CHAPTER 7

THE FEDERAL RESERVE, MONETARY POLICY, AND

INTEREST RATES

Origins of the Federal Reserve System

• Prior to 1863, banks issued bank notes that functioned like our present day currency but were the obligations of individual banks.– Because of the risk of failure, some banks’

notes traded at a discount.– The quantity of money in circulation

fluctuated with the business cycle, possibly exaggerating those cycles.

Origins of the Federal Reserve System (continued)

• From 1863 to 1914 banknotes were backed by holdings of U.S. government bonds.– In 1863, the National Banking Act placed a tax on

banknotes issued by state-chartered banks (thereby leading to their demise) and required national banks to back their banknotes with holdings of U.S. government bonds.

– State banks continued operating by issuing demand deposits.

Origins of the Federal Reserve System (concluded)

– Demand deposits were not insured, so they were often discounted when the bank was distant, suspect, or unknown.

– Further, banks were subject to liquidity problems and the economy suffered several recessions and crises, culminating in the crash of 1907.

– These problems lead to the passage of the Federal Reserve Act in 1913.

The Initial Purposes of the Fed Were to:

• Provide an elastic currency supply (money supply control).

• Serve as a lender of last resort (discount window).

• Provide for a sounder banking system (regulatory powers).

• Improve the payments system (check clearing and promoting payments system technology).

Nonmonetary Powers of the Fed

• Regulation Q -- established the maximum rate that depository institutions could pay on deposit accounts until it was phased out over the 1980-1986 period.

• Securities Credit Regulation -- establishes borrowing (margin) limits for buyers of securities on margin.

• Supervision and Examination of State Member Banks.

Nonmonetary Powers of the Fed(concluded)

• Regulation of Bank Holding Companies.

• Regulation of Payment System.

• Control of International Banking Activities.

• Consumer Credit Regulation.

Organization of the Federal Reserve System

Federal Open Market Committee(Board of Governors and 5 Federal Reserve bank presidents)

• Directs open market operations, which is the primary instrument of monetary policy.

Federal Reserve banks(12 districts)

• Propose discount rates.• Hold reserve balances for depository

institutions and lend to them at thediscount window.

• Furnish Currency.• Collect and clear checks and transfer

funds for depository institutions.• Handle U.S. government debt and cash

balances

Board of Governors(7 appointed members)

• Sets reserve requirements and approvesdiscount rates as part of monetary policy.

• Supervises and regulates member banks andbank holding companies.

• Establishes and administers protectiveregulations in consumer finance.

• Oversees Federal Reserve Banks.

Advisory Councils

ExercisesGeneralSupervision

Advise

Compose

The Fed's Balance Sheet (1998)

Assets Percent Liabilities PercentLoansGovernment and AgencySecurities and ReposCoinsCash Items in Process ofCollection (CIPC)Other Assets Gold certificates and SDRs Foreign-Denom. Assets Other Assets and premises

0.05%

89.02%0.08%

0.48%

3.97%3.45%2.93%

Federal Reserve NotesDeposits: Depository Inst. Reserves U.S. Treasury Deposits Foreign and OtherDeferred Availability CashItems (DACI)Other Liabilities and AccruedDividendsCapital and Surplus

90.80%

3.99%1.31%0.10%

0.39%

0.93%2.48%

Total ($510.1 billion) 100.0% Total ($510.1 billion) 100.0%

Source: Board of Governors, Federal Reserve System.

Banks Hold Deposits in Other Banks and the Federal Reserve Banks in Order to Clear Checks

• While the physical paper check moves from bank to bank, the deposit accounts of banks are merely debited or credited.

• Many checks are cleared locally through clearing house associations. Checks drawn on association member banks are netted out.

The Federal Reserve Banks Are Heavily Involved in the Check Clearing of Out of Town Checks

• Most depository institutions either directly or indirectly (through other banks) hold reserve deposits in the Fed.

• Checks written on other banks are sent to the Fed and, depending on the distance and time needed to present the check to the paying bank, the reserve account of the check depositing bank may receive immediate or delayed (DACI) credit.

The Federal Reserve Banks Are Heavily Involved in the Check Clearing of Out of Town Checks (concluded)

• When a check is cleared and a deposit transfer is made at the Fed, the total bank reserves remain the same; only the ownership (one bank to another) changes.

Three Tools of Federal Reserve Monetary Policy

1. Establishing reserve requirements, the minimum proportion (percentage) of bank deposits they must keep on deposit at the Fed.– Increasing reserve requirements (%) increases the

percentage of bank deposits kept in noninterest bearing deposits at the Fed and limits bank lending.

– Decreasing reserve requirements (%) reduces the percentage of bank deposits kept in the Fed and provides the banking system with excess reserves.

Three Tools of Federal Reserve Monetary Policy (continued)

– Bank deposits (reserves) in the Fed are needed to clear checks and to satisfy reserve requirements.

– Actual reserves (AR) are balances needed to meet check clearing and legal reserve requirements including

• vault cash.

• noninterest bearing bank deposits in Federal Reserve banks.

Three Tools of Federal Reserve Monetary Policy (continued)

– Required reserves (RR) is the dollar level of reserves needed to meet legal reserve requirements.

• Reserve requirements (%) and the level and type of deposits determine the level of required reserves in a period.

• Actual reserves (have) needed for check clearing may exceed required reserves (have to have) and vice versa.

Three Tools of Federal Reserve Monetary Policy (continued)

– Excess reserves (ER) equals actual minus required reserves.

• Excess reserves may be loaned to customers or sold to other banks (federal funds market) by an individual bank.

• If the level of the banking system's Federal Reserve borrowed reserves (BR) (Fed loan credited to reserve accounts) exceeds the level of excess reserves in a period, the banking system is in a net borrowed reserve position, is less likely to promote lending activities, and interest rates are most likely to be increasing.

Three Tools of Federal Reserve Monetary Policy (continued)

• If the level of level of excess reserves exceeds Fed borrowing, the banking system is in a net-free reserve position, credit is easier and interest rates are generally lower.

Three Tools of Federal Reserve Monetary Policy (continued)

2. Open market operations affect the level of member bank reserves and the monetary base.– Buying government securities from the private

sector, the Fed eventually credits member bank deposits, thus increasing the level of bank reserves and the banks' ability to make loans and expand the money supply.

– Selling securities (could be any asset) to private security dealers or banks, the Fed is paid with a bank check which reduces the level of member bank actual reserves.

Three Tools of Federal Reserve Monetary Policy (concluded)

3.Discount Rate Policy -- The rate of interest depository institutions pay for borrowing from the Fed.– Raising the discount rate increases the cost

of borrowing for needed reserve balances.– Lowering the discount rate lowers the cost of

bank liquidity and encourages lending and money supply expansion.

Impacts of FederalReserve Policy

• Expansionary monetary policy– Open market operations -- purchase securities --

increase bank excess reserves and the monetary base.

– Reserve requirements -- reduce reserve requirements -- increase excess reserves and increase the deposit expansion multiplier.

– Discount rate -- reduce the rate -- reduce the cost of borrowing reserves.

– Expands the money supply; reduces interest rates.

Impacts of FederalReserve Policy (concluded)

• Restrictive monetary policy– Open market operations -- sell securities, reduce

bank reserves and the monetary base.

– Reserve requirements -- increase reserve requirements, reduces excess reserves and the deposit expansion multiplier.

– Discount rate -- increase the discount rate and the cost of borrowing reserve deficiencies.

– Reduce the money supply or its growth rate; increase interest rates.

Effects of Federal Reserve Policy in the Financial System

• Changes in the Money Supply– When the Fed either increases the monetary

base or reduces reserve requirements, banks’ excess reserves increase.

– Excess reserves are loaned out or invested.– Transaction deposits increase as loaned or

invested funds are deposited.– The money supply increases.

Effects of Federal Reserve Policy in the Financial System

(continued)• Changes in Interest Rates– Expansion of the monetary base or reductions in

reserve requirements increase bank liquidity.– Federal Funds rate declines.– Price of other money market securities increase

(rates decline) as banks invest their liquidity.– Loan rates and other security rates decline with

continued increases in bank liquidity.– Monetary policy starts in the bank money market

and spreads to other financial institutions and markets and to the real economy.

Effects of Federal Reserve Policy in the Financial System

(concluded)• Credit availability is increased with the

expansion of bank liquidity and reduced interest rates.

• Wealth Effects -- reduced interest rates (increased security prices) increases the wealth of individuals.– Increased wealth prompts increased spending.

– Increased spending has a current income, Y, impact and a multiplier effect in future income periods.

Short-Run Effects ofMonetary Policy

• Monetary policy affects spending– Investment.– Consumption.– State and local government.

• Effects of Monetary Policy on Changes in Investment– Investment demand, traditionally, has been

sensitive to changes in interest rates.

Short-Run Effects ofMonetary Policy (continued)

– Housing investment -- both credit availability and mortgage rates have been impacted severely by monetary policy.

– Plant and equipment investment is related to expected rates of return relative to the cost of financing.

– Planned inventory investment is sensitive to the cost and availability of credit.

Short-Run Effects ofMonetary Policy (continued)

• Consumption expenditures are affected several ways:– Increased or decreased holdings of money

affect spending.– Credit availability and interest rate levels

affect the purchase of durable goods.– Changes in wealth affect spending in the

current period.

Short-Run Effects ofMonetary Policy (concluded)

• Foreign trade is affected by monetary policy.– Increased interest rates increase the value of the

dollar relative to the other currencies.

– Increased dollar exchange rates encourage imports; discourage exports.

• State and Local Government Expenditures– Monetary policy affects capital project

expenditures.

– Higher interest rates limit expenditures.

Changes in the Discount Rate

Long-Run Effects ofMonetary Policy

• Expectations are affected by current, short-run monetary policy actions.

• High money growth to stimulate the economy may increase interest rates (interest rate effects).– Market expects inflation from near-term

policy action.– Investors sell long-term bonds, prices fall,

and interest rates increase.

Long-Run Effects ofMonetary Policy (concluded)

• Expected inflation may cause increased spending and borrowing and increased interest rates.– Pay back lower value debts.– Buy before the price goes up psychology.– May move the economy to inflationary income

levels.– Cost increases (interest and labor) faster than price

increases will cause reductions in investment spending.

Practical Considerationsin Monetary Policy

• Expectations may nullify intent of policy.

• Time lags in implementing monetary policy reduce its effectiveness.

• Political pressures influence Federal Reserve policy.