Econ 201 Lecture 18: Money, Banks and the Federal Reserve System

Econ 201 Lecture 18: Money, Banks and the Federal Reserve System

Chapter 14: Overview

  • Content Focus: Money, Banks, and the Federal Reserve System.

Federal Reserve System

  • Definition: The central banking system of the United States, responsible for managing the nation's monetary policy.

Bank Balance Sheets

  • Fractional Reserve Banking System:

    • Definition: A banking system in which banks keep less than 100 percent of deposits as reserves.

    • Implications: This allows banks to lend more money than they actually have in reserve, potentially increasing the money supply.

  • Bank Run:

    • Definition: A situation in which many depositors simultaneously decide to withdraw money from a bank, leading to liquidity issues for the bank.

  • Bank Panic:

    • Definition: A situation in which many banks experience runs at the same time, often leading to widespread economic distress.

Structure of the Federal Reserve System

  • Federal Reserve Districts:

    • The United States is divided into 12 Federal Reserve districts, each containing its own Federal Reserve Bank.

  • Board of Governors:

    • Located in Washington, DC.

    • Comprises 7 members appointed by the President of the United States.

  • Federal Open Market Committee (FOMC):

    • A 14-member committee responsible for conducting open market operations and managing the money supply.

How the Federal Reserve Manages the Money Supply

  • Monetary Policy:

    • Definition: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.

  • Monetary Policy Tools:

    1. Open Market Operations

    2. Discount Policy

    3. Reserve Requirements

Open Market Operations

  • Definition: The buying and selling of Treasury securities by the Federal Reserve to control the money supply.

  • FOMC's Role: Responsible for deciding on these operations.

Discount Policy

  • Discount Loans: Loans that the Federal Reserve makes to banks to ensure liquidity.

  • Discount Rate: The interest rate the Federal Reserve charges banks on these discount loans, influencing the cost of borrowing.

Reserve Requirements

  • Definition: Regulations on the minimum amount of reserves that banks must hold against deposits.

  • Implication: When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves, allowing banks to lend more.

The Influence on Money Supply

  • The Federal Reserve, while having substantial influence over the money supply through its tools, does not have absolute control.

  • Actors Influencing Money Supply:

    • Nonbank Public: Consumers and businesses that make choices affecting deposits.

    • Banks: Determine how much they choose to lend out from their reserves.

Shadow Banking System & Financial Crisis (2007–2009)

Introduction to Shadow Banking

  • Securitization:

    • Definition: The process of transforming loans or other financial assets into securities.

  • Financial Asset: Any tradable monetary contract and a key concept in financial markets.

Securitization Process

  • Illustration:

    • Banks grant loans to households.

    • The loans are bundled into securities sold to investors.

    • Banks collect payments from loans and send them to investors after deducting fees.

Financial Crisis of 2007–2009

  • As banks and financial firms sold assets and reduced lending, a credit crunch ensued, significantly worsening the recession starting in December 2007.

  • Responses: The Fed and Treasury conducted extraordinary actions that stabilized the financial system, yet by mid-2009, normal lending levels were not restored.

  • Debate: The effectiveness and wisdom of some of the Fed's stabilizing actions were questioned by economists and policymakers.

Connecting Money and Prices: The Quantity Equation

  • Quantity Equation: Formulated by Irving Fisher, expresses the relationship between money supply and prices, represented as: M imes V = P imes Y

    • Where:

    • M = Money supply

    • V = Velocity of money

    • P = Price level

    • Y = Real output (GDP)

Velocity of Money

  • Definition: The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

  • Assumption in Quantity Theory of Money: Velocity is constant over time.

Implications of the Quantity Theory of Money

  • The theory connects the growth rates of money supply, velocity, price level, and real output:

    • Growth rate of money supply + Growth rate of velocity = Growth rate of price level (or inflation rate) + Growth rate of real output.

  • If velocity is constant, the equation simplifies to:
    Inflation
    ate = Growth
    ate
    ightarrow ext{ of the money supply} - Growth
    ate
    ightarrow ext{ of real output}

Predictions from Quantity Theory

  1. Inflation: Occurs when the money supply grows faster than real GDP.

  2. Deflation: Occurs when the money supply grows slower than real GDP (deflation is a decline in price level).

  3. Stable Price Level: Occurs when the money supply grows at the same rate as real GDP.

Hyperinflation

  • Definition: Extremely high rates of inflation, often exceeding hundreds or thousands of percentage points per year.

  • Consequences: Economies suffering from hyperinflation typically also endure very slow growth or severe recession.