Money banking finance exam 1

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The federal reserve system

The federal reserve system

-headed by board of governors -12 federal reserve banks located throughout the nation -US monetary policy determined by the FOMC

federal reserve bank functions

-clear checks -issue new currency -withdraw damaged currency from circulation -administer and make discount loans to banks in their district -evaluate proposed mergers and applications for banks to expand their activities -collect data on local business conditions

federal reserve banks and monetary policy

-Directors "establish" the discount rate -Decide which banks can obtain discount loans -Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the Board of Governors and provides information to help conduct monetary policy -Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

member banks

-All national banks are required to be members of the Federal Reserve System -Commercial banks chartered by states are not required but may choose to be members -Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities

special role of the federal reserve bank of NY (FRBNY)

-executes monetary policy -agent of the US Treasury conducts US gov financing operations -executes intervention in foreign market -provides custody and related services to foreign central banks -President serves as vice chair of FOMC and permanent voting member -assumed a number of roles associated with the Fed's crisis related "Credit Policies"

Board of Governors of the Federal Reserve System

-The seven-member board that supervises the banking system of the United States -appointed by president, confirmed by state -14-year non renewable term -required to come from different districts -pres selects chairman, a governor, serves as a four-year renewable term as chair

Duties of the Board of Governors

-Votes on conduct of open market operations -Sets reserve requirements -Controls the discount rate through "review and determination" process -Sets margin requirements -Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank's budget -Approves bank mergers and applications for new activities -Specifies the permissible activities of bank holding companies -Supervises the activities of foreign banks operating in the U.S.

FOMC- Policy making arm the fed

-meets 8 times a year -7 members of the board of governors, president of the FRBNY, presidents of four other federal reserve banks -chariman of the board of governors is also chair of FOMC, president of FRBNY is vice chair of FOMC -issues directives to the trading desk at the FRBNY- sets Fed Funds Target

Role of Chairman

-sets agenda for FOMC meetings -supervises professional economists and advisers -volcker/greenspan/bernanke/yellen - differences in style

How independent is the Fed?

• Instrument and goal independence

• Independent revenue

• Fed's structure is written by Congress, and is subject to change at any time.

• Presidential influence: *Influence on Congress *Appoints members *Appoints chairman although terms are not concurrent

FOMC releases

-post meeting statement: afternoon of meeting -survey of economic projections: afternoon following meeting (4 times per year) -post meeting press conference following meeting wherein SEP were compiled -Minutes: 3 weeks after meeting -transcripts: 5 years after meeting

Benefits of fed transparency

-levels playing field -makes fed more accountable -reduces policy lags by cutting recognition lags to zero -improves transmission of policy via the expectations theory of yield curve -reduces "liquidity" or "term premiums" embedded in yield curve

How high fed become more transparent?

-establish an explicit inflation target -broadcast FOMC meetings on C-span -release minutes sooner -make transcripts with shorter lags -provide more frequent forecasts

why central bank independence?

-political pressure would impart an inflationary bias to monetary policy -political business cycle -could be used to facilitate treasury financing of large budget deficits - monetarizing the federal debt -too important to leave the politicians

Case against independence

-Undemocratic -Unaccountable -Difficult to coordinate fiscal and monetary policy

what determines potential gdp?

-growth of the labor force -conventions regarding work week -productivity growth = to the growth rate of labor force + growth rate of productivity

• can be viewed as economy's "speed limit"

what is money?

medium of exchange, store of value, unit of account, standard of deferred payment

important characteristics of money

divisibility, portability, stability, durability, difficulty of counterfeiting, scarce

Gold Standard

-the value of currency is fixed in terms of quantity of gold -sets the money supply and price level generally with limited central bank intervention

Problems with gold standard

-money supply cannot be adjusted in response to changing economic conditions -all countries on gold standard are forced to maintain fixed exchange rates -the effects of bad policies in one country can be transmitted to other countries -if not perfectly credible, it is subject to speculative attack and ultimate collapse -didnt prevent financial panics -medium run- caused periods of inflation/deflation

the payment system

outside money - created by the gov, coins and federal reserve notes (currency) -inside money - money created in the private sector, checking accounts, travelers checks, etc

money growth rule

a rule that focuses only on the growth rate of money in the economy; under such a rule, the central bank simply would set money growth in the long run, ignoring short-run fluctuations in the economy Fire

Equation of Exchange

MV=PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is the output of goods and services produced in an economy.

Monetarists

economists who believe the velocity of money is fairly constant or predictable

Money and Price level

P=MV/Q P=MV/Real GDP

Activist rule

a rule for monetary policy under which monetary policy is allowed to change over the course of the business cycle

nonactivist rule

a rule for monetary policy under which the same monetary policy is pursued whether the economy is in a recession or an expansion (Monetarists believed in this)

Friedman's Basic Thesis

-in LR, increased monetary growth increases prices but has little or no effect on output -in SR, increases in money supply causes employment and output to increase, and decreases in money supply have the opposite effect

Keynes motives for holding money balances

Transaction motive precautionary motive speculative motive

Transaction motive

the amount of desired money balances is a function of income: the higher the income, the more money demanded for carrying out increased spending

Precautionary motive

people prefer to have liquidity incase of unexpected problems: the higher the degree of uncertainty, the greater the demand for precautionary balances

speculative motive

people retain liquidity when interest rates are low and buy bonds when interest rates are high

liquidity trap

nominal interest rate has been lowered nearly to or equal to zero to avoid recession

What is a bank?

-a place for safe keeping of money -checks can be written -channels funds to borrowers

bank assets include

-bank building & furniture etc -cash in vault -deposits at other banks (fed) -securities (treasury bills, bonds, etc) -loans

bank liabilities include

-demand deposits (checking accounts) -various savings accounts -large certificates of deposits -other borrowed monies

How do commercial banks make money?

they earn more interest on assets than they pay on liabilities

National banks

chartered by federal gov (must be members of federal reserve)

state banks

chartered by a state government, if they meet the financial standards set by the Board of Governors they may become a member bank

financial intermediaries other than commercial banks

-thrifts (saving institutions) -mutual funds -money market funds -investment banks -hedge funds -insurance companies -structured investment vehicles

steps to start a bank?

1. get state or national charter

2. inject capital to buy building, vault, and to have cash on hand

3. take in deposits

4. make loans

New York Clearing house

-member banks hold clearing balances at clearing house -"debits" or reduces the account of the payer bank -"credits" or increases the account of payee bank

Reserve requirements

depository institutions must set aside a % of their deposits as reserves to be held either as cash on hand, or as reserve account - balances at a federal reserve bank

capital requirement

bank regulators require that banks maintain adequate capital to serve as a buffer against losses

fractional reserve banking

a banking system that keeps only a fraction of funds on hand and lends out the remainder

Agents in the Money Supply Process

-federal reserve system -banks -depositors -borrowers

open market operations

-purchase increases the volume of bank reserves -sale decreases the volume of bank reserves

factors affecting bank reserves and monetary base

-float -treasury deposits at the federal reserve -interventions in the foreign exchange market -redemptions from fed's portfolio

total bank reserves = required reserves + excess reserves

required reserves = reserve ratio X deposits excess reserves =any reserves above required

Who controls deposit growth (money supply)?

-determined by a combination of the fed actions, and market dynamics

Lagged Reserve Accounting (LRA)

renders a disconnect between deposit growth and required reserve

federal funds rate targeting

if the demand for reserves increases because a bank without excess reserve wants to make a loan, the funds rate would ride, and the fed would then add the needed reserves to get the funds rate back to target

What is the Bailey Brothers Building & Loan (BBB&L) to do?

-choice 1: call in loans -choice 2: sell assets -choice 3: try to borrow money -choice 4: jump off bridge to collect on life insurance policy

federal funds market

A market for overnight lending and borrowing of reserves among banks; the market for reserves on account at the FED

The Fed Controls the Supply of Bank Reserves

-federal reserve determines the supply of bank reserves -by buying/selling securities. buying = securities shifts supply curve to the right. selling = securities shifts supply curve to the left

What determines demand for bank reserves?

-required reserves= the mandated required reserves ratio X reservable deposit liabilities -excess reserves = all reserves beyond that required to meet mandated required reserves.

excess reserves demand

-determines levels of funds rate -influences by degree of uncertainty. onset of credit crisis uncertainty rose, so did the demand for excess reserves. -increase in uncertainty shifts the demand for reserves outward, and unless the supply is increase will cause the funds rate to rise.

dynamic open market operations

aimed at fundamentally changing the funds rate target - Policy Decision

defensive open market operations

aimed at offsetting changes in the autonomous reserve factors (those that add or drain reserves) with an intent of getting the funds rate to trade close to target

money market instruments

-federal funds -large negotiable certificates of deposit -eurodollars repurchase agreements and reserves RPs -treasury bills -commercial paper