The United States Federal Reserve

By Dr. Paul Lockard

Professor

Black Hawk College

Fighting Inflation

• To understand the last two jobs of the Federal Reserve, we need to understand the monetary policy tools of the Federal Reserve.

Monetary Policy Tools

• Change the reserve requirement

• Change the discount rate

• Open market operations

The Federal Reserve and the Economy

• Federal reserve monetary policy actions impacts bank reserves

• Bank reserves impact money supply

• Money supply impacts interest rates

• Interest rates impact the economy

Reserve Requirements

Changing Reserve Requirements

• Total Reserves = Total deposits of a bank

• Required reserves = a fixed percentage of the total deposits of a bank

• Excess reserves = money available to a bank for lending

Changing Reserve Requirements

• If the Federal Reserve increases the reserve requirement, this reduces the excess reserves of a bank.

• Fewer excess reserves means the bank has less money to lend.

• Less lending means smaller money supply.• This leads to slower economic growth or a

decline in the economy.

Discount Rate

Changing the Discount Rate

• When banks apply to the Federal Reserve for loans, the Feds determine which banks will receive them.

• The Federal Reserve also determines the interest rate it will charge for these loans.

• That interest rate is called the discount rate.

Changing the Discount Rate

• If the Federal Reserve increases the discount rate this will reduce the amount of money banks have to lend out.

• With fewer reserves, bank lending will fall.• Less bank lending leads to a smaller money

supply.• This leads to slower economic growth or a

decline in the economy.

The Federal Funds Rate

The Federal Funds Rate

• Banks often find that they need extra funds, either to make loans, or to have enough required reserves.

• Banks used to borrow from the Federal Reserves.

• Increasingly they borrow from other banks

The Federal Funds Rate

• The Federal Funds Rate is the interest rate that lending banks charge to other banks.

• The Federal Funds Rate is influenced by demand and supply of funds, and by the actions of the Federal Reserve.

• The discount rate directly affects the federal funds rate.

Open Market Operations

Why Open Market Operations?

• However, experience has shown that changing reserve requirements is too drastic a tool to use.

• And experience has shown that changing the discount rate no longer works.

• Therefore the federal reserve now depends upon open market operations to affect the economy.

Open Market Operations

• Open market operations are the purchase and sale of Treasury Bonds by the Federal Reserve to influence the money supply.

Open Market Operations

• The Federal Reserve sells Treasury Bonds to reduce the money supply.

• The Federal Reserve buys Treasury Bonds to increase the money supply.

Open Market Operations

• The Federal Reserve has bought and sold Treasury bonds at different times in the past, depending upon how it wants the economy to move.

• In the past 25 years, the Feds has more often sold bonds to fight inflation.

Open Market Operations

• Using open market operations, the Federal Reserve sells bonds.

• The sale of bonds leads to a fall in customer deposits as investors write checks to buy bonds.

• Banks now have fewer deposits.• Since customer deposits fall, bank liabilities

and assets both fall.

Open Market Operations

• With fewer deposits, banks are able to lend less.

• Banks now have to ration their lending by raising prices.

• So they raise interest rates.• Higher interest rates leads to fewer

consumers and businesses borrowing money.

Open Market Operations

1) Affects economy through consumers’ demand.

2) Affects economy through business price changes.

3) Affects economy through layoffs.

4) Affects economy through investment changes.

1) Open Market Operations:Change in Consumer Demand

• Since consumers borrow less to make purchases, consumption falls.

• Falling consumption leads to falling demand.

• The fall in demand reduces inflationary pressures.

2) Open Market Operations:Business Price Cuts

• Falling consumption also leads to a rise in business inventories.

• Rising inventories force firms to cut prices, or at least not to raise prices.

• And if large numbers of companies are cutting prices, what happens to inflation?

3) Open Market Operations:Layoffs

• If price cuts by businesses don’t lead to increases in sales, businesses will be forced to lay off people.

• Then the rising number of layoffs will lead to a fall in consumption.

• The fall in consumption puts an additional squeeze on inflation.

4) Open Market Operations:Fall in Business Investment

• Rising interest rates also force businesses to borrow less.

• This leads to a fall in investment.

• The fall in investment leads to a fall in the purchases of all types of capital goods.

• The fall in the sale of capital goods forces those companies to cut prices.

Open Market Operations

• As businesses that produce capital goods cut their prices, this leads to a fall in inflation.

• If cutting prices doesn’t help the company, it can always lay people off.

• Increased layoffs lead to a reduction in demand, which reduces inflation.

Open Market Operations and the Fight Against Inflation

The sale of Treasury bonds through open market operations is the tool the Federal Reserve has for reducing inflation.

Open Market Operations and Disciplining the Labor Force

• But open market operations have been found to be useful for keeping wages lower as well.

Open Market Operations and Tight Labor Markets

Tight labor market

Defined as:

- lows levels of unemployment

- plenty of jobs

Open Market Operations and Loose Labor Markets

Loose labor market

Defined as:

- higher levels of unemployment

- scarcity of jobs

Loose Labor Markets

• In times of rising layoffs and higher unemployment, what happens to the ability of unions to obtain wage and benefit increases?

• What happens to ordinary people’s ability to ask for, and obtain, raises?

• What happens to people’s ability to switch jobs if they work for a bad employer?

Open Market Operations and Loose Labor Markets

• The Federal Reserve has repeatedly signaled that keeping wages down is what if believes it should do.

• “The tightening labor market might lead to inflationary expectations for the future. Therefore to reduce the potential for future inflation, interest rates will be raised.”

Open Market Operations andLoose Labor Markets

• Translation: to prevent the possibility of inflation, because tight labor markets might lead to pay increases, we at the Federal Reserve will increase interest rates now.

Loose Labor Markets

• Who is hurt by rising unemployment caused by higher interest rates?

• Who benefits by the higher unemployment caused by higher interest rates?

• Who else might benefit by high interest rates?

Bondholders and the Federal Reserve

• People buy bonds because they are the only risk free investment that earns interest.

• However, the bonds have low rates of interest, on the order of 3-7%.

• Bondholders are very sensitive to inflation. (Recall how to find real rates of interest?)

Bondholders and the Federal Reserve

• Approximately 89% of bonds directly or indirectly owned by families are owned by the richest 10% of the population.

• In periods of higher inflation, the value of the income from their bonds falls.

• In periods of low inflation, (higher unemployment) the value of their income rises.

Bondholders and the Federal Reserve

What class(es) might wish for very low levels of inflation, regardless of the level of unemployment required to achieve it?