Chapter 15: The Federal Reserve System And Open Market Operations

Seven members appointed by the President and confirmed by the Senate for 14 year terms.

Appointed by the president from the board for 4 year term(s)

The most important policy making body of the Fed and includes the presidents of the regional banks

The U.S. is divided into 12 regions, each with a non-profit bank that has 9 directors

Regulating the U.S. money supply

Anything that is widely accepted as a means of payment.

An asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments

Central bank of the U.S.

1. Can issue and create money (power) 2. Is a bank with 2 customers a. The government b. The banker

1. Maintains the bank account of the U.S. Treasury. 2. It manages government borrowing. 3. Issuing, transferring, and redeeming of U.S. Treasury bonds, bill, and notes.

1. Banks keep their own accounts at the Fed. 2. Banks can borrow from the Fed.

1. Regulates other banks. 2. Manages the nation's payment system. 3. Protects financial consumers with disclosure regulations.

1. Currency—Paper bills and coins. 2. Total reserves held by banks at the Fed. 3. Checkable deposits—your checking or debit account. 4. Savings deposits, money market mutual funds, and small-time deposits.

1. Almost $900 billion or $3,000 per person. 2. A lot is held by people in other countries. a. Panama, Ecuador, and El Salvador use the U.S. dollar as their official currency. b. Dollars are held by others in unstable countries to protect their wealth.

All major banks have accounts at the Federal Reserve System, can easily be converted to currency.

Are deposits you can write checks on or can access with a debit card.

1. Not as liquid as the other means of payment. 2. Each can be used to pay for goods and services, but this requires a little extra effort.

1. The monetary base (MB) 2. M1 3. M2

Currency outstanding and total reserves at the Fed.

Currency outstanding and checkable deposits.

M1 plus saving deposits, money market mutual funds, and small-time deposits.

only over the monetary base and uses that control to influence M1 and M2.

1. M1 and M2 can shrink or grow independent of what the Fed does. 2. Aggregate demand can shrink or grow for other reasons than changes in M1 and M2.

A system where banks hold only a fraction of deposits on reserve, lending the rest. This causes the banking system to be able to create money.

The reserve ration.

RR=Value of Reserves/Value of Deposits The fraction of deposits held on reserve.

1. The reserve requirement is determined primarily by how liquid banks wish to be. 2. The Fed sets a minimum RR.

MM=1/RR The amount the money supply expands with each dollar increase in reserves.

Change in Money Supply= MMxΔReserves=ΔReserves/RR

Fractional reserve banking, RR, and MM all work together to create money.

1. Open market operations: buying and selling of U.S. government bonds on the open market. 2. Discount rate lending and the term auction facility: Federal Reserve lending to banks and other financial institutions. 3. Required reserves and payment of interest on reserves: Changing the minimum RR; paying interest on any reserves held by banks at the Fed.

1. When the Fed buys anything (even apples) reserves increase. 2. Government bonds can be stored and shipped electronically, and the market for government bonds is liquid and deep, the Fed can buy and sell billions of dollars worth of government bonds in a matter of minutes. The Fed usually buys and sells short-term bonds called Treasury bills or T-bills (sometimes called Treasury securities or Treasuries).

They will buy T-bills. To pay for the T-bills: Fed electronically increases the reserves of the seller and with more reserves banks increase loans so money supply increases.

They will sell T-bills. Fed sells T-bills: Decrease in reserves of the buyer causes bank to decrease loans so money supply decreases.

ΔM = ΔReserves X MM where MM=1/RR

They keep reserves low, and MM will be high, so changes in MB will have a larger effect on the money supply

They hold reserves high, and MM will be low, so changes in MB will have a smaller effect.

1. The Fed can increase or decrease reserves at banks by buying and selling government bonds. 2. The increase in reserves boosts the money supply through a multiplier process. 3. The size of the multiplier is not fixed but depends on how much of their assets banks want to hold as reserves.

Buying and selling government bonds not only causes monetary base changes but interest rates change as well: 1. Fed buys bonds so increase in demands and price of bonds causes interest rates to drop. 2. Fed sells bonds so decrease in demands and price of bonds causes interest rates to rise.

Fed buys bonds

Fed sells bonds

1. Increased money supply → increased supply of loans. 2. Lower interest rates → increased demand for loans.

Interest rates are determined by the supply and demand for loans.

Is the overnight lending rate that banks charge each other.

The Federal Funds rate

through its control of the monetary base.

Because the Fed can create money at will, it is lender of last resort.

depend on the real interest rate.

only in the short-run.

1. It is a convenient signal of monetary policy. 2. It responds quickly to actions by the Fed. 3. It can be monitored on a day-to-day basis.

Loans money to banks and other financial institutions when no one else will.

The interest rate the Fed charges banks for loans. -These loans increase the monetary basis. -The monetary basis shrinks back when banks repay the loans.

Help banks that are in financial stress, so there is a stigma to borrowing from the Fed.

Other banks

The portion of their deposits that banks are required by law to hold as reserves, which the Fed pays interest on.

influence aggregate demand (AD)

Fed buys government bonds, so money supply increases and interest rates decrease, causing increased spending (AD)

1. We don't know exactly how much M1 and M2 will change. 2. We don't know exactly by how much lower interest rates will stimulate investment spending. 3. The Fed has most influence over short-term rates while investment is most affected by long-term rates.

1. Whether banks will lend out all of their new reserves or simply hold higher reserves. 2. How quickly increases in the monetary base will translate into new bank loans and thus larger increases in M1 and M2? 3. Do businesses want to borrow? How low do short-term interest rates have to go to stimulate more investment borrowing? 4. If businesses do borrow, will they promptly hire labor and capital?