Chapter 14

The BSP and Monetary Policy

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
 The main topics of this chapter are:
1. 2. 3. 4. 5. 6. 7. 8. 9. The organization of the BSP. Reserve requirements. The deposit expansion multiplier. Creation and destruction of money. The tools of monetary policy. The Feds effectiveness in fighting inflation and recession. The Banking Act of 1980 and 1999. Monetary policy lags. The housing bubble and the subprime mortgage crisis.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Legal Reserve Requirements

 To ensure stability of banking system, as well as to control the money supply, the Fed sets legal reserve requirements. Every financial institution in the country is legally required to hold a certain percentage of its deposits on reserve. Legal reserves can be held at the Federal Reserve District Bank or in the banks own vaults. Time deposits have 0% reserve requirement (or reserve ratio). Legal Reserve Requirements for Checking Accounts, February 11, 2008*

* Numerical boundaries of these limits are revised annually.

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Question for Discussion

If a bank had $100 million in checking deposits (Demand Deposits), how much reserves would it be required to hold?
Use this table:

Answer: First $9.3 million of deposits: 0% reserve requirement Next 34.6 million: $34,600,000 X .03 = Next 56.1 million: $51,700,000 X .10 = Required Reserves =
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

$1,038,000 $5,610,000 $6,648,000

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Definitions
 Required Reserves (RR) is the minimum amount of vault cash and deposits at the Federal Reserve District Bank that must be held (kept on the books).  Actual Reserves (RD) is what the bank is holdingor its Reserve Deposits.  Excess Reserves (ER) occur if bank holds more than the required minimum on reserve. ER = RD RR  Remember: Banks do not make profits on funds held as reserves.
ER can be loaned out. So banks want to hold ER as close to zero as possible.

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What Happens if the Bank is Short?

 If Actual Reserves (RD) are less than Required Reserves (RR), the Excess Reserves (ER) are negative.
ER = RD RR, so ER will be negative if RR < RD.

 Negative ER means the bank is short of the legal reserve requirement.

When this happens, banks usually borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charged is called the federal funds rate. A bank may also borrow reserves from its Federal Reserve District Bank at its discount window. The interest rate charged is the discount rate. rate. Or, the bank can sell some of its secondary reserves

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Primary and Secondary Reserves

 Primary reserves: A banks vault cash and its deposits at the the Federal District Bank.
Only primary reserves count toward the legal RR.

 Secondary reserves: Treasury bills, notes, certificates, and bonds that will mature in less than a year.
These are easily converted into cash for reserves by selling them to another bank.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Reserve Requirements and the Deposit Expansion Multiplier

 New money injected into the economy will have a multiplied effect on the macroeconomy (real GDP).
Remember: Banks, like goldsmiths, create money when they make loans. If the reserve requirement is low, the bank has to keep less in their vaults (or with the Fed) and can lend out more money. If the reserve requirement is high, the bank has to keep more in their vaults (or with the Fed) and can lend out less money.

 The reserve requirement affects the size of the deposit expansion multiplier.
Lets look at an example of the deposit expansion process

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Example of Deposit Expansion

 Assume a 10% reserve ratio.  Someone deposits $100,000 in a bank.
The bank must keep $10,000 as RR (10% x 100,000). It can lend out $90,000.

 The company with the $90,000 loan writes a check to spend it. This is deposited in another bank.
This bank must keep $9,000 in reserves to cover the new depositby borrowing cash or selling secondary reserves. But the second bank can lend out $81,000 ($90,000 $9,000).

 This $81,000 becomes a deposit in another bank, and the process continues.

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Example of Deposit Expansion

If the process continued, there would be $100,000 in deposits credited to various bank accounts, backed by $100,000 in reserves.
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Calculating the Deposit Expansion Multiplier (DEM)

1 DEM = Reserve Ratio Example: Assume a RR of 10%:
DEM = 1 .10

= 10

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Question for Thought and Discussion

 What would happen to the DEM if the reserve ratio were increased to 25%?  Answer:

DEM =

1 .25

= 4

When RR increases, the DEM decreases. When RR decreases, the DEM increases.

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Modifications of the DEM

 The real DEM is lower than if it were based solely on the reserve ratio.  Three modifications:
1. Some people will keep part of their loans in cash, rather than depositing them in a checking account. 2. Banks may carry excess reserves, to avoid getting caught short. 3. There are leakages of dollars to foreign countries, due to our trade imbalance.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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How Money Moves: Cash, Checks, and Electronic Money

 We still carry out about 80% of our transactions in cash.
However, cash covers less than one percent of the total monetary value of our transactions. Electronic transfers account for five out of every six dollars that move in the economy.

 In 2004 Congress passed the Check Clearing Act of the 21st Century (Check 21).
Law intended to facilitate electronic check processing. How? Lets look at the check clearing process.

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The Check Clearing Process is Changing

 Slavin writes $50 check to Bob in San Francisco.
Slavins bank is Citibank. Bobs bank is Bank of America.

 Follow the check

Feds District Banks transfer the value from one banks reserve account to anothers reserve account.

 Check 21 sped up this process.

Digital pictures of the check are transferred, instead of the physical check.

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Electronic Transfers
 Increasingly, money is changing hands electronically.
Example: When you use your debit card the amount is deducted within seconds after the card is swiped. Example: Paypal accounts facilitate paperless transfers.

 Today, $1.5 trillion a day is transferred electronically.

About one-third of these transfers are carried out by the Federal Reserves electronic network. About two-thirds are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 10 big New York Banks.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Tools of Monetary Policy

 The most important job of the Fed is to control the rate of growth of the money supply.  How? The Fed controls the money supply by using 3 monetary policy tools:
1. Open market operations: buying and selling government securities to financial institutions. 2. Discount rate and federal funds rate: key interest rates that affect other interest rates. 3. Reserve requirements: changing the reserve ratio.

 Open market operations have been the most commonly used monetary policy tool.
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Scenario #1: Increasing the Money Supply

 To increase the money supply, the Fed buys bonds from banks and other financial institutions.  Follow the money:
The banks get money in exchange for some of the bonds in their portfolios. This money is put into circulation and increases the banks demand deposits. Because of the DEM, there is a multiplied increase in the money supply.

 How does the Fed get the banks to sell?

It makes an offer they cant refuse! Price of bonds is pushed up.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Scenario #2: Decreasing the Money Supply

 To decrease the money supply, the Fed sells bonds to banks and other financial institutions.  Follow the money:
The Fed gets money in exchange for some of the bonds in their portfolios. This money is taken out of circulation by the Fed. Because of the DEM, there is a multiplied decrease in the money supply.

 How does the Fed get the banks to buy?

It makes an offer they cant refuse! The price of bonds is pushed down.

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Questions for Thought and Discussion

 What happens to interest rates when the Fed buys or sells bonds?  Use the following formula:

Interest paid Interest rate = Price of bond

Hint: When the Fed buys or sells bonds, they affect the market price of the bonds.

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Impact of Increasing the Money Supply

 Increasing the money supply leads to a decrease in interest rates.  During a recession, lower interest rates may encourage businesses to increase Investment and households to increase Consumption.  If C and I increase, the fiscal policy multiplier will lead to a greater increase in real GDP.

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Impact of Decreasing the Money Supply

 Decreasing the money supply leads to an increase in interest rates.  During inflation, higher interest rates may discourage business Investment and household Consumption.  If C and I decrease, the fiscal policy multiplier will lead to a greater decrease in real GDP, but it will also bring down the price level.

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Open Market Operations Fed buys $1000 bond from a commercial bank
New Reserves

$1000
$1000 Excess Reserves

$5000 Bank System Lending Total Increase in the Money Supply, ($5,000)
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Open Market Operations Fed buys $1,000 bond from the public
Check is Deposited New Reserves

$1000
$800 Excess Reserves $200 Required Reserves

$4000 Bank System Lending

$1000 Initial Checkable Deposit

Total Increase in the Money Supply, ($5000)

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Monetary Policy Tool #2: Key Interest Rates

 Discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District Bank.  Federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other.
Federal funds rate is higher than the discount rate.

 Lowering interest rates is expansionary response to recession.  Raising interest rates is contractionary response to inflation.

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Monetary Policy Tool #3: Changing Reserve Requirements

 The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14 percent for checkable deposits.
Changing reserve requirements is the ultimate weapon and is rarely used (about once per decade).

 To combat recession, Fed lowers required reserve ratio to create more excess reserves.
Example: Lowered from 12% to 10% in 1992.

 To combat inflation, Fed would increase required reserve ratio.

Banks would have to scramble to increase reserves.

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Summary: The Tools of Monetary Policy

 To fight recession, the Fed will:

1. Buy securities on the open market. 2. Lower discount rate and federal funds rate. 3. Lower reserve requirements.

 To fight inflation, the Fed will:

1. Sell securities on the open market. 2. Raise the discount rate and federal funds rate. 3. Raise reserve requirements (only as a last resort).

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Contractionary Monetary Policy Transmission Mechanism

 Like pulling on a string, when the Fed fights inflation, it get resultsprovided of course, it pulls hard enough.

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Restrictive Monetary Policy

Problem: inflation CAUSE-EFFECT CHAIN CAUSEFed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines
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Expansionary Monetary Policy Transmission Mechanism

 Fighting a recession is another matter.  Like pushing on a string, no matter how hard the Fed works, it might not get anywhere.  If Aggregate Demand is low, businesses may not invest, no matter how low interest rates are.  Keynes Liquidity Trap: if interest rates are too low, people will simply hold on to their money.

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Expansionary Monetary Policy

Problem: unemployment and recession CAUSE-EFFECT CHAIN CAUSEFed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises
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Monetary Policy Lags

 Monetary policy has the same three lags as fiscal policy:
Recognition lag Decision lag Impact lag

 The first two lags may be shorter because of consolidated power of Feds Board of Governors.  But the impact lag may be longer.

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