116-1Monetary Policy and the Federal Reserve System,Part 116-2Agenda• Principles of Money Supply Creation• The Federal Reserve System• Monetary Policy Tools16-3Money Creation• Three groups affect the money supply:¾ The central bank conducts monetary policy.¾ Depository institutions (banks) accept deposits and make loans.¾ The public (people and firms) holds money as currency and coin and as bank deposits. 16-4Money Creation• A central bank can print money:¾ Central bank can print money to buy real assets from the public.• This is how money gets into circulation.• People accept money if they believe other people will accept it in exchange.• The government usually decrees that the paper money is legal tender.216-5Money Creation• A central bank can print money:¾ The central bank’s assets are the real assets it buys from the public.¾ The central bank’s liabilities are the money it issued to the public.• That money is called the monetary base, or high-powered money16-6Money creation• Required conditions for money creation:¾ The equivalence of cash and deposits.¾ The redeposit of loan proceeds.¾ The holding of (fractional) cash reserves.¾ The presence of willing borrowers.¾ The presence of willing lenders.16-7The monetary base• Definitions:¾ BASE = CU + RES, where• BASE = Monetary Base,• CU = Currency held by the non-bank public, and• RES = Reserves held by banks.¾ Required reserves.¾ Excess reserves.16-8The monetary base316-9Currency• Definitions (continued):¾ CU = cuDEP, where• DEP = deposits and• cu > 0 and is called the currency holding ratio.– Determined by the public.¾ Currency held is a proportion of deposits.16-10Bank reserves• Definitions (continued):¾ RES = resDEP + exDEP, where• DEP = deposits and•0 < res < 1 and is called the required reserve ratio.– The legal minimum, determined by the central bank.•0 < ex < 1 and is called the excess reserve ratio.– Above the legal minimum, determined by banks.¾ Reserves held are a fraction of deposits.16-11The monetary base and deposits• Relationships:¾ BASE = CU + RES¾ BASE = cuDEP + resDEP + exDEP¾ BASE = (cu + res + ex)DEP•or¾ DEP = BASE/(cu + res + ex)16-12The money supply• Definitions:¾ M = CU + DEP, where• M = Money supply¾ M1 = currency + checking deposits.¾ M2 = M1 + savings deposits.¾ M3 = M2 + institutional deposits (no longer published).416-13The money supply• Relationships (continued):¾ M = CU + DEP ¾ M = cuDEP + DEP¾ M = (1 + cu)DEP16-14The money supply and the monetary base• Relationships (continued):¾ If M = (1 + cu)DEPand DEP = BASE/(cu + res + ex), then:¾ M = (1 + cu)BASE/(cu + res + ex)¾ M = [ (1 + cu)/(cu + res + ex) ] * BASE16-15The money multiplier•The term:(1 + cu)/(cu + res + ex)is called the money multiplier.¾ If res + ex < 1, the money multiplier will be > 1. 16-16The money multiplier• Each unit of the monetary base allows(1 + cu)/(cu + res + ex)units of money to be created.¾ The monetary base is called high-powered moneybecause each unit of the base that is issued leads to the creation of more than one unit of money.516-17Monetary base, money multiplier, and money supply16-18Money creation• Peculiarities:¾ Gold discoveries.• and BASE.¾ Bank panics.• and cu.¾ Credit crunches.• and ex.16-19The Federal Reserve System• Created by an Act of Congress. ¾ on December 23, 1913.¾ The nation’s central bank.• Responsibilities:¾ Functions as the government’s bank.¾ Regulates and supervises banks and thrifts.¾ Acts as lender of last resort.¾ Implements monetary policy.16-20The Federal Reserve System• Consists of:¾ Board of Governors • In Washington, DC¾ 12 regional Federal Reserve Banks• Located throughout the country¾ Federal Open Market Committee (FOMC)616-21The Federal Reserve System• The Board of Governors:¾ 7 members with overlapping 14-year terms.• Appointed by the President.• Confirmed by the Senate.¾ Chairman and Vice Chairman with 4-year terms.• Designated by the President.• Confirmed by the Senate.16-22The Federal Reserve System• Regional Bank Presidents:¾ Appointed by regional Federal Reserve Bank’s Board of Directors.• Renewable 5-year terms.¾ Approved by the Board of Governors.16-23The Federal Reserve System16-24The Federal Reserve System• Independent within the Government.¾ Independent:• Appointment of Governors.• Appointment of Bank Presidents.• Financed from its own resources.¾ Surplus turned over to Treasury.¾ Within the government:• Ultimately responsible to Congress.716-25Federal Open Market Committee• Created by an Act of Congress.¾ On March 1, 1936.¾ Primary monetary policy decision-making body.16-26Federal Open Market Committee• Consists of 12 voting members: ¾ 7 members of the Board of Governors.¾ President of the New York Federal Reserve Bank.• Has operational responsibility for open market operations.¾ 4 other regional Federal Reserve Presidents.• Serve on an annually rotating basis.• And 7 non-voting members:¾ The other regional Federal Reserve Presidents.16-27Federal Open Market Committee• Chairman:¾ Traditionally the Chairman of the Board of Governors.• Vice Chairman:¾ Traditionally the President of the New York Federal Reserve Bank.16-28Federal Open Market Committee• Meetings:¾ 8 per year at 5 – 8 week intervals.• Minimum of 4 meetings per year.• Also have conference calls when warranted.¾ Provides direction for open market operations to the New York Federal Reserve Bank.816-29Federal Open Market Committee• Meetings (continued):¾ Policy statement follows meeting announcing:• Any policy action taken.• Summary of economic and inflationary conditions.• The policy bias.¾ Symmetrical.¾ Asymmetrical.• The vote.16-30Federal Open Market Committee• Meetings (continued):¾ Releases minutes 3 weeks following the meeting.¾ Releases semi-annual Monetary Policy Report: • Typically, in February and July.• Presented by Chairman to Congress.¾ Releases meeting transcripts after a 5-year lag.16-31The Federal Reserve’s balance sheet • The Federal Reserve’s balance sheet:¾ Assets:• U.S. Treasury securities• Federal agency securities•Gold• Loans to depository institutions• Other assets (mostly foreign exchange reserves)16-32The Federal Reserve’s balance sheet • The Federal Reserve’s balance sheet:¾Liabilities:• Currency outstanding.– Some is held in bank