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Principles of Macroeconomics

3e

Chapter 15 MONETARY POLICY AND BANK REGULATION PowerPoint Image Slideshow

Ch.15 OUTLINE

• (^) 15.1: The Federal Reserve Banking System and Central Banks
• (^) 15.2: Bank Regulation
• (^) 15.3: How a Central Bank Executes Monetary Policy
• (^) 15.4: Monetary Policy and Economic Outcomes
• (^) 15.5: Pitfalls for Monetary Policy

15.1 The Federal Reserve Banking System and Central Banks

• (^) Central bank - the organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly.
• (^) In the U.S. the central bank is the Federal Reserve (“the Fed”). - (^) Semi-decentralized, mixing government appointees with representation from private-sector banks. - (^) Run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate.

Chair of the Federal Reserve Board

• (^) Jerome H. Powell (Credit: “_NZ79221” by Board of Governors of the Federal Reserve System/Flickr, Public Domain)
• (^) While the Chair of the Federal Reserve has only one vote, they control the agenda, and is the Fed's public voice.

What Does a Central Bank Do?

• (^) The Federal Reserve is designed to perform three important functions: 1. To conduct monetary policy 2. To promote stability of the financial system 3. To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government.

15.2 Bank Regulation

• (^) Bank regulation is intended to maintain banks' solvency by avoiding excessive risk.
• (^) Regulation falls into a number of categories:
  • (^) reserve requirements
  • (^) capital requirements
  • (^) restrictions on the types of investments banks may make.
• (^) Regulation requires that banks maintain a minimum net worth, usually expressed as a percent of their assets, to protect their depositors and other creditors.

A Run on the Bank

• (^) Bank run - when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost. - (^) Bank runs during the Great Depression only served to worsen the economic situation. (Credit: “Depression: "Runs on Banks” by National Archives and Records Administration, Public Domain)

Deposit Insurance and Lender of Last Resort

• (^) The risk of bank runs can create instability in the banking system.
• (^) To protect against bank runs, Congress has put two strategies into place: - (^) Deposit insurance - an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. - (^) Banks pay an insurance premium to the Federal Deposit Insurance Corporation (FDIC). - (^) Lender of last resort - an institution that provides short-term emergency loans in conditions of financial crisis.

How Open Market Operations Increase the Money Supply

• (^) (a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million.
• (^) (b) shows when the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million.

How Open Market Operations Increase the Money Supply, Continued

• (^) However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves with which it started),
• (^) So, (c) shows the bank loans out the extra $20 million in reserves and its loans rise by $20 million.
• (^) The central bank's open market operation causes an expansion of the money supply.

How Open Market Operations Decrease the Money Supply, Continued

• (^) However, (c) shows that Happy Bank wants to hold $40 million in reserves, so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level.
• (^) A bank can easily reduce its quantity of loans by slowing down or briefly stopping to make new loans.
• (^) This operation causes the money supply to decrease.

Changing Reserve Requirements

• (^) A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement.
• (^) Reserve requirement - the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank.
• (^) Greater reserve requirement = less money available to lend out.
• (^) Smaller reserve requirement = greater amount of money available to lend out.
• (^) The Fed rarely uses large changes in reserve requirements to execute monetary policy; the pandemic was an exception for obvious reasons.

15.4 Monetary Policy and Economic Outcomes

• (^) Expansionary monetary policy or loose monetary policy - a monetary policy that increases the supply of money and the quantity of loans.
• (^) Contractionary monetary policy or tight monetary policy - a monetary policy that reduces the supply of money and loans

The Effect of Monetary Policy on Interest Rates

• (^) Federal funds rate - the interest rate at which one bank lends funds to another bank overnight.
• (^) How does a central bank “raise” interest rates?
  • (^) Through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds.
  • (^) The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.
  • (^) If open market operations do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.