Chapter 16
The Banking System,
The Federal Reserve,
and Monetary Policy
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 16 / THE BANKING SYSTEM, THE FEDERAL RESERVE, …
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
The Banking System, the Federal
Reserve, and Monetary Policy


Where does money actually come from?
 The government just prints it, right?
Much of our money supply is paper currency
printed by our national monetary authority
 Most of our money supply is not paper currency and is
not printed by anyone
 The monetary authority in the United States—the Federal
Reserve System—is not technically a part of the
government
• But a quasi-independent agency that operates along side of the
government
Lieberman & Hall; Introduction to Economics, 2005
2
What Is Counted as Money





Money is the means of payment in the economy
The standard definition of money is cash, checking account
balances, and traveler’s checks
First, only assets—things of value that people own—are
regarded as money
Second, only things that are widely acceptable as a means
of payment are regarded as money
The Federal Reserve keeps track of the total money supply
and reports it each week
Lieberman & Hall; Introduction to Economics, 2005
3
The Components of The Money Supply



We count as money cash in the hands of the public
In July, 2003 the Fed reported that cash in the
hands of the public totaled $646 billion
Almost half of this cash is circulating in foreign
countries
 In July, 2003 the public held about $8 billion in traveler’s
checks

The remaining component of the money supply is
checking account balances
 The U.S. public held $314 billion in demand deposits in
July, 2003
Lieberman & Hall; Introduction to Economics, 2005
4
The Components of The Money Supply

Other checkable deposits is the catchall category for several
types of checking accounts that work like demand deposits
 In July, 2003 the U.S. public held $298 billion of these types of
checkable deposits
 Money Supply = cash in the hands of the public + Traveler’s checks
+ demand deposits + other checkable deposits


In July, 2003 this amounted to
 Money Supply = $646 billion + $8 billion + $314 billion + $298 billion
 = $1,266 billion
It is important to understand that our measure of the money
supply excludes many things that people use regularly as a
means of payment
Lieberman & Hall; Introduction to Economics, 2005
5
Financial Intermediaries

Banks are important examples of

• A business firm that specializes in brokering between savers and borrowers
An intermediary helps to solve problems by combining a large number of
small savers’ funds into custom designed packages
 Financial Intermediaries
 Then lends them to larger borrowers
 The intermediary can reduce the risk to savers by spreading its loans among
a number of different borrowers

Four types of depository institutions




Savings and loan associations (S&Ls)
Mutual savings banks
Credit unions
Commercial banks
Lieberman & Hall; Introduction to Economics, 2005
6
Commercial Banks


A commercial bank is a private corporation, owned
by its stockholders, that provides services to the
public
 Most important service is to provide checking accounts
Banks provide checking account services in order
to earn a profit
 Bank profits come from lending
 Banks do not lend out every dollar of deposits they
receive
• They hold some back as reserves
Lieberman & Hall; Introduction to Economics, 2005
7
Bank Reserves and The Required
Reserve Ratio

Commercial bank’s reserves are funds that it has not lent out
 But instead keeps in a form that is readily available to its depositors
• Bank holds its reserves in two places



Why does the bank hold reserves?
 First, on any given day, some of the bank’s customers might want to

withdraw more cash than other customers are depositing
Second, banks are required by law to hold reserves
• Required reserve ratio, set by the Federal Reserve


In its vault
In a special reserve account managed by the Federal Reserve
Tells banks the fraction of their checking accounts that they must hold as required
reserves
The relationship between a bank’s required reserves (RR), demand
deposits (DD), and the required reserve ratio (RRR) is
 RR = RRR × DD
Lieberman & Hall; Introduction to Economics, 2005
8
The Federal Reserve System


Every large nation controls its banking system with a central
bank
 The Bank of England was created in 1694
 France waited until 1800 to establish the Banque de France
 Congress established the Federal Reserve System in 1913
Why did it take the United States so long to take control of
its monetary system?
 Suspicion of central authority
 Large size and extreme diversity of our country
 These characteristics explain why our central bank is different in
form from its European counterparts

One major difference is that it does not have the word
“central” or “bank” anywhere in its title
Lieberman & Hall; Introduction to Economics, 2005
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The Federal Reserve System


Instead of a single central bank, the United States is divided
into 12 different Federal Reserve districts
 Each one served by its own Federal Reserve Bank
Another interesting feature of the Federal Reserve System
is its peculiar status within the government
 It is not even a part of the government, but rather a corporation
whose stockholders are the private banks that it regulates
 But it is unlike other corporations in several ways
• Fed was created by Congress and could be eliminated by Congress if it
•
•
so desired
Both the president and Congress exert some influence on the Fed
through their appointments of key officals in the system
Fed’s mission is not to make a profit for its stockholders like an ordinary
corporation, but rather to serve the general public
Lieberman & Hall; Introduction to Economics, 2005
10
Figure 1: The Geography of the
Federal Reserve System
1
9
Minneapolis
12
San Francisco
2
7
Boston
New York
Philadelphia
10
Cleveland
Washington
Kansas City
4 Richmond
St. Louis
5
8
3
Chicago
Atlanta
11
6
Dallas
Note: Both Alaska and Hawaii are in the Twelfth District
District boundaries
State boundaries
Reserve Bank cities
Board of Governors of the Federal Reserve System
Lieberman & Hall; Introduction to Economics, 2005
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The Structure of The Fed

Near the top is the Board of Governors, consisting of seven members
 Who are appointed by the president and confirmed by the Senate for a 14
year term
• The most powerful person at the Fed is the chairman of the Board of Governors
• To keep any president or Congress from having too much influence over the Fed,
the 4-year term of the chair is not coterminous with the 4-year term of the
president

Each of the 12 Federal Reserve Banks is supervised by nine directors,
three of whom are appointed by the Board of Governors
 The other six are elected by private commercial banks
 The directors of each Federal Reserve Bank choose a president of that bank

• Who manages its day-to-day operations
3,000 of the 9,000 commercial banks in the United States are members
of the Federal Reserve System
 They include all national banks and some state banks
 All of the largest banks in the United States are nationally chartered banks
and therefore member banks as well
Lieberman & Hall; Introduction to Economics, 2005
12
Figure 2: The Structure of the Federal
Reserve System
President
appoints
Senate
confirms
Chair of Board of Governors
Board of Governors
(7 members, including chair)
• Supervises and regulates
member banks
• Supervises 12 Federal
Reserve District Banks
• Sets reserve requirements
and approves discount rate
Federal Open Market
Committee
(7 Governors + 5 Reserve
Bank Presidents)
• Conducts open market
operations to control the
money supply
Lieberman & Hall; Introduction to Economics, 2005
Appoints 3 directors of each
Federal Reserve Bank
12 Federal Reserve
District Banks
• Lend reserves
• Clear checks
• Provide currency
Elect 6 directors
of each
Federal Reserve
Bank
3,500 Member Banks
13
The Federal Open Market Committee


Most economists regard FOMC as most important
part of Fed
Federal Open Market Committee (FOMC)
 A committee of Federal Reserve officials that establishes


U.S. monetary policy
After determining the current state of the economy, the
FOMC sets the general course for the nation’s money
supply
Summaries of its meetings are published only after
a delay of a month or more
 FOMC controls the nation’s money supply by buying and
selling bonds in the public (“open”) bond market
Lieberman & Hall; Introduction to Economics, 2005
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The Functions of the Federal Reserve

Federal Reserve, as overseer of the nation’s
monetary system, has a variety of important
responsibilities
 Supervising and regulating banks
 Acting as a “bank for banks”
 Issuing paper currency
 Check clearing
 Controlling the money supply
Lieberman & Hall; Introduction to Economics, 2005
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How the Fed Increases the Money
Supply

To increase money supply, Fed will buy government bonds
 Called an open market purchase

Open Market Operations
 Purchases or sales of bonds by the Federal Reserve System



The demand deposit multiplier is the number by which we must multiply
the injection of reserves to get the total change in demand deposits
For any value of the required reserve ratio (RRR), the formula for the
demand deposit multiplier is 1/RRR
Using our general formula for the demand deposit multiplier, we can
restate what happens when the Fed injects reserves into the banking
system as follows
 ΔDD = (1/RRR) × ΔReserves
Lieberman & Hall; Introduction to Economics, 2005
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How the Fed Decreases the Money
Supply


Fed can also decrease money supply by selling
government bonds
 An open market sale
The Fed has trillions of dollars worth of government
bonds from open market purchases it has
conducted in the past
 A withdrawal of reserves is a negative change in
reserves
• Can still use our demand deposit multiplier—1/(RRR)—and our
general formula
• ΔDD = (1/RRR) x ΔReserves
Lieberman & Hall; Introduction to Economics, 2005
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Some Important Provisos About the
Demand Deposit Multiplier

Our formula for demand deposit multiplier—
1/RRR—is oversimplified
 The multiplier is likely to be smaller than formula
suggests
• As the money supply increases, the public typically
•
will want to hold part of the increase as demand
deposits, and part of the increase as cash
Banks may want to hold excess reserves—reserves
beyond those legally required
Lieberman & Hall; Introduction to Economics, 2005
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Other Tools for Controlling the Money
Supply





There are other tools that the Fed can use to increase or
decrease the money supply
 Changes in the Required Reserve Ratio
 Changes in the Discount Ratio
Changes in either the required reserve ratio or the discount
rate could change the money supply by causing banks to
expand or contract their lending
 Neither of these policy tools is used very often
Why are these other tools used so seldom?
 They can have unpredictable effects
While other tools can affect the money supply, open market
operations have two advantages over them
 Precision and secrecy
This is why open market operations remain the Fed’s
primary means of changing the money supply
Lieberman & Hall; Introduction to Economics, 2005
19
The Demand For Money
Don’t people always want as much money as
possible?
 Isn’t their demand for money infinite?
 Actually, no
 The “demand for money”

• Means how much money people would like to hold,
given the constraints that they face
Lieberman & Hall; Introduction to Economics, 2005
20
An Individual’s Demand for Money
Money is one of the ways that each of us, as
individuals, can hold our wealth
 An individual’s demand for money is the
amount of wealth that the individual chooses
to hold as money, rather than as other assets
 When you hold money, you bear an
opportunity cost
 Interest or other financial return you could have

earned if you held your wealth in some other
form
Lieberman & Hall; Introduction to Economics, 2005
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An Individual’s Demand for Money

Bond
 IOU issued by a corporation or a government agency
when it borrows money

Individuals choose how to divide wealth between
two assets
 Money, which can be used as a means of payment but
earns no interest
 Bonds, which earn interest, but cannot be used as a
means of payment

Since interest is the opportunity cost of holding
money
 The greater the interest rate, the less money an
Individual will want to hold
Lieberman & Hall; Introduction to Economics, 2005
22
The Demand for Money by Businesses

Businesses face the same types of
constraints as individuals
 They have only so much wealth, and they must
decide how much of it to hold in money rather
than in other assets
 The quantity of money demanded by businesses
follows the same principles we have developed
for individuals
• They want to hold more money when the opportunity
cost is lower and less money when the interest rate is
higher
Lieberman & Hall; Introduction to Economics, 2005
23
The Economy-Wide Demand for Money



When we use the term “demand for money” without
the word “individual,” we mean the total demand for
money by all wealth holders in the economy
The demand for money is the amount of total
wealth in the economy that all households and
businesses, together, choose to hold as money
 Rather than as bonds
A rise in the interest rate will decrease the quantity
of money demanded
 A drop in the interest rate will increase the quantity of
money demanded
Lieberman & Hall; Introduction to Economics, 2005
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The Money Demand Curve

This tells us the total quantity of money
demanded in the economy at each interest
rate
 The curve is downward sloping
 As long as the other influences on money
demanded don’t change, a drop in the interest
rate will increase the quantity of money
demanded
• Lowers the opportunity cost of holding money
Lieberman & Hall; Introduction to Economics, 2005
25
Figure 3: The Money Demand Curve
Interest
Rate
6%
The money demand curve is
drawn for a given real GDP
and a given price level.
E
At an interest rate of 6
percent, $500 billion of
money is demanded.
F
3%
If the interest rate drops to
3 percent, the quantity of
money demanded increases
to $800 billion.
Md
500
Lieberman & Hall; Introduction to Economics, 2005
800
Money ($ Billions)
26
The Supply of Money

Just as we did for money demand, we would like to
draw a curve showing the quantity of money
supplied at each interest rate
 The interest rate can rise or fall, but the money supply
will remain constant unless and until the Fed decides to
change it

Open market purchases of bonds inject reserves
into the banking system
 Shift the money supply curve rightward by a multiple of
the reserve injection
• Open market sales have the opposite effect

They withdraw reserves from the system and shift the money supply
curve leftward by a multiple of the reserve withdrawal
Lieberman & Hall; Introduction to Economics, 2005
27
Figure 4: The Supply of Money
Interest Rate
6%
3%
M1S
E
J
500
Lieberman & Hall; Introduction to Economics, 2005
M 2S
700
Money ($ Billions)
28
Equilibrium in the Money Market

We want to find the equilibrium interest rate
 The rate at which the quantity of money
demanded and the quantity of money supplied
are equal

Equilibrium in the money market occurs
 When the quantity of money people are actually
holding is equal to the quantity of money they
want to hold
Lieberman & Hall; Introduction to Economics, 2005
29
How the Money Market Achieves
Equilibrium

When there is an excess supply of money in the
economy, there is also an excess demand for
bonds
 Excess Supply of Money
• The amount of money supplied exceeds the amount demanded
at a particular interest rate
 Excess Demand for Bonds
• The amount of bonds demanded exceeds the amount supplied at
a particular interest rate

When the interest rate is higher than its equilibrium
value
 The price of bonds will rise
Lieberman & Hall; Introduction to Economics, 2005
30
Figure 5: Money Market Equilibrium
Interest Rate
Ms At a higher interest rate, an
excess supply of money
causes the interest rate to fall.
9%
At the equilibrium
interest rate of
6%, the public is
content to hold
6%
the quantity
of money it is
actually holding.
3%
E
At a lower interest rate,
an excess demand for
money causes the
interest rate to rise.
Md
300
Lieberman & Hall; Introduction to Economics, 2005
500
800 Money ($ Billions)
31
An Important Detour: Bond Prices and
Interest Rates

A bond
 A promise to pay back borrowed funds at a certain date or dates in
the future



The interest rate that you will earn on your bond depends
entirely on the price of the bond
 The higher the price, the lower the interest rate
When the price of bonds rises, the interest rate falls
 When the price of bonds falls, the interest rate rises
The relationship between bond prices and interest rate
helps explain why the government, the press, and the public
are so concerned about the bond market
 Where bonds issued in previous periods are bought and sold
Lieberman & Hall; Introduction to Economics, 2005
32
Back to the Money Market


A rise in the price of bonds means a decrease in the interest
rate
 The complete sequence of events is
In the case of an excess demand for money and an excess
supply of bonds
 The following would happen
Lieberman & Hall; Introduction to Economics, 2005
33
How the Fed Changes the Interest Rate

To change the interest rate, the Fed must change the equilibrium interest
rate in the money market, and it does this by changing the money supply
 The process works like this
 Or this

If the Fed increases the money supply by buying government bonds, the
interest rate falls
 If the Fed decreases the money supply by selling government bonds, the

interest rate rises
By controlling the money supply through purchases and sales of bonds, the
Fed can also control the interest rate
Lieberman & Hall; Introduction to Economics, 2005
34
Figure 6: An Increase in the Money
Supply
At point E, the money market is in
equilibrium at an interest rate of 6 percent.
Interest
Rate
6%
M1S
M 2S
The excess supply of money (and
excess demand for bonds) would
cause bond prices to rise, and the
interest rate to fall until a new
equilibrium is established at point F
with an interest rate of 3 percent.
E
3%
To lower the interest rate, the
Fed could increase the
money supply to $800 billion.
F
Md
500
Lieberman & Hall; Introduction to Economics, 2005
800
Money ($ Billions)
35
How the Interest Rate Affects Spending

We can summarize the impact of monetary
policy as follows
 When the Fed increases the money supply, the
interest rate falls and spending on three
categories of goods increases
• Plant and equipment
• New housing
• Consumer durables
 When the Fed decreases the money supply, the
interest rate rises and these categories of
spending fall
Lieberman & Hall; Introduction to Economics, 2005
36
Monetary Policy and the Economy



When the Fed controls or manipulates the money
supply in order to achieve any macroeconomic goal
it is engaging in monetary policy
This is what happens when the Fed conducts open
market purchases of bonds
Open market sales by the Fed have exactly the
opposite effects
Lieberman & Hall; Introduction to Economics, 2005
37
Figure 7: Monetary Policy and the
Economy
Interest Rate
M1S M 2S
E
6%
F
3%
Md
500 800
r
↓
Spending on plant
and equipment,
housing, and
durables
Lieberman & Hall; Introduction to Economics, 2005
↑
Money ($ Billions)
Total
Spending
↑
GDP
↑
38
Expectations and Money Demand

Why should expectations about the future interest rate affect
money demand today?
 If you expect the interest rate to rise in the future, then you also
expect the price of bonds to fall in the future



A general expectation that interest rates will rise in the future
will cause the money demand curve to shift rightward in the
present
When the public as a whole expects the interest rate to rise
in the future
 They will drive up the interest rate in the present
When the public expects the interest rate to drop in the
future
 They will drive down the interest rate in the present
Lieberman & Hall; Introduction to Economics, 2005
39
Figure 9: Interest Rate Expectations
Interest Rate
Ms
10%
5%
E
M2d
M1d
500
Lieberman & Hall; Introduction to Economics, 2005
Money ($ Billions)
40
Expectations and the Fed

Changes in interest rates due to changes in
expectations can have important consequences
 Fortunes can be won and lost depending on how people
have bet on the future

Another consequence of changes in expectations is
the effect on the overall economy
 When a change in expectations becomes a self-fulfilling
prophecy, it causes current interest rates to change

The public’s ever-changing expectations about
future interest rates make the Fed’s job more
difficult
Lieberman & Hall; Introduction to Economics, 2005
41
The Fed’s Response to Changes in
Money Demand
 Changes
in the expected future interest
rate can shift the money demand curve
 Changes in tastes for holding money and
other assets, or changes in technology,
can also shift the money demand curve
 Money
demand shifts—if ignored—
would create problems for the economy
 If the Fed’s goal is to stabilize real GDP,
it cannot sit by while these events occur
Lieberman & Hall; Introduction to Economics, 2005
42
The Fed’s Response to Changes in
Money Demand

To stabilize real GDP when money demand changes on its
own (not in response to a spending shock), the Fed must
change the money supply
 Specifically, it must increase the money supply in response to an
increase in money demand
• And decrease the money supply in response to a decrease in money
demand


To prevent changes in money demand from affecting real
GDP, the Fed should set a target for the interest rate
 And adjust the money supply as necessary to maintain that target
Since the Fed conducts open market operations each day
 It is able to use continuous feedback to keep the interest rate
relatively constant
Lieberman & Hall; Introduction to Economics, 2005
43
Figure 9: The Fed’s Response to
Changes in Money Demand
Interest Rate
M1S
M 2S
10%
5%
E
E'
d
1
M
500
Lieberman & Hall; Introduction to Economics, 2005
M2d
1,000 Money ($ Billions)
44
The Fed’s Response to Spending
Shocks

Shifts in total spending—due to changes in autonomous consumption,
investment spending, taxes, or government purchases—cause changes
in real GDP
 How can the Fed keep real GDP close to potential output when there are
direct spending shocks like these?

To stabilize real GDP, the Fed must change its interest rate target in
response to a spending shock
 And change the money supply to hit its new target
• It must raise its interest rate target (decrease the money supply) in response to a
positive spending shock and lower the interest rate target (increase the money
supply) in response to a negative spending shock

Fed’s policy of stabilizing real GDP comes at a price

Fluctuations in the interest rate are costly
 Fluctuations in the interest rate
 Fluctuations in real GDP are costly too, and the Fed has concluded that it is
a good idea to adjust its interest rate targets aggressively when necessary to
stabilize real GDP
Lieberman & Hall; Introduction to Economics, 2005
45
Figure 10: The Fed’s Response to
Spending Shocks
Interest
Rate
M 2S
M1S
H
7.5%
E
5%
Md
300
Lieberman & Hall; Introduction to Economics, 2005
500
Money ($ Billions)
46
Using the Theory: The Fed and the
Recession of 2001

Our most recent recession lasted from March to November
of 2001
 What did policy makers do to try to prevent the recession, and to
deal with it once it started?
 Why did consumption spending behave abnormally, rising as income
fell and preventing the recession from becoming a more serious
downturn?

Starting in January 2001 the Fed began to worry
 The Fed feared that if it did nothing, the investment slowdown would
lead through the multiplier to a significant drop in real GDP

The Fed decided to take action
 Beginning in January, the Fed began increasing the money supply
rapidly
 The federal funds rate is the interest rate that banks with excess
reserves charge for lending reserves to other banks
 In September of 2001, during which real GDP probably hit bottom,
the federal funds rate averaged about 3.1 percent
Lieberman & Hall; Introduction to Economics, 2005
47
Using the Theory: The Fed and the
Recession of 2001

Although the Fed’s policy did not completely
prevent the recession
 It no doubt saved the economy from a more severe and
longer-lasting one


Lower interest rates stimulate consumption
spending on consumer durables
Moreover, when interest rates drop dramatically
and rapidly—as they did in 2001—a frenzy of home
mortgage refinancing can occur
 Home refinancing and additional borrowing on homes
seemed to play a major role in boosting consumption
spending during the recession of 2001
Lieberman & Hall; Introduction to Economics, 2005
48
Figure 11(a): The Fed in Action:
2001
(a)
Interest Rate
6.4%
M1S
M 2S
A
During 2001, the Fed
repeatedly increased the
money supply . . .
3.1%
C
MYd $9,243 billion
MYd $9,130 billion
$1,093
Lieberman & Hall; Introduction to Economics, 2005
1,170
Money ($ Billions)
49
Figure 11(b): The Fed in Action:
2001
(b)
Money (M1)
($ Billions)
1,200
During 2001, the Fed
repeatedly increased the
money supply . . .
1,150
1,100
1,050
1,000
Aug.
2000
Lieberman & Hall; Introduction to Economics, 2005
Dec.
2000
Apr.
2001
Aug.
2001
Dec.
2001
50
Figure 11(c): The Fed in Action:
2001
(c)
Federal
Funds Rate
Percent
which caused the
interest rate to drop.
6.0
5.0
4.0
3.0
2.0
Aug.
2000
Lieberman & Hall; Introduction to Economics, 2005
Dec.
2000
Apr.
2001
Aug.
2001
Dec.
2001
51