Monetary Policy

Central Banks and the Federal Reserve System

Central Bank Definition: A central bank makes decisions about the money supply, influencing interest rates to achieve macroeconomic goals like low unemployment and inflation.
Responsibilities: Central banks regulate the banking system, protect depositors, and ensure the health of banks' balance sheets.

The Federal Reserve, like most central banks, performs three main functions:

Conducting Monetary Policy: Influencing the money supply and credit conditions to manage inflation and unemployment.
Promoting Financial System Stability: Regulating banks and other financial institutions to prevent crises.
Providing Banking Services: Offering services to commercial banks, depository institutions, and the federal government.

Definition: An organization responsible for monetary policy and ensuring the smooth operation of a nation's financial system.
Examples: European Central Bank, Bank of Japan, Bank of England, and the U.S. Federal Reserve (the Fed).

Semi-Decentralized: The Federal Reserve combines government appointees with representation from private-sector banks.
Board of Governors:
- Seven members appointed by the U.S. President and confirmed by the Senate.
- Fourteen-year terms, staggered so one term expires on January 31st of every even-numbered year.
- Long, staggered terms insulate governors from political pressure, allowing decisions based on economic merits.
- Members typically serve only one term.
- Policy decisions do not require congressional approval.
- The President cannot request a Governor's resignation.

The Chair is a member of the Board of Governors.
Examples of Chairs: Alan Greenspan (1987-2006), Ben Bernanke (2006-2014), and Janet Yellen.
Role: Controls the agenda and is the Fed's public voice, wielding significant influence.

Structure: 12 regional Federal Reserve banks support commercial banks and the economy in their respective districts.
Leadership: Commercial banks in each district elect a Board of Directors, which chooses a president for the regional bank.
Federal and Private Sector Involvement: The Federal Reserve System includes both federally appointed and private-sector leaders.

Goal: Maintain a safe and stable national financial system by protecting individuals’ savings and the financial system's integrity.
Importance: Evident during the 2008-2009 financial crisis.
Purpose: Prevent excessive risk-taking by banks by ensuring banks' solvency.
Categories of Regulation:
- Reserve Requirements: Banks must hold a minimum percentage of deposits as reserves, either as cash or in their account at the Federal Reserve.
- Capital Requirements: Banks must maintain a minimum net worth.
- Investment Restrictions: Limiting the types of investments banks can make (e.g., prohibiting investments in the stock market).

Definition: The difference between a bank’s assets and liabilities (net worth).
Requirement: Banks must maintain a positive net worth to remain solvent.

Agencies Involved:
- Office of the Comptroller of the Currency (within the U.S. Department of the Treasury): Conducts on-site reviews of national banks and foreign bank branches.
- National Credit Union Administration (NCUA): Supervises credit unions.
- Federal Reserve: Supervises bank holding companies.
Process: Government agencies monitor banks' balance sheets.
Actions: If a bank has low or negative net worth or is taking excessive risks, supervisors can require changes or force closure/sale.

Practical Questions: Measuring the value of a bank’s assets (loans) is complex due to the risk of default.
Political Questions: Supervisors face pressure from bank owners and politicians when requiring changes or closures.
Examples: Issues with Japanese banks in the 1990s and the 2008-2009 U.S. recession.
Reforms: Laws in the 1990s in the U.S. required supervisors to make findings public and act promptly.

Market for Loanable Funds: Expansionary policy shifts the supply curve to the right, lowering interest rates. Contractionary policy shifts the supply curve to the left, raising interest rates.
Example:
- Original equilibrium (E0): 8% interest rate, 10 billion in funds.
- Expansionary policy (S0 to S1): Interest rate falls to 6%, quantity increases to 14 billion.
- Contractionary policy (S0 to S2): Interest rate rises to 10%, quantity decreases to 8 billion.
Central Bank Actions: Central banks use open market operations to change bank reserves, affecting the supply of loanable funds and interest rates.
Federal Funds Rate: The specific interest rate targeted by the Fed.
Impact on Other Rates: Changes in the federal funds rate influence other interest rates, though the effect may be less pronounced for longer-term loans.

Central Bank Purchases Bonds: Increases money supply.
- Happy Bank Example:
  - Initial assets: 460 million (reserves, bonds, loans).
  - Liabilities: 400 million (deposits), net worth: 60 million.
  - Fed buys 20 million in bonds: Happy Bank's reserves increase by 20 million.
  - Happy Bank loans out extra 20 million.
- This process expands the money supply through new loans and the money multiplier effect.
Central Bank Sells Bonds: Decreases money supply.
- Money flows from banks to the Fed, reducing commercial banks' reserve balances.
  *Small Bank Example:
  *Initial reserves: 50 million.
  *Fed sells bonds, reserves decrease to 30 million.
  *Small Bank slows new loans to restore reserves.
  *Big Bank Example:
  *Initial reserves: 20 million.
  *Fed buys bonds, reserves increase to 30 million.
  *Big Bank loans out extra 10 million.
Creating Money: Central banks create money to purchase bonds.
Reducing Loans: Banks reduce loan quantities by slowing down or halting new loans.

Central Bank Buys Bonds: Money flows from the central bank to individual banks, increasing the money supply.
Central Bank Sells Bonds: Money flows from individual banks to the central bank, decreasing the money supply.
Lowering the Federal Funds Rate: The Fed buys securities to increase the money supply, decreasing demand for reserves among banks.
Increasing the Federal Funds Rate: The Fed sells treasury bills to decrease the money supply, often in response to rising inflation.

Definition: The percentage of each bank’s deposits that it must hold as reserves (cash or deposit with the central bank).
Impact:
- Higher reserve requirements reduce the amount of money banks can lend.
- Lower reserve requirements increase the amount of money banks can lend.
Example: In early 2015, the Federal Reserve required banks to hold:
- 0% of the first 14.5 million in deposits.
- 3% of deposits up to 103.6 million.
- 10% of any amount above $$103.6 million.
Practical Use: The Fed rarely uses large changes in reserve requirements due to potential disruptions.

Context: The Federal Reserve was founded after the 1907 Financial Panic to act as the