Chapter 04 - The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

Chapter Four
The Federal Reserve System, Monetary
Policy, and Interest Rates
I. Chapter Outline
1. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview
2. Structure of the Federal Reserve System
a. Organization of the Federal Reserve System
b. Board of Governors of the Federal Reserve System
c. Federal Open Market Committee
d. Functions Performed by Federal Reserve Banks
e. Balance Sheet of the Federal Reserve
3. Monetary Policy Tools
a. Open Market Operations
b. The Discount Rate
c. Reserve Requirements (Reserve Ratios)
4. The Federal Reserve, the Money Supply, and Interest Rates
a. Effects of Monetary Tools on Various Economic Variables
b. Money Supply versus Interest Rate Targeting
5. International Monetary Policies and Strategies
a. Systemwide Rescue Programs Employed During the Financial Crisis

II. Learning Goals

1. Understand the major functions of the Federal Reserve System.
2. Identify the structure of the Federal Reserve System.
3. Identify the monetary policy tools used by the Federal Reserve.
4. Appreciate how monetary policy changes affect key economic variables.
5. Understand how central banks around the world adjusted their monetary policy
during the financial crisis.

III. Chapter in Perspective

This chapter presents an overview of the Federal Reserve System, including a brief look
at its history and structure. The major functions performed by the Fed are covered and
the balance sheet of the Fed is examined. The chapter provides the reader with a non-
technical explanation of the effects of monetary policy on interest rates and the economy.
The deposit growth multiplier concept is introduced and a simple ‘transmission
mechanism’ depicting the effects of a change in Fed policy on the economy is presented.
Different monetary targets such as borrowed and non-borrowed reserves and interest
rate targets are also discussed. Intervention into foreign exchange markets is also
briefly covered. The new edition also discusses the Fed’s rescue programs employed
during the financial crisis.

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IV. Key Concepts and Definitions to Communicate to Students

Discount rate FRB NY Trading Desk

Discount window Policy directive

Check clearing Repurchase agreement

ACH and Fed Wire Primary credit

Federal Open Market Committee Seasonal credit

Open market operations Secondary credit

Reserves Deposit growth multiplier

Monetary base M1 and M2

Required and excess reserves Foreign exchange intervention

Fed funds rate Borrowed and non-borrowed reserve

targets
Transmission mechanism
Policies of other major central banks
TALF
Quantitative easing

V. Teaching Notes

1. Major Duties and Responsibilities of the Federal Reserve System: Chapter

Overview
The Federal Reserve was created in 1913 in response to a series of U.S. financial panics
which culminated in a particularly severe panic in 1907. The Fed was created to serve as
a lender of last resort, as a bank regulator and as a monitor of the money supply. Current
objectives of the Fed include stimulating sustainable non-inflationary economic
growth while keeping employment high. Not everyone agrees with the dual mandate of
the Fed. Monetarists feel that the Fed’s purpose should be to limit inflation. The Fed
also assists in facilitating the nation’s payment systems. The Fed operates the Fed Wire
which facilitates trading of bank reserves and an Automated Clearing House (ACH),
which is a similar payments mechanism for debit and credit transactions.1 The Fed is
largely independent of Congress and the President, at least in the short run. The
Humphrey-Hawkins Act of 1978 however requires the Fed to present their monetary
policy goals and an assessment of how well they are meeting their goals to Congress

1
The Clearing House Interbank Payments System (CHIPS) provides yet another payment mechanism.
CHIPS is a private sector electronic network operated by about 100 U.S. and foreign banks to facilitate
correspondent services and international transactions.

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twice a year.

The four major functions of the Fed today include: a) conducting monetary policy, b)
supervising and regulating depository institutions, 3) maintaining the stability of the
financial system and 4) providing payment and other financial services to many
institutions, including governments.

2. Structure of the Federal Reserve System

a. Organization of the Federal Reserve System
There are 12 Federal Reserve Banks (FRBs) located throughout the country. The
structure was originally intended to disperse power along regional lines throughout the
country. To some extent this dispersion still remains, but the major authority to
promulgate and implement monetary policy now lies in Washington, D.C. with the
Board. Each FRB has a nine member Board of Directors consisting as follows:
 Six are elected by member banks in the district, of these six, three are non-bank
business people.
 Three are appointed by the Board of Governors of the Federal Reserve System.
FRBs are nonprofit organizations, but they are owned by the member banks in their
district. Part of the independence of the Fed arises because the Fed generates positive net
income from interest and fees so it is not directly dependent on Congressional funding.
The Fed now pays interest on bank reserves and this reduces the profitability of the Fed.
If the interest rate paid increases with the Fed funds rate this could also create a perverse
incentive that could conceivably affect Fed policy because Fed profitability would be
reduced if the Fed increased interest rate targets. The Fed argues that paying interest
minimizes reserve volatility.

Teaching Tip: In a bid to stave off negative inflation in Europe the ECB is considering
charging negative deposit rates on bank reserves. This should encourage banks to lend
excess reserves and stimulate the Eucopean economyrather than pay interest.

b. Board of Governors of the Federal Reserve System (BoGov)

The BoGov is comprised of seven members and each member is appointed to a non-
renewable 14 year term by the President of the United States and confirmed by the
Senate. Terms are staggered so that one term expires every other January. The President
appoints the chairman and vice-chairman of the board from among BoGov members to
four year terms that can be repeated. The board has two major areas of responsibility; the
formulation and conduct of monetary policy through the FOMC (see below), and the
promulgation of bank regulations. The board can change the discount rate and bank
reserve requirements.

c. Federal Open Market Committee (FOMC)

The 12 member FOMC is the body that formulates and conducts monetary policy. Seven
of the 12 members are comprised by the BoGov; thus, the BoGov has a controlling vote
on the FOMC. The remaining members are 1) the President of the New York Federal
Reserve Bank and 2) four presidents of other Federal Reserve Banks, chosen on a
rotating basis. The FOMC conducts open market operations to implement monetary

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policy. Open market operations are the purchase and sale of U.S. government securities
to increase or decrease the level of bank reserves (money supply) respectively. Open
market operations are the most commonly used policy tool to conduct monetary policy.
The results of each FOMC meeting are compiled in the so called “Beige Book,” which
summarizes information on current economic conditions compiled by the district banks,
and from interviews with business leaders and economists, etc.

d. Functions Performed by Federal Reserve Banks

Functions include:
 Assisting in the conduct of monetary policy and economic analysis
 Supervision and regulation of banks and bank holding companies in their district
 The new Wall Street Reform and Consumer Protection Act of July 2010 requires
the Fed to supervise complex financial institutions that could generate systemic
risk to the economy. The Fed (and others) has now been given broader powers to
seize or break up institutions whose actions could harm the economy.
 The Fed is now also charged with implementing federal laws designed to protect
consumers in credit and other financial transactions. The Fed is charged with
implementing regulations to ensure compliance, investigating complaints, and
ensuring availability of services to low and moderate income groups and certain
geographic regions.
 Provision of government services for the U.S. Treasury
 Replacement of old currency and issuance of new currency
 Providing check clearing services for a fee

 The number of checks cleared peaked at 17 billion in 2000 and has since declined
as alternatives to checks have risen and industry consolidations. In October 2004
the Check 21 Act authorized the use of an electronic image rather than a paper
check for settlement.2 This switch was expected to save the banking industry as
much as $3 billion per year. Presumably competition forces banks to pass on the
cost savings to customers in the form of reduced checking fees. Customers will
lose the ability to play the float (which can be several days) as checks may now be
very quickly cleared (as soon as deposited), making them more similar to most
debit cards. Customers must take care that sufficient funds are available at the
time the check is spent with most retailers or they could overdraw. For instance a
customer could no longer write a check in the afternoon the day before payday,
knowing that the check will not clear before the payroll deposit the next day. This
is a dubious practice anyway (technically it is kiting, an illegal activity).
Customers who run low balances would be advised to apply for overdraft
protection. Banks can no longer automatically cover overdrafts without written
permission of the bank customer.
 The Fed ACH (the Fed’s automated clearing house) is now offering same day
check clearing for certain checks converted to electronic images rather than next
day settlement.

2
The grounding of cargo aircraft after the September 11, 2001 terrorist attacks also ‘grounded’
millions of checks waiting to be flown around the country in the clearing and settlement process. This
spurred Congress on to passing the Check 21 law.

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 Providing wire transfer services through the Fed Wire

 Providing district economic analysis and research

 According to the Financial Services Policy Committee of the Federal Reserve’s 2012
report, in 2011 more than 85% of noncash payments were electronic. The breakdown
was as follows:
47 billion debit transactions
26 billion credit
22 billion ACH
9 billion prepaid cards

e. Balance Sheet of the Federal Reserve & Growth due to Financial Crisis

Balance Sheet of the Federal Reserve

Change over Period
2007 2008 2013 2007-2013
Assets (bill $) % (bill $) % (bill $) % $ %
Gold and Foreign Exchange $34.2 3.6% $35.7 3.8% $34.5 1.1% $0.3 0.9%
SDR Certificates 2.2 0.2% 2.2 0.2% 5.2 0.2% $3.0 136.4%
Treasury Currency 38.7 4.1% 38.7 4.1% 45.0 1.4% $6.3 16.3%
Federal Reserve Float 0 0.0% -1.5 -0.2% -0.6 0.0% ($0.6) na
Loans to Domestic Banks 48.6 5.1% 559.7 58.8% 0.0 0.0% ($48.6) -100.0%
Security Repurchase Agreements 46.5 4.9% 80.0 8.4% 0.0 0.0% ($46.5) -100.0%
U.S. Treasury Securities 740.6 77.9% 475.9 50.0% 1796 55.4% $1,055.4 142.5%
U.S. Government Agency Securities 0.0 0.0% 19.7 2.1% 1143.4 35.2% $1,143.4 na
Miscellaneous Assets 40.5 4.3% 1060.2 111.4% 220.3 6.8% $179.8 444.0%
Total Assets $ 951.3 100% $ 2,270.6 239% $3,243.8 100% $2,292.5 241.0%

The Federal Reserve’s balance sheet grew 241% from 2007 to 2013 due to the ongoing
financial crisis. Much of the extraordinary growth is due to the Fed’s usage of
quantitative easing in an attempt to support mortgage markets and stimulate growth.

Balance Sheet of the Federal Reserve

Change over Period
2007 2008 2013 2007-2013
Liabilities and Equity (bill $) % (bill $) % (bill $) % $ %
Depository Institution Reserves $20.8 2.2% $860.0 90.4% $1,790.4 55.2% $ 1,035.60 4978.8%
Vault cash of Commercial Banks 55.0 5.8% 57.7 6.1% 59.7 1.8% $ 10.70 19.5%
Deposits due to Fed. Government 16.4 1.7% 365.7 38.4% 79.4 2.4% $ 212.20 1293.9%
Deposits due to government agencies 1.7 0.2% 21.1 2.2% 20.2 0.6% $ 19.20 1129.4%
Currency Outside Banks 773.9 81.4% 832.2 87.5% 1,117.30 34.4% $ 118.20 15.3%
Security Repurchase Agreements 44.0 4.6% 88.4 9.3% 105.5 3.3% $ 57.80 131.4%
Miscellaneous Liabilities 2.5 0.3% 3.4 0.4% 16.2 0.5% $ (36.80) -1472.0%
Federal Reserve Bank Stock 18.5 1.9% 21.1 2.2% 27.6 0.9% $ 10.50 56.8%
Equity 18.5 1.9% 21.0 2.2% 27.5 0.8% $ 8.90 48.1%
Total Liabilities and Equity $951.3 100% $2,270.6 239% $3,243.8 100% $ 1,436.30 151.0%

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Notice the extraordinary growth in depository institution reserves. Banks have not lent
anywhere near their available capital. Some have argued that this is because the Fed
began paying interest on reserves in October 2008 although this is unlikely to be the main
cause. The interest rate is set to equal the target Fed Funds rate. This may reduce the
incentive for banks to lend excess reserves in the Fed Funds market. Of course loan rates
(and thus profits) are higher than the Fed Funds rate. Nevertheless this is posited as one
problem with the effectiveness of Fed policy in stimulating growth in the economy. The
Fed’s lending facilities created more bank reserves, but did not result in greater lending.
Total bank lending turned up in 2013.

The Fed expanded availability of Discount Window borrowing to investment banks in

order to encourage liquidity in the financial system at the start of the financial crisis.
Liquidity had been impaired by the credit crunch spurred by the fallout in the subprime
mortgage markets. The Fed and the Treasury helped arrange a bailout of Bear Stearns by
J.P. Morgan Chase. Bear Stearns was a failing investment bank heavily involved in the
mortgage markets and was on the brink of defaulting on many of its repo arrangements.
The Fed took the unprecedented step of guaranteeing $30 billion of Bear Stearns’ illiquid
mortgage assets.3 Even before the bailout of Bear Stearns the Fed had agreed to swap up
to $200 billion of Treasuries it holds for illiquid mortgage backed securities in an effort
to restore liquidity to the markets.4 In particular the short term repo markets had stopped
functioning on worries about failures of underlying mortgages backing securities, many
through CDO structures.

The growth in the balance sheet reflects the Fed’s responses to the financial crisis. At the
end of 2007 the Fed created a Term Auction Facility (TAF) extended discount window
borrowing on an auction basis. In March 2008 the Fed facilitated the J.P. Morgan Chase
purchase of Bear Stearns that took some of Bear’s risky assets off their books (and onto
the Fed’s). The Fed also created the Term Securities Lending Facility (TSLF) which
swapped Treasury securities for less liquid and riskier securities and the Primary Dealer
Credit Facility (PDCF) which expanded discount window loans to non-banks. In the fall
of 2008 with the collapse of Lehman Brothers and Goldman-Sachs and Morgan Stanley
becoming commercial banks, the Fed created additional facilities to assist in credit flows.
The Fed created the Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money
Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan
Facility (TALF). The AMLF and the CPFF were created because liquidity collapsed in
the commercial paper market. The MMIFF was created to help stem liquidity problems
in money market mutual funds that resulted when one fund failed. The TALF was
designed to encourage securitization to continue. Slowdowns in securitization reduced
the amount of credit available to borrowers in certain markets. Average weekly lending
from the Fed grew from about $59 million in 2006 to almost $850 billion in late 2008.

3. Monetary Policy Tools

3
“The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” by Robin Sidel, Greg Ip,
Michael Phillips and Kate Kelly, The Wall Street Journal Online, March 18, 2008 Page A1.
4
“Fed Offers Lifeline for Spurned Debt,” by Greg Ip, The Wall Street Journal Online, March 12, 2008,
Page A1.

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The major process by which the Fed normally impacts the economy is through
influencing the market for bank reserves. Banks trade excess reserves among themselves
at the interest rate called the fed funds rate. The Fed attempts to influence the fed funds
rate by either affecting demand or supply of funds available for lending between banks.
Targeting the level of reserves in the economy is tantamount to targeting the supply of
funds available for bank to bank lending (and by inference, the amount of funds available
for lending to non-bank customers). Targeting interest rates, as the Fed has done since
1993, is the same as influencing the demand for bank reserves. The Fed cut interest rates
11 times in 2001 to stimulate the weakening economy. The fed funds target rate was
increased 5 times in 2004 from a low of 1% to a year ending high of 2.5% (each increase
was 25 basis points). In June 2005 the target fed funds rate was 3.25% but by August
2006 the target rate had been increased to 5.25% due to inflation fears. In 2007 the Fed
reversed its interest rate policy and began to decrease the Fed funds target. In April 2008
the Fed funds target was 2.00% and the discount rate was 2.25%. By year end 2008 the
Fed funds target was reduced to between 0 and 0.25% and the discount rate was 0.5%.
These rates were maintained throughout 2009. In Feb 2010 the Fed kept the target Fed
funds rate at 0 to 0.25% but raised the discount rate to 0.75% where both rates remain as
of this writing. In November of 2008 the Fed announced it would engage in up to $600
billion of purchases of Treasuries and mortgage backed securities, a process termed
quantitative easing in order to encourage the flow of credit in the economy. This amount
was increased in March 2009 to $1.7 trillion. From the end of 2008 through the first
quarter of 2010 the Fed bought $1.7 trillion of securities. In November 2010 the Fed
announced a new series of bond buying of up to $600 billion in what has been termed
QE2. QE3 began in September of 2012 with the Fed announcing the purchase of $40
billion Treasuries and $40 billion mortgage backed securities per month. The Fed began
tapering (gradually reducing) the monthly purchases in 2013 and on into 2014 even
though the Fed has repeatedly reiterated that short term interest rates would remain low
on into 2015 unless conditions improved rapidly. The Fed backed away from switching
policy when unemployment fell to or below 6.5% because of slow economic growth and
declines in the labor force participation rate. The Fed also has a target inflation rate of
2%.

The text mentions that Fed policy appears to follow a Taylor rule. A Taylor rule suggest
the Fed should increase interest rates when inflation is above target or if employment is
above full employment and decrease rates when inflation is below target or if the
economy is at less than full employment. Because of expectations and external shocks
monetary policy rules must be applied with discretion.

Ben Bernanke’s term ended in January 2014 and Janet Yellen became the new chairman
of the Fed. Chair Yellen has not changed the policy course set by Bernanke’s board
although she is considered to be ‘doveish’ or more likely to pursue a loose monetary
policy for longer than inflation hawks would.

Current rates & risks over the year, with links to meeting minutes can quickly be found at
the Federal Reserve Monitor of the Wall Street Journal Online website. Levels of M1
and M2 can be found on the same website under Federal Reserve Data.

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Chapter 04 - The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

a. Open Market Operations

Open market operations are the buying and selling of U.S. government securities by the
Fed. The FOMC drafts a policy directive to change a targeted monetary aggregate such
as M1, M2, M3 or an interest rate target such as the fed funds rate and sends it to the
N.Y. Federal Reserve Bank Trading Desk.5 If the FOMC wishes to increase the money
supply the directive will specify that the Trading Desk is to buy U.S. government
securities and credit the seller with additional reserves at the Fed. In this manner new
money is created. If the FOMC wishes to decrease the money supply, securities will be
sold and the buyer will pay for them by having bank reserves removed from their
account. Temporary changes in the money supply can be enacted by using repurchase
agreements. Fed use of a repo will temporarily increase the money supply; a reverse
repo could be used to temporarily reduce bank reserves and the money supply.

As noted in the text, in March 2009 the Fed announced it would buy $300 billion of long-
term Treasury securities in what would become known as quantitative easing 1. This is
unusual in the size of the announced purchase and in purchasing long term securities.
This was the first time the Fed had done so since the 1960s. The Fed wanted to add
liquidity and to keep long term interest rates down. The Fed also wished to signal that
they would do whatever it took to stabilize the economy.

Teaching Tip: Many students think that the primary method of increasing the money
supply is by printing new money. In actuality, increases in the money supply are usually
accomplished by increasing bank reserves.

Teaching Tip: The U.S. Treasury operates the mints for coins.

Teaching Tip: Part of the importance of the target fed funds rate is that this rate affects
other rates because this interest rate reflects the bank’s cost of short term funds. In
particular, the prime rate usually changes after a change in the fed funds rate.

b. The Discount Rate

Historically, the discount rate is the rate the Federal Reserve Banks charge to make
emergency loans to DIs in fulfilling its role as lender of last resort. The Fed implemented
changes in its discount window policy in January 2003. The changes did two things, 1)
raise the cost of borrowing from the Fed and 2) make it easier for banks to borrow from
the Fed. There are now three lending programs available from the discount window:

1. Primary credit – Primary credit is available to healthy depository institutions

(DIs) on a short term basis. The borrowed funds are not restricted in their use.
The rate paid is typically 1% above the fed funds target rate. As of June 2005, the
discount rate was 4.25%. Traditionally the discount rate was kept below the fed
funds rate, but banks were limited to borrowing from the Fed only if they could
show they could not borrow from the private markets (such as the fed funds
market).
5
This is why the President of the N.Y. Fed always sits on the FOMC.

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Chapter 04 - The Federal Reserve System, Monetary Policy, and Interest Rates 6th edition

2. Secondary credit – Short term secondary credit is available to troubled

institutions. The interest rate charged is higher than the rate on primary credit.
Secondary credit is restricted in how the funds may be used. The borrowing bank
cannot use secondary credit to expand the bank’s assets.
3. Seasonal credit – Seasonal credit is available for institutions that can demonstrate
a pattern of intra-year changes in borrowing needs, usually due to seasonal
deposit changes and loan demand as occurs in agricultural or tourist dependent
areas. Seasonal credit is available on a longer term basis and allows the
borrowing institution to carry less liquid assets which are low earning to meet
funds needs.
The discount rate is not usually a direct monetary policy tool and it would be very
difficult to predict the change in borrowing that would result from a change in the
discount rate. Changes in the discount rate have at times however signaled the Fed’s
intentions to allow interest rates to move in one direction or the other. As mentioned
earlier, the Fed has now opened up the discount window to securities brokers and dealers
and has decreased the spread between the Fed funds target rate and the Discount Rate to
25 basis points.

As discussed above with the Fed’s balance sheet, in 2008 the Fed broadened access to the
Discount Window facility through the PDCF. The move was welcomed by securities
dealers whose average daily borrowing was over $30 billion initially. The Fed also
lowered the spread between the discount rate and the target fed funds rate during the
crisis to only a quarter of a point. This move, along with a slowdown in lending in
private bank funding markets encouraged additional borrowing from the discount
window. These moves provided liquidity to institutions but it is less clear that the
ultimate goal of stimulating private sector credit growth was achieved.

c. Reserve Requirements (Reserve Ratios)

The third, and least used, monetary policy tool is changes to the reserve requirement
ratios. Banks are required to maintain reserves on deposit at the Fed to back a certain
percentage (basically 10%) of transaction deposits. If this ratio is increased, or if it is
imposed on more types of accounts, banks will have to hold more reserves at the Fed and
less money will be available to flow through the economy. The change in bank deposits
is (1 / New reserve requirement)  New excess reserves, assuming no drains.6

If reserves are $2 billion and the Fed increases reserves by 1% or $20 million when banks
have a 10% reserve requirement then the predicted increase in bank deposits would
equal:
1/0.10 * $20 million = $200 million increase in bank deposits.

If the Fed reduced the reserve requirement to 9% instead then the new level of excess
reserves would be 1% of $2 billion or $20 million. The predicted increase in bank
deposits would then equal:
1/0.09 * $20 million = $222 million

6
The multiplier used assumes that all possible amounts of money (subject to reserve requirements)
loaned out are re-deposited into banks and then re-lent and re-deposited, ad infinitum.

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The amount of drains is not very predictable. For instance, decreases in reserve
requirements cannot be guaranteed to lead to increases in the money available for lending
if banks choose to hold higher amounts of excess reserves at the Fed (as they did in the
early 1990s and again in 2008.) Changes in the reserve requirement are rarely used as a
monetary policy tool. This is perhaps because it is difficult to predict the effect of
changes in the reserve ratio on the money supply. Changing the ratio frequently would
likely impose additional costs on the banking system which attempts to manage and
minimize its excess reserves.

4. The Federal Reserve, the Money Supply, and Interest Rates

a. Effects of Monetary Tools on Various Economic Variables
If the Fed wishes to increase the money supply it can
 Buy U.S. Government Securities
 Decrease the Discount Rate
 Lower reserve requirements
All three result in lower interest rates which encourage additional borrowing for
consumption and investment. As household and business spending increase, the total
value of goods and services produced in the economy (nominal Gross Domestic Product
or GDP) increases. Employment should increase as a result. The converse holds for
opposite movements in the variables.

Teaching Tip: Lower interest rates normally lead to increases in nominal GDP. Nominal
GDP =  (Price  Quantity) for all goods and services produced in the economy. Either
Price (inflation) or Quantity (real output), or both, will rise, albeit with lags. If the
economy is not at full capacity, or if productivity is growing so that capacity is growing,
the increase in nominal GDP will occur primarily through an increase in the quantity of
goods and services produced, at least in the short run. If the economy is near capacity the
GDP growth is liable to occur through price increases (inflation). Moreover, if economic
participants have expectations of inflation, then prices are likely to rise.

Teaching Tip: Inflation is a fairly recent phenomenon and probably results from fiat
money. If one takes a historical perspective there is no reason to expect constant positive
inflation and no reason to fear deflation. It is entirely possible that during the 1990s the
Fed allowed overly rapid monetary growth under the mistaken belief that disinflation
would be undesirable. Central bankers tend to fear Keynes’ liquidity trap: during
deflation, high real rates can occur and the Fed may then be unable to lower nominal
interest rates enough to stimulate the economy. Something very similar to this recently
occurred in Japan. In those cases fiscal policy is needed to stimulate economic growth.7
It is quite plausible that with the recent large productivity gains in the U.S. during the
1990s, prices should actually have fallen without the stimulative monetary policy at that
time.

Teaching Tip: Until recently the U.S. had enjoyed mild real asset inflation overall for

7
Fiscal policy was largely unable to stimulate growth in Japan because of huge structural problems
centered in the banking and constructions industries and a large overhang of bad debts in the economy.

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quite some time, but financial asset inflation was prevalent throughout the 1990s in the
stock market and selected real asset markets such as real estate have experienced inflation
in certain segments of the economy. An interesting question is whether the Fed should
have responded sooner to the financial asset inflation. Historically, long inflationary
cycles tend to be followed by long periods of poor growth. We will have to see if the
U.S. real estate sector will experience a long slump in housing prices. Experience in
Japan (and historically in the U.S.) indicates that if a cycle of deflation occurs in the real
estate sector the U.S. economy may slump and that slump may well indeed be protracted.

Teaching Tip: Many food prices have increased at a faster rate than the CPI numbers
indicate so people believe inflation is higher than reported. With the large amount of
bank reserves and high volume of money creation the Fed may have to act very quickly
when growth and inflationary pressures return. If labor force participation and income
growth is still weak at that time, the Fed may be faced with difficult policy choices that
may be politically unpalatable. The Fed’s independence may be challenged at that point.
Even with extraordinary monetary stimulus the economy in 2014 is not exhibiting rapid
growth. GDP growth in 2012 was 2.8%, 1.9% in 2013 and actually fell 1% in the first
quarter of 2014.

b. Money Supply versus Interest Rate Targeting

The Fed can target either some monetary aggregate (M1 or M2 for example) or interest
rates, but not both simultaneously. During the 1970s, Arthur Burns and other Fed
chairmen targeted interest rates. During the 1970s the United States experienced rapid
inflation, due in part to the oil embargoes. During this time period the Fed
overstimulated the economy by trying to maintain a target fed funds rate. Recall that the
Fisher effect states that nominal rates will rise due to expected inflation. The Fed
continually increased the money supply to offset the pressure high expected inflation was
exerting on interest rates. However, inflation is caused by excess demand (too much
money available relative to the goods and services produced). By keeping interest rates
low the Fed actually fueled excess demand for borrowing. Paul Volcker became
chairman of the Fed in 1979 and he changed the Fed’s target from interest rates to non-
borrowed reserves and managed to purge inflation from the economy. Due to increases
in volatility of M1 and growing instability of velocity (the relationship between money
and economic activity), the Fed had trouble hitting money supply targets. In 1993 the
Fed announced it would once again target interest rates and began publicly announcing
the desired fed funds rate for the first time.

Teaching Tip:
The instructor should emphasize that an interest rate target as practiced in the 1970s will
not work in an environment with rapid inflation. If we return to an inflationary
environment, the Fed will have to be willing to significantly raise the fed funds rate to
reduce inflation.

Teaching Tip:

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The difference between M1 and M2 is liquidity. Recall Keynes’ functional definition of

money as any asset that serves as a medium of exchange, a store of value and a unit of
account. Accounts in M1 are clearly mediums of exchange and the additional accounts in
M2, while less liquid than those in M1, meet the store of value function of money.

Money Supply measures % of Total money supply as

Billions $
January 2014 measured by M2
M1 $2,650 24%
M2 (includes M1) $10,986
Money supply growth for 2013 was about 5.5%, which was greater than GDP growth.
Some economists believe that money supply growth rates faster than GDP growth are
inflationary.

Teaching Tip:
Ben Bernanke, the former Chairman of the Federal Reserve, broke with Greenspan’s
policy of only gradually changing interest rates in small increments, usually 25 basis
points. This policy gave investors time to adjust to changing interest rates.

Teaching Tip:
The instructor may wish to ask students to think about the following:
1. What are the implications of the bailouts of the financial crisis? Is the system
safer now or can we expect another crisis in the future?
2. What does it mean to be too big to fail or systemically risky? Does designating an
institution as systemically risky make the system safer?
3. What are the pros and cons of deposit insurance? Should the U.S. employ
unlimited deposit insurance as some other countries do?

Teaching Tip:
Was the financial crisis a result of excessively loose monetary policy and weak
enforcement of regulations in the 1990s when Allan Greenspan was Fed Chair?

Greenspan was fortunate to be Fed Chair during a very long period of global growth
(albeit with some significant bumps along the way). During his tenure global growth was
quite high on average and 1990s U.S. productivity growth was extremely high.
Throughout much of his tenure inflation was benign and he was able to allow long
periods of rapid U.S. monetary growth without generating inflation (annual money
supply growth rates have generally been much greater than our economic growth rates).
This strategy succeeded in large part because of foreigners’ ongoing willingness to
acquire dollars and dollar denominated assets. Earlier in his tenure, foreign private
agents were acquiring dollars, but in recent years a greater proportion of acquisitions of
dollars have been made by foreign central banks attempting to keep their currency from
appreciating. To the extent that they have succeeded, their actions have probably hurt
U.S. firms competing with foreign imports. His low rate policies also allowed U.S.
economic agents, such as the government, households and firms, to rack up record high
debt levels without generating pressure on interest rates to rise. Until the financial crisis,
the repercussions did not seem significant. Was he smart or just lucky?

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The Fed can affect the exchange value of the dollar by buying and selling foreign
currencies against the dollar (foreign exchange intervention). The U.S. practices a
managed float and attempts to influence the value of the dollar in concert with other
central banks. The Fed faces a tradeoff in maintaining a stable currency value and low
U.S. inflation. If the U.S. has lower inflation than other countries, the value of the U.S.
dollar will tend to appreciate, ceteris paribus. An appreciating dollar can hurt U.S.
exports and worsen our trade deficit. Conversely, a falling dollar can generate U.S.
inflation by putting pressure on foreign firms (exporters to the U.S.) to raise U.S. prices
to preserve their local currency value of their revenues. The Fed has difficulty
maintaining the value of the dollar and managing U.S. inflation simultaneously.8
Suppose inflation is just where the Fed wants it, but the dollar is falling against the yen
because Japan is running lower inflation than the U.S. If the U.S. wishes to stop the
dollar from falling, the Fed could theoretically sell $1 billion worth of yen denominated
assets to commercial bank currency traders for dollars. The Fed would receive payment
from the commercial bank purchasers by debiting the commercial banks’ reserves at the
Fed by $1 billion. This would decrease the U.S. money supply and should then result in a
decrease in U.S. inflation. Consequently, cooperation between central banks is needed to
work out the tradeoffs between domestic inflation and currency values around the world.

Teaching Tip:
Because currency intervention normally requires foreign currency reserves, the levels of
these reserves in developing countries that may experience a currency devaluation are
closely watched by currency speculators. The Economist publishes foreign currency
reserves for most developing countries.

8
The U.S. Treasury is actually responsible for the value of the dollar in the foreign exchange
markets, but the Fed implements the Treasury’s decisions on when and how much to intervene in the
currency markets.

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5. International Monetary Policies and Strategies

a. Systemwide Rescue Programs Employed During the Financial Crisis
September 2008 was the flash point of the financial crisis. On September 8, the
government seized Fannie Mae and Freddie Mac, the two entities that directly or
indirectly funded about ¾ of the nation’s home mortgages. On September 15, Lehman
Brothers, a 150 year old investment bank, collapsed. Merrill Lynch let itself be bought
by Bank of America rather than fail, AIG met with federal authorities to arrange a bailout
and Washington Mutual, the largest savings institution in the U.S. announced it needed a
buyer. The Dow fell more than 500 points, the biggest drop in over 20 years.

Individual country responses:

The contagion quickly spread around the globe. Germany announced a guarantee of all
deposits in October and arranged a bailout of their second largest mortgage lender Hypo
Real Estate. The UK nationalized Bradford and Bingley and increased deposit insurance.
Ireland guaranteed deposits and debt of its six major banks; a move that led to a
sovereign bailout later on. The Icelandic government bailed out its largest bank and
seized all the banks, eventually the economy of Iceland collapsed nonetheless. The list
goes on with Asian central banks forced to inject liquidity into their systems to prevent
contagion.

Common responses:
The central banks of 11 countries (Australia, Canada, France, Germany, Italy, Japan, the
Netherlands, Spain, Switzerland, the UK, and the US) acted to ease monetary conditions
in response to the crisis. These moves can be grouped into five areas:
a) Expansion of retail deposit insurance
b) Direct injections of capital to improve lender’s balance sheets
c) Debt guarantees
d) Asset purchases or asset guarantees
e) Stress tests of banks (not in text)

Many countries increased deposit insurance. The U.S. temporarily insured all deposits
without limit. Nine other countries also provided unlimited deposit insurance to prevent
any panics. The U.S. first announced they would engage in extensive asset purchases
from problem institutions although it did not. It was very difficult to price the assets
correctly in the absence of functioning markets. Paying too much was politically perilous
and paying too little would encounter bank resistance and force large losses on the debt
holders. So this plan was never extensively implemented. The FDIC announced a
temporary debt guarantee program for new issues by banks that met with some success.
Capital injections were the main method utilized. The Netherlands and the UK used debt
guarantees extensively providing commitments worth 33% and 17% of their GDP
respectively.

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Europe has been undergoing a major crisis that has undermined many European’s belief
in the desirability of maintaining the Euro area as indicated by recent elections and polls
in Europe. Europe is not a ‘natural currency area,’ which means that with the current
differences in their economies, regulations and labor mobility employing a common
currency is problematic. Exchange rate changes can adjust for differences in
competitiveness. Without this, more onerous adjustments such as wages and benefits
must be reduced in less competitive countries to make their products saleable. Their
economies need more unity if the safety valve of a currency adjustment is not allowed to
offset differing competitive conditions. Otherwise large scale fiscal transfers or
excessive money creation are likely to be needed periodically. The Greek crisis that
began in 2010 was thus perhaps predictable. The Greek government over-borrowed at
unrealistically low interest rates for the risk because of the common currency backed by
the economic clout of Germany. Much of the money was not invested wisely and a $480
billion + crisis ensued with large spillover effects in other weak European economies
such as Spain, Ireland and Portugal. At one point even Italy’s financial viability was in
question. If the euro is to be maintained either Germany will have to periodically finance
problem countries or greater economic integration must be achieved. In the long run
ignoring economic forces will have consequences.

Teaching Tip:
Even with the monetary stimulus (and the earlier fiscal stimulus) the economy is not
recovering as rapidly as desired and growth is projected to remain below trend through
2015. This is in part because the crisis was a debt crisis and debt overhangs typically
lead to subpar recoveries. Stimulative monetary policy is not very effective when
potential borrowers are over leveraged to begin with. Tight credit restrictions by
regulators and uncertain capital requirements have discouraged banks from aggressively
lending their excess reserves. The health care entitlement program has not helped either
as it created uncertainty about labor costs. The rules changes have also exacerbated the
problem. CFO Magazine reports that businesspeople are not necessarily opposed to the
law, but they are uncertain about its effects and costs so they are proceeding cautiously in
hiring. As of 2014, other headwinds to growth include the weak housing market, slowing
growth in China, uncertainty over the Ukraine situation, and uncertainty over future taxes
given the high government debt levels.9

Teaching Tip:
Capital is what is needed to ride out a crisis, and this is why higher capital requirements
are necessary to improve the safety of the financial system. As the time since the last
crisis increases implementing this need becomes less popular however. New rules under
Basel III, which governs international capital standards, are increasing capital
requirements for banks. The new core tier 1 ratios have been raised from 2.5% to 4.5%
and general capital requirements must be at least 7%.

9
Source: Leubsdorf, B. Economy Shrank, U.S. Now Says, Downturn, Though Likely Weather-
Driven, Reflects Pattern of Sluggishness Seen Over Past Five Years, The Wall Street Journal Online,
May 29, 2014.

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Although these are increases, they are unlikely to be large enough to stabilize banks in
the next crisis given the size of losses witnessed during the recent turmoil. Capital ratios
would probably have to be in the 20% range for that. Higher capital ratios lower ROE
and may increase the cost of credit. What price are we willing to pay to safeguard the
industry? Capital injections varied by country and sometimes came with restrictions on
executive compensation and dividend payments. Capital commitments ranged from 1%
to 6% of GDP.

Finally many central banks or other financial authorities conducted stress tests of their
major banks to ensure the banks could withstand varying economic conditions. These
tests helped assure the financial markets of the soundness of the financial institutions in
the various economies.

VI. Web Links

www.federalreserve.gov Website of the Board of Governors of the Federal Reserve

www.ft.com Financial Times, won two Espy awards for best new site
and best non U.S. news site. Coverage of global events and
markets

www.wsj.com Website of the Wall Street Journal Interactive edition. The

web version of the well known financial newspaper can be
personalized to meet your own needs. Instructors can also
receive via e-mail current events cases keyed to financial
market news complete with discussion questions

www.ny.frb.org Federal Reserve Bank of New York website, complete with

research, links to the Treasury Direct program and job
opportunities

www.stlouis.frb.org Federal Reserve Bank of St. Louis website, contains

tremendous amount of economic data, including charts and
graphs.

http://www.ecb.int/home/html/index.en.html European Central Bank website,

contains announcements of interest policy
in the euro area and discussions of the
euro system.

VII. Student Learning Activities

1. Discuss the differences in strategy followed by the Federal Reserve and the European
Central Bank with respect to monetary policy. What are the advantages and
disadvantages of each?

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2. Explain how the actions of a recent FOMC meeting will affect you personally. Hint:
Think about the effect on the economy and various interest rates.

3. Can the Fed have an effect on long term interest rates as well as the fed funds rate?
Examine the Wall Street Journal on several recent days when the Fed announced
changes in the fed funds rate target. What, if anything, happened to long term interest
rates? Explain any changes.

4. Why does the stock market often respond after a FOMC meeting even when there are
no announced changes in the target Fed funds rate? Do the bond markets respond
also? Would you expect them to respond similarly? Why or why not?

5. On the web locate the Wall Street Journal Economic Forecasting Survey. According
to the survey, what are the major risks facing the U.S. economy today? In general
terms what do you believe should be the government’s response to these risks?

6. What do you think of the Fed’s dual goal of stimulating growth and limiting
inflation? Should one or the other of these be the top priority?

7. a) How has the role of the Fed changed due to the financial crisis?
b) How has the public’s perception of the Fed changed since the financial crisis?

8. a) Why is it that to the ordinary person inflation ‘feels’ higher than the CPI
indicates?
b) Why do most Americans say that the country is not heading in the right direction?
Can the Fed fix this?

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