Chapter 15 Macroeconomics

Central Bank

The organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly

In the U.S. the Central Bank is the Federal Reserve (“the Fed”)

Semi-decentralized, mixed government appointees with representation from private-sector banks

Run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate

Federal Reserve is Designed to Perform Three Important Functions

To conduct monetary policy

To promote stability of the financial system

To provide banking services to commercial banks, other depository institutions, and the federal government

Regulation Falls into a Number of Categories

Reserve requirements

Capital requirements

Restrictions on the types of investments banks may make

Bank Run

When depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost

To Protect Against Bank Runs, Congress has put Two Strategies into Place

Deposit insurance

Lender of last resort

Deposit Insurance

An insurance system that makes sure depositors in a bank does not lose their money, even if the bank goes bankrupt

Banks pay an insurance premium to the Federal Deposit Insurance Corporation (FDIC)

Lender of Last Resort

An institution that provides short-term emergency loans in conditions of financial crisis

The Most Common Monetary Policy Tool in the U.S. has been

Open market operations

Open Market Operations

The central bank selling or buying Treasury bonds to influence the quantity of money and the level of interest rates

Federal Open Market Committee (FOMC)

Makes the decisions regarding open market operations, and is comprised of 7 members of the Federal Reserve’s Board of Governors and 5 voting members from the Federal Reserve Banks

Reserve Requirement

The percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank

Discount Rate

The interest rate charged by the central bank on the loans that it gives to other commercial banks

Expansionary Monetary Policy/Loose Monetary Policy

A monetary policy that increases the supply of money and the quantity of loans

Contractionary Monetary Policy/Tight Monetary Policy

A monetary policy that reduces the supply of money and loans

Federal Funds Rate

The interest rate at which one bank lends funds to another bank overnight

How Does a Central Bank “Raise” Interest Rates?

Through an open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds

The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations

If open market operations do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do

Tight or Contractionary Monetary Policy will Reduce Two Components of Aggregate Demand

Business investment (declines because it is less attractive for firms to borrow money)

Consumer borrowing for big-ticket items

Loose or Expansionary Monetary Policy Will

Tend to increase business investment and consumer borrowing for big-ticket items

Countercyclical

Moving in the opposite direction of the business cycle of economic downturns and upswings

Quantitative Easing (QE)

The purchase of long term government and private mortgage-backed securities by central banks to make credit available in hopes of stimulating aggregate demand

Quantitative Easing Differs from Traditional Monetary Policy in Several Key Ways

The Fed purchasing long term Treasury bonds, rather than short term Treasury bills

Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities

Excess Reserves

Reserves banks hold that exceed the legally mandated limit

Velocity

The speed which money circulates through the economy

Velocity=Nominal GDP/Money Supply

Basic Quantity Equation of Money

Money supply x velocity = Nominal GDP

Recall that:

Nominal GDP = Price level (or GDP deflator) x Real GDP

Therefore:

Money supply x velocity = Price level x Real GDP

We can see that changes in velocity can cause problems for monetary policy

Inflation Targeting

A rule that the central bank is required to focus only on keeping inflation low