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 Fed¶s 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.

14-2

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 bank¶s 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.
Copyright •2009 by The McGraw-Hill Companies, Inc. All rights reserved. 14-3

All rights reserved. Inc.000 $5. how much reserves would it be required to hold? Use this table: Answer: First $9.038.610.000 $6.03 = Next 56.000 X .600.000 X .000 14-4 .700.3 million of deposits: 0% reserve requirement Next 34. $1.1 million: $51.648.10 = Required Reserves = Copyright •2009 by The McGraw-Hill Companies.6 million: $34.Question for Discussion If a bank had $100 million in checking deposits (Demand Deposits).

All rights reserved. ‡ ER can be loaned out. Inc.  Actual Reserves (RD) is what the bank is holding±or its Reserve Deposits. ‡ So banks want to hold ER as close to zero as possible. 14-5 .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). ‡ ER = RD ± RR  Remember: Banks do not make profits on funds held as reserves.  Excess Reserves (ER) occur if bank holds more than the required minimum on reserve. Copyright •2009 by The McGraw-Hill Companies.

rate.  Negative ER means the bank is short of the legal reserve requirement.What Happens if the Bank is Short?  If Actual Reserves (RD) are less than Required Reserves (RR). 14-6 . the bank can sell some of its secondary reserves« Copyright •2009 by The McGraw-Hill Companies. ‡ These are called federal funds and the interest rate charged is called the federal funds rate. ‡ Or. Inc.´ The interest rate charged is the discount rate. so ER will be negative if RR < RD. banks usually borrow reserves from another bank that does have excess reserves. ‡ When this happens. ‡ ER = RD ± RR. All rights reserved. the Excess Reserves (ER) are negative. ‡ A bank may also borrow reserves from its Federal Reserve District Bank at its ³discount window.

All rights reserved. certificates. ‡ These are easily converted into cash for reserves by selling them to another bank. Copyright •2009 by The McGraw-Hill Companies. 14-7 . Inc. and bonds that will mature in less than a year. ‡ Only primary reserves count toward the legal RR. notes.  Secondary reserves: Treasury bills.Primary and Secondary Reserves  Primary reserves: A bank¶s vault cash and its deposits at the the Federal District Bank.

the bank has to keep more in their vaults (or with the Fed) and can lend out less money. ‡ Let¶s look at an example of the deposit expansion process« Copyright •2009 by The McGraw-Hill Companies. All rights reserved. like goldsmiths. 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. ‡ Remember: Banks. ‡ If the reserve requirement is low. 14-8 . create money when they make loans.  The reserve requirement affects the size of the deposit expansion multiplier.Reserve Requirements and the Deposit Expansion Multiplier  New money injected into the economy will have a multiplied effect on the macroeconomy (real GDP). Inc.

14-9 .000 ± $9. ‡ But the second bank can lend out $81. and the process continues. ‡ It can lend out $90.000 as RR (10% x 100. ‡ This bank must keep $9. All rights reserved. This is deposited in another bank.000 in reserves to cover the new deposit²by borrowing cash or selling secondary reserves. Copyright •2009 by The McGraw-Hill Companies.000 becomes a deposit in another bank.Example of Deposit Expansion  Assume a 10% reserve ratio. Inc.  The company with the $90.000).000).000 loan writes a check to spend it.000 in a bank.  This $81. ‡ The bank must keep $10.000.  Someone deposits $100.000 ($90.

there would be $100. Copyright •2009 by The McGraw-Hill Companies. Inc.000 in deposits credited to various bank accounts.Example of Deposit Expansion If the process continued. 14-10 .000 in reserves. backed by $100. All rights reserved.

Calculating the Deposit Expansion Multiplier (DEM) 1 DEM = Reserve Ratio Example: Assume a RR of 10%: DEM = 1 .10 = 10 Copyright •2009 by The McGraw-Hill Companies. 14-11 . Inc. All rights reserved.

When RR decreases. the DEM decreases. the DEM increases. Copyright •2009 by The McGraw-Hill Companies. Inc. All rights reserved. 14-12 .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.

to avoid getting caught short. 14-13 . due to our trade imbalance. rather than depositing them in a checking account. Copyright •2009 by The McGraw-Hill Companies. Banks may carry excess reserves. 2. Some people will keep part of their loans in cash. 3. All rights reserved.  Three modifications: 1. Inc. There are leakages of dollars to foreign countries.Modifications of the DEM  The real DEM is lower than if it were based solely on the reserve ratio.

‡ How? Let¶s look at the check clearing process. Checks. cash covers less than one percent of the total monetary value of our transactions.  In 2004 Congress passed the Check Clearing Act of the 21st Century (³Check 21´). ‡ Law intended to facilitate electronic check processing. ‡ However. and Electronic Money  We still carry out about 80% of our transactions in cash.How Money Moves: Cash. All rights reserved. Inc. 14-14 . Copyright •2009 by The McGraw-Hill Companies. ‡ Electronic transfers account for five out of every six dollars that move in the economy.

‡ Slavin¶s bank is Citibank. Inc. Copyright •2009 by The McGraw-Hill Companies. ‡ Bob¶s bank is Bank of America.  ³Check 21´ sped up this process. 14-15 .The Check Clearing Process is Changing  Slavin writes $50 check to Bob in San Francisco. instead of the physical check. All rights reserved. ‡ Digital pictures of the check are transferred.  Follow the check ‡ Fed¶s District Banks transfer the value from one bank¶s reserve account to another¶s reserve account.

$1. Inc. All rights reserved. ‡ Example: Paypal accounts facilitate paperless transfers. ‡ About one-third of these transfers are carried out by the Federal Reserve¶s electronic network. money is changing hands electronically. ‡ Example: When you use your debit card the amount is deducted within seconds after the card is swiped. 14-16 . Copyright •2009 by The McGraw-Hill Companies.  Today.Electronic Transfers  Increasingly. ‡ About two-thirds are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 10 big New York Banks.5 trillion a day is transferred electronically.

Copyright •2009 by The McGraw-Hill Companies. Inc. All rights reserved. Reserve requirements: changing the reserve ratio. Discount rate and federal funds rate: key interest rates that affect other interest rates. 3.Tools of Monetary Policy  The most important job of the Fed is to control the rate of growth of the money supply. 2.  Open market operations have been the most commonly used monetary policy tool.  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. 14-17 .

Inc. there is a multiplied increase in the money supply. ‡ This money is put into circulation and increases the banks¶ demand deposits.  How does the Fed get the banks to sell? ‡ It makes an offer they can¶t refuse! ‡ Price of bonds is pushed up.  Follow the money: ‡ The banks get money in exchange for some of the bonds in their portfolios. ‡ Because of the DEM. 14-18 . All rights reserved. the Fed buys bonds from banks and other financial institutions. Copyright •2009 by The McGraw-Hill Companies.Scenario #1: Increasing the Money Supply  To increase the money supply.

there is a multiplied decrease in the money supply. ‡ Because of the DEM. the Fed sells bonds to banks and other financial institutions. Inc. All rights reserved.  Follow the money: ‡ The Fed gets money in exchange for some of the bonds in their portfolios.  How does the Fed get the banks to buy? ‡ It makes an offer they can¶t refuse! ‡ The price of bonds is pushed down. Copyright •2009 by The McGraw-Hill Companies. 14-19 . ‡ This money is taken out of circulation by the Fed.Scenario #2: Decreasing the Money Supply  To decrease the money supply.

All rights reserved. Copyright •2009 by The McGraw-Hill Companies. 14-20 .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. Inc.

the fiscal policy multiplier will lead to a greater increase in real GDP. All rights reserved. lower interest rates may encourage businesses to increase Investment and households to increase Consumption. 14-21 .  If C and I increase.Impact of Increasing the Money Supply  Increasing the money supply leads to a decrease in interest rates. Copyright •2009 by The McGraw-Hill Companies.  During a recession. Inc.

Impact of Decreasing the Money Supply  Decreasing the money supply leads to an increase in interest rates. Copyright •2009 by The McGraw-Hill Companies. 14-22 .  If C and I decrease. higher interest rates may discourage business Investment and household Consumption. but it will also bring down the price level. Inc. All rights reserved.  During inflation. the fiscal policy multiplier will lead to a greater decrease in real GDP.

000) Copyright •2009 by The McGraw-Hill Companies. Inc. All rights reserved.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. 3333 14-23 -23 . ($5.

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. All rights reserved. 3333 14-24 -24 .Open Market Operations Fed buys $1. ($5000) Copyright •2009 by The McGraw-Hill Companies. Inc.

 Federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other.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.  Raising interest rates is contractionary response to inflation.  Lowering interest rates is expansionary response to recession. ‡ Federal funds rate is higher than the discount rate. All rights reserved. Inc. 14-25 . Copyright •2009 by The McGraw-Hill Companies.

‡ Changing reserve requirements is the ultimate weapon and is rarely used (about once per decade). All rights reserved.  To combat inflation. Fed would increase required reserve ratio. Fed lowers required reserve ratio to create more excess reserves. Inc. ‡ Example: Lowered from 12% to 10% in 1992. 14-26 .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.  To combat recession. ‡ Banks would have to scramble to increase reserves. Copyright •2009 by The McGraw-Hill Companies.

the Fed will: 1. Lower reserve requirements.Summary: The Tools of Monetary Policy  To fight recession. Raise reserve requirements (only as a last resort). Sell securities on the open market. 14-27 . 3. 3. 2. the Fed will: 1. Buy securities on the open market. 2. All rights reserved. Copyright •2009 by The McGraw-Hill Companies.  To fight inflation. Inc. Raise the discount rate and federal funds rate. Lower discount rate and federal funds rate.

it pulls hard enough. Copyright •2009 by The McGraw-Hill Companies.Contractionary Monetary Policy Transmission Mechanism  Like pulling on a string. it get results²provided of course. All rights reserved. when the Fed fights inflation. 14-28 . Inc.

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 Copyright •2009 by The McGraw-Hill Companies. increases the discount rate. Inc. 3333 14-29 -29 . increases reserve ratio.Restrictive Monetary Policy Problem: inflation CAUSE-EFFECT CHAIN CAUSEFed sells bonds. All rights reserved.

 Keynes¶ Liquidity Trap: if interest rates are too low. no matter how low interest rates are. people will simply hold on to their money.  Like pushing on a string.Expansionary Monetary Policy Transmission Mechanism  Fighting a recession is another matter.  If Aggregate Demand is low. it might not get anywhere. All rights reserved. no matter how hard the Fed works. businesses may not invest. Inc. Copyright •2009 by The McGraw-Hill Companies. 14-30 .

lowers the discount rate. lowers reserve ratio. 3333 14-31 -31 .Expansionary Monetary Policy Problem: unemployment and recession CAUSE-EFFECT CHAIN CAUSEFed buys bonds. All rights reserved. Inc. 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 Copyright •2009 by The McGraw-Hill Companies.

 But the impact lag may be longer. Inc. All rights reserved.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 Fed¶s Board of Governors. 14-32 . Copyright •2009 by The McGraw-Hill Companies.

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