Chapter 15: The Federal Reserve System and Aggregate Demand Notes

What Is Money?

• Definition: Money is a widely accepted means of payment.

• Types of Money:

  • Currency: Coins and paper bills that can facilitate small transactions but are less useful for larger transactions.

  • Transfers:

  • Businesses often transfer money between banks through electronic wires.

  • Consumers may use debit cards or transfer services like Venmo.

• Bank Accounts at the Federal Reserve:

  • Major banks hold accounts at the Fed, allowing them to manage transfers between banks.

  • These accounts are referred to as total reserves, crucial for the financial system.

• Money Creation:

  • The Fed has the power to create money by adding reserves to banks' accounts, impacting aggregate demand.

• Key Means of Payment in the U.S.:

  • Currency: Physical money (paper bills & coins).

  • Total Reserves at the Fed: Funds held by banks.

  • Liquid Deposits: Checking and savings accounts.

  • Money Market Mutual Funds and Small Time Deposits.

• Liquid Assets: An asset that can be used for payments or converted into a payable asset quickly without significant loss of value.

• Definitions of Money Supply:

  • MB (Monetary Base): Currency + Total Reserves at the Fed.

  • M1: Currency + Demand Deposits + Other Liquid Deposits.

  • M2: M1 + Money Market Mutual Funds + Small Time Deposits.

What Is the Federal Reserve System?

• The Fed, or the Federal Reserve, is the central bank of the U.S.

  • Role as Bankers' Bank:

  • Regulates banks, lends money to them.

  • Manages the payment system and implements consumer protection through regulations.

  • Role as Government's Bank:

  • Maintains the U.S. Treasury account.

  • Manages government borrowing (Treasury bonds, bills, and notes).

How Does the Federal Reserve Influence Aggregate Demand?

• Primary Tools:

  • Interest on Reserves: Affects banks' willingness to lend.

  • Open Market Operations: Buying/selling government securities to influence the money supply.

  • Repurchase Agreements (Repos): Provides liquidity to banks.

  • Quantitative Easing: Used during economic downturns when rates are near zero.

  • Acting as Lender of Last Resort: Provides liquidity during financial panic.

Payment of Interest on Reserves:

• Banks hold significant reserves at the Fed ($2-$4 trillion).

• Cost vs. Benefit:

  • Cost: Funds could be used to earn interest via lending.

  • Benefit: Interest earned on reserves.

• Interest Rate Impact:

  • If the Fed raises rates on reserves, banks lend less, reducing aggregate demand.

  • If rates are lowered, banks lend more, increasing aggregate demand.

Open Market Operations:

• Process of buying/selling bonds to alter monetary base and interest rates.

  • Buying Bonds: Increases demand, lowers interest rates, stimulates economy.

  • Selling Bonds: Decreases demand, raises interest rates, contracts economy.

Repos:

• A repo is a short-term loan from the Fed to banks, boosting liquidity.

• Reverse Repos: The opposite transaction where the Fed borrows reserves.

Quantitative Easing:

• Implemented during economic crises (e.g., 2008, 2020) to lower long-term interest rates by buying government securities.

Limits to the Federal Reserve's Powers

• Limitations arise from banks' responses to interest rate changes:

  • Predictions on how rate changes affect spending, borrowing, and lending are crucial.

  • The Fed must gauge whether changes will prompt businesses and consumers to invest or simply hold cash as a precaution.

• Medium-term Impact: The Fed influences real rates primarily in the short run; long-term effects are neutral.

Who Controls the Fed?

• Governance:

  • 7-member Board of Governors, each appointed by the president for 14-year terms.

  • Chairperson appointed from the Board for a 4-year term.

• Independence: The Fed operates independently of direct government control, with power dispersed across regions and sectors.

Takeaway

• The Federal Reserve is integral in managing the U.S. economy, influencing aggregate demand and money supply through various tools.

• Its independence and diverse governance structure play a significant role in its operations.

Money is a widely accepted payment method consisting of various forms like currency, electronic transfers, and reserves in bank accounts at the Federal Reserve. The Federal Reserve can create money, influencing aggregate demand via its tools such as interest on reserves, open market operations, repos, and quantitative easing. Money supply definitions include MB (Monetary Base), M1, and M2. The Federal Reserve, as the U.S. central bank, regulates banks, manages government accounts, and acts as a last-resort lender, while facing limitations based on banks' responses to interest rates. Its governance includes a Board of Governors, and it operates independently from the government, crucially impacting the U.S. economy.

• Definition: Money is a widely accepted means of payment that facilitates transactions between parties.

• Types of Money:

  • Currency: This includes coins and paper bills that are primarily used for smaller transactions. While convenient, currency becomes less practical for larger purchases.

  • Transfers:

  • Businesses commonly transfer money digitally between banks using electronic wires, ensuring swift transactions.

  • Consumers utilize debit cards or transfer services, such as Venmo, for convenience in making payments.

• Bank Accounts at the Federal Reserve:

  • Major banks maintain accounts at the Federal Reserve (the Fed), enabling them to efficiently manage transactions among themselves.

  • These accounts are referred to as total reserves, which are crucial for liquidity and stability in the financial system.

• Money Creation:

  • The Federal Reserve possesses the authority to create money, primarily by adding reserves to banks' accounts. This action influences the overall aggregate demand in the economy.

• Key Means of Payment in the U.S.:

  • Currency: Physical forms of money, specifically paper bills and coins, used for everyday transactions.

  • Total Reserves at the Fed: These represent the funds held by banks at the Federal Reserve, which influences their ability to lend money.

  • Liquid Deposits: Includes checking accounts and savings accounts, which can be accessed easily for payments.

  • Money Market Mutual Funds and Small Time Deposits: Financial instruments that individuals can use to save or invest while having relatively high liquidity.

• Liquid Assets:

  • Any asset that can readily be converted into a cash-like asset, allowing it to be used for immediate payments without a significant loss in value.

• Definitions of Money Supply:

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

  • M1: Includes the monetary base and encompasses currency, demand deposits (checking accounts), and other forms of liquid deposits.

  • M2: A broader measure that includes M1 along with money market mutual funds and small time deposits to capture a wider array of liquid assets.

Reserves refer to the amount of money that banks are required to hold against deposits made by their customers. It ensures that banks have sufficient funds available to meet withdrawal demands and maintain stability in the financial system. Reserves can be held in two forms:

• Required Reserves: This is the minimum amount of reserves that a bank must hold as mandated by the central bank (e.g., the Federal Reserve in the U.S.). This requirement helps to manage liquidity and reduce the risk of bank failures.

• Excess Reserves: These are reserves that banks hold in excess of the required minimum. Banks may choose to keep excess reserves for added security, to manage uncertainties, or to prepare for unexpected demands from customers.

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. It involves the central bank purchasing government securities and other financial assets from the market to inject liquidity directly into the economy. This action is intended to lower long-term interest rates, encourage lending, support asset prices, and increase overall economic activity. Quantitative easing was notably implemented during the economic crises of 2008 and 2020 to help stabilize the economy and promote recovery.

The Federal Reserve influences aggregate demand using various monetary policy tools, which include:

• 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 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. For example, if a bank has a reserve ratio of 10%, it must keep $10 in reserves for every $100 deposited, meaning it can lend out $90. The reserve ratio is an important tool in monetary policy, affecting how much money banks can create through lending.