Lecture Materials

ECONOMICS, MONEY MARKETS AND BANKING

James McAndrews Wharton Financial Institutions Center

Philadelphia, Pennsylvania jamesjmcandrews@gmail.com

917-609-0086

August 4, 2017

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Monetary Policy and the Fed

James McAndrewsECONOMICS, MONEY MARKETS AND BANKING Section Leader ‐ James M. Johannes

August 4, 2017University of Wisconsin

Bank of England 1694

• Granted monopoly on joint stock banking by Parliament in return for war loans.

• Not an invention of economists, started off as a powerful bank that was able to demand that other banks held deposits in it.

• Did not have government monopoly on note issue, but achieved it through its monopoly power.

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Banks of the United States

• Loosely modeled after Bank of England• First Bank of the United States 1791-1811,

was promoted by Alexander Hamilton• Second Bank of the United States 1816-

1836. President Andrew Jackson called it a “dangerous monopoly,” conflict with Nicholas Biddle, president.

• Suffolk System, Massachusetts

The National Banking Act of 1863 allowed Nationally chartered banks to distribute bank notes

National Banks controlled the supply of currency in the US through their lending policies

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National Banks were the primary source of credit

Small State banks who were short of funds would borrow from larger state banks

Larger State banks who were short of funds would borrow from National banks

National banks who were short of funds would borrow from money center banks

Money center banks were the “root source” of credit

Nineteenth Century Problems and Solutions

• Privately issued bank notes• Discounts on notes• Banking panics associated with business

depressions• National Banking System, 1863, mostly ended

panics until 1907.• 1907 panic saved by J. P. Morgan• Under National Banking System inflexible money

supply, strongly seasonal interest rate• Led to creation of Federal Reserve

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Credit Channels under the National/State Banking System

The Federal Reserve System was created in 1913 by Congress, law signed by Woodrow Wilson.

• Regulates the banking industry

• “Lender of Last Resort”

• Controls the money supply

• Provides banking services for the federal government

• Check ClearingThe Federal Reserve System has two elements:

The Federal Reserve Board—a federal agency

Federal Reserve Banks—instrumentalities of Congress. Profits go to U.S. Treasury after minor payments to nominal stockholders (local commercial banks)

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The Federal Reserve transfers its net earnings to the U.S. Treasury.

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The Federal Reserve System Divides the country into 12 Districts numbered 1 - 12 from east to west

Board of Governors

• 7 members, 14-year terms

• Chairman has 4-year term. Traditional power of the chairman

• Independent of executive and legislative branch. An “independent central bank.”

• Chairman must make semiannual monetary policy reports (Humphrey Hawkins)

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The Board oversees the operations of the 12 Reserve Banks and shares with them the responsibility for supervising and regulating certain financial institutions and activities. The Board also provides general guidance, direction, and oversight when the Reserve Banks lend to depository institutions and others and when the Reserve Banks provide financial services to depository institutions and the federal government. The Board also has broad oversight responsibility for the operations and activities of the Federal Reserve Banks. This authority includes oversight of the Reserve Banks' services to depository institutions, and to the U.S. Treasury, and of the Reserve Banks' examination and supervision of various financial institutions. As part of this oversight, the Board reviews and approves the budgets of each of the Reserve Banks.

The Board also helps to ensure that the voices and concerns of consumers and communities are heard at the central bank by conducting consumer-focused supervision, research, and policy analysis, and, more generally, by promoting a fair and transparent consumer financial services market.

Reserve Bank ResponsibilitiesThe Reserve Banks carry out Federal Reserve core functions by1.supervising and examining state member banks (state-chartered banks that have chosen to become members of the Federal Reserve System), bank and thrift holding companies, and nonbank financial institutions that have been designated as systemically important under authority delegated to them by the Board;2.lending to depository institutions to ensure liquidity in the financial system;3.providing key financial services that undergird the nation's payment system, including distributing the nation's currency and coin to depository institutions, clearing checks, operating the FedWire and automated clearinghouse (ACH) systems, and serving as a bank for the U.S. Treasury; and4.examining certain financial institutions to ensure and enforce compliance with federal consumer protection and fair lending laws, while also promoting local community development.

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Each district has a Federal Reserve Bank with a bank president elected by the bank’s board of directors for 4 year renewable terms

Board of Directors

Bank President

Class A (4) Class B (4) Class C (4)

Member Banks Local Business Federal Reserve Board

Banking Panic of 1933

• Despite Fed’s lending, a banking panic forced Roosevelt to declare a banking holiday

• Led to establishment of Federal Deposit Insurance Company (FDIC) opened doors in 1934, funded by premia paid by banks

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The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

Monetary policy is the Federal Reserve's actions, as a central bank, to achieve three goals specified by Congress: maximum employment, stable prices, and moderate long-term interest rates in the United States (specified by the Humphrey-Hawkins 1978 amendments to the Employment Act of 1946.)

The Federal Reserve conducts the nation's monetary policy by managing the level of short-term interest rates and influencing the availability and cost of credit in the economy. Monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation in the United States.

Instruments refer to the policy options the Fed has to control the supply of money…

Open Market Operations

By purchasing or selling US Treasuries, the Fed can alter the supply of bank reserves (MB)

Discount Window Loans

The Fed can also influence reserves by altering the interest rate charged on loans to commercial banks. (MB)

Reserve Requirements

Reserve Requirements influence the ability of banks to create new loans which affects the broader aggregates (M1,M2)

This is the most often used instrument!

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1. Open market operations (Fed’s securities usually Treasuries trading)

2. Discount policy (setting discount % & discount lending terms, for banks liquidity)

3. Reserve requirement (% of checkable deposits held as vault cash or Fed deposits)

During fin crisis Fed introduced two new tools connected with bank reserve accounts:1. Interest on reserve balances (Complaint: no interest on reserve

deposits is a tax.By adjusting the rate of interest paid on reserves, the Fed can influence market interest rates.

The Fed’s toolkit

The Fed expresses its policy stance by the level of the federal funds rate, or fed funds rate. It is a market rate at which banks lend to one another overnight. It influences other interest rates of borrowers throughout the economy, including households and businesses.

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“The monetary transmission mechanism in the United States: some answers and further questions,” Kenneth N Kuttner and Patricia CMosser, Federal Reserve Bank of New York

How does monetary policy affect economic outcomes?

The Reserve Requirement is the least used of the Fed’s policy tools. A Bank is required to keep a minimum percentage of its deposits either as cash or on deposit at the federal reserve (reserve deposits pay no interest)

Assets Liabilities Assets Liabilities

$45,000 (T-Bills)

$50,000 (Deposits)

$100,000 (Equity)

Federal Reserve Acme National Bank

$100,000(Loans)

$ 2,500 (Cash)

$ 2,500 (Reserves)

$ 2,500 (Reserves)

Acme currently has 10% of its deposit liabilities on Reserve (Cash + Reserves)/Deposits

Reserve Accounts are liabilities of the Fed

$2,500 (bonds)

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Suppose Acme Bank wanted to create a $30,000 loan. This is done by establishing a line of credit (i.e. creating a new checkable deposit)

Assets Liabilities

$45,000 (T-Bills)

$50,000 (Deposits)

$100,000 (Equity)

Acme National Bank

$100,000(Loans)

$ 2,500 (Cash)

$ 2,500 (Reserves)

Acme’s reserve ratio drops to 6.25% (5/80)

$30,000 (Loan)

$30,000 (Deposit)

The loan shows up on both sides of the balance sheet

Type of Liability Reserve Requirement

Transaction Account

$0 - $15.5M 0%

$15.5M - $115.1M 3%

More than $115.1M 10%

Time Deposits 0%

Eurocurrencies 0%

The Reserve Requirement has no impact on the monetary base, but it restricts the ability of banks to create loans – this influences the broader aggregates.

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The discount window was the primary policy tool of the federal reserve when it was first established in 1913. Discount window loans are collateralized by the assets of the bank (equal to around 90% of the loan)

Assets Liabilities Assets Liabilities

$45,000 (T-Bills)

$80,000 (Deposits)

$50,000 (Equity)

Federal Reserve Acme National Bank

$130,000(Loans)

$ 2,500 (Cash)$ 2,500 (Reserves)

$ 2,500 (Reserves)

This bank would like to create a $70,000 loan, but doesn’t have the reserves to back it up

Res. Req. = 5%

A $2,500 loan from the discount window would raise reserves to the required 5%

$ 2,500 (Reserves)$ 2,500 (Reserves)

$ 2,500 (Loan)

$ 2,500 (Disc. Loan)

Type of Credit Interest Rate Policy

Primary (No Questions Asked) Fed Funds + .5%

Secondary (Additional Financial Information

Required)

Fed Funds + 1.0%

Seasonal (Must demonstrate reoccurring seasonal liquidity needs, <$500M in Deposits)

Bottom of target Fed Funds range

The Fed actually has several discount lending programs

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Discount Lending (1959-Present)

Currently, open market operations are the primary policy tool of the Fed. Trading takes place in NYC

Assets Liabilities Assets Liabilities

$45,000 (T-Bills)

$80,000 (Deposits)

$50,000 (Equity)

Federal Reserve Acme National Bank

$130,000(Loans)

$ 2,500 (Cash)$ 2,500 (Reserves)

$ 2,500 (Reserves)

Res. Req. = 5%

An open market purchase increases the reserves of the banking sector – this raises M0

$ 2,500 (Reserves)- $ 2,500 (T- Bills)

$ 2,500 (Reserves)$ 2,500 (T- Bills)

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Fed Policy from start to finish….

Staff economists at each federal reserve bank brief the president of local/national economic conditions

Bank Presidents/Governors present policy recommendations to the FOMC – A vote is taken. The monetary base is to be increased by $100M

This order is passed to the trading desk in NYC

Trading desk calls bond dealers and asks for bids

“Old-fashioned” way to influence interest rates and implement monetary policy

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Current way of influencing interest rates and implementing Monetary policy.

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Recent monetary policy outcomes: Unemployment rate = 4.3 % (May)Core Personal Consumption Expenditure inflation = 1.5 % (April)

Source: Charles Evans, FRB Chicago, Feb 28, 2014

European Central Bank

• Founded 1998• Eurozone members and non Eurozone

members• Had to construct Eurozone data for first

time• President Jean-Claude Trichet since 2003• Otmar Issing

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New Euro Currency

• Currency first issued January 1, 2002

• “The parallel lines [in €] “represent the stability of the euro.”