Ch. 15 Federal Reserve System and Aggregate Demand Notes
Ch. 15 – The Federal Reserve System and Aggregate Demand
The Federal Reserve (the Fed) influences aggregate demand more than any other institution through its control over the money supply.
Shifts in aggregate demand can significantly impact the economy in the short run.
The chapter will explore the tools the Fed uses to influence aggregate demand.
15.1 What is Money?
Money is a widely accepted means of payment.
If an asset is easily used to pay for goods or services, it is considered money.
Currency (paper bills and coins) is money because it efficiently facilitates small transactions.
Money: a widely accepted means of payment.
U.S. currency is provided by the Federal Reserve, as indicated by "Federal Reserve Note" on bills.
Businesses transfer trillions of dollars annually via electronic checks or wire transfers.
Consumers use debit cards or services like Venmo for money transfers, especially for large transactions.
Using a debit card authorizes a bank to send money to the seller's bank.
Banks maintain accounts at the Federal Reserve.
When bank A pays bank B, it instructs the Federal Reserve to deduct the amount from its account and credit bank B's account.
Total reserves held at the Fed are a final means of payment.
The Fed controls the two major final means of payment: currency and reserves held at the Fed.
The Fed can create money electronically by adding reserves to bank accounts held at the Fed.
New money can be lent out or spent, increasing aggregate demand.
Assets serving as means of payment in the U.S.:
Currency: paper bills and coins
Total reserves held by banks at the Fed
Liquid deposits: checking and savings accounts
Money market mutual funds and small time deposits
Credit cards are not included to avoid double-counting.
Demand deposits and other liquid deposits are primarily checking accounts.
Money market mutual funds invest in short-term debt and government securities, allowing check writing and transfers to checking accounts.
Small time deposits (CDs) cannot be withdrawn without penalty before a specified period.
Economists use various definitions of the money supply:
MB (monetary base): Currency in circulation and total reserves held at the Fed
M1: Currency plus demand deposits and other liquid deposits
M2: M1 plus money market mutual funds and small time deposits
These definitions help analyze money's effect on the economy.
The money supply definition depends on which liquid assets are included.
Financial assets' liquidity can change over time due to bank innovations.
Bitcoin is not considered money because it is not a widely accepted means of payment.
Digital assets may become part of the money supply if they gain wider acceptance.
15.2 What is the Federal Reserve System?
Every major U.S. bank has an account at the Fed.
The Fed is the bank for bankers.
Large payments are made by transferring money between bank accounts at the Fed.
The Fed lends money to banks, regulates their investments, and protects financial consumers with disclosure regulations.
The Fed is the U.S. government’s bank.
It maintains the U.S. Treasury's bank account.
Tax payments to the IRS end up in the Treasury’s account at the Fed.
The Fed manages the borrowing of the Treasury by issuing, transferring, and redeeming Treasury bonds, bills, and notes.
The Federal Reserve influences aggregate demand in the U.S. economy.
15.3 How Does the Federal Reserve Influence Aggregate Demand? Tools and Transmission Mechanisms
The Federal Reserve’s main tools to influence aggregate demand:
Paying interest on reserves held by banks at the Fed
Open market operations, repurchase agreements (repos), and quantitative easing.
These tools manage the supply of money, or “liquidity,” in the financial system.
Open market operations: buying and selling short-term U.S. government bonds.
Repos: temporarily buying or selling T-bills, usually overnight.
Quantitative easing (and tightening): buying (and selling) longer-term financial assets.
Acting as lender of last resort in a panic
Coordinating expectations
Payment of Interest on Reserves
Banks hold substantial reserves in their accounts at the Federal Reserve.
Banks compare the earnings from lending funds to customers versus holding funds at the Federal Reserve.
The Federal Reserve influences lending and aggregate demand by setting the interest rate on reserves.
Increasing the interest rate on reserves encourages banks to hold more reserves and decrease lending, thus decreasing aggregate demand.
Decreasing the interest rate on reserves encourages banks to hold fewer reserves and increase lending, thus increasing aggregate demand.
Transmission Mechanism: The Lending and Interest Rate Channel
The Fed’s decision to change the interest rate on reserves impacts borrowing and lending in the Federal Funds market.
The Federal Funds rate (the rate banks charge to lend to one another) closely follows the interest rate the Fed pays on reserves.
The Fed targets the Federal Funds rate to stimulate the economy by increasing bank lending.
The Federal Reserve cut the interest rate on reserves from about 1.5% to 0.1% as the economy entered the COVID-19 recession in 2020 and the Federal Funds rate dropped in parallel. As the economy recovered and inflation increased in 2022, the Federal Reserve Increased rate paid on reserves, and the Federal Funds rate also increased.
Changes in the Federal Funds market influence interest rates for auto loans, investment projects, etc.
The Federal Funds market indicates the Fed’s stance on the economy.
Reducing the rate paid on reserves increases short-term loans to other banks, households, and businesses.
Lower interest rates make borrowing and investing more appealing to consumers and businesses.
Rates of return on short-term debt securities issued by private companies (commercial paper) and the federal government (T-bills) move with the interest rate on reserves.
Changes in T-bill rates are reflected in floating-rate loans, including floating-rate mortgages and credit lines.
Increasing the rate paid on reserves encourages banks to hold more funds as reserves and lend less.
The lending channel of monetary policy is the effect of the Fed’s influence on the amount of lending in the economy.
The interest rate is a price, the price of spending now versus later.
A lower interest rate implies that spending in the present is more affordable, and higher interest rates encourage savings.
Adjusting the cost of consuming or investing today relative to future opportunities, interest rates play a critical role in balancing economic activity and resource allocation over time.
The interest rate channel of monetary policy refers to the effects of monetary policy that operate by altering the price of spending now versus later.
The lending and interest rate channels work together.
By changing the interest rate on reserves, the Fed initiates a process that changes interest rates and thus lending, borrowing, spending, and investing throughout the economy.
Changing the interest rate on reserves is the Fed’s primary means of adjusting aggregate demand on a day-to-day basis, and the Fed has the power to create money.
The Fed creates money to pay interest on reserves by crediting the accounts that banks hold at the Fed.
Tools That Change the Supply of Money or “Liquidity”
The Fed can create money by printing or adding numbers to bank accounts.
When the Fed increases the money supply, it spreads throughout the economy as people and businesses spend and invest.
The Fed can reduce the money supply by selling assets it bought earlier.
The Fed buys and sells financial assets, typically short-term bonds called Treasury bills or T-bills (Treasury securities or Treasuries).
Government bonds can be stored and shipped electronically, and the market for government bonds is liquid and deep.
Buying and selling T-bills is called an open market operation, temporarily buying and selling T-bills is called a repurchase or reverse repurchase agreement, and buying long-term government bonds, mortgage-backed securities, or other financial assets is called quantitative easing.
Open Market Operations
The Fed can change the money supply by buying or selling government bonds.
To pay for the T-bills, the Fed electronically increases the reserves of the seller.
With more reserves on hand, that bank will respond by increasing its loans.
Transmission Mechanism: The Asset Price and Wealth Effect Channel
Bond prices and interest rates are inversely related: when bond prices go up, interest rates go down, and vice versa.
When the Fed buys or sells bonds, it changes the quantity of reserves and influences interest rates.
When the Fed buys bonds, it increases the demand for bonds, which pushes up the price of bonds, thus lowering the interest rate.
Increasing the supply of money with an open market operation decreases the interest rate. Decreasing the interest rate that the Fed pays on reserves increases the supply of money.
A lower interest rate means a lower “discount rate” on the future.
A rise in the interest rate means a higher “discount rate” on the future.
When interest rates fall, any asset with future payments will be more valuable.
Many businesses, including banks and financial intermediaries, will be more solvent as their assets rise in value, and they will feel richer and may invest more.
Households owning stocks and bonds will feel wealthier too, and they may spend more money or start new businesses.
When the Fed sells bonds, the process works in reverse. Selling bonds reduces the money supply, and pushes the price of bonds down along with the price of other long-term assets.
Changing the interest rate on reserves and open market operations have similar transmission mechanisms.
Both a lower interest rate on reserves and open market purchases will lower many interest rates throughout the economy and increase the value of assets with future payments.
The interest rate and asset price channels are two of the channels of monetary policy.
Repos
The Fed buys or sells T-bills temporarily using repo and reverse repo.
Repo: a temporary purchase of securities from a financial institution or, equivalently, a short-term loan of reserves from the Fed to a financial institution with Treasuries as collateral.
Reverse Repo: a temporary sale of securities to a financial institution or, equivalently, a short term borrowing of reserves by the Fed from a financial institution with Treasuries as collateral.
Repo is short for a repurchase agreement; that is, the Fed buys securities with the agreement that the seller will repurchase the securities from the Fed at a later date.
A repo is a temporary open market purchase.
A repo is a short-term loan from the Fed to the bank.
Reverse repo is the opposite of this; that is, the Fed sells securities with the agreement that it will repurchase them at a later date.
A reverse repo is similar to an open market sale because it removes liquid reserves from the banking system.
In a reverse repo, the bank is temporarily “lending” reserves to the Fed.
The Fed is changing the amount of liquid reserves in the broader financial system with open market operations and with repos and reverse repos.
Repos and reverse repos are done with nonbank financial institutions like money market mutual funds.
Repos give the Fed an additional tool to access the broader financial system and influence short-term interest rates.
Changing the interest rate on reserves, open market operations, and repo transactions are all tools that the Fed uses to change the amount of money or “liquidity” in the financial system.
Quantitative Easing
The Fed usually conducts open market operations by buying or selling T-bills—short- term government securities—but if the Fed thinks there are problems in specific borrowing and lending markets, they can buy and sell specialized and long-term securities.
During the COVID-19 recession and the financial crisis, for example, the Fed bought trillions of dollars’ worth of mortgage-backed securities to help sustain liquidity in the housing market.
During the COVID-19 pandemic, many people started to withdraw funds from their money market mutual funds.
To avoid contagion, the Fed stepped in to buy assets from the funds, thereby ensuring their solvency.
This kind of policy is sometimes called quantitative easing.
Quantitative easing can be especially useful when short-term interest rates are at or near the zero lower bound.
Zero lower bound: situation in which the Federal Funds rate is close to zero.
Transmission Mechanism: The Banking Lending Channel
You can think of quantitative easing and acting as a lender of last resort as a special version of the lending channel of monetary policy.
Events in the housing market can make mortgage loans more or less difficult to obtain independently of what is happening in other loan markets.
When the Federal Reserve engages in quantitative easing or acting as a lender of last resort, it is typically trying to maintain the lines of lending or credit in one of these specialized sectors.
When times normalize, the Fed sells securities back to the private markets, which can be called reversing or ending quantitative easing or sometimes quantitative tightening.
Acting as the Lender of Last Resort
Panic is an important part of many recessions, especially financial recessions.
In a panic, depositors are trying to withdraw their money from shadow banks, asset prices are plummeting in fire sales, lenders are refusing to lend, and businesses are desperate to borrow money just to finance ordinary business expenses, such as wage payments and inventories.
In a situation like this, everyone turns to the Fed—the lender of last resort.
A panic might start with a simple rumor that a financial institution, like a bank, is insolvent.
An insolvent institution is one with more liabilities than assets.
If depositors and lenders fear that a bank is insolvent, they will rush to withdraw their money, knowing that the last people attempting to withdraw will be the ones holding the bag.
Perhaps the bank has plenty of assets but its assets are illiquid.
An illiquid asset is an asset that cannot be quickly converted into cash without a large loss in value; note that a bank could be illiquid but not insolvent.
A bank run can break the continuity necessary to fund long-term projects.
The depositors can’t tell whether the bank is really insolvent or just illiquid, and any hint that the bank isn’t ready to pay everyone on demand could make the panic spread.
Deposit insurance and the Federal Deposit Insurance Corporation (FDIC) tells depositors, don’t worry, even if the bank is insolvent, you will still be paid.
When deposit insurance isn’t enough or when the financial institution isn’t covered by deposit insurance, then the Fed can step in as the lender of last resort.
The Fed provides the bank with enough cash to pay off any depositor who wants to be paid off, again without requiring the bank to liquidate its assets too early.
Systemic Risk and Moral Hazard
The problem during a panic is the problem of systemic risk—if one financial institution goes down, it’s likely to take others with it, like dominos.
Systemic risk: the risk that the failure of one financial institution can bring down other institutions.
The Fed sometimes has to bail out some insolvent banks in order to protect the entire system.
The Federal Reserve, along with the U.S. Treasury, stepped in to support the financial system on an unprecedented scale during the Covid-19 recession.
The Fed went from lender of last resort to owner of last resort when it assumed a majority ownership stake in the insurance company AIG during the financial crisis of 2008–2009.
What would you do if you were told that you could invest in anything and that the government would step in and bail you out if you failed?
This is the problem of moral hazard.
Moral hazard: occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out.
One of the main reasons the Federal Reserve is also responsible for regulating banks is to minimize moral hazard.
The Fed requires that banks have more assets than liabilities—the difference between a bank’s assets and its liabilities is called the bank’s capital, so we can also say that the Fed requires that banks have capital.
The bank’s capital ensures that banks can absorb some losses while still being able to pay all their depositors.
The Fed periodically subjects large, globally important banks like the Bank of America to “stress tests.”
Smaller banks face less stringent regulations than large, globally important banks
Banks are penalized for holding risky assets, but that means that some borrowers find it more difficult to borrow money from banks.
The Fed stepped in with the FDIC and the U.S. Treasury and guaranteed the depositors of Silicon Valley Bank, as they had done during the 2008–2009 financial crisis
The Fed is trying to steer a course between limiting systemic risk and checking moral hazard while also making sure that the financial system is serving its role of moving funds from savers to borrowers.
There are trade-offs here, and it may not be easy to simultaneously create a safe and a productive banking system. This is the great dilemma of modern banking regulation.
Coordinating Expectations
The Fed’s final tool is talking, which can help the Fed to manage and coordinate expectations.
People listen to what the Fed says because the Fed is powerful but also because they know everyone else is also listening to the Fed.
Expectations, however, are tricky to manage.
When the Fed takes an action, for example, will the public expect that action to be permanent or temporary?
The Fed might not always have an incentive to tell the truth.
“Although we are mindful of certain downside risks and uncertainties, our current outlook remains cautiously optimistic.” This vague way of talking is sometimes called “Fed Speak.”
15.4 Limits to the Federal Reserve’s Powers
Suppose the Fed wants to increase aggregate demand and thus buys a T-bill from a bank in an open market operation. What will the bank do now that it has more money: Will the bank use that money to make more loans and thus stimulate aggregate demand, or will the bank simply hold the reserves?
If the bank simply holds the reserves, the Fed’s actions will have failed.
The Fed can incentivize banks to make loans by increasing the quantity of reserves in an open market operation or by reducing the interest rate on reserves, but if the banks don’t see profitable lending opportunities, they won’t lend. Sometimes it is said that when the banks don’t want to lend, the Fed’s operations are like “pushing on a string.”
Some of the things the Fed must try to predict and monitor are the following:
How much will changes in interest rates affect spending, borrowing, and lending?
How quickly will changes in interest rates affect spending, borrowing, and lending?
Do businesses and consumers want to invest and borrow?
How low do short-term and long-term interest rates have to go to stimulate spending, borrowing, and investment?
If businesses do borrow, will they promptly hire labor and capital, or will they just hold the money as a precaution against bad times?
How will the expectations of people and firms respond to the Fed’s actions? Will the Fed’s actions be regarded as permanent or temporary?
Even in situations when banks don’t want to lend, the Fed isn’t entirely out of ammunition.
The Fed could purchase long-term bonds, quantitative easing, thus stimulating certain sectors of the economy, such as housing.
The Fed could also intervene in foreign exchange markets as it has done occasionally in the past, say, by selling dollars, which would make U.S. exports cheaper, or by buying dollars, which would make U.S. exports more expensive.
The Fed could even buy bonds, and the Treasury could then write checks to every American and thereby stimulate spending.
The Federal Reserve’s power should not be underestimated, but the economy is not an oven that can be run hot or cold at the will of a central authority. The Fed has a limited set of tools, and it must constantly adapt those tools to new circumstances and conditions.
The Fed can influence real variables only in, at best, the short run.
The Fed Influences a Real Rate Only in the Short Run
The Fed is also limited because lending and borrowing decisions depend on the real interest rate; the interest rate after inflation has been taken into account
The Fed has an influence on real interest rates only in the short run.
Money is neutral in the long run—that neutrality includes real interest rates.
For example, if the Fed starts buying more securities (open market purchases), then interest rates will initially fall as the new money enters the financial system.
If the Fed continues this policy, people will soon come to expect the new money, and prices will rise along with interest rates (the Fisher effect from Chapter 12).
In the long run, prices adjust, and the real interest rate doesn’t change.
An increase in aggregate demand (AD) increases the real growth rate only in the short run.
The long-run neutrality of money, the long-run neutrality of aggregate demand, and the long-run neutrality of Federal Reserve influence over real rates are all different sides of the same “coin.”
15.5 Who controls the Fed?
The Fed has a seven-member Board of Governors who are appointed by the president and confirmed by the Senate.
Governors are appointed for 14-year terms and cannot be reappointed—this means that a single president will rarely appoint a majority of the board. Once appointed, members of the Board of Governors cannot be easily fired.
The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years.
The Fed has to periodically report to overseers in both houses of Congress.
The Fed is not just one bank but 12 Federal Reserve Banks, each headquartered in a different region of the country.
Each regional bank is a nonprofit bank with nine directors: Six of these directors are elected by commercial banks from the region, and three are elected by the Board of Governors.
Six of the directors must be non-bankers, and these are drawn from business, labor, academia, and other fields.
The directors of the regional banks appoint a regional bank president.
The seven members of the Board of Governors, along with five rotating presidents of the regional Fed banks, make up the Federal Open Market Committee.
The Federal Open Market Committee determines the stance of monetary policy by controlling open market policy.
The confusing structure of the Federal Reserve system has a purpose.
The Federal Reserve is powerful, so in keeping with the U.S. system of checks and balances, the power of the Fed is dispersed—no single president appoints all the governors of the Fed, the governors do not have complete control over Fed policy, and the regional bank presidents come from all over the United States and are appointed by directors who are drawn not just from banking but from a wide variety of fields as well.
The Federal Reserve is usually one of the most independent agencies in the U.S. government.
It is relatively insulated from politics, party, and elections—perhaps only the Supreme Court is more independent.
In the financial crisis of 2008, the Fed had to work closely with the Treasury Department
The independence of the Federal Reserve worries some people who would prefer that the Fed be more directly accountable to democratically elected politicians.
Political pressures have been put on the Federal Reserve, and some chairpersons have been less independent than others. In 1972, President Nixon asked Arthur Burns, the chair of the Fed, to stimulate the economy before the election.
An independent Federal Reserve is defended by most economists as part of the U.S. system of checks and balances.
Quantitative easing is a monetary policy tool used by central banks, such as the Federal Reserve, to stimulate the economy when standard monetary policy becomes ineffective, typically during periods of economic downturn.
The Federal Reserve Influences Aggregate Demand Using Various Monetary Policy Tools
Interest on Reserves: This affects banks' willingness to lend. Higher interest on reserves may discourage lending, thus reducing aggregate demand, while lower rates encourage more lending and increase aggregate demand.
Open Market Operations: This involves the buying and selling of government securities to alter the money supply and influence interest rates.
Buying Bonds: Increases demand and lowers interest rates, stimulating the economy by encouraging borrowing and spending.
Selling Bonds: Decreases demand and raises interest rates, leading to a contraction in economic activity.
Repurchase Agreements (Repos): These are short-term loans from the Fed to banks that provide liquidity and can help increase lending.
Quantitative Easing: This is implemented during economic downturns, such as in 2008 and 2020. The Fed buys government securities to lower long-term interest rates and stimulate economic activity.
Acting as Lender of Last Resort: The Fed provides liquidity to banks during financial panic, which helps stabilize the financial system and supports aggregate demand by ensuring banks can continue to lend to businesses and consumers.
The Reserve Ratio
The reserve ratio is the fraction of deposits that a bank must hold as reserves and not lend out. It is a required minimum set by the central bank (e.g., the Federal Reserve in the U.S.) to ensure that banks maintain a certain level of liquidity and can meet customer withdrawal demands.