Functions of Federal Reserve District Banks
• Clear checks
• Issue new currency/withdraw damaged currency
• Make discount loans to banks in district
• Evaluate mergers/expansions of bank activities
• Liaison between business community and the Fed
• Examine bank holding companies and state-chartered member banks
• Collect data on local business conditions
• Research Money, Banking and the Financial System
FRBNY’s special roles
• Bond and currency open market operations
• Supervise bank holding companies in NY district
• Member of Bank for International Settlements
How Independent is the Fed?
• Instrument independent
• Goal independent … undemocratic?
– Political pressure would impart inflationary bias to monetary policy
– Political business cycle?
– Could facilitate Treasury financing of large budget deficits—
accommodation
• Independent revenue
• Structured by Congress/accountable to Congress
• Presidential influence
– Influence on Congress
– Appoints members
– Appoints chairman
European Central Bank
• Patterned after the Federal Reserve
• Central banks from each country play similar role as
Fed district banks
– Monetary operations are not centralized
– ECB does not supervise and regulate financial
institutions
– More independent than Fed
• Maastricht Treaty would have to be revised to change
ECB charge
– But less goal independent than Fed
Price Stability Rules
Multiple Creation of Money and Credit
• Fed buys something … MB up
A bond
Owes
.
A bank IOU
Federal Reserve Notes
•Currency in Circulation • Seller deposits proceed in Bank A
The Fed’s Balance Sheet
Owns
Gold, Forex
•Vault Cash
Reserves
Bank IOUs
(Discount loans)
Securities
Bank Deposits @ Fed
Bank A
Bank B
:
Gov’t Deposits
Gov’t Bonds
MBSs
Miscellaneous
Monetary Base
High Powered
= MB
Money = H = MB
Note: MB = Currency + Bank Reserves = C + R
Ms = Currency + Demand Deposits = C + D
Money supply increases
• Bank A’s deposits @ Fed up
Bank A now has more reserves
• Bank A holds reserves against its
new deposit (required + excess)
• Bank A makes loan to customer
Borrower now has more deposits
Money has just been created
• Borrower buys something
Seller holds onto currency and
deposits the rest in its Bank B
• Bank B’s deposits @ Fed up
:
Money Supply Response
Reserve Requirements
• Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the
reserve requirement the same for all depository
institutions
• 3% of the first $48.3 million of checkable
deposits; 10% of checkable deposits over $48.3
million
• The Fed can vary the 10% requirement between
8% to 14%
Deriving the Money Multiplier
M=D+C
MB = R + C = Required Reserves + Excess Reserves + C
r = Required reserves/Deposits = RR / D  RR= r x D
e = Excess reserves/Deposits = ER/D  ER = e x D
c = {C / D}  C = c  D and
e = {ER / D}  ER = e  D
Substituting in the previous equation
MB  (r  D)  (e  D)  (c  D)  (r  e  c)  D
Divide both sides by the term in parentheses
1
D
 MB
r ec
M  D  C and C  c  D
M  D  (c  D)  (1 c)  D
Substituting again
1 c
M
 MB
r ec
The money multiplier is then
1 c
m
r ec
The Great Depression: Alternative Views
The Descent, 1929 - 1933
•Lionel Robbins/Friedrich von Hayek/Ludwig von Mises
•Prior credit expansion  Malinvestment  Bust
•Irving Fisher: Debt Deflation Crisis – Balance Sheet Recession
•John Maynard Keynes: Animal Spirits  Investment BOOMS and busts
:
•Milton Friedman and Anna Schwartz: Monetary Contraction
A Great Contraction:
Excess Reserves Ratio and Currency Ratio, 1929–1933
Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton
University Press, 1963), p. 333.
A Great Contraction:
M1 and the Monetary Base, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton
University Press, 1963), p. 333.
The Great Depression: Alternative Views
The Descent, 1929 - 1933
•Lionel Robbins/Friedrich von Hayek/Ludwig von Mises
•Prior credit expansion  Malinvestment  Bust
•Irving Fisher: Debt Deflation Crisis – Balance Sheet Recession
•John Maynard Keynes: Animal Spirits  Investment BOOMS and busts
:
•Milton Friedman and Anna Schwartz: Monetary Contraction
•Peter Temin: Consumption bust
•Charles Kindleberger: Lack of leader – lender of last resort
•Ben Bernanke: Agency costs  Credit contraction
Ben S. Bernanke
Nonmonetary Effects of the Financial Crisis in the
Propagation of the Great Depression
American Economic Review, June 1983
Why was the Great Depression so deep?
Why did it last so long?
•The credit channel: a career is launched!
Why was the Great Depression so deep?
Why did it last so long?
• Friedman and Schwartz: monetary contraction.
• Bernanke: true, but there’s more.
Financial crisis – bank failures – reduced borrower net worth
Increased Cost of Credit Intermediation (CCI)
(A “rational” credit squeeze)
• Opposed to Keynes, Minsky, Kindleberger, Shiller:
Animal spirits/Irrational exuberance
 Inherent instability of financial capitalism
• Bernanke: “push rationality postulate as far as it will go.”
Cost of Credit Intermediation
• Intermediaries separate “good” from “bad” borrowers
–
–
–
–
Screening costs
Monitoring costs
Accounting costs
Bad loan losses
• Debt build-up in Roaring ‘20s
• Erosion of collateral values
Either write more complex debt contracts or bear higher bad loan losses
Either way, CCI rises and lending is reduced.
• Banks liquidate loans/rush to quality assets (T-bonds)
• Observe low interest rate…but money isn’t easy.
Real Consequences of Credit Contraction
• Aggregate supply impacts
Reduced intermediation  reduced allocative efficiency
Large, indivisible projects not funded
• Production Possibilities Frontier shifts inward
• Upward shift of AS  Y down, i up … but i didn’t rise
• Aggregate demand impacts
High cost of credit when CCI rises
 would-be borrowers buy less stuff (substitution effect)
• AD down  Y down and i down … as observed in Great
Depression
Why did it last so long?
• New credit channels emerge only slowly.
• Insolvent debtors recover only slowly.
– Credit difficulties for small business lasted 2+ years after 1933
banking holiday
– Very little mortgage lending occurred for years after 1933
{Bernanke uses narrative methodology to make these points.
Cites comments of contemporary authorities, news items, etc.}
• New Deal recovery:
• Rehabilitating the financial system was only positive
contribution.
» New Deal fiscal stimulus was weak
» National Industrial Recovery Act (cartelization) hurt recovery
The Great Depression: Alternative Views
The Descent, 1929 - 1933
•Lionel Robbins/Friedrich von Hayek/Ludwig von Mises
•Prior credit expansion  Malinvestment  Bust
•Irving Fisher: Debt Deflation Crisis – Balance Sheet Recession
•John Maynard Keynes: Animal Spirits  Investment BOOMS and busts
:
•Milton Friedman and Anna Schwartz: Monetary Contraction
•Peter Temin: Consumption bust
•Charles Kindleberger: Lack of leader – lack of lender of last resort
•Ben Bernanke: Agency costs  Credit contraction
•Barry Eichengreen/Ben Bernanke: Golden Fetters
Recovery: 1933 – 1937
•Christina Romer: Monetary expansion
•Barry Eichengreen/Ben Bernanke: Abandoning Gold  M - expansion
•Peter Temin/Gauti Eggertsson: Reflationary expectations
Tools of Monetary Policy
• Open market operations
– Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves
– Affect the monetary base
• Changes in reserve requirements
– Affect the money multiplier
• Federal funds rate: the interest rate on overnight loans of
reserves from one bank to another
– Primary instrument of monetary policy
Equilibrium in the Market for Reserves
Primary credit rate
 Discount rate
Federal funds rate
Interest paid on excess reserves
Response to an Open Market Operation
When the Fed buys something on
the open market, the quantity of non-borrowed
reserves (and total reserves) in the banking
system increases, driving down the federal funds
rate.
By paying interest on reserves, the Fed can expand
its balance sheet – inject liquidity into financial
system by lending via exotic “facilities” –
without increasing the money supply. The
increased NBRs are absorbed as excess reserves.
How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate
By paying interest on reserves, the Fed has been able to increase its balance sheet
(MB) without much increasing the money supply. Once the quantity of
non-borrowed reserves in the banking system drives the federal funds rate to ier, banks
hold on to excess reserves.
Advantages and Disadvantages of
Discount Policy
• Used to perform role of lender of last resort
– Important during the subprime financial crisis of
2007-2008.
• Cannot be controlled by the Fed; the decision
maker is the bank
• Discount facility is used as a backup facility to
prevent the federal funds rate from rising too
far above the target
Open Market Operations
•
•
•
•
Dynamic open market operations
Defensive open market operations
Primary dealers
TRAPS (Trading Room Automated Processing
System linked to primary dealers)
• Repurchase agreements
• Matched sale-purchase agreements
• Outright transactions
List of the Primary Government Securities Dealers Reporting to the Government Securities
Dealers Statistics Unit of the Federal Reserve Bank of New York
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
UBS Securities LLC.