Lecture 19
MONEY SUPPLY AND THE CENTRAL BANK

1. Role of the central bank (Federal Reserve)

• Objectives
  • To keep inflation in check
  • To promote economic growth
  • Question: Are these goals at odds with each other?

• Conducting monetary policy
  • Change money supply (equivalently, interest rates)

• Independence of the central bank
  • Is it okay that Chair of the Fed is not an elected official?

2. The Fed's balance sheet

• Assets:
  Government securities, loans to commercial banks

• Liabilities:
  Currency in circulation, reserves of commercial banks

3. Changes in money supply

How does the Fed do it?

NOTE: Since the Great Financial Crisis of 2007-09, the Fed has radically revamped the conduct of its monteray policy--see #5 below.

• To increase money supply, the Fed will inject (excess) reserves into the banking system
• To decrease money supply, the Fed will soak up (excess) reserves from the banking system

Method 1: Open-market operations

• Purchase, or sale of government securities to commercial banks

• Suppose the Fed buys Treasury bonds from Citibank
  • Citibank's holdings of govt. securities will fall ...
    ... and its reserves will rise (why?)
    
  • Citibank will lend out its excess reserves ...
    ... causing M1 to increase
    
  • The overall increase in M1 will depend on the required reserve ratio

• If the Fed sells govt. securities to the commercial banks, money supply will [ increase / decrease ].

Method 2: Changes in reserve requirements

• Commercial banks are required to maintain a certain proportion of their checking deposits in reserves
• In order to decrease money supply, the Fed will [ raise / lower ] the required reserve ratio (m)

Method 3: Changes in the discount rate

• What is the discount rate?
• If the Fed wants to increase money supply, it will [ increase / decrease ] the discount rate. Explain how this works.

4. The federal funds rate

• Interest rate at which banks lend to each other
  
  - Why would Citibank borrow from Chase?

• The Fed generally tries to target the federal funds rate

• The current federal funds rate is _______%. (Look at WSJ.)

5. How is monetary policy conducted now?

• The FOMC conducts monetary policy by setting the target range for the federal funds rate
• The primary tool for adjusting the federal funds rate is the interest paid on reserve balances (IORB)
  • By changing the interest paid on reserve balances (IORB) that banks hold in their accounts at a Federal Reserve Bank, the Fed can engineer an increase or decrease in the federal funds rate
• The discount rate serves as a ceiling (upper bound) for the federal funds rate
• Open market operations--the buying and selling of government securities by the Federal Reserve--are used to ensure that reserves remain ample.

Source: FRED blog