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
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.
Res 30 D.Dep 210
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