Robert F. Mulligan WESTERN CAROLINA UNIVERSITY COLLEGE OF BUSINESS Department of Economics, Finance, & International Business

MBA 505 ECONOMICS AND PUBLIC POLICY

Chapter 26 CENTRAL BANKING AND MONETARY POLICY

I. THE FEDERAL RESERVE SYSTEM A. The Federal Reserve System is the central bank of the U.S. It is really a network of twelve regional central banks, each of which issues money and regulates commercial banking in its federal reserve district. A central bank is the public authority in charge of controlling and regulating the nation's money supply and financial markets. The Fed is also in charge of the nation's monetary policy, which is the attempt to control inflation and smooth the business cycle by changing the quantity of money and adjusting interest rates.

B. The Fed was created by Congress with the Federal Reserve Act of 1913.

C. There are three main players in the Fed:

1. The Board of Governors is composed of seven members appointed by the President of the U.S. and confirmed by the Senate. Each governor serves a 14 year term which overlaps so one position comes vacant every two years. One member is appointed by the President to serve a four year term as chair, also with the advice and consent of the Senate.

2. There is a Federal Reserve Bank for each of the 12 federal reserve districts. Each bank is owned by the member banks in the district, with shares based on the size of each member bank. Each of the federal reserve banks has a nine member board of directors and a president. The Fifth Federal Reserve District is served by the Federal Reserve Bank of Richmond, with branches in Charlotte and Baltimore. The district consists of North Carolina, South Carolina, Virginia, West Virginia, Maryland, Delaware, and the District of Columbia.

3. The Federal Open Market Committee (FOMC) is the major policy making group in the Federal Reserve System. It consists of the Board of Governors, the president of the Federal Reserve Bank of New York, and, on a rotating basis, four of the eleven presidents of the other regional Feds. The New York Fed is always represented because it carries out open market operations - sales and purchases of U.S. Treasury bills, bonds, and notes.

D. The Fed uses three policy tools to carry out monetary policy: 1. Open market operations are the sale or purchase of government securities by the Fed.

2. The Fed sets the required reserve ratio (or reserve requirement), the minimum percentages of deposits that banks must hold as reserves. The Fed does not change these ratios very often. Raising the required reserve ratio makes the banking system safer but less profitable.

3. The discount rate or rediscount rate is the interest rate the Fed charges commercial banks when they borrow reserves from the Fed. Increasing (decreasing) the discount rate makes it more costly to borrow reserves and thereby reduces (increases) the money supply.

E. On the Fed's balance sheet, the largest and most important asset is U.S. government securities. The most important liabilities are Federal Reserve notes in circulation and deposits held at the Fed by commercial banks. 1. The sum of Federal Reserve notes and bank deposits at the Fed is the monetary base.
F. When the Fed conducts an open market operation by buying a government security, it increases banks' reserves. Banks loan the excess reserves. By making loans banks create money. The reverse occurs when the Fed sells a government security to the public.

G. The money multiplier is the amount by which a change in the monetary base is multiplied to calculated the final change in the money supply.

1. The "money multiplier" differs from the deposit expansion multiplier (DEM) because the DEM multiplier shows how much a change in reserves affects the money supply while the money multiplier shows how much a change in the monetary base affects the money supply.

2. A currency drain occurs when people hold currency rather than depositing it in banks. A currency drain reduces the amount of banks' reserves, thereby reducing the amount banks can loan and thus reducing the money multiplier.

3. The money multiplier was 2.9 in 1991. Increases in the ratio of banks' reserves to bank deposits and the ratio of the public's currency holdings to bank deposits reduce the money multiplier. 

II. INTEREST RATE DETERMINATION A. An interest rate is the "percentage yield on a financial security such as a bond or a stock."

B. There is an inverse relationship between the price of a bond and the interest rate: as the interest rate rises (falls), the price of the bond decreases (increases).

C. Equilibrium in the money market determines the equilibrium interest rate, r*.

1. Equilibrium in the money market is a stock equilibrium, i.e., a situation where the entire stock of the available asset is willingly demanded.

2. Equilibrium in the goods market is a flow equilibrium, i.e., a situation where the quantity of goods or services supplied over some period of time is willingly demanded.

3. If the interest rate initially exceeds the equilibrium interest rate r*, people demand less money than exists. Thus, they try to get rid of their "excess" money by buying financial assets (e.g., bonds.) This drives down the interest paid on the assets, thereby restoring the interest rate to its equilibrium level r*.

D. If the Fed increases the supply of money the money supply curve shifts to the right. As a result the interest rate falls. If the Fed decreases the supply of money, the interest rate rises. 1. In the early 1980s, the Fed (under Paul Volker) slowed the growth rate of the money supply and interest rates rose dramatically.

2. In 1988 the Fed (under Alan Greenspan) again slowed the growth rate of the money supply and interest rates again rose. Then in 1991 the Fed increased the growth rate of the money supply and interest rates fell.

E. People try to predict the Fed's actions because correct predictions allow profits to be made by buying or selling bonds. If the Fed's actions can be predicted, bond prices-and interest rates-will already have changed by the time the Fed carries out its actions.