Chapter 15 - The Federal Reserve System and Open Market Operations

CHAPTER 15 - THE FEDERAL RESERVE SYSTEM AND OPEN MARKET OPERATIONS

Introduction

  • The Federal Reserve’s influence over aggregate demand is significant due to its control of the money supply.

  • This chapter discusses the Federal Reserve System and tools used for impacting money supply, aggregate demand, and the economy.

What is the Federal Reserve System ("The Fed")?

  • Definition: The Federal Reserve System is the central bank of the United States.

  • Functions:

    • Government’s Bank:

    • Maintains the bank account of the U.S. Treasury.

    • Manages government borrowing through U.S. Treasury bonds, bills, and notes.

    • Banker’s Bank:

    • Regulates banks and provides lending services to them.

    • Manages the nation’s payment system.

  • Key Role: Regulating the money supply.

    • The Fed adds reserves to bank accounts rather than physically printing money.

    • Adding reserves allows for an increase in aggregate demand through lending.

The Fed's Most Important Job – Regulating the Money Supply

  • Definition of Money: Any widely accepted means of payment.

  • Important assets in payment methods:

    • Currency: Paper bills and coins.

    • Total Reserves at the Fed: Reserves banks hold at the Federal Reserve.

    • Checkable Deposits: Funds in checking accounts or debit accounts.

    • Savings Deposits, Money Market Mutual Funds, and Small-size Deposits (CDs): Funds held in savings accounts or investments.

Definitions of the U.S. Money Supplies

  • Total Reserves held at the Fed: Electronic claims that can convert into currency.

  • Monetary Base (MB): Currency in circulation plus total reserves held at the Federal Reserve.

  • M1 Definition: Currency plus checkable deposits.

  • M2 Definition: M1 plus savings deposits, money market mutual funds, and small-time deposits.

Liquid Asset - Defined

  • Liquid Asset: An asset that can be used for payments or quickly converted into a payment-usable asset without significant value loss.

Composition of U.S. Money Supplies

  • Currency

    • Total U.S. currency averages about $4,300 per person.

    • Currency is used in various countries including Panama, Ecuador, and El Salvador.

  • Total Reserves

    • Represents the reserves held by banks at the Federal Reserve.

    • Not physical currency but electronic claims.

  • Checkable Deposits

    • Allow for writing checks or debit card access, commonly used in daily transactions.

  • Savings Accounts, Money Market Mutual Funds, and CDs

    • Less liquid than currency or checkable deposits.

    • These require transfers to checkable accounts for payment use.

Fractional Reserve Banking and the Reserve Ratio

  • Fractional Reserve Banking: A banking system where banks hold only a fraction of deposits as reserves while lending the remainder.

    • Banks profit from lending while providing services such as checking.

  • Reserve Ratio (RR): The ratio of reserves to deposits, defined mathematically as:
    RR = \frac{Reserves}{Deposits}

  • Example: If $100 is held in reserves for every $1000 in deposits, the reserve ratio is 0.1 or 10%.

Money Multiplier

  • Money Multiplier (MM): The ratio of deposits to reserves, calculated as:
    MM = \frac{Deposits}{Reserves} = \frac{1}{RR}

  • The multiplier indicates how much the money supply increases with a change in Bank reserves.

Money Multiplier Process

  • Interaction Example:

    • If Ann deposits $1000, and the bank keeps $100 as reserves, it loans $900 to Bob. The money supply increases by $900.

    • If Bob then deposits $900, the bank again holds 10% in reserves and loans out $810, continuing the cycle.

    • This process allows for the creation of substantial money supply increases based on the reserve ratio.

  • Total Impact: With a 10% reserve ratio, an initial increase in reserves could expand the total deposits significantly.

Open Market Operations

  • Definition: Open Market Operations involve the buying and selling of government bonds by the Federal Reserve.

  • Objectives: Influence the growth of the Money Supply and/or interest rates.

  • Mechanism:

    • When the Fed buys bonds, bank reserves increase, leading to more loans, increased spending, and higher aggregate demand.

    • Conversely, selling bonds contracts the money supply.

Interest Rates and Monetary Policy

  • Federal Funds Rate: The overnight lending rate between major banks, used as a monetary policy signal.

  • Liquidity Trap: A scenario where traditional monetary policy becomes ineffective due to very low interest rates.

  • The Fed influences interest rates along with the money supply during its operations by buying and selling bonds.

Federal Reserve Tools Summary

  • Major tools include:

    • Open Market Operations: Buying/selling short-term government bonds to influence money supply and interest rates.

    • Payment of Interest on Reserves: Encourages banks to hold reserves, affecting bank lending capacity.

    • Quantitative Easing: Involves larger long-term securities purchases to influence rates directly.

    • Lender of Last Resort: Providing loans to banks during crisis situations.

Takeaways from Chapter 15

  • The Federal Reserve exerts control over money supply and influences interest rates through various tools, affecting aggregate demand in the economy.

  • The Fed's actions demonstrate the balance of maintaining economic stability while providing liquidity in times of need.