Targeting
occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target. Beginning in New Zealand in 1991, a growing number of central banks have begun announcing a inflation target. The Federal Reserve first announced its inflation target of 2% in 2012
Principal-agent view
the Fed is a bureaucratic organization that acts to maximize its personal well being (e.g., power, influence, and prestige). To do this, the Fed may avoid conflict with groups that could threaten the Fed's power (e.g., Congress, US President). 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.
Public Interest View
the Fed seeks to achieve goals that are in the best interest of its primary constituency, the general public.
Disintermediation
the cutting out of marketing channel intermediaries by product or service producers or the displacement of traditional resellers by radical new types of intermediaries The regulation led savers and borrowers to exit banks in favor of the financial markets
Orderly Liquidation
the treasury can designate a failing financial firm be taken over by the FDIC who would operate it as long as necessary to ensure its failure does not jeopardize the financial system
The 2010 Dodd-Frank Act
was the most significant legislation affecting financial regulation since the Great Depression. It includes: - Ending the too-big-to-fail policy - Advance warning system - Orderly liquidation - Fed lending restrictions
