The Federal Reserve The Federal Reserve SystemSystem

ECO 473 – Money & Banking – Dr. D. Foster

I. Its History, I. Its History, Functions & Functions & StructureStructure

II. Fed Policy II. Fed Policy Tools & GoalsTools & Goals

The Origins of U.S. Central Banking

Bank of England The Bank of North America (1781) The First Bank of the United States (1791) The Second Bank of the United States (1816)

1837–18651837–1865 The Free-Banking period. The Civil War & Greenbacks - a fiat money.

1791–18361791–1836

1865–19121865–1912

The Gold Standard (1875).

Brief foray into bimetalism.

Panics of 1873, 1893 and 1907

Federal Reserve Act of 1913

Central Banking – The Bank of Central Banking – The Bank of EnglandEngland

• Created in 1694– Bought gov’t bonds and issued notes.– Held all government debt.– Notes were not “legal tender,” but widely accepted.– Insolvent in 2 years.– Parliament allowed them to suspend specie

payment.– Brief competition (Nat’l Land Bank; South Seas)– 1708: monopoly on bank notes & short term loans.– Late 1700s, massive suspension lasted 24 years.– 1833: notes made legal tender.

• Peel Act – limit fractional reserve notes.– Failed to recognize deposits as money.

Central Banking - The 1Central Banking - The 1stst and 2 and 2ndnd BUSBUS

• Mercantilist movement behind banks.

• Fed owns 20%, deposits funds here.

• Banks buy government debt; issue notes.

• 1791-1796 wholesale prices up 72%.

• Periodic specie suspension and bank panics.

• BUS will hold bank notes.

• 2nd BUS inflates, then deflates in 1819.

• ““The bank was saved, but the people The bank was saved, but the people ruined.”ruined.”

• Jackson kills the 2nd BUS.

The “Free Banking” Era: 1836-1863The “Free Banking” Era: 1836-1863

• Van Buren sets up Independent Treasury System.– Came and went and lasted only until Civil War.– Fed’l government held only specie, not paper.

• Decentralized banking 1836-1862.– Still heavily regulated.– State banks required to hold state gov’t. debt to

back their note/dd issue.– Notes accepted for taxes.– Restricted branching making redemption harder.

• Private note clearing – Suffolk System– Held specie reserve of members.– Different bank notes accepted.– Insulated banks from panics.

The National Banking SystemThe National Banking System

• Specie suspension & greenbacks 12/1861.

• 1861 to 1863, MS doubled.– Wholesale prices up 22% per year during war.

• The National Banking Act of 1863– Created national currency.

– Taxed non-nat’l bank notes.

– Bought gov’t debt & issued notes.

– The rise & fall of Jay Cooke.

– State banks benefit by holdingreserves in nat’l notes.

– Didn’t stop periodic panics.

The Federal Reserve SystemThe Federal Reserve System

• “An engine of inflation.”

• An addition layer means more money creation.

• 1914 to 1920, MS doubles

– member banks dd 250%.

– non-member banks dd 33%.

• Reserve deposits on savings falls.

– Shift from dd to td.

– Generally accepted that savings are“payable upon demand.”

• Ben Strong & the Morgans.

Pyramiding the Money SupplyPyramiding the Money Supply

Banks have $1 mill. of gold and rr = 25%.They can issue $4 mill. of loans = notes + demand deposits.Add national banks. They can hold $1 mill. of gold

and expand money to $4 million.Other banks can treat $4 mill. as their reserves and

expand the MS (by increasing dd) to$16 million.

Add the Federal Reserve. They can hold $1 mill. of gold and expand money to $4 million.

National banks can treat $4 mill. as their reserves and expand the MS (by increasing dd) to $16 million.

Other banks can treat $16 mill. as their reserves and expand the MS to $64 million.

The Federal Reserve Banking System

Board of Governors of the FRSBoard of Governors of the FRS 7 members, equal standing . . . but, includes

Secretary of the Treasury and Comptroller of the Currency.

ProblemsProblems: Only using discount window, Each District Bank sets its own policy.

PurposePurpose:1. Develop, supervise & control the nation’s

money.2. Serve as a national check-clearing system.3. Serve as depository for federal gov’t.

funds.

The Federal Reserve Banking System

The Early Fed, 1913–1935

The Great Depression - Failure of the FedThe Great Depression - Failure of the Fed Initially increased liquidity, but pulled back.By 1933, 33% of banks fail, MS fallen 33%.

Accommodates the Treasury Dept. during WWI.Accommodates the Treasury Dept. during WWI.Buys Treasury bonds to finance G

spending(aka “monetizing the debt”).

From 1916 to 1918, this increases MS by 70%.

Huge risk of inflation.

The Fed - version 2.0, 1935

Serves as a “lender of last resort.”Serves as a “lender of last resort.”

Board of Governors reconstituted:Board of Governors reconstituted:

All 7 member selected by President/Senate confirms.Can’t include Treasury Sec.

nor Comptroller of Currency.Members serve 14 yr. terms on staggered basis.Political party diversity.Office of Chairman and Vice Chairman created.Has authority over district banks.

Federal Open Market Committee (FOMC)Federal Open Market Committee (FOMC)

12 members; primary policy-making body.

The Evolution of the Modern Fed

WWII - working “for” the U.S. TreasuryWWII - working “for” the U.S. Treasury Federal Reserve–Treasury Accord (1951)Federal Reserve–Treasury Accord (1951) ““Leaning Against The Wind”Leaning Against The Wind”

– Martin (1953-1970) The technocratic FedThe technocratic Fed

– Burns (1970-1978) . . . the “political business cycle”

Coping with inflationCoping with inflation– Volcker (1979-1987)

Keeping the economy stable?Keeping the economy stable?– Greenspan (1987-2006)

Coping with recessionCoping with recession– Bernanke (2006-2014)– Yellen (2014-?)

The Fed’s Balance Sheet

• THE FED’S ASSETS

– Treasury securitiesTreasury securities

– U.S. agency securities

– Discount window loans

– Gold certificates.

– Special Drawing Right (SDR) certificates

– Foreign currency reserves

– Cash items in the process of collection

• LIABILITIES AND EQUITY CAPITAL

– Federal Reserve notes Federal Reserve notes

– Bank reserve deposits

– U.S. Treasury deposits

– Foreign official deposits

– Deferred availability cash items

– Equity capital

The Fed’s Balance Sheet - 2005

782,003

The Consolidated Balance Sheet of

the Federal Reserve System ($ Millions, as of January 31,

2005)

2012

The Federal Reserve The Federal Reserve SystemSystem

ECO 473 – Money & Banking – Dr. D. Foster

I. Its History, I. Its History, Functions & Functions & StructureStructure

II. Fed Policy II. Fed Policy Tools & GoalsTools & Goals