Chapter 5

CENTRAL BANKS AND THE CREATION

OF MONEY

The Federal Reserve System

Board of Governors

Federal Reserve Banks

Member Banks

Federal Open Market Committee

Tools of Monetary Policy

Reserve Requirements

Open Market Operations

Open Market Repurchase

Agreements

Discount Rate

Reserve Requirements

Fractional Reserve Banking System Required reserve ratio

Demand depositsTime deposits

Total reservesRequired reservesExcess reserves

Open Market OperationsFed purchases and sales of

government securitiesFed purchases

Increase excess reserves Increase new loans Increase money supply

Fed sales Decrease excess reserves Decrease loans Decrease money supply

Open Market Repurchase Agreements

Repurchase Agreement Fed buys securities from a seller who agrees to

repurchase them at a higher price on a certain date in the future. (Temporary increase in excess reserves.)

Reverse Repurchase Agreement Fed sells securities and agrees to repurchase

them at a higher price on a certain date in the future. (Temporary decrease in excess reserves.)

Discount Rate

Rate charged on loans from the Fed’s discount window.

Administratively set by Board of Governors

An increase in the discount rate discourages banks from borrowing from the Fed

A decrease in the discount rate encourages banks to borrow from the Fed

Different Uses of Money

Unit of Account Numeraire

Medium of Exchange Currency and demand deposits

Store of Value Time deposits

Monetary Aggregates

Monetary Base: Currency in circulation Currency and coins plus total reserves

M1 Money Supply Currency plus demand deposits

M2 Money Supply M1 plus short-term time deposits

M3 Money Supply M2 plus long-term time deposits

Money Multiplier

Process by which changes in bank reserves generate larger changes in the money supply.

Size of Multiplier Influenced by: Reserve requirement ratio Public’s demand for cash Banks’ willingness to make loans Level of interest Rates

The Money Supply Process in an Open Economy

Foreign Exchange Market Intervention The Fed’s purchase and sale of foreign

currencies Purchase of foreign currencies

Increases monetary baseReduces value of the U.S. currency

Sale of foreign currenciesDecreases monetary baseIncreases value of the U.S. currency

Central Banks Around the World

European Central Bank

Bank of England

Bank of Japan

European Central Bank (ECB)

Replaced central banks in the 11 countries participating in the European Economic Community

Structure of ECB is decentralizedMajor Issues: Weakness of EuroMajor Aspects: TransparencyPolicy objective: price stability

England: Bank of England

Primary Roles: Monetary Policy and Stability of Financial System

Bank of England Act (1998) No longer under control of Exchequer Management of Government debt

Policy objective: price stabilityIndependenceTransparency

Japan: Bank of Japan

Ministry of FinanceBank of Japan Law (1998)

Independence Transparency

Policy objective: price stabilityPolicy BoardTanKan Report