The Federal Reserve System Outline What is the Federal Reserve System The U S Money Supplies Fractional Reserve Banking the Reserve Ratio and the Money Multiplier How the Fed Controls the Money Supply The Federal Reserve and Systemic Risk Revisiting Aggregate Demand and Monetary Policy Who Controls the Fed Why was the Fed created 1907 there was a crisis Bank runs Government had no appropriate response Only one man could save them JP Morgan Asked the big bankers to donate 25 million to make sure the US didn t collapse Roughly 180 million in today s money Having one man bail out everyone Clearly a bad idea Sen Nelson Aldrich decided the US needed a central bank Got a group of New York bankers on a train Woodrow Wilson signed into law the creation of the Fed December 23rd 1913 Brief Aside Minneapolis Fed Minneapolis has a Federal Reserve Bank Long history of important research both at the U and the Fed Nobel Laureates Prescott Sargent Sims Many current professors also do research there Introduction 2008 The worldwide financial system was in a crisis and banks and other financial institutions wanted to borrow more than 2 trillion The only person in the world capable of lending that kind of money at the time Ben Bernanke then the Chairman of the Federal Reserve System Current Chairwoman Janet Yellen Why was the Fed able to do this What is the Federal Reserve System The Central Bank of the United States Acquires its unique powers through its ability to issue and create money Take a bill out of your wallet or purse and see what it says at the top The Fed doesn t have to literally print money it can create money by computer What is the Federal Reserve System A Bank with two Customers The government s bank It maintains the bank account of the U S Treasury It manages government borrowing Issuing transferring and redeeming of U S Treasury bonds bill and notes What is the Federal Reserve System It is the banker s bank Large private banks keep their own accounts at the Fed Banks can borrow from the Fed What is the Federal Reserve System The Fed Also Regulates other banks Manages the nation s payment system Protects financial consumers with disclosure regulations Most important Function Regulating the U S money supply The U S Money Supply Money a widely accepted means of payment Most important assets that serve as means of payment in the U S today Currency Paper bills and coins Total reserves held by banks at the Fed Checkable deposits your checking or debit account Savings deposits money market mutual funds and small time deposits The U S Money Supply The U S Money Supply Currency Coins and paper bills Some of it is cash on hand as well as in cash registers and ATMs Drug dealers hold a lot of cash A lot is held by people in other countries Panama Ecuador and El Salvador use the U S dollar as their official currency Dollars are held by others in unstable countries to protect their wealth The U S Money Supply Total Reserves Value of accounts banks have at the Federal Reserve System Used to trade with other banks Used for dealings with the Federal Reserve itself Not currency but electronic claims Part of the money supply because these claims can be easily converted into currency The U S Money Supply Checkable Deposits deposits you can write checks on or access with a debit card Savings deposits money market mutual funds small time deposits Not as liquid as the other means of payment Each can be used to pay for goods and services but this requires a little extra effort The U S Money Supply Liquid asset an asset that can be used for payments or quickly and without loss of value be converted into an asset that can be used for payments The money supply can be defined in different ways depending on exactly what kinds of liquid assets are included The U S Money Supply The three most important definitions of the money supply are The monetary base MB currency outstanding and total reserves at the Fed M1 currency outstanding and checkable deposits M2 M1 plus savings deposits money market mutual funds etc These definitions correspond to an inverted pyramid shown in the next figure The U S Money Supply The U S Money Supply Difficulty of Central Banking The Fed has direct control only over the monetary base But it is M1 and M2 that have the greatest impact on AD It tries to use its control over MB to influence M1 and M2 M1 and M2 can change independent of what the Fed does Aggregate demand can change for other reasons than changes in M1 and M2 Fractional Reserve Banking Fractional reserve banking banks hold only a fraction of deposits on reserve The amount of money created depends on The reserve ratio RR the fraction of deposits held on reserve RR is determined by how liquid banks wish to be The Fed sets a minimum RR Money multiplier MM the amount the money supply expands with each dollar increase in reserves Example of FRB Jo finds 1000 under a mattress and deposits at her bank Assets Liabilities 200 Required 1000 Deposit 800 Excess Total 1000 1000 Example of FRB Mike needs a loan of 800 to repair his car Assets Liabilities 200 Required 1000 Deposit 800 loan Total 1000 1000 Example of FRB Mike pays this 800 to a garage to fix his car the garage deposit this into the same bank Mike took the loan from Assets Liabilities 200 Required Jo 160 Required Garage 1000 Jo 800 Loan Mike 800 Garage 640 Excess Total 1800 1800 Example of FRB Smith family takes 640 loan to paint their house and pay Jo to do it she deposits it into the bank Example of FRB Assets 200 Required Jo 160 Reuired Quick Repair Liabilities 1000 Jo 128 Required Jo 800 Loan Mike 800 Quick Repair 640 Loan Smith 640 Jo 512 Excess Total 2440 2440 How was the money supply changed Gone from 1000 to 2440 Kept going would be a much larger amount Expands because money can be lent out without it all being there in the bank Money Multiplier 1 MM RR DDeposits Change in Money Supply MM DDeposits RR Suppose RR 10 Deposits 1 000 1 000 Change in Money Supply 10 000 0 10 Fractional Reserve Banking Fed credits your banking account with an additional 1 000 Assume RR 10 for all banks Your bank loans out 900 90 of your increased deposit Sam borrows the 900 and deposits it in his bank Total M 1 900 1 000 900 Sam s bank loans out 810 90 of his increased deposit Total M 2 710 The rippling process continues until the total change in the money supply 10 000 How the Fed Controls the MS Three Major Tools Open market operations the buying and selling of U S government bonds
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