Chapter 14: The Federal Reserve System

Chapter 14: The Federal Reserve System

Learning Objectives

  • Understand the organization of the Federal Reserve ("The Fed").
  • Identify the Fed’s major policy tools.
  • Explain the workings of open market operations.

Chapter Goals

  • Identify the government agency responsible for controlling the money supply.
  • Explore the policy tools utilized to govern the money supply in the economy.
  • Analyze the effects of government policies on banks and bond markets.
  • Examine the mechanics of government control over the money supply.

The Federal Reserve System

  • The Federal Reserve System was established in 1913.
  • Comprises 12 Federal Reserve banks, each serving as the central bank for private banks in its corresponding region.
  • Key Functions of the Federal Reserve include:
    • Clearing checks between private banks.
    • Holding bank reserves.
    • Providing currency.
    • Offering loans to banks.
Monetary Policy
  • Definition: Monetary policy refers to the use of money and credit controls to influence macroeconomic outcomes.
  • This chapter will focus on the various tools available for implementing monetary policy.

Federal Reserve Banks

  • The core institutional framework consists of 12 Federal Reserve banks.
  • Each bank operates as a central bank for private banks within its jurisdiction.

The Board of Governors

  • Located in Washington, D.C., the Board of Governors is responsible for setting monetary policy.
  • Composed of seven members appointed by the U.S. President for 14-year terms.
  • Independence from the political sphere is a key aspect to ensure control over the money supply remains insulated from political pressures.

The Federal Open Market Committee (FOMC)

  • The FOMC oversees the Fed’s daily activities in financial markets.
  • Plays a crucial role in determining:
    • Short-term interest rates.
    • The level of reserves that private banks hold.
  • Membership includes:
    • All seven governors of the Board.
    • 5 out of 12 regional Reserve bank presidents.
  • FOMC Meetings occur in Washington, D.C. every 4 to 5 weeks to assess the economy’s performance and adjust monetary policy as deemed necessary.

Monetary Tools

  • The Fed exercises control over the money supply through four primary policy tools:
    • Reserve Requirements.
    • Interest Rate on Bank Reserve Balances.
    • Discount Rates.
    • Open Market Operations.
Reserve Requirements
  • Private banks must maintain a specific fraction of their deposits as reserves.
    • Required Reserves: The minimum amount a bank is required to hold.
  • Adjusting the reserve requirements allows the Fed to directly influence the lending capacity of the banking system.
Example: Computing Excess Reserves
  • Calculations:
    • Total deposits held by banks: 100extbillion100 ext{ billion}
    • Total reserves: 30extbillion30 ext{ billion}
    • Minimum reserve requirement: 20 ext{%}
    • Required reserves:
      extRequiredreserves=extRequiredreserveratioimesextTotaldepositsext{Required reserves} = ext{Required reserve ratio} imes ext{Total deposits}
      =0.20imes100extbillion=20extbillion= 0.20 imes 100 ext{ billion} = 20 ext{ billion}
    • Excess reserves:
      extExcessreserves=extTotalreserves−extRequiredreserves=30extbillion−20extbillion=10extbillionext{Excess reserves} = ext{Total reserves} - ext{Required reserves} = 30 ext{ billion} - 20 ext{ billion} = 10 ext{ billion}
Lending Capacity
  • Concept: The presence of excess reserves indicates that banks are not fully using their potential lending capacity.
  • Formula for Additional Loans:
    • extAvailablelendingcapacity=extExcessreservesimesextMoneymultiplierext{Available lending capacity} = ext{Excess reserves} imes ext{Money multiplier}
    • For a required reserve ratio of 0.200.20, the money multiplier is:
      extMoneymultiplier=10.20=5ext{Money multiplier} = \frac{1}{0.20} = 5.
    • Thus, extAvailablelendingcapacity=10extbillionimes5=50extbillionext{Available lending capacity} = 10 ext{ billion} imes 5 = 50 ext{ billion}.
Impact of Increased Reserve Requirement
  • An increase in the required reserve ratio results in:
    • A decrease in excess reserves.
    • A decrease in the money multiplier.
    • A decrease in the lending capacity of the banking system.

World View: China Cuts Reserve Requirements

  • In response to economic growth slowdown due to zero-Covid policies, China reduced the reserve requirement to 7.8 ext{%}, thereby releasing roughly 70extbillion70 ext{ billion} in reserves.
  • Analysis: Lowering the reserve requirement transforms required reserves into excess reserves and heightens the money multiplier, thus aiming to boost lending and stimulate economic growth.

Interest on Bank Reserve Balances (IORB)

  • Definition: IORB is the interest rate paid by the Federal Reserve on reserve balances held by private banks.
  • Incentives:
    • Increasing IORB encourages more bank lending.
    • Decreasing IORB slows down the pace of lending.
Changes in IORB
  • In 2022, multiple increases in IORB aimed at providing banks with stronger reasons to retain reserves at the Fed rather than loaning them to market participants.

Managing Reserves

  • Profit-maximizing banks prefer to maintain low excess reserves while avoiding falling below required reserves.
  • Banks can manage reserves through three avenues:
    • The Federal Funds Market.
    • Sale of securities.
    • Discounting (borrowing from the Federal Reserve).
The Federal Funds Rate
  • Concept: A reserve-poor bank may borrow reserves from a reserve-rich bank in what is known as the federal funds market.
  • The federal funds rate is the interest rate charged for these interbank reserve loans.
Sale of Securities
  • Banks often buy government bonds with their excess reserves.
  • If reserves are needed to satisfy federal regulations, banks can sell these securities and deposit the proceeds, thereby enhancing their reserve positions.
Discounting
  • Banks experiencing shortages may borrow from the Federal Reserve's discount window.
  • Discount Rate: The interest rate the Fed charges banks for borrowing reserves.
  • The Fed's adjustments to the discount rate alters the cost of borrowing for banks, which in turn affects their incentive to manage reserves.

Excess Reserves and Borrowings (1930-2020)

  • Historical data highlight banks' tendency to keep excess reserves minimal and their need to borrow, either from other banks or the Fed, when short of required reserves.
No Required Reserves
  • In 2020, the Fed reduced the required reserve ratio to zero, effectively eliminating required reserves and the associated risk of falling below them.
  • Nonetheless, the discount rate remains a tool for influencing bank lending.

Open Market Operations

  • Definition: Open market operations involve buying and selling government bonds to directly impact the banking system's reserves.
  • Significance: Crucial for private banks and the overall economy; these operations inform the distribution of idle funds.
Portfolio Decisions
  • Investors do not hold all idle funds in cash; capital may be allocated to:
    • Stocks, savings accounts, bonds, etc.
  • The decision on where to allocate these funds is known as the portfolio decision.
Hold Money or Bonds
  • Open market operations target an individual’s choice between keeping idle funds in cash or using them to invest in government bonds.
  • The Fed aims to influence these choices by altering the attractiveness of bonds, which in turn affects bank lending capacity through varying reserves.
Bond Market
  • Definition: A bond is a financial instrument (certificate) acknowledging debt repayment along with interest payments slated for specific periods.
  • Bonds are actively traded in the bond market and represent IOUs typically issued by corporations or government entities.
Bond Yields
  • Interest on bonds incentivizes purchase; for example, an 8% bond from GM worth $1,000 pays $80 annually until maturity (2035).
  • The yield on a bond fluctuates depending on its purchase price relative to the interest promised:
    • extYield=extAnnualInterestextPricePaidforBondext{Yield} = \frac{ ext{Annual Interest}}{ ext{Price Paid for Bond}}
  • Example Calculation:
    • Purchase Price of $1000, Yield = rac{80}{1000} = 0.08 ext{ or } 8 ext{%}.
    • Purchase Price of $900, Yield = rac{80}{900} = 0.089 ext{ or } 8.9 ext{%}.

Open Market Activity

  • Activities involve the Fed's purchases and sales of government bonds to modify bank reserves.
  • Bond market responses are closely tied to shifts in bond prices and yield, with greater liquidity affecting demand and supply.
Open Market Purchases
  • To enhance money supply, the Fed attempts to encourage more funds to flow into banking systems by convincing individuals to deposit larger shares in banks instead of holding them in bonds.
  • By increasing bond prices, the Fed reduces bond yields, thereby promoting selling of bonds in exchange for deposits in banks.
Quantitative Easing (QE)
  • A distinctive approach, QE was pursued aggressively between 2009-2011; this strategy expanded the bank's asset purchases through longer-term bonds and non-conventional securities.
Quantitative Tightening (QT)
  • The Fed can also reduce liquidity by selling bonds, effectively raising the bond yields.
  • When the Fed sells bonds, bank reserves diminish immediately as deposited checks are returned to their originating accounts.

The Fed Funds Rate

  • The federal funds rate serves as an important economic indicator signifying the cost of overnight reserve trades between banks.
  • An increase in bank reserves due to Fed purchases lowers this rate, while selling bonds raises it.
The Target Rate
  • The Fed establishes target rates, adjusting its open market operations accordingly to reach desired monetary conditions, such as controlling inflation or stimulating growth.

Volume of Activity

  • The trading volume in U.S. bond markets exceeds $1 trillion daily, highlighting the significant influence of the Fed’s actions on the economy.
  • As of the start of 2023, the Fed owned above $9 trillion in government securities.

Increasing the Money Supply

  • The Fed can increase the money supply through various approaches:
    • Lowering reserve requirements.
    • Reducing IORB.
    • Lowering discount rates.
    • Engaging in bond purchases.
Lowering Reserve Requirements
  • To increase money supply from $340 billion to $400 billion, reserve requirement adjustments are necessary.
  • To support $300 billion in deposits, reserve requirements must decrease accordingly.
  • Example Calculation: When lowered to 20% from a higher threshold, required reserves for deposits reduce accordingly, triggering a shift in excess reserves and lending capacity.

Reducing IORB and Lowering the Discount Rate

  • By lowering interest rates paid on reserves and discount rates, banks can be incentivized to extend more loans, thereby enhancing market liquidity.

Buying Bonds

  • To achieve a targeted increase in money supply, strategic bond purchases can yield significant immediate and multiplier effects in lending capacities and bank reserves.

Decreasing the Money Supply

  • To mitigate the money supply, the Fed can:
    • Raise reserve requirements.
    • Increase IORB.
    • Augment discount rates.
    • Sell bonds.

Policy Decisions: Can We Crowdfund the Future?

  • Crowdfunding is emerging as a method for financing through individual contributions, circumventing traditional banking systems.
  • It offers an alternative that may weaken the link between the money supply and aggregate demand, reducing the significance of bank reserves as an indicator of lending capacity.