Money and Banking
Lesson 21

The Federal Reserve System

Federal Reserve System (Fed) - central bank of United States

• The U.S. government created the Federal Reserve System in 1913
  • European countries created central banks in the 17, 18, and 19th centuries.
  • U.S. was a late comer
• Congress, government officials, and the public did not want to create a powerful financial institution
  • The Fed has many checks and balances.
• The Fed is composed of 12 Federal Reserve regional banks.
  • Each region has a Federal Reserve Bank.
  • Different regions in U.S. are different
  • A Federal Reserve Bank can provide services to its unique region.
  • Example:
    • Michigan originally manufactured all U.S. cars
    • Texas and Oklahoma supplied oil and natural gas.

A regional Federal Reserve Bank:

1. Manages the currency.
   • The Fed issues new currency and removes old currency from the economy through the banking system.
2. Helps banks clear checks between banks in different regions or countries.
   • All banks have deposits at the Fed.
   • The Fed clears a check by adjusting banks’ deposits.
   • If a person write a $500 check drawn from a bank in Miami to pay for goods in California, the Fed subtracts $500 from the Miami bank deposit at the Fed and adds $500 to the California bank account at the Fed.
3. Regulates member commercial banks.
4. Collects and publishes data for the public.
5. Sets reserve requirements.
   • A reserve requirement - percentage of a deposit that a commercial bank must hold as cash or as a deposit at the Fed.
   • Thus, banks have cash when depositors come to the bank to withdraw some of their funds
6. Prevent financial panics.
   • A Federal Reserve Bank is a “lender of the last resort.”
   • A bank having financial trouble can temporarily borrow from the Fed.
   • Example
     • A bank needs money, so the bank gives a $10,000 asset to the Fed as collateral.
     • The Fed increases the bank’s reserves by $9,000 (i.e. the loan).
     • The difference is called the discount, which reflects the interest rate that the Fed charges for the loan.
     • This interest rate is called the discount rate.
7. The government did not create the Fed to alter the money supply, manipulate interest and currency exchange rates, or manipulate the financial markets to achieve economic goals.
   • The Fed learned to do this during the 1920s.

Each Federal Reserve Bank is a federally chartered corporation.

• Every national commercial bank has to purchase stock of the Federal Reserve Bank in its district
  • Stock purchase is 6% of the commercial bank’s net equity (capital).
  • National commercial banks have a carter from the U.S. government.
• Commercial banks earn dividends on their Fed bank stock.
• Each bank has stockholders, directors, and a president.
• Each Federal Reserve Bank has 9 directors.
  • A combination of Board of Governors and member commercial banks elect the directors,
    • 3 directors are bankers
    • 3 are from business.
    • The Fed appoints the last 3 directors.
  • The 9 directors elect the president of the Fed district bank
    • Even though the Fed district banks are privately owned, the commercial banks have no control over the Fed banks.
  • A Fed bank is not like a corporation where the stockholders can freely elect the board of directors and vote on major corporate policies.
    • The reason the Fed has this odd structure was that Congress did not want the Fed to be part of government or controlled by the banks, but somewhere in between.
• The Fed is a part of government or quasi-government.

The Board of Governors - controls the Federal Reserve System.

• The Board of Governors determines monetary policy, reserve requirements, and discount policy.
  • The board consists of 7 members, who serve a 14-year term.
  • A U.S. president along with Senate approval appoints the members.
  • A U.S. President also appoints the chairperson and vice-chairperson of the board.
    • Each serve 4 year terms
• Originally, the Fed was decentralized and the power was dispersed among the 12 Fed banks.

The Board of Governors is independent of the U.S. federal government

1. The Board of Governors gets its revenue from the 12 district banks.
   • The Fed does not have to go to Congress for money.
   • Whoever controls the money is directly or indirectly in charge.
2. The terms of the board members are staggered.
   • Every two years, the U.S. President appoints one director to the Board of Governors
   • 7 - members, 14-year term
   • Prevents a President from coming into office and appointing all members at once, so the members would be loyal to the President.
3. The government cannot completely audit the Fed.
   • The less government knows, the less it can tamper with things.
4. The Comptroller of the Currency and Secretary of the Treasury cannot be members of the board
   • Prevent the government from “printing money” to cover budget deficits.

• Note - if the Federal Reserve angers Congress too much, Congress can rewrite the laws that created the Fed.

The Federal Open Market Committee (FOMC) makes decisions concerning open market operations.

• Open market operations - the buying and selling of government securities
  • Influences the money supply and interest rates
• FOMC sends a directive to the manager at the New York City Federal Reserve bank to actually buy and sell U.S. government securities.
• The FOMC consists of the Board of Governors, plus 5 Fed district bank presidents.
  • The president of the Federal Reserve Bank of New York City is a permanent member of the FOMC and always the FOMC vice-chairperson.
  • New York City is the financial center of the U.S.
  • The Fed buys and sells government securities through the New York Fed Bank.
• The four other positions for the FOMC are rotated among the other 11 Fed district bank presidents.
• The chairperson of the Board of Governors is also chairperson of the FOMC.

The chairperson of the Fed is a powerful man.

• This person can advise the President, informs Congress of the Fed’s actions
• Spokesperson of the whole Federal Reserve System.
  • When he speaks, the financial markets listen.
• Currently the chairperson is Ben Bernanke
• He is considered the second most power man in the United States right next to the U.S. president.

Trends in the Financial Markets

The financial markets and institutions are constantly changing.

1. Financial innovation - people quickly adopt new financial products if it lowers risk, increase liquidity, or increase information.
   1. Mutual funds
      • A mutual fund pools together money from many people into a fund and the fund manager invests the fund in a variety of stocks.
        • Lowers investors’ risk through diversification of stocks.
        • Example: You started you own mutual fund and bought 30 different corporate stock.
          • Coca-Cola stock may go up one day, while IBM stock goes down
          • Overall, the average of the fund’s 30 stocks will earn a return
      • Money Market Mutual Funds (MMMF) - offered by non-bank financial institutions
        • Mutual fund with check writing privileges
        • Not insured by the FDIC
      • Money Market Deposit Accounts (MMDC) - offered by commercial banks
        • Mutual fund with check writing privileges
        • Insured by Federal Deposit Insurance Corporation (FDIC)
          • If bank bankrupts, then FDIC insures account holders up to $100,000 in total deposits
   2. Automated Teller Machine (ATM) - allows bank customers to receive banking services through computer terminals located at banks, stores, and shopping malls.
      • Make deposits, withdrawals, and credit card transactions
      • Consumers have access to their bank anywhere within the U.S. and many countries around the world.
        • ATMS are connected in networks
          • CIRRUS - one of the largest networks
   3. Debit Cards - a customer uses a card that electronically wires funds from his bank account to a store's bank account
      • Similar to a credit card
      • Some businesses do not accept checks, but take debit cards, because the store is certain it will get the funds from the customer
2. Globalization - savers and borrowers are linked through international financial markets
   • Example: Japanese bank transfers funds from savers in Japan to build a new factory in China.
   • What causes globalization?
     • Many countries repealed laws that restricted savers from investing into foreign countries.
     • Countries are economically growing
       • More savings are channeled in international financial markets
     • Corporations are global
       • Corporations produce in one country and transport to another
       • Corporations need financing to build factories in foreign countries
3. Deregulation - U.S. government is deregulating financial markets
   • Banks are allowed to cross state lines and merge with other banks
     • Regulations prevented banks from crossing state lines
   • Commercial banks are merging with insurance companies and investment banks
     • Regulations from the 1930s separated commercial banking and investment banking
       • commercial banks - accepts deposits and makes loan
       • investment banks - help corporations issue new stocks or bonds and help government issue new bonds
         • Merrill Lynch, Charles Schwab
   • Many financial institutions are merging together
     • U.S. banks will become larger and fewer
     • Banks will offer a variety of services like investment advice and insurance

Money's Function and Definitions

1. Medium of exchange - money is used for payments of goods and services and repayment of debts.
   • Promotes efficiency
   • Example - the author is an economics instructor.
     • Under a barter system, the author would have to go to the market and teach another person for goods and services that he need.
     • Could have considerable search costs for people wanting economics instruction.
     • With money, the author does what he does best and teach for money.
     • Then he takes this money to the market, and buys goods and services that he wants.
   • Eliminates the problem of double coincidence of wants under a barter system.
   • Allows the specialization of labor to occur
2. Unit of account - money puts a values on goods and services
   • Example: a two-liter of Coca-Cola costs $0.89 while Pepsi costs $0.99.
   • Customers can easily judge which product is cheaper.
   • Extremely important for businesses.
     • Businesses place values on buildings, machines, computers, and other assets.
     • Record this information in financial statements
     • Investors read the financial statements and can gauge which companies are profitable.
3. Store of value -money has to retain its value.
   • Example: If a two-liter of Coca-Cola costs $0.99 today, then it should cost $0.99 tomorrow
   • Inflation erodes the “store of value” of money.
     • As the price level increases, the value of money decreases, because each unit of money buys less goods and services.
   • Inflation causes consumers to lose their purchasing power over time.
   • If the inflation rate becomes too high, then money as a “medium of exchange” breaks down too!
     • People in countries with have high inflation rates use barter more and immediately exchange their local money for more stable money, such as Euros or U.S. dollars
   • "legal tender" - Many government laws legally require people to accept money as a means of payment to pay off a debt or to pay taxes.
4. Standard of deferred payment - combines the “medium of exchange” and “unit of account” of money.
   • Debts are stated in terms of a “unit of account,” and paid by “medium of exchange."
   • Extremely important for business transactions that will occur in the future.
   • Businesses and people can borrow or lend money based on future transactions

A central bank can introduce two types of currency into its economy

• Commodity money - government selects a commodity to be money
  • Gold and silver
  • If society did not use this commodity as money, this commodity still has a purpose.
  • Commodity money could be anything.
  • Example:
    • U.S. prisons, prisoners use cigarettes as money.
    • In rural Russia, vodka, cigarettes, and bullets have been used as money
  • Government made a discovery about commodity money
    • If the government made one-ounce gold coins
      • One ounce of gold costs $800
      • The face value of a coin is equal to $1,000
      • The government created a value of $200 out of thin air!
    • This is a form of "printing money"
    • Over the life of the ancient Roman Empire, the Roman government “printed money” by recalling its gold and silver coins, and re-minting them with less gold and silver.
    • Towards the end of the empire, Roman coins contained specks of gold and silver.
      • Called debasing
  • Metal coins
    • The face value of an one-ounce pure gold coin is $1,000
    • The market price of gold is $1,500 per ounce
    • People will melt down the coin and sell to the market
• Fiat Money (or Token Money ) - money used in the modern world
  • 20th century invention.
  • The Federal Reserve System issues U.S. dollars.
    • This money cannot be used as anything else, and cannot be exchanged for another commodity from government.
    • No authority limits how much money the Federal Reserve System can issue.
    • Milton Friedman, concluded “Inflation is always and everywhere a monetary phenomenon.”

Money needs five desirable properties for people and businesses to use as money. The desirable properties are:

1. Acceptable: The businesses and public accept it as payment for goods and services.
2. Standardized quality: The same units of money must be the same size, quality, color, so people are certain what they are getting.
3. Durable: Has to be physically durable or it may lose its value quickly.
4. Valuable relative to its weight: People can easily carry large amounts of money and use is in transactions.
5. Divisible: Money must be broken down into smaller units to purchase low value goods and services.

All countries today use coins and paper bills as money, which has the five desirable properties. The value of paper bills and coins is currency.

Federal Reserve's Definition of the Money Supply

• Two approaches to define the money supply
  1. Transaction approach - emphasizes the money’s function as a medium of exchange
     • Only a few assets possess this property.
  2. Liquidity approach - include assets that are highly liquid
     • Liquidity - an asset is easily exchanged for goods and services without high transaction costs
     • The money supply includes all assets that have high liquidity.
     • Emphasizes money’s function as a “store of value,”
       • If the liquid asset retains its value and is highly liquid, it can easily be used to purchase goods and services directly or indirectly
     • Liquidity forms a scale

• The Federal Reserve System defines money supply as M1, M2, M3, and L.
  • Many central banks in the world measure their money supply similarly to United States.
  • Which financial instruments are included differs
• Two U.S. definitions of money supply are:
  • M1 is the narrowest definition of the money supply
    • Uses the transaction approach in defining what financial instruments are included.
    • Add the following 3 items together:
      • Currency held by the public and in bank vaults.
        • Not currency held by the government.
      • All forms of checking accounts
        • Does not include mutual fund checking accounts
      • Traveler’s Checks that are held by people and not by the banks
  • M2 is a broader definition than M1
    • Uses the liquidity approach of defining the money supply
    • Add the following items together
      • Include everything from M1
      • Include mutual fund checking accounts
      • Include all small denomination savings deposits and time accounts at all financial institutions.
        • Small denomination in the U.S. means the account is less than a $100,000.
        • Certificates of Deposit (CDs)
        • savings accounts at banks
• Which is the “Best” definition of the Money Supply?
  • The monetary aggregates grow at different rates, at different times, and even in different directions.
  • Before 1981, a stable relationship existed between M1 and GDP
  • With deregulation of the financial markets in the 1970s and early 1980s obscured this relationship.
    • Many economists use the M2 definition of the money supply to explain changes in the GDP and inflation.

Terminology