Chapter Fifteen: Lecture Notes -- The Federal Reserve and Monetary Policy

• History & Structure of the Federal Reserve
• Tools of Monetary Policy
  • Open Market Operations
  • Change in the Discount Rate
  • Change in the Required Reserve Ratio
  • Summary of Monetary Policy Tools
• Impacts of Monetary Policy on the Economy
  • The Loanable Funds Market
  • Monetary Policy and Interest Rates
• The Impact of Monetary Policy on the Economy
• Useful Web Resources

The Federal Reserve is the United States Central Bank. It is probably the most powerful, yet least understood organization in the U.S. economy. Its actions may affect everyday consumers whenever we purchase things on credit, take out a loan, or feel the effects of inflation or unemployment. In this chapter, we examine the history, structure, and operations of the Federal Reserve.

History & Structure of the Federal Reserve

The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the financial system. The lender of last resort is probably the Fed's biggest responsibility. Many economists believe that the Great Depression was due mainly to the collapse of the banking system. The Fed did not do enough to prevent its collapse. When a business needs money, it can often go to the bank for help. Before the Federal Reserve was created, banks had nowhere to turn to when they were in trouble. The Fed is now there to back them up.

The unique structure of the Federal Reserve is a consequence of history and politics. Figure 1 gives a breakdown of the main divisions within the Fed.

Figure 1

The other six members of the Board of Governors are appointed to 14-year terms by the President and they must be confirmed by the Senate. The long terms try to assure stability and continuity in the Fed's policy decisions. Many of the board members, however, do not serve their full terms and leave early to work in the private sector.

[Outside Econweb] The Twelve District Banks were initially designed to decentralize the power in the Federal Reserve. The United States has a long history of being fearful of centralization, and this organizational structure was a way to diffuse that power. The District Banks perform numerous functions in their respective areas. They regulate and supervise banks and bank holding companies, run a check-clearing service, do research and monitor regional and national economic activity, circulate the currency, sell savings bonds, and so on. Moreover, the New York Federal Reserve Bank conducts open market operations and foreign exchange stabilization.

Tools of Monetary Policy

Recall from the chapter on Fiscal Policy and Supply Side Economics that fiscal policy can be a blunt stabilization policy instrument because of the long implementation time lags. A recent example illustrates the point. President Bush was first elected in November 2000 and was sworn in on January 21 2001. It took until June 2001 to push his tax cuts through Congress, and the tax refunds weren't delivered until late summer of that year. It took about nine months, therefore, to fully implement the tax cut. This time table was actually quite rapid relative to other fiscal policy measures.

A significant advantage of monetary policy is that the implementation is swift. When the F.O.M.C. decides to change interest rates, the effect is nearly instantaneous. Within minutes after receiving the directive, the New York Fed carries out the policy change. In addition, the Fed is relatively free from politics. The long terms of the governors combined with the broad Congressional oversight gives the Fed ample opportunity to make decisions with limited retribution. Because of the swift implementation and the insulation from politics, many--perhaps most--economist prefer that monetary policy be the main stabilization policy tool.

The F.O.M.C. has three "tools" at its disposal to conduct monetary policy. These are:

1. Open Market Operations (OMO),
2. Change in the discount rate, and
3. Change in the reserve requirement ratio.

An [Outside Econweb] Open Market Operation is by far the most important tool of the Fed and it is used daily. An open market operation is the Fed's purchase or sale of government securities via transactions in the open market. Government securities are government debt--T-Bills, T-Notes, and T-Bonds. An open market operation, therefore, is simply the purchase or sale of secondary government debt by the Federal Reserve. An open market purchase is the Fed's purchase of government securities while an open market sale is the Fed's sale of government securities. The Open Market Desk is on the 8th floor of the New York Fed. This site is where the trading in government securities actually occurs. The traders take their orders from the F.O.M.C. and carry them out in a timely fashion.

An open market operation impacts the banking system by changing bank reserves initially and, ultimately, the money supply. Let's look at an example of an open market purchase.

Suppose that the Fed purchases $100 million of government securities from commercial banks. How does the banking system and the economy adjust? First, let's stop to think where the money to purchase the securities comes from. The answer may surprise you. The money for its open market operations comes from computer terminals; it is completely electronic! But once the money exists on the computer, it is as real as a dollar bill.

Because of its money creating powers, the Federal Reserve System is off-budget, meaning that it generates its own operating revenue. In fact, the Fed makes such a profit from its holdings of government securities each year that it gives billions of dollars back to the U.S. Treasury.

Now let's answer our original question as to the effects of the $100 million open market purchase. To understand the effects, we must examine our bank T-accounts again in Figure 2. This T-account tracks the changes in assets and liabilities at all commercial banks combined. When the Fed purchases $100 million in government bonds from banks, it simultaneously puts $100 million of reserves in the hands of banks as they exchange their stocks of government securities for the reserves. Again, the reserves that the banks receive from the Fed are created by Fed entries into computer terminals.

Figure 2

Because the $100 million are not deposits, the entire $100 million becomes excess reserves. Banks can begin lending out the $100 million, which leads to the money expansion we looked at in Chapter 14. From the money multiplier formula, we know that the open market operation process could generate a maximum increase in the money supply of $1,000 million, or $1 billion.

Sometimes banks need access to funding quickly. That is, bank operations may be sound, but a heavy depositor withdrawal, an unexpected delay of payment from a customers, or an attractive but unexpected loan opportunity leaves the bank without enough cash to meet its reserve requirements. A bank in this situation has two primary sources of funds. One source is the fed funds market, the interbank market for trading excess reserves. Banks who have excess reserves can lend those reserves to banks who are short of reserves. The interest rate that is charged when one bank lends reserves to another is called the fed funds rate. In fact, the fed funds rate is the primary interest rate target of open market operations. By changing the quantity of excess reserves in the banking system, the F.O.M.C. indirectly sets the fed funds rate. An open market purchase lowers the fed funds rate because the supply of excess reserves increases as banks replace government securities with reserves; conversely, an open market sale raises the fed funds rate as banks purchase government securities from the Fed with their excess reserves.

A bank needing reserves could also turn to the Federal Reserve's [Outside Econweb] discount window. If the Fed decides to lend to the bank, it charges an interest rate called the discount rate. The discount rate is the interest rate at which the Federal Reserve lends funds to banks. It is the only interest rate that the Fed sets directly. Borrowings from the discount window are short-term, usually with a maturity between one day and two weeks. Longer-term loans are discouraged except through a special seasonal borrowing program through which loans are available to small banks for up to nine months. All loans through the discount window are collateralized.

The Federal Reserve controls the discount rate in order to influence the supply of money in the economy. If the Federal Reserve lowers the discount rate, it is signaling to banks that it is loosening the money supply; consequently, banks will be more willing to make loans to customers and make up any shortage in reserves by borrowing from the Fed. Conversely, if the Fed raises the discount rate, it is signaling to banks that monetary policy is tightening and banks had better be more diligent about having enough reserves on hand. Lowering the discount rate increases the money supply; raising the discount rate contracts the money supply. Let's look at an example.

Suppose that the Fed decreases the discount rate by one percentage point, say, from six percent to five percent. This change might induce banks to borrow $5 million more in reserves from the Fed to fund additional loan opportunities. As Figure 3 illustrates, the $5 million is an asset that goes in the banks' reserves. The $5 million is simultaneously a liability--a loan from the Fed. The loan, however, carries no reserve requirements. The bank is free to lend out the entire $5 million provided that it has enough reserves to meet its required reserve ratio.

The discount window is the tool in which the Fed potentially acts as the lender of last resort. A prime example is the operations of the window following the terrorist attacks on September 11, 2001. Reserve Banks lent $45.5 billion to depository institutions on September 12, 2001, setting a single-day record. Why was there such a need for funds? In a potential crisis situation such as the terrorist attacks, depositors and businesses may panic by withdrawing funds in large quantities, causing a liquidity crisis at some banks. The discount window provided banks with quick, easy access to sufficient quantities of funds. The depositor panic never occurred, and the banks ended up not needing the majority of the funds, so they paid them back (with interest) to the Fed over the next several days. While it is true that open market operations could have provided liquidity in the banking system as well (and indeed open market operations supplemented the discount window borrowings), that process may not have been able to get funds quickly enough to particular banks facing panics. The Fed is often times the only organization willing to lend funds to a bank in a crisis situation.

Despite the potential power of the discount window as the lender of last resort, in "normal" circumstances it is a passive monetary policy tool. When the F.O.M.C. conducts open market operations to change the targeted fed funds rate by a given amount, it typically adjusts the discount rate by the same amount. Beginning January 9, 2003, the Federal Reserve implemented some changes to its discount window program. Previously, the discount rate was set 50 basis points below the fed funds rate, leading to the criticism that the Fed was subsidizing bank borrowing. Now, the discount window has two programs that replace the adjustment credit (short-term lending) program.

Primary credit is available to financial institutions that Reserve Banks deem to be in generally safe and sound financial condition. Normally, the credit will be granted on a "no questions asked" basis, and the interest rate charged will be 100 basis points above the federal funds rate. Secondary credit is available to financial institutions that are not eligible for primary credit. These institutions will be under supervisory scrutiny. The interest rate on secondary credit will be 50 basis points higher than the primary credit rate. Collateral requirements remain unchaged for both programs.

TABLE 1
	RRR of 12.5%	RRR of 10%
Total Deposits:	$100,000	$100,000
Reserves on hand:	$12,500	$12,500
Required Reserves	$12,500	$10,000
Excess Reserves	$0	$2,500

The last tool of monetary policy is to change the [Outside Econweb] required reserve ratio. Currently in the U.S. banking system, the required reserve ratio is 10 percent. If the Federal Reserve lowers the required reserve ratio, then a bank has to hold fewer reserves on a given amount of deposits. For example, as Table 1 illustrates, if a bank has deposits of $100,000 and a required reserve ratio of 12.5 percent, then it has to hold $12,500 as reserves. If the Fed lowers this to 10 percent, then the bank only has to hold $10,000 as reserves. Therefore, $2,500 in excess reserves are created.

The Federal Reserve does not use this tool often because banks must constantly estimate their reserves to meet the required level. If the rules of the game keep changing, then it becomes more difficult for banks to manage their assets. The F.O.M.C. prefers to use Open Market Operations as its primary monetary policy tool.

Summary of Monetary Policy Tools

TABLE 2
Tool	Expansionary	Contractionary
OMO	Purchase	Sale
Discount Rate	Lower	Raise
RRR	Lower	Raise

In sum, the F.O.M.C. has three monetary tools at its disposal to change the money supply. The first and most important is open market operations. By conducting an open market purchase, the Fed injects excess reserves into the banking system and so begins the money expansion process. Similarly, a reduction in the discount rate or a lowering of the required reserve ratio increases the money supply. Each of these actions is expansionary monetary policy. In contrast, the Fed can reduce the money supply by conducting an open market sale, raising the discount rate, or increasing the required reserve ratio. Each of these actions drains excess reserves from the banking system and causes the money multiplier process to function in reverse, destroying money along the way.

Impacts of Monetary Policy on the Economy

This section establishes the link between monetary policy and the behavior of the economy. We explain how Federal Reserve actions impact the behavior of output, inflation, and unemployment.

Monetary policy ultimately works by changing the level of demand for goods and services in the economy. When the Fed expands the money supply, banks have more reserves to lend out (which lowers the fed funds rate). Banks will usually "sell" these additional reserves to the public by lowering lending interest rates and prompting more borrowers to come forward. The lower interest rate will induce higher levels of investment and consumption, which will lead to more demand for goods and services, boosting the economy's level of output.

We best illustrate the impacts of monetary policy by examining the loanable funds market. Demand for loanable funds comes from anyone wishing to borrow money, whether it be to buy a home, pay for a television on a credit card, or finance a college education. As the interest rate falls, the cost of borrowing funds falls, so more potential borrowers want funds. Therefore, the demand curve for loanable funds is downward sloping. The supply of loanable funds comes from anyone wishing to lend money, whether it be a bank, a mortgage company, or an individual. As interest rate rises, the profit opportunity for lending funds rises, so more people wish to lend their funds. Therefore, the supply curve is upward sloping. Equilibrium occurs where demand and supply for loanable funds are equal, as illustrated in the figure titled "Loanable Funds Market." The intersection of the supply and demand curves determines the equilibrium interest rate and the quantity of loanable funds in the economy.

When the Fed conducts expansionary monetary policy, it is giving banks more funds to lend out. Thus the supply of loanable funds shifts to the right. This action lowers interest rates and increases the quantity of loanable funds in the economy. As the figure titled "Expansionary Monetary Policy and Interest Rates" illustrate, expansionary monetary policy moves the economy from point A to point B; interest rates in the economy fall.

Contractionary monetary policy has the opposite effect on interest rates. An open market sale, for example, reduces the supply of loanable funds in the economy and shifts the supply curve leftward. Interest rates rise and the quantity of loanable funds falls. In sum, expansionary monetary policy lowers interest rates while contractionary monetary policy raises interest rates.

Where does the money supply fit into the analysis? We could have modeled the exact same scenario by using the demand and supply of money rather than the demand and supply of loanable funds. With some simplifying assumptions, we could simply relabel the horizontal axis of the figure titled "Expansionary Monetary Policy and Interest Rates" from Loanable Funds to Money and the story would be unchanged. Remember that an open market purchase injects excess reserves into the banking system when the Fed purchases government securities from banks. Banks lend out the excess reserves (expanding loanable funds), which are then redeposited (expanding the money supply). In this context, loanable funds and the money supply are like two sides of the same coin. They expand and contract together.

The Impact of Monetary Policy on the Economy

So far we have described how monetary policy effects the banking system and the market for loanable funds. But how does monetary policy impact the real economy? Let's examine expansionary monetary policy, specifically, an open market purchase. When interest rates fall due to the increase in loanable funds, expenditures on investment and consumption items that are sensitive to the interest rates rise. (Recall that investment and the interest rate are inversely related.) For example, if mortgage rates fall, demand for new houses increases. Demand for cars might also increase as the interest payments to finance cars fall. People may buy more items on credit if credit card rates are reduced, and so on. Therefore, expansionary monetary policy increases Aggregate Demand, as illustrated by the rightward shift in Aggregate Demand in the figure titled "Economic Impact of Expansionary Monetary Policy." When demand for goods and services increases, more production must occur to meet the demand. This creates jobs and lowers the unemployment rate. Notice too that the Price Level increases. Other things equal, expansionary monetary policy increases output, employment, and inflation.

Conversely, contractionary monetary policy shifts the Aggregate Demand curve to the left, resulting in lower levels of GDP and employment, and a lower inflation rate. The Fed conducts contractionary monetary policy when it wishes to slow the economy and ease inflationary pressures.

In late June, 2006, the FOMC rasied the federal funds rate to 5.25 percent -- the 17th consecutive Fed meeting in which they hiked rates. Why did the Fed follow this pattern of rate hikes? Beginning in 2002, the economy began to recover from the 2001 recession and oil prices edged higher as the potential for terrorist attacks increased. Other commodites such as food and natural gas also edged higher. With the economy recovering and inflation creeping upward, the FOMC decided that it needed to tap its foot on the brakes to prevent inflation from going even higher. In other words, the Fed was trying to prevent the Aggregate Demand curve from shifting too far to the right. Only time will tell us if the Fed has raised interest rates sufficiently to prevent inflation from creeping upward.

Monetary policy is an extremely powerful tool with profound effects on the economy. By changing interest rates, the Federal Reserve can cause an economic expansion or contraction that influences millions of people in the United States and around the world.

• Read how the Federal Reserve responded to the terrorist attacks of September 11 from this St. Louis Federal Reserve article.

• The structure and activites of the Federal Reserve System, including monetary policy, are explained at this Board of Governor's web site.

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