Lecture 15

CENTRAL BANK

  • A central bank is an institution responsible for the conduct of monetary policy.

  • Monetary Policy: The management of interest rates and the quantity of money (the money supply).

  • Major Central Banks:

    • The Federal Reserve (The Fed)

    • The European Central Bank

    • The Bank of England

    • The Bank of Japan

    • The Bank of Canada

  • The world’s oldest central bank is Sweden’s Sveriges Riksbank, founded in 1668, which established the Nobel Prize in Economics.

THE FEDERAL RESERVE SYSTEM

  • Federal Reserve Act of 1913: Established the Federal Reserve as a central bank in the U.S.

  • Structure of the Federal Reserve System:

    • Board of Governors:

    • Located in Washington, D.C.

    • Composed of 7 members appointed by the President for a term of 14 years, with the Chairman serving for 4 years.

    • 12 Regional Federal Reserve Banks:

    • Serve different districts across the United States.

    • Quasi-public banks, owned by private commercial banks in their districts.

    • Recognized as bankers’ banks.

  • Role in Banking System:

    • Acts as a lender of last resort to the banking system.

THE SPECIAL ROLE OF THE FEDERAL RESERVE BANK OF NEW YORK

  • Its district contains many of the largest commercial banks in the U.S.

  • It is the only Federal Reserve Bank that is a member of the Bank for International Settlements (BIS) located in Basel, Switzerland.

  • The BIS is the world's oldest international financial institution, established in 1930, primarily aimed at promoting international monetary and financial cooperation among central banks.

  • The president of the Federal Reserve Bank of New York is the only permanent voting member of the Federal Open Market Committee among Federal Reserve Bank presidents, serving as the committee’s vice-chair.

FUNCTIONS OF CENTRAL BANKS

  1. Issuing currency.

  2. Setting reserve requirements and holding reserves (the fractions of checking account balances).

  3. Lending money to banks at the discount rate.

  4. Acting as fiscal agent.

  5. Regulating and supervising banks.

  6. Controlling the money supply.

  • Decisions about monetary policy are made by the Federal Open Market Committee.

  • Money Supply Equation:
    ext{Money Supply} = ext{Bank Deposits} + ext{Currency in circulation}

CONVENTIONAL TOOLS OF MONETARY POLICY

  1. Open-Market Operations:

    • Involves buying and selling U.S. Treasury bills.

    • U.S. Treasury Bills: Short-term bonds of the U.S. government issued in one-, three-, and six-month maturities to finance the federal government.

  2. Reserve Requirements: 10% in the U.S.

  3. Discount Rate:

    • The Federal Reserve charges the discount rate that member banks pay to borrow from the Federal Reserve if they are not meeting reserve requirements.

    • This rate is essentially the cost of acquiring reserves.

  • Monetary Base Definition: ext{Monetary Base} = ext{Currency in circulation} + ext{Bank Reserves}

    • Where bank reserves consist of bank deposits at the Fed and vault cash.

CENTRAL BANK BALANCE SHEET

  • Assets:

    • Government debt/securities (Treasury bills)

    • Loans to commercial banks (discount loans)

  • Liabilities:

    • Currency in circulation (in the hands of the public)

    • Bank reserves (bank deposits at the Fed and vault cash)

TOOLS OF MONETARY POLICY: OPEN MARKET OPERATIONS

  • Open-Market Operations:

    • The central bank buys or sells government securities/debt (Treasury bills) in the open market to control the monetary base (currency in circulation + total reserves in the banking system).

  • Open Market Purchases (Expansionary Policy):

    • The Fed buys Treasury bills from commercial banks.

    • This action increases banking reserves, thereby increasing the monetary base.

  • Open Market Sales (Contractionary Policy):

    • The Fed sells Treasury bills to commercial banks.

    • This action decreases bank reserves, thus reducing the monetary base.

OPEN-MARKET OPERATIONS EXAMPLES

  • Open-Market Purchase:

    • Example: An open-market purchase of $100 million.

  • Open-Market Sale:

    • Example: An open-market sale of $100 million.

FEDERAL FUNDS RATE: MONETARY POLICY INSTRUMENT

  • The Fed uses open-market operations to achieve the desired Federal Funds Rate:

    • This is the rate that commercial banks charge one another for overnight loans of reserves and is the primary instrument of monetary policy.

  • Impact of Shifting the Federal Funds Rate:

    • Changing this rate alters banks' costs of funds.

  • Prime Rate:

    • Banks adjust the rates they charge their best customers, such as large corporations that pose the lowest risk of default.

    • Example: If the Fed Funds rate is 5%, the Prime Rate will typically be around 8%.

    • Interest rates on mortgages, auto loans, and student loans generally move in the same direction as the Federal Funds Rate.

FEDERAL FUNDS RATE TABLE

  • Policy Direction and Effects:

    • Expansionary:

    • Fed Action (Tool): Buys Treasury Bills

    • Change in Reserves: Increases

    • Federal Funds Rate Impact: Decreases

    • Impact on Other Rates: Lower rates on mortgages, auto, and student loans stimulate spending and investment to boost economic growth.

    • Restrictive:

    • Fed Action (Tool): Sells Treasury Bills

    • Change in Reserves: Decreases

    • Federal Funds Rate Impact: Increases

    • Impact on Other Rates: Higher rates on mortgages, auto, and student loans slow down the economy to control inflation.

FEDERAL FUNDS RATE HISTORICAL DATA

  • Source: Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS]

    • Retrieved from FRED, Federal Reserve Bank of St. Louis.

    • Website: https://fred.stlouisfed.org/series/FEDFUNDS