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Lecture 10

Lecture 10 Spring 2014.pdf

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Department
Economics
Course
ECON 1132
Professor
Andrew Petersen
Semester
Spring

Description
Ec. 132 Harold Petersen Principles of Economics-Macro February 20, 2014 Lecture 10: Central Banking: How the Fed Conducts Monetary Policy We noted last time that the Federal Reserve System was established in 1913 and that its first responsibility was to be a lender of last resort. We will come back to how the Fed has filled this role in the current financial collapse. But first I want to look at how the Fed functions on an ongoing basis, serving as a stabilizer of the economy. If you have a dollar bill, take one out and look at it. Look at the side with Washington’s picture on it. What does it say? It says “Federal Reserve Note.” And in small print it says “This note is legal tender for all debts public and private?” Meaning what? That if you owe someone money, the person has to accept these as payment of the debt. Now look at the letter to the left of Washington and the small print beneath it? What letter do you have? B. And what does it say beneath? New York. A is Boston. E is Richmond, F is Atlanta, L is San Francisco. Others are for Cleveland and Dallas and Chicago and Minneapolis and St. Louis. The Fed was initially established as a system of 12 regional banks--the U.S. had a great distrust of centralized authority, most particularly a fear that the Eastern moneyed interests would control money and credit for their own benefit. Thus we established 12 regional banks, one in Boston, one in New York and in Atlanta and St. Louis and Dallas and San Francisco and Kansas City and Chicago and Minneapolis, and so on. As the system has developed, it operates essentially as a single central bank, with control lodged in the Board of Governors and in the Open Market Committee. The Board of Governors is a group of 7 people, appointed by the President of the U.S. to fourteen-year terms, with one expiring every two years, whose chairman is appointed by the President to a four-year term. The long terms were intended to give the Fed independence from undue political influence. In fact, many of the governors resign before their 14-year terms are up, and thus a President typically has three or four appointments in a four-year period. There are currently two vacancies on the Board due to resignations and President Obama has appointed all five current members, including Janet Yellen, who was recently named to succeed Ben Bernanke as chair. The appointees to the Board are subject to confirmation by the U.S. Senate, and political differences can impede the filling of open spots. Under the Board of Governors we have the 12 Regional Banks, each with its own President and other officers, and we have committees of the Board. 2 Board of Governors Regional Banks Committees of the Board The most important committee of the Fed is the Open -Market Committee , consisting of 12 persons--the seven Governors and five of the regional bank presidents, always including the President of the New York Fed, and others of the 12 who rotate on and off the committee. The open market committee meets periodically (about every six weeks), reviews economic conditions, and then decides whether to ease money and credit, tighten money and credit, or to maintain a steady course. Suppose we are entering a recession--an average type recession of the kind we have had over the past 60 years. What would the Fed do? Ease money and credit. How would it do this? By buying U.S. government securities on the open market; i.e., through established dealers centered in New York City. We can best understand this by looking at balance sheets of commercial banks, the public, and the Fed. We will just list the major items. ___Comm. Banks___ ______The Fed______ ____The Public______ Res. 20 D.Dep. 200 Securities 110 FR Notes 100 Curr. 100 Loans 180 L & I 180 Owed to Fed 3 Loans to CBs 3 C.Bk. Res20 ChkDep 200 Other 20 Net Worth 17 Other 17 Gov Dep 10 Gov Sec 600 220 220 130 130 Other Think of all of the above as being in millions of dollars. (In fact it is in billions.) Commercial Banks receive demand deposits (checking accounts) and make loans, holding 10% on reserve. Note how many of the items are assets of one group and liabilities of another. Reserves are an asset of the commercial banks but for the most part are held at the Fed. Thus the Commercial bank asset of 20 in reserves is a liability at the Fed. The Commercial Banks’ asset of Loans and Investments of 180 is a liability of the public. (This is what the households and business firms have borrowed from banks and thus owe the banks.) The demand deposits of 200 are a liability of the banks (they owe it to depositors) and are an asset of the households and business firms. Banks might occasionally borrow from the Fed, and thus we might have a liability called “Owed to Fed,” which is an asset of the Fed and a liability of the commercial banks. The major asset of the Fed is securities (primarily government securities) and the major liability is Federal Reserve Notes (or currency).This is a strange sort of liability in that it is not really owed to anyonIt is money that has been printed and issued in exchange for assets such as securities. The Federal Reserve Notes are listed as a liability on the balance sheet of the Fed and they are an asset of the public (listed above as currency). The Fed balance sheet also shows Gov. Deposits, which is a checking account at the Fed for the U.S. Treasury. Many checks from the U.S. Treasury are checks drawn against their 3 deposit at the Fed. The Public holds Currency (the FR Notes, Checking acct. deposits, Gov. Securities, and other assets (including real estate, stocks, bonds, antiques, etc.) and they owe money to banks and possibly to others as well (the debt to others is not shown here). Now suppose the Fed wishes to shift the AD curve to the right. It will ease money so as to push down interest rates and encourage borrowing. The Fed has three major weapons by which to do so, the most important of which is open market operations. The Fed will buy government securities from the public on the open market; i.e. through government securities dealers in New York City, from anyone who wants to sell them. If need be it will bid up the price to induce people to sell. Let's suppose the Fed buys 10 million of Gov. Sec. from the G.E. pension fund. Imagine first that the Fed pays for them with a check, but it fact it is all a single electronic entry. The Fed sends a check to GE and GE puts the check in its commercial bank. GE notes its Gov. Sec. are down by 10 and its checking account deposit is up by 10. The Comm. Bank notes its deposits are up by 10 and its reserves are up by 10. The Comm. Bank sends the check back to the Fed for deposit in its account at the Fed. the Fed notes that commercial bank reserve deposits are up by 10. ___Comm. Banks____ ______The Fed________ _____The Public_____ Reserves. +10 D.Dep +10 Gov Sec +10 C.Bk.Res.Dep +10 Gov.Sec. -10 Chk.Dep. +10 Now recognize that the Fed does not in fact send a check. Rather there is a single electronic entry that notes all of these entries. This is all step one. The Fed has bought government securities and in so doing has increased reserves and deposits in the banking system, dollar for dollar. But now the banks have excess reserves. They can increase their lending. By how much? By some multiple of their excess reserves. Let's focus on excess reserves. The banks now have reserves of 30. (They started with 20 and have gained 10.) And how much do they need to have in reserves? They need 10% of demand deposits. These started at 200 and have gone up by 10 to 210. ___Comm. Banks___ Res 30 D.Dep 210 Loans 180 Thus required reserves are 10% of 210, or 21. Since banks have reserves of 30 and are required to have 21, they have excess reserves of 9. We have a money supply multiplier of 10 (1/RR = 1/.10 = 10.) Thus the potential loan expansion is 10 times the excess reserves, or in this case 10 times 9 or 90. 4 Reser
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