Sunday, January 25, 2009

A primer on the Federal Reserve

As much as Ben Bernanke and the Federal Reserve have been mentioned in the news as of late, most people still don't have the slightest idea of how the Fed conducts it's monetary policy. I figured it'd be useful to write up a primer on the topic, so here it is.

Nearly all of this information in the rest of this post comes straight from the Federal Reserve's educational website:


There are some interactive tutorials there worth checking out.


The Federal Reserve is wholly responsible for controlling the nation's money supply, and manipulates it in an attempt to achieve whatever economic goals they have are currently pursuing. According to them:

The goals of monetary policy include the promotion of sustainable economic growth, full employment, and stable prices. Through monetary policy, the Fed is most able to maintain stable prices, thereby promoting economic growth and maximum employment.

A simplified explanation of the dollar expansion/contraction process:

The Fed manages the banking system and controls the expansion and contraction of the money supply through the banking system.

When dollars are added to the money supply, they are deposited at member banks. When dollars removed from the money supply, they are removed from member banks.

These dollars, added and removed, count toward the member banks' reserves. Reserves are primarily made up of demand deposits (checking accounts that citizens and businesses hold at banks). These reserves are the money that a bank uses to make loans.

(Aside: "Demand deposits" are deposits in which bank customers, at anytime, may choose to withdraw. Because banks use the dollars from these deposits to make loans, they never have, in reserve, all of the dollars that they have guaranteed their customers access to. They only hold a fraction of what they owe to their customers. This is why this system of banking is called "fractional-reserve banking". They can get away with this because, at any given moment, their customers will only withdraw a portion of what is supposed to be in the banks' reserves. If every customer at a given bank chose to withdraw their money at once, the bank would not be able to honor all of these requests, and would be bankrupt. This situation of everyone trying to withdraw at once is called a "bank run".)

The Fed involves banks in the dollar creation process as well. The Fed mandates a "reserve requirement" for banks, which is usually 10% of the dollar amount in loans issued by a given bank. So if a bank has loaned out $100,000, it must hold $10,000 in its reserves. If a bank drops below this reserve minimum, it's bankrupt.

(Aside: In practice, dollars are not the only thing banks can count towards their reserves. Certain assets/investments can count towards their reserve requirement. The rise and fall in value of these assets affect what the bank can say it has in reserve. The housing crisis turned into a banking crisis in large part because banks were counting mortgage-backed securities as part of their reserves. When they were suddenly forced to value these assets as worthless, all of a sudden they were at great risk of dropping under their reserve minimum and, consequently, going bankrupt)

So the dollar creation process as we now understand it is:

- The Fed decides to expand the money supply. It deposits $10,000 into a member bank's reserves. Having $10,000 extra in reserves, this bank is now allowed to loan an extra $100,000 to the public. Hence, $100,000 has just been created.

- The Fed decides to contract the money supply. It withdraws $10,000 from a member bank's reserves. Losing that $10,000, that bank must reduce the amount of money it has lent out by $100,000. Hence, $100,000 has been eliminated from the money supply.

The dollar expansion/contraction process in more detail:

Member banks all hold most of their reserves in accounts at the Federal Reserve. (They keep a portion of their reserves with them for day to day customer transactions such as: withdrawals from tellers, ATMs, etc.) When the Fed wants to expand or contract the money supply, it doesn't actually deposit or withdraw directly from the reserve accounts of member banks. Instead, it acts through financial institutions designated as primary dealers.

Say, as in the above example, the Fed wants to expand the money supply by $100,000. It informs all of its primary dealers that it wishes to purchase a financial instrument of some sort (usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored ). After a bidding process, the Fed then purchases a security from a primary dealer, using a check for $10,000 redeemable only at the Fed. The primary dealer deposits this check at its bank, which in turn deposits this check into its reserve account at the Fed. The Fed takes this check and credits that bank's reserve account with $10,000. Assuming a reserve requirement of 10%, this bank can now lend out up to $100,000. The money supply has increased by $100,000.

If the Fed wishes to contract the money supply by $100,000, it alerts its primary dealers that it wishes to sell a financial instrument. After a bidding process, the Fed sells a security to a primary dealer for $10,000. The primary dealer withdraws $10,000 from its demand deposit at a given bank; this bank loses $10,000 from its reserves and must reduce the amount of money it has lent out by $100,000. The money supply has decreased by $100,000.

Transactions between the Federal Reserve and its primary dealers are called open market operations.

Here's the current list of Primary Dealers.

The effect of reserves on interest rates

Supplying a bank with more money in its reserves doesn't just increase the amount of money it can lend out, it also affects the interest rate it charges when it lends out money. Under normal circumstances, when banks have more money to lend, they will lower interest rates to attract more borrowers. When banks have less money to lend, they will raise interest rates to take advantage of the decrease in loan supply.

The Federal Reserve is acutely aware of this issue, as interest rates affect the amount of loans issued and the resulting level of economic activity. Low interest rates, they believe, result in more loans, more economic activity, and ultimately more growth.

Inter-bank loans, and the Federal Funds Rate

The money supply is not distributed amongst the banks equally. At any given moment, one bank may be low on reserves (which implies it is uncomfortably close to its reserve minimum ) while another may have an excess of reserves (it has more reserves than it requires for the loans it has issued). In these cases, banks may lend to each other using money from their reserve accounts.

This inter-bank interest rate is called the effective Federal Funds Rate. This is the interest rate that the Federal Reserve primarily concerns itself with and attempts to manipulate. It tries to control the economy through this interest rate. It does so by setting a nominal Federal Funds Rate, which is a target (usually a range) that the Fed wants the effective Federal Funds Rate to reach. When you hear on the news that the Federal Reserve has cut interest rates, they are referring to the nominal Federal Funds rate. It manipulates the rate through the process described above: buying or selling assets from primary dealers to affect the amount of dollars in bank reserves and, consequently, the interest rates that these banks charge each other for loans.

(Aside: Under normal circumstances, interest rates respond to changes in reserves as I described above. We are currently not in a situation that can be considered remotely normal. The Federal Reserve has pumped an unprecedented amount of money into bank reserves over the past year, but still can't get the banks to lend to each other at any rate, let alone the target rate. The banks are terrified at the prospect of loaning to a bank that will go bankrupt before the loan is paid off)

The discount window

This is the last of the Federal Reserves traditional tools to manipulate the money supply. Instead of borrowing from each other, banks have the option of borrowing money directly from the Federal Reserve. Since it is the entity actually issuing the loan, the Fed directly controls the interest rate charged for these loans. Setting a very low interest rate will encourage lending and expand the money supply, as banks will borrow from the Fed and loan the borrowed money to the public at a higher interest rate. (Note: the borrowed money goes straight to their reserve account, so they can loan out 10x more than they borrowed from the discount window, assuming a 10% reserve requirement.) Setting a very high interest rate positions the Fed as the lender of last resort, as banks will not resort borrowing at this rate unless they are desperate to replenish their reserves.

Which money is new money

Just to review:

- When the Fed buys an asset from a primary dealer, the dollars used in that purchase are newly created

- When the Fed sells an asset to a primary dealer, the dollars used in that sale cease to exist.

- When the Fed issues a loan through the Discount Window, the dollars loaned are newly created

- When a loan issued through the Discount Window is repaid, those dollars cease to exist. I believe the dollars paid in interest to the Fed also ceases to exist, but I'm not sure.

- When a bank lends dollars in excess of the reserves it holds, those dollars are newly created

- When a loan is repaid to a bank, those dollars cease to exist. The interest the bank received on the loan is deposited into its reserve account at the Fed.

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