.Notes on the FED, Credit Expansion, and Monetary Policy (ECON 272)
The Federal Reserve (FED) is the central bank of the United States. (Created by act of Congress in 1913)
Federal Reserve System:
Created to be a Lender of Last Resort:
Now - Monetary Policy:
Federal Reserve Board of Governors : (7 members appointed by the president, with the consent of the U.S. Senate). Establish national monetary policy.
The Chairman of the Board of Governors - List
Who is the Chairman now?
Federal Advisory Council : (12 commercial bankers for 12 districts). Gives advice to the Board of Governors. Role is very limited.
Federal
Open Market Committee (FOMC). The FOMC
holds eight regularly scheduled meetings per year.
(Board of Governors plus 5 Federal Reserve bank presidents (alternating terms,
NY always represented) Directs open market operations.
12
Federal Reserve banks -http://www.federalreserveonline.org/
25 Federal Reserve branch banks
Commercial banks and other depository institutions
How does the system work?
The FED is a fractional reserve banking system:
Cash Reserves:
Kept where?
1.
2.
Required Reserve Ratio:
Required Reserves:
Excess Reserves:
Let's first look at a single bank:
How A Single Bank Creates Loans in a Fractional Reserve Banking System
When Bob deposits money (say $100.00) into Bob's checking or savings account, your bank does not hold all of that money. It will keep what is required by the FED (and sometimes more) and lend out (or invest generally) the balance. Therefore, Bob's checking account has $100.00 in it (which he can spend at any time) and when the excess reserves from his deposit are lent out -- someone else's account is simply credited with the amount of the loan (say $90.00 if the required reserve ratio is 10%) which they (let's say Betty) can now spend at any time. Just with that initial deposit of $100.00, your bank has potentially created $90.00 worth of "new money" by lending out its excess reserves.
The ability of a single bank to lend and create new checkable deposits (thereby potentially increasing the money supply) is strictly limited by the amount of excess reserves it has. Why? This is because the deposits created can be "checked away" to other banks.
Why potentially increase the money supply? Because it depends upon where the initial $100 came from. If Bob's deposit of $100 was taken out of another account (let's say of a different bank but it can be from the same bank), then that bank's excess reserves falls by
$90.00 (in our example). This means that this bank must decrease it's loans by $90.00. So the overall money supply has not changed.
However, if the initial $100 deposit came from "new money" created by the FED, for example, then there is no off-setting decrease in deposits elsewhere -- and therefore this is an increase in the money supply of $90.00 with the initial 100.00 deposit (assuming a 10% required reserve ratio).
Now let's look at the system as a whole (and not just a single bank):
Credit Expansion in the
Federal Reserve Banking System as Whole
Once the initial deposit is made ($100.00) and the initial loan is made ($90.00 of excess reserves) - then the question is, what happens to the $90.00 loan?
Let's assume that banks hold zero excess reserves and that the public deposits all cash into the banking system.
Actually, neither of these assumptions are usually true. Banks will hold excess reserves when they need to be more "liquid" (to meet the public's demand for cash) and/or when interest rates are lower and therefore the opportunity cost of holding more reserves is lower. The public does not deposit all cash into the banking system.
Then what happens: The $90.00 is spent and re-deposited into a bank. That bank then must keep the required reserves (say $9.00 if the required reserve ratio is 10%) and can lend out $81.00. This then becomes another deposit and so forth.
We could add up all of the new loans made to determine the overall potential increase in the money supply but we don't have to. There is a formula that tells us this:
But Wait!! Again - When/How Does This Process Actually Increase the Money Supply?
But remember, we have to be careful here. Because, the initial deposit made in our process here had to come from somewhere. That is it had to come from existing money. So therefore -- the new deposit in say, First National Bank was a withdrawal from Deb's bank. So that bank's excess reserves will decline, reversing the process. There is no new money actually created with this system.
AGAIN HOWEVER: if the new deposit is NEW money coming from the FED, for example, then this process can increase the money supply. So what the FED will do is create new money -- put this new money into the excess reserves of banks (and we will see how) -- and as this process takes place -- actually increasing the money supply in the economy.
So let's talk about how the FED actually does this. But first:
Monetary Policy - How It Happens
Ways
the Fed Attempts to Manipulates Reserves (and therefore loans -- and therefore credit
expansion -- and therefore the money supply)
Obviously the money supply can be increased by the government by printing more currency and putting it into circulation (through the Treasury, for example). The Treasury prints more money and it gets into the economy through G (government spending). You don't hear about this in the news but that doesn't mean it isn't being done.
However, the FED mostly manipulates the money supply via credit controls. This is what you hear about in the news most often.
Traditionally (before 2008) - the Fed used three main monetary policy tools (sometimes called credit controls) to change the money supply. Since 2008 the Fed has added new ways - we will look at these later.
The three major credit controls (ways the Fed attempts to change the money supply) are:
1. Open market operations and manipulation of the federal funds rate
2. Changes in the discount rate
3. Alterations in the reserve requirements
1. Open market operations and manipulation of the federal funds rate:
Remember - the price of a bond and its return (interest rate or yield) are inversely related. Simple example:
Generally speaking - when the Fed increases the demand for government (and other now) debt, this increases the price of bonds and decreases their return (inversely related). Therefore, people move into stocks and corporate bonds -- increasing their prices and decreasing their returns (or interest rates). All in the hopes of increasing liquidity in the system.
Federal funds rate:
2. Discount Window (rate):
http://www.frbdiscountwindow.org/discountwindowbook.cfm?hdrID=14&dtlID=43
3. Required Reserve Ratio/Exemptions from Reserve Requirements:
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
However, since 2008 the FED has added to its list of "tools" in its attempt to manipulate the economy (To save time - read this out of class on your own).
The actions of the FED since 2008 have been known as quantitative easing (basically increasing the money supply). So let's look specifically at what they have done and what that means.
First some humor:
http://www.wealthwire.com/news/economy/2909
What the FED has done is designed to improve market liquidity (since financial institutions were not lending like the FED wanted them to). Although these changes were made incrementally in response to changing market conditions, they share the common objectives of supposedly reducing risks to financial stability and strengthening the "effectiveness" of monetary policy.
So specific examples include, since 2008, the Fed has:
1. lent directly to non-bank corporations (such as AIG - American International Group, an insurance firm)
2. began purchasing obligations (debt) of government sponsored mortgage market firms Fannie Mae and Freddie Mac
3. exchanged "risk-free" federal bonds for high risk private bonds that commercial banks held.
AND: The Fed began picking and choosing who would get dollars and who would not -- not just financial institutions, but corporations, etc. This is why some people are calling for an audit of the Fed -- there needs to be transparency.
So basically there are three things that this is supposed to accomplish:
1. The banks have fewer "bad debt" on their books and therefore their portfolios look a lot better - making them more likely to loan, invest again thereby increasing spending in the economy.
2. The banks have a whole lot more money (new money created out of thin air) which can (supposedly) be loaned, invested, etc. thereby increasing spending in the economy.
3. Interest rates are lower -- leading to more people taking out loans -- thereby again, increasing spending in the economy.
All of this spending is supposed to bring down unemployment.
Also important, in 2008 the FED began paying interest on reserves held by commercial banks (both required and excess). This was designed to help them manipulate the federal funds rate.
Here is the rationale from the FED:
"Paying interest on excess balances
should help to establish a lower bound on the federal funds rate."
From time to time the FED was
unable to keep the federal funds rate from falling to very low levels.
With the payment of interest on excess balances, financial institutions will
have little incentive for arranging federal funds transactions at rates below
the rate paid on excess. By helping set a floor on market rates in this way,
payment of interest on excess balances will enhance the FED's ability to keep
the federal funds rate around the target rate.
In other words, if a financial institution has say, excess reserves, which it could lend in the federal funds market for say 1%, but the FED is paying above 1% on those reserves, why would the financial institution loan it out? Without the interest, the excess supply of funds could be loaned out -- in some cases (due to the excess supply vs. demand for the funds) at very low rates. Basically the FED is trying to stop this market from trading at these low levels.
From the FED: "The interest rate on required reserves (IORR rate) is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. The interest rate on excess reserves (IOER rate) is also determined by the Board and gives the Federal Reserve an additional tool for the conduct of monetary policy."
http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
Monetary Policy - Problems
Remember the whole point behind monetary policy - increase spending (C + I) in order to bring down unemployment (the Phillip's Curve theory). Keep this mind.
One important question is: how much control does the FED really have in a very dynamic economy? After all, there are a lot of problems with the FED trying to manipulate the economy successfully - especially since those running the FED do not have perfect information (to say the least):
a. There are lags:
(many argue it takes 14 months for monetary policy to have an effect - good or bad). This is why some argue the FED has been pro-cyclical (creating business cycles) instead of countercyclical. This is because when the effect of the policy takes place, the economy has changed. So the "stimulus" is not necessary when it takes place and actually creates a pronounced business cycle.
b. Ultimately, the FED cannot control what banks do with the new excess reserves it creates - will the banks loan or invest it? or what the people do - will they borrow it? So even if the FED increases the money supply, for example - the new money might simply sit in the bank's reserves and not get "spent" as intended by the FED.
For example - get ready to be shocked
.
The FED paying interest on these reserves is one reason for the excess reserves being held in banks today - but probably mostly this is due to regulatory uncertainty!!
c. Related to this is the Keynesian idea of a "Liquidity Trap"-
Thus far we have only discussed the transactions demand for money (we demand money in order to buy stuff). But Keynes said there are more reasons to demand (and hold) money.
Keynes' different reasons for demanding money:
1.
2.
3.
Because of #3, according
to Keynes, monetary policy (change in the MS) is not effective
during a recession/depression due to “liquidity preference” or the liquidity trap
Basically, the speculative demand for money will be high -- therefore, if the FED increased the money supply, people would hold the money and not spend it. Therefore, the policy would not be effective (as per a Keynesian - meaning that demand would not increase).
Let's see when this will happen (two reasons):
The Speculative Demand for money is a function of the interest rate because the interest rate is the opportunity cost of holding money. If you hold cash instead of an interest-bearing bond, for example, you are foregoing the interest.
An increase in the interest rate raises the cost of holding money and therefore decreases the speculative demand for money and vice versa.
1. So when interest rates are low people will hold money because their opportunity cost is low.
2. But also: remember that the price of a bond and it's yield or interest rate are inversely related.
So when interest rates are low, people are speculating that bond prices will fall when
interest rates go up (which is the only thing they can do since they are so low
now) – so they don’t want to be holding bonds, they want to
be holding money.
So
if the money supply is increased by the FED, people simply hold the money (this
is the liquidity trap) –
and aggregate demand does not increase.
Therefore Keynes wanted to use:
Fiscal Policy (change in G and/or T) during times of low interest rates. However, Keynesians will use both fiscal and monetary policy when "stimulus" is needed (as according to their theory). We will go into the Keynesian fiscal policy model later.
d. The FED can cause short term interest rates to move -- but does not have control over the long term productivity of the economy. Although, what the FED does in the short run could either hinder or help long term growth -- as unintended consequences of what they do.
e. The FED creates distortions in the economy. Many economist's argue that the FED has played a major role in the economic downturns that have taken place in the economy (including the Great Depression and the Great Recession - i.e., helped create the "housing bubble"). So does the FED do more harm than good? After all, those running the FED do not have perfect knowledge about the economy - nor do those who are making decisions within the economy. So therefore, when interest rates and prices are "distorted" by the FED, decisions that depend upon these market signals are also distorted. This leads to malinvestment as we have discussed.
So it is not that monetary policy is not effective - it actually creates problems in the economy.