EC 111 1st Edition Lecture 13PREVIOUS LECTUREI. What is Money and why is it Important?II. The Three Functions of MoneyIII. The Two Kinds of MoneyIV. The Money SupplyV. Measures of the US Money SupplyVI. Where is All the Currency?VII. Central Banks and Monetary PolicyVIII. The Fed’s OrganizationIX. Federal Open Market CommitteeX. The Structure of the FedXI. Bank ReservesXII. Bank T-AccountsXIII. Banks and Money SupplyXIV. The Money MultiplierCURRENT LECTUREI. The Fed’s Three Tools of Monetary ControlII. The Federal Funds RateIII. Monetary Policy and the Federal Funds RateIV. Problems Controlling the Money SupplyV. Bank Runs and the Money SupplyVI. Financial Crisis of 2008-2009THE FED’S THREE TOOLS OF MONETARY CONTROL1. Open Market Operations (OMOs): the purchase and sale of US government bonds by the Feda. To increase the money supply, Fed buys government bonds, paying with new dollarsi. Which are deposited in banks, increasing reservesii. Which banks use to make loans, causing the money supply to expandb. To reduce money supply, Fed sells government bonds, taking dollars out of circulation, and the process works in reversec. The Federal Reserve makes money. It is a highly profitable government institution d. OMOs are easy to conduct and are the Fed’s monetary policy of choice2. Reserve Requirements (RR):a. Affects how much money banks can create by making loansb. To increase money supply, the Fed reduces RR. Banks have more loans from each dollar of reserves, decreasing the reserve ratio, increasing the money multiplier and the money supplyc. To reduce money supply, the Fed raises RR. Banks make fewer loans and in the process works in reverse. The reserve ratio increases and the money multiplier and money supply decreasesd. The Fed rarely uses RR to control money supply. Frequent changes to the RR would disrupt banking3. Discount Rate: the interest rate on loans the Fed makes to banksa. When banks are running low on reserves they may borrow reserves from the Fedb. To increase money supply, Fed can lower discount rate , which encourages banks to borrow more reserves from the Fedi. Banks can make more loans which increases supplyc. To reduce the money supply, Fed can raise discount rated. The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble e. The Fed rarely uses this method to control the money supplyf. If there is no crisis, Fed rarely uses discount lending-Fed is a “lender of last resort”THE FEDERAL FUNDS RATE- On any given day, banks with insufficient reserves can borrow from banks with excess reserves- Federal Funds Rate: the interest rate on these loans^- The FOMC and OMOs target the federal funds rate- Many interest rates are highly correlates, so changes in the federal funds rate causes changes in other rates and have a big impact on the economy MONETARY POLICY AND THE FEDERAL FUNDS RATE- To raise federal funds rate, the Fed sells government bonds (OMOs)- This removes reserves from the banking system and reduces the supply of federalfunds and causes rt to risePROBLEMS CONTROLLING THE MONEY SUPPLY- If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls- If banks hold more reserves than required, they make fewer loans , and the money multiplier, and the money multiplier and money supply falls- Yet, the Fed can compensate for household and bank behavior to retain fairly precise control over the money supplyFINANCIAL CRISIS OF 2008-2009- Bank capitalo Resources a bank’s owners have put into the institution o Used to generate profito Banks also include debt- Leverageo Use of borrowed money to supplement existing funds for the purpose of investment- Leverage Ratioo Ratio of assets to bank capital o (Reserves+Loans+Securities)/Capital- Capital Requirement o Government regulation specifying a minimum amount of bank capital o Depends on the type of asset a bank holds If assets are safe (like bonds) then the amount will be lower- Banks in 2008 and 2009o Shortage of capital After they had incurred losses on some of their assets- Mortgage loans- Securities backed by mortgaged loans- “Subprime Mortgage Crisis” (40% of mortgages in 2008/2009 were subprime)o Reduction of lending (credit crunch) Contributed to a severe downturn in economic activity- If you default on a mortgage, banks get the house- US Treasury an the Fedo Put billions of dollars of pubic funds into the banking system  To increase the amount of bank capital  Called TARPo It temporarily made the US taxpayer a part owner of many bankso Goal: to recapitalize the banking system Banking lending could return to a more normal level- Returned to normal level by late