ASSIGNMENT 4

96

In the first half of 2007, as the extent of declining

home prices became apparent, banks and other

financial market participants started to reassess the

value of mortgages and mortgage-backed securities

that they owned, especially those in the subprime

segment of the housing market. The autumn of

2007 saw increasing strains in a number of mar-

ket segments, including asset-backed commercial

paper, and banks also began to exhibit a reluctance

to lend to one another for terms much longer

than overnight. This reluctance was reflected in a

dramatic rise in the London Interbank Offered Rate

(LIBOR) at most maturities greater than overnight.

LIBOR is a measure of the rates at which inter-

national banks make dollar loans to one another.

Since that initial disruption, financial markets have

remained in a state of high volatility, with many

interest rate spreads at historically high levels.

In response to this turbulence, the Fed and the

federal government have taken a series of dramatic

steps. As 2007 came to a close, the Federal

Reserve Board announced the creation of a Term

Auction Facility (TAF), in which fixed amounts of

term funds are auctioned to depository institutions

against any collateral eligible for discount window

loans. So while the TAF substituted an auction

mechanism for the usual fixed interest rate, this

facility can be seen essentially as an extension

of more conventional discount window lending.

In March 2008, the New York Fed provided term

financing to facilitate the purchase of Bear Stearns

by J. P. Morgan Chase through the creation of

a facility that took a set of risky assets off the

company’s balance sheet. That month, the Board

also announced the creation of the Term Securi-

ties Lending Facility (TSLF), swapping Treasury

securities on its balance sheet for less liquid

The Financial Crisis: Toward an Explanation

and Policy Response

I N T H E N E W S

private securities held in the private sector, and the

Primary Dealer Credit Facility (PDCF). These actions,

particularly the latter, represented a significant

expansion of the federal financial safety net by

making available a greater amount of central bank

credit, at prices unavailable in the market, to insti-

tutions (the primary dealers) beyond those banks

that typically borrow at the discount window. . .

In the fall of 2008, financial markets worldwide

experienced another round of heightened volatil-

ity and historic changes: Lehman Brothers filed for

Chapter 11 bankruptcy protection; investment banking

companies Goldman Sachs and Morgan Stanley

successfully submitted applications to become bank

holding companies; Bank of America purchased

Merrill Lynch; Wells Fargo acquired Wachovia; PNC

Financial Services Group purchased National City

Corporation; and the American International Group

received significant financial assistance from the

Federal Reserve and the Treasury Department. On

the policy front, the Federal Reserve announced the

creation of several new lending facilities—including

the Asset-Backed Commercial Paper Money Market

Mutual Fund Liquidity Facility (AMLF), the Commercial

Paper Funding Facility (CPFF), the Money Market

Investor Funding Facility (MMIFF), and the Term

Asset-Backed Securities Loan Facility (TALF), the last

of which became operational in March 2009. The

TALF was designed to support the issuance of asset-

backed securities collateralized by student loans,

auto loans, credit card loans, and loans guaranteed

by the Small Business Administration, while also

expanding the TAF and the TSLF. The creation of

these programs resulted in a tremendous expansion

of the Federal Reserve’s balance sheet. Further-

more, Congress passed the Troubled Asset Relief

Program (TARP) to be administered by the Treasury

Department. And in February 2009, the president

signed the American Recovery and Reinvestment Act,

a fiscal stimulus program of roughly $789 billion. . .

Much of the public policy response to turmoil in

financial markets over the last two years has taken

the form of expanded lending by the Fed and cen-

tral banks in other countries. The extension of credit

to financial institutions has long been one of the

tools available to a central bank for managing the

supply of money—specifically, bank reserves—to

the economy. Indeed, discount window lending

by the 12 Reserve Banks was the primary means

for affecting the money supply at the time the Fed

was created. Over time, open market operations, in

which the Fed buys and sells securities in transac-

tions with market participants, have become the

main tool for managing the money supply. Lending

has became a relatively little-used tool, mainly

accessed by banks with occasional unexpected

flows into or out of their Fed reserve accounts late

in the day. If such banks were to seek funding in

the market, they would likely have to pay above-

normal rates for a short-term (overnight) loan. In

this way, the discount window became a tool for

dampening day-to-day fluctuations in the federal

funds rate. In 2006, average weekly lending by the

Reserve Banks through the discount window was

$59 million. Since the outset of the widespread

market disruptions in the summer of 2007, the Fed

has changed the terms of its lending to banks and

created new lending facilities. In the first three quar-

ters of 2008, weekly Fed lending averaged $132.2

billion, and in the fourth quarter of the year, that

figure rose to $847.8 billion.

Source: Federal Reserve Bank of Richmond Annual

Report 2008, April 2009, by Aaron Steelman and

John A. Weinberg.

Assistance in the Conduct of Monetary Policy. As mentioned above, a primary respon- sibility of the Federal Reserve System is to influence the monetary (and financial) condi-

tions in U.S. financial markets and thus the economy. Federal Reserve Banks conduct

monetary policy in several ways. For example, as discussed above, 5 of the 12 Federal

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 97

Reserve Bank presidents serve on the Federal Open Market Committee (FOMC), which

determines monetary policy with respect to the open market sale and purchase of govern-

ment securities and, therefore, interest rates. The Boards of Directors of each Federal

Reserve Bank set and change the discount rate (the interest rate on loans made by Federal Reserve Banks to depository institutions). These loans are transacted through

each Federal Reserve Bank’s discount window and involve the discounting of eligible short-term securities in return for cash loans. Federal Reserve Bank Boards also have dis-

cretion in deciding which banks qualify for discount window loans. As discussed above,

any discount rate change must be reviewed by the Board of Governors of the Federal

Reserve. For example, in an attempt to stimulate the U.S. economy and prevent a severe

economic recession, the Federal Reserve approved 11 decreases in the discount (and fed-

eral funds) rate in 2001.

In the spring of 2008, in an attempt to avoid a deep recession and rescue a failing

financial system, the Federal Reserve took a series of unprecedented steps in the con-

duct of monetary policy. First, Federal Reserve Banks cut interest rates sharply, includ-

ing one cut on a Sunday night in March 2008 (see below). Second, the Federal Reserve

Bank of New York brokered the sale of Bear Stearns, the then fifth largest investment

bank in the United States, to J. P. Morgan Chase. Without this deal, Bear Stearns was

highly likely to fail (and along with it other investment banks in similar situations as

Bear Stearns). To get J. P. Morgan Chase to purchase Bear Stearns, the Fed agreed to

take any losses in Bear Stearns’s investment portfolio up to $29 billion. Similarly, in

September 2008 AIG (one of the world’s largest insurance companies) met with Federal

Reserve officials to ask for desperately needed cash. Concerned about how the firm’s

failure would impact the U.S. financial system, the Federal Reserve agreed to lend $40

billion to AIG to prevent its failure. The financial crisis saw the Fed’s widening regula-

tory arm moving beyond depository institutions to other types of financial institutions.

Third, for the first time Federal Reserve Banks lent directly to Wall Street investment

banks. In the first three days, securities firms borrowed an average of $31.3 billion per

day from the Fed.

While the Federal Reserve’s conduct of monetary policy is primarily designed to

affect the U.S. economy, in our ever increasing global economy, any policy changes

made by the Fed also influence, and are influenced by, international developments. For

example, as discussed below and in Chapter 9, the Fed’s monetary policy actions affect

the U.S. dollar for foreign currency exchange rates. A change in the foreign exchange

value of the dollar affects the foreign currency price of U.S. goods bought and sold on

world markets as well as the dollar price of foreign goods purchased by U.S. citizens.

These transactions, in turn, affect output and price levels in the U.S. economy. There-

fore, it is essential that the Federal Reserve and the FOMC incorporate information about

and analysis of international transactions, movements in foreign exchange rates, and

other international developments as well as U.S. domestic influences when formulating

appropriate monetary policy.

Supervision and Regulation. Each Federal Reserve Bank has supervisory and regula- tory authority over the activities of state-chartered member banks and bank holding com-

panies located in their districts. These activities include (1) the conduct of examinations

and inspections of member banks, bank holding companies, and foreign bank offices by

teams of bank examiners; (2) the authority to issue warnings (e.g., cease and desist orders

should some banking activity be viewed as unsafe or unsound); and (3) the authority to

approve various bank and bank holding company applications for expanded activities (e.g.,

mergers and acquisitions). Further, in the area of bank supervision and regulation, innova-

tions in international banking require continual assessments of, and occasional modifica-

tions in, the Federal Reserve’s procedures and regulations.

Notably, after March 2008, as the Fed stepped in to save investment bank Bear

Stearns from failure, politicians proposed an expanded role for the Fed as the main

supervisor for all financial institutions. In July 2010, the U.S. Congress passed the Wall

discount rate

The interest rate on loans

made by Federal Reserve

Banks to depository

institutions.

discount window

The facility through which

Federal Reserve Banks issue

loans to depository institutions.

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98 Part 1 Introduction and Overview of Financial Markets

Street Reform and Consumer Protection Act, which called for the Fed to supervise the

most complex financial companies in the United States and gave regulators (including

the Fed) authority to seize and break up any troubled financial firm whose collapse

might cause widespread economic damage. Thus, the Fed’s supervision and regula-

tion duties have spread to include commercial banks as well as other types of financial

institutions.

Consumer Protection and Community Affairs. The U.S. Congress has assigned the Federal Reserve, through FRBs, with the responsibility to implement federal laws intended

to protect consumers in credit and other financial transactions. These responsibilities

include: writing and interpreting regulations to carry out many of the major consumer

protection laws; reviewing bank compliance with the regulations; investigating complaints

from the public about state member banks’ compliance with consumer protection laws;

addressing issues of state and federal jurisdiction; testifying before Congress on consumer

protection issues; and conducting community development activities. Further, commu-

nity affairs offices at FRBs engage in a wide variety of activities to help financial insti-

tutions, community-based organizations, government entities, and the public understand

and address financial services issues that affect low- and moderate-income people and

geographic regions.

Government Services. As discussed above, the Federal Reserve serves as the com- mercial bank for the U.S. Treasury (U.S. government). Each year government agencies

and departments deposit and withdraw billions of dollars from U.S. Treasury operating

accounts held by Federal Reserve Banks. For example, it is the Federal Reserve Banks that

receive deposits relating to federal unemployment taxes, individual income taxes with-

held by payroll deduction, and so on. Further, some of these deposits are not protected by

deposit insurance and must be fully collateralized at all times. It is the Federal Reserve

Banks that hold collateral put up by government agencies. Finally, Federal Reserve Banks

are responsible for the operation of the U.S. savings bond scheme, the issuance of Treasury

securities, and other government-sponsored securities (e.g., Fannie Mae, Freddie Mac—

see Chapter 7). Federal Reserve Banks issue and redeem savings bonds and Treasury secu-

rities, deliver government securities to investors, provide for a wire transfer system for

these securities (the Fedwire), and make periodic payments of interest and principal on

these securities.

New Currency Issue. Federal Reserve Banks are responsible for the collection and replacement of currency (paper and coin) from circulation. They also distribute new cur-

rency to meet the public’s need for cash. For example, at the end of 1999, the Fed increased

the printing of currency to meet the estimated $697 billion demand for currency result-

ing from the Y2K scare, in which it was feared that computers worldwide (incapable of

recognizing the year 2000) would cease to function on January 1, 2000. Afraid that bank

accounts would be lost, depositors withdrew funds in record amounts. More recently,

beginning in 2011, there was talk of the Treasury minting a $1 trillion platinum coin as

a way of addressing the U.S. debt ceiling crisis. A few, otherwise intended, sentences in

the 1997 Omnibus Consolidated Appropriations Act allowed such a minting as long as the

coin was platinum. Advocates argued that minting the $1 trillion coin to pay off some of

the national debt was a better option than the continued fighting by political leaders over

raising the U.S. debt ceiling. However, talk of this solution was relatively short-lived, as

in January 2013 the Federal Reserve announced that if the Treasury did mint the coin and

present it for payment, the Fed would not accept it.

Check Clearing. The Federal Reserve System operates a central check clearing sys- tem for U.S. banks, routing interbank checks to depository institutions on which they are

written and transferring the appropriate funds from one bank to another. All depository

institutions have accounts with the Federal Reserve Bank in their district for this purpose.

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 99

Table 4–2 shows the number and value of checks collected by the Federal Reserve Banks

from 1920 through 2012.

The number of checks cleared through the system peaked in 1990, with 18.60 billion

checks cleared. For several reasons, this fell to 6.62 billion by 2012. Industry consolidation

and greater use of electronic products has resulted in a reduction in the number of checks

written and thus cleared through the Federal Reserve System. Further, in October 2004,

the Check 21 Act, enacted by the Congress and the Federal Reserve, allowed banks to

destroy checks after taking a digital image that is then processed electronically. The Act

begins the process of moving to a paperless environment. Check 21 authorizes the use of a

substitute check (Image Replacement Document) for settlement. The new law is designed

to encourage the adoption of electronic check imaging. It was prompted partly by the

September 11 attacks, which grounded the cargo airplanes that fly 42 billion checks a

year around the United States, threatening to disrupt the financial system. The switch to

electronic processing of checks has saved as much as $3 billion a year for the banking

industry. For customers, the implications are mixed. Because checks are processed much

more quickly, check writers have lost the “float” of several days between the time checks

are deposited and when they are debited from the account.

Wire Transfer Services. The Federal Reserve Banks and their member banks are linked electronically through the Federal Reserve Communications System. This network allows

these institutions to transfer funds and securities nationwide in a matter of minutes. Two

electronic (wire) transfer systems are operated by the Federal Reserve: Fedwire and the

Automated Clearinghouse (ACH). Fedwire is a network linking more than 9,000 domes-

tic banks with the Federal Reserve System. Banks use this network to make deposit and

loan payments, to transfer book entry securities among themselves, and to act as payment

agents on behalf of large corporate customers. 6 Fedwire transfers are typically large dollar

payments (averaging almost $3.0 million per transaction). The Automated Clearinghouse

(ACH) was developed jointly by the private sector and the Federal Reserve System in the

early 1970s and has evolved as a nationwide method to electronically process credit and

debit transfers of funds. Table 4–2 shows the number and dollar value of Fedwire and ACH

6. A second major wire transfer service is the Clearing House Interbank Payments System (CHIPS). CHIPS operates

as a private network, independent of the Federal Reserve. At the core of the CHIPS system are approximately 50 large

U.S. and foreign banks acting as correspondent banks for smaller domestic and international banks in clearing mostly

international transactions in dollars.

Checks Cleared Fedwire Transactions Processed ACH Transactions Processed

Year Number

(in billions)

Value (in trillions of dollars)

Number (in billions)

Value (in trillions of dollars)

Number (in billions)

Value (in trillions of dollars)

1920 0.42 $ 0.15 0.5 $ 0.03 n.a. n.a. 1930 0.91 0.32 2.0 0.20 n.a. n.a.

1940 1.18 0.28 0.8 0.09 n.a. n.a.

1950 1.96 0.86 1.0 0.51 n.a. n.a.

1960 3.42 1.15 3.0 2.43 n.a. n.a.

1970 7.16 3.33 7.0 12.33 n.a. n.a.

1980 15.72 8.04 43.0 78.59 227 $ 0.29

1990 18.60 12.52 62.6 199.07 1,435 4.66

2000 16.99 13.85 108.3 379.76 4,651 14.02

2005 12.23 15.68 132.4 518.50 8,303 15.96

2010 7.71 8.81 125.1 608.32 11,455 21.37

2012 6.62 8.12 131.6 599.20 12,047 23.90

TABLE 4–2 Number and Value of Checks and Electronic Transactions Processed by the Federal Reserve

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100 Part 1 Introduction and Overview of Financial Markets

transactions processed by Federal Reserve Banks from 1920 through 2012. In contrast to

the falling volume of checks cleared by the Federal Reserve, electronic Fedwire and ACH

transactions processed have grown significantly in recent years.

Research Services. Each Federal Reserve Bank has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sec-

tor as well as the overall economy. These research projects are often used in the conduct

of monetary policy by the Federal Reserve. Research papers are freely accessible to the

public, are of very high quality, and are quite readable. This makes them one of the best

resources for economists, investors, FI managers, and any other individual interested in the

operations and performance of the financial system.

Balance Sheet of the Federal Reserve

Table 4–3 shows the balance sheet for the Federal Reserve System for various years from

2007 through 2013. The conduct of monetary policy by the Federal Reserve involves

changes in the assets and liabilities of the Federal Reserve System, which are reflected in

the Federal Reserve System’s balance sheet.

Liabilities. The major liabilities on the Fed’s balance sheet are currency in circulation and reserves (depository institution reserve balances in accounts at Federal Reserve Banks reserves

Depository institutions’ vault

cash plus reserves deposited

at Federal Reserve Banks.

Assets 2007 2008 2010 2013 Percent of Total, 2013

U.S. official reserve assets $ 34.2 $ 35.7 $ 37.0 $ 34.5 1.1%

SDR certificates 2.2 2.2 5.2 5.2 0.1

Treasury currency 38.7 38.7 43.5 45.0 1.4

Federal Reserve float -0.0 -1.5 -1.4 -0.6 -0.0

Interbank loans 48.6 559.7 0.2 0.0 0.0

Security repurchase

agreements 46.5 80.0 0.0 0.0 0.0

U.S. Treasury securities 740.6 475.9 1,021.5 1,796.0 55.4

U.S. government agency

securities 0.0 19.7 1,139.6 1,143.4 35.2

Miscellaneous assets 40.5 1,060.2 207.6 220.3 6.8

Total assets $951.3 $2,270.6 $2,453.2 $3,243.8 100.0%

Liabilities and Equity

Depository institution

reserves $ 20.8 $ 860.0 $ 968.1 $1,790.4 55.2%

Vault cash of commercial

banks 55.0 57.7 52.7 59.7 1.8

Deposits due to federal

government 16.4 365.7 340.9 79.4 2.5

Deposits due to government

agencies 1.7 21.1 13.5 20.2 0.6

Currency outside banks 773.9 832.2 930.0 1,117.3 34.4

Security repurchase

agreements 44.0 88.4 59.7 105.5 3.3

Miscellaneous liabilities 2.5 3.4 35.3 16.2 0.5

Federal Reserve Bank stock 18.5 21.1 26.5 27.6 0.9

Equity 18.5 21.0 26.5 27.5 0.8

Total liabilities and equity $951.3 $2,270.6 $2,453.2 $3,243.8 100.0%

TABLE 4–3 Balance Sheet of the Federal Reserve (in billions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” Monetary Authority, June 2013, p. L.108. www.federalreserve.gov

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 101

plus vault cash on hand at commercial banks). Their sum is often referred to as the Fed’s

monetary base or money base. We can represent these as follows:

Reserves —depository institution reserve balances at the Fed plus vault cash. Money base —currency in circulation plus reserves.

For example, in March 2013 the monetary base totaled $2.97 trillion, of which $1.85

trillion was reserves and $1.12 trillion was currency in circulation. As we show below,

changes in these accounts are the major determinants of the size of the nation’s money

supply—increases (decreases) in either or both of these balances (e.g., currency in circula-

tion or reserves) will lead to an increase (decrease) in the money supply (see below for a

definition of the U.S. money supply).

Reserve Deposits. The largest liability on the Federal Reserve’s balance sheet (55.2 per- cent of total liabilities and equity) is depository institution reserves. All banks hold reserve

accounts at their local Federal Reserve Bank. These reserve holdings are used to settle

accounts between depository institutions when checks and wire transfers are cleared (see

above). Reserve accounts also influence the size of the money supply (as described below).

Total reserves can be classified into two categories: (1) required reserves (reserves that the Fed requires banks to hold by law) and (2) excess reserves (additional reserves over and above required reserves) that banks choose to hold themselves. Required reserves

are reserves banks must hold by law to back a portion of their customer transaction

accounts (deposits). For example, the Federal Reserve currently requires up to 10 cents of

every dollar of transaction deposit accounts at U.S. commercial banks to be backed with

reserves (see Chapter 13). Thus, required reserves expand or contract with the level of

transaction deposits and with the required reserve ratio set by the Federal Reserve Board.

Because these deposits earn little interest, banks try to keep excess reserves to a minimum.

Excess reserves, on the other hand, may be lent by banks to other banks that do not have

sufficient reserves on hand to meet their required levels.

As the Federal Reserve implements monetary policy, it uses the market for excess

reserves. For example, in the fall of 2008, the Federal Reserve implemented several mea-

sures to provide liquidity to financial markets that had frozen up as a result of the financial

crisis. The liquidity facilities introduced by the Federal Reserve in response to the crisis

created a large quantity of excess reserves at depository institutions (DIs). Specifically, in

October 2008 the Federal Reserve began paying interest on excess reserves for the first

time. 7 Further, during the financial crisis, the Fed set the interest rate it paid on excess

reserves equal to its target for the federal funds rate (see below). This policy essentially

removed the opportunity cost of holding reserves. That is, the interest banks earned by

holding excess reserves was approximately equal to what was previously earned by lend-

ing to other FIs. As a result, banks drastically increased their holdings of excess reserves at

Federal Reserve Banks. Because the U.S. economy was slow to recover from the financial

crisis, the Fed kept the fed funds rate at historic lows into 2013. Thus, banks continued

to hold large amounts of excess reserves. Note in Table 4–3 that depository institution

reserves were 55.2 percent of total liabilities and equity of the Fed in 2013, up from

37.9 percent in 2008. This in turn was up from 2.2 percent in 2007, prior to the start of the

financial crisis.

Some observers claim that the large increase in excess reserves implied that many of

the policies introduced by the Federal Reserve in response to the financial crisis were inef-

fective. Rather than promoting the flow of credit to firms and households, critics argued

that the increase in excess reserves indicated that the money lent to banks and other FIs

by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve

accounts. Many asked why banks were choosing to hold so many reserves instead of lend-

ing them out, and some claimed that banks’ lending of their excess reserves was crucial for

monetary base

Currency in circulation and

reserves (depository institution

reserves and vault cash of

commercial banks) held by the

Federal Reserve.

required reserves

Reserves the Federal Reserve

requires banks to hold.

excess reserves

Additional reserves banks

choose to hold.

7. On October 1, 2008, the Board of Governors amended its rules governing the payment of interest on excess reserves so that the interest rate on excess balances was set at 25 basis points.

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102 Part 1 Introduction and Overview of Financial Markets

resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity

of excess reserves without changing banks’ incentives to lend to firms and households.

Thus, the total level of reserves in the banking system is determined almost entirely by

the actions of the central bank and is not necessarily affected by private banks’ lending

decisions.

Currency Outside Banks. The second largest liability, in terms of percent of total liabil- ities and equity, of the Federal Reserve System is currency in circulation (34.4 percent of

total liabilities and equity in 2013). At the top of each Federal Reserve note ($1 bill, $5 bill,

$10 bill, etc.) is the seal of the Federal Reserve Bank that issued it. Federal Reserve notes

are basically IOUs from the issuing Federal Reserve Bank to the bearer. In the United

States, Federal Reserve notes are recognized as the principal medium of exchange and

therefore function as money (see Chapter 1).

Assets. The major assets on the Federal Reserve’s balance sheet are Treasury and gov- ernment agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold

and foreign exchange. While interbank loans (loans to domestic banks) are quite a small

portion of the Federal Reserve’s assets, they play an important role in implementing mon-

etary policy (see below).

Treasury Securities. Treasury securities (55.4 percent of total assets in 2013) are the largest asset on the Fed’s balance sheet. They represent the Fed’s holdings of securities

issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve

the buying and selling of these securities. An increase (decrease) in Treasury securities

held by the Fed leads to an increase (decrease) in the money supply.

U.S. Government Agency Securities. U.S. government agency securities are the sec- ond largest asset account on the Fed’s balance sheet (35.2 percent of total assets in 2013).

However, in 2007, this account was 0.0 percent of total assets. This account grew as the

Fed took steps to improve credit market liquidity and support the mortgage and housing

markets during the financial crisis by buying mortgage-backed securities (MBS)

backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase

program, the FOMC called for the purchase of up to $1.25 trillion of agency MBS.

The purchase activity began on January 5, 2009, and continued through 2013.

Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial

markets.

Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds Treasury gold certificates that are redeemable at the U.S. Treasury for

gold. The Fed also holds small amounts of Treasury-issued coinage and foreign-

denominated assets to assist in foreign currency transactions or currency swap

agreements with the central banks of other nations.

Interbank Loans. As mentioned earlier, depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window (discussed in detail below).

The interest rate or discount rate charged on these loans is often lower than other interest

rates in the short-term money markets (see Chapter 5). As we discuss below, in January

2003 the Fed implemented changes to its discount window lending policy that increased

the cost of discount window borrowing but eased the requirements on which depository

institutions can borrow. As part of this change, the discount window rate was increased so

that it would be higher than the fed funds rate. As a result, (discount) interbank loans are

normally a relatively small portion of the Fed’s total assets.

Miscellaneous Assets. Generally, miscellaneous assets are a small portion of the Fed’s total assets (e.g., 6.8 percent in 2013). However, during the financial crisis, the Fed

D O Y O U U N D E R S T A N D :

1. What the main functions of Federal

Reserve Banks are?

2. What the main responsibilities of the

Federal Reserve Board are?

3. How the FOMC implements

monetary policy?

4. What the main assets and liabilities

of the Federal Reserve are?

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 103

undertook a number of measures to support various sectors of the financial markets. For

example, as mentioned above (and below), during the financial crisis, the Fed provided

AIG with a loan to prevent its failure; lent funds (for the first time ever) through its dis-

count window to brokers and dealers; and committed over $1 trillion of loans to support

the commercial paper market. These temporary programs were recorded as miscellaneous

assets and, as a result, this item rose to 46.7 percent of total assets in 2008.

MONETARY POLICY TOOLS

In the previous section of this chapter, we referred briefly to tools or instruments that the

Federal Reserve uses to implement its monetary policy. These included open market oper-

ations, the discount rate, and reserve requirements. In this section, we explore the tools

or instruments used by the Fed to implement its monetary policy strategy. 8 Figure 4–2

illustrates the monetary policy implementation process that we will be discussing in more

detail below. Regardless of the tool the Federal Reserve uses to implement monetary pol-

icy, the major link by which monetary policy impacts the macroeconomy occurs through

the Federal Reserve influencing the market for bank reserves (required and excess reserves

held as depository institution reserve balances in accounts at Federal Reserve Banks plus

the vault cash on hand of commercial banks). Specifically, the Federal Reserve’s monetary

policy seeks to influence either the demand for, or supply of, excess reserves at depository

institutions and in turn the money supply and the level of interest rates. As we describe in

the next section, a change in excess reserves resulting from the implementation of mon-

etary policy triggers a sequence of events that affect such economic factors as short-term

interest rates, long-term interest rates, foreign exchange rates, the amount of money and

credit in the economy, and ultimately the levels of employment, output, and prices.

Depository institutions trade excess reserves held at their local Federal Reserve

Banks among themselves. Banks with excess reserves—whose reserves exceed their

required reserves—have an incentive to lend these funds (generally overnight) to banks in

need of reserves since excess reserves held in the vault or on deposit at the Federal Reserve

LG 4-3

8. In addition to the tools described here, the Fed (as well as the Federal Deposit Insurance Corporation and the Office

of the Comptroller of the Currency) can indirectly affect the money supply by signaling to bankers to tighten or loosen

credit availability. Further, changes in other types of regulations such as capital requirements can affect the money sup-

ply. Finally, the U.S. Congress and the U.S. Treasury can use fiscal policy (the use of government expenditure and reve-

nue collection through taxation) to affect the level of aggregate demand in the economy to achieve economic objectives.

Figure 4–2 Federal Reserve Monetary Policy Activities

Extensions Add

Reserves

Securities Purchases

Add Reserves

Securities Sales Drain

Reserves

Repayment Drains

Reserves

Discount Window Loans

Banks with Excess Reserves

Federal Reserve

Open Market Operations

Banks That Want Reserves

Total Reserves in the

Banking System

Trade Reserves

Source: Federal Reserve Board website, “Purposes & Functions,” July 2013. www.federalreserve.gov

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104 Part 1 Introduction and Overview of Financial Markets

earn little or no interest. The rate of interest (or price) on these interbank transactions is a

benchmark interest rate, called the federal funds rate or fed funds rate, which is used in the United States to guide monetary policy. The fed funds rate is a function of the supply

and demand for federal funds among banks and the effects of the Fed’s trading through

the FOMC.

In implementing monetary policy, the Federal Reserve can take one of two basic

approaches to affect the market for banks’ excess reserves: (1) it can target the quantity

of reserves in the market based on the FOMC’s objectives for the growth in the monetary

base (the sum of currency in circulation and reserves) and, in turn, the money supply

(see below), or (2) it can target the interest rate on those reserves (the fed funds rate).

The actual approach used by the Federal Reserve has varied according to considerations

such as the need to combat inflation or the desire to encourage sustainable economic

growth (we discuss the various approaches below). Since 1993, the FOMC has imple-

mented monetary policy mainly by targeting interest rates (mainly using the fed funds

rate as a target).

As mentioned earlier, to reduce the effects of an economic slowdown in the United

States, the Fed decreased the fed funds rate 11 times in 2001. This was done to soften the

effects of the collapse of the dot-com bubble and the September 2001 terrorist attacks, as

well as to combat the perceived risk of deflation. Even into August 2003 the FOMC took

the unusual step of foreshadowing its future policy course by announcing that the histori-

cally low interest rates could be maintained for a considerable period. Although the FOMC

did not specify the length of the considerable period, it was not until the summer of 2004

that the Fed increased the fed funds rate (initially by 0.25 percent). It has been argued that

this lowering of interest rates was a contributing factor to the rise in housing prices. From

2000 to 2003, the Federal Reserve lowered the fed funds target from 6.5 percent to 1.0 per-

cent. The Fed believed that interest rates could be lowered safely primarily because the rate

of inflation was low. However, some have argued that the Fed’s interest rate policy dur-

ing the early 2000s was misguided, because measured inflation in those years was below

true inflation, which led to a monetary policy that contributed to the housing bubble. Low

interest rates and the increased liquidity provided by the central bank resulted in a rapid

expansion in mortgage financing as demand for residential mortgages rose dramatically,

especially among those who had previously been excluded from participating in the market

because of their poor credit ratings.

The Fed then raised the fed funds rate significantly between July 2004 and August

2006; the Fed increased the rate by 0.25 percent for 17 straight meetings. As a result, the

fed funds rate rose from a 46-year low of 1 percent in July 2004 to 5.25 percent in August

2006. This contributed to an increase in one-year and five-year adjustable-rate mortgage

(ARM) rates and triggered resets of rates on existing ARMs, making ARM interest pay-

ments more expensive for homeowners. This also may have contributed to the deflating of

the housing bubble, as asset prices generally move inversely to interest rates and it became

riskier to speculate in housing.

Then, on December 16, 2008, as the U.S. economy faced a severe financial crisis

and fell into its deepest recession since the Great Depression, the Fed, in a historic move,

unexpectedly announced that it would drop its target fed funds rate to a range between 0

and one-quarter of 1 percent and lowered its discount window rate (see below) to one-half

percent, the lowest level since the 1940s (see the Notable Events from the Financial Crisis

box in this section). The overall reduction in the federal funds rate between late 2007 and

December 2008 was dramatic, going from 5.26 percent in September 2007 to a range of

0 percent to 0.25 percent as of December 16, 2008. The rate remained at these historically

low levels into 2010, and in June 2010 the Fed announced that the fed funds rate would

remain at these levels for an “extended period.” It was not until the spring and summer of

2013 that the Fed mentioned the end of these low interest rates and the tightening of mon-

etary policy. And even then, the Fed repeatedly stated that the end of its monetary easing

actions would not come until the very slow economic growth picked up. However, the Fed

expected that to begin to occur later in 2013.

fed funds rate

The interest rate on short-

term funds transferred

between financial institutions,

usually for a period of one day.

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105

Open Market Operations

As mentioned earlier, open market operations are the Federal Reserves’s purchases or sales

of securities in the U.S. Treasury securities market. When a targeted monetary aggregate or

interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a state- ment called the policy directive. The manager of the Trading Desk uses the policy direc- tive to instruct traders on the daily amount of open market purchases or sales to transact.

These transactions take place on an over-the-counter market in which traders are linked to

each other electronically (see Chapter 5).

To determine a day’s activity for open market operations, the staff at the FRBNY

begins each day with a review of developments in the fed funds market since the previous

day and a determination of the actual amount of reserves in the banking system the previ-

ous day. The staff also reviews forecasts of short-term factors that may affect the supply

and demand of reserves on that day. With this information, the staff decides the level of

transactions needed to obtain the desired fed funds rate. The process is completed with a

daily conference call to the Monetary Affairs Division at the Board of Governors and one

of the four voting Reserve Bank presidents (outside of New York) to discuss the FRBNY

plans for the day’s open market operations. Once a plan is approved, the Trading Desk is

instructed to execute the day’s transactions.

Open market operations are particularly important because they are the primary deter-

minant of changes in bank excess reserves in the banking system and thus directly impact

www.newyorkfed.org

Federal Reserve Board Trading Desk

Unit of the Federal Reserve

Bank of New York through

which open market operations

are conducted.

policy directive

Statement sent to the Federal

Reserve Board Trading Desk

from the FOMC that specifies

the money supply target.

In an effort to pull the U.S. economy out of its

current recession, Federal Reserve officials met for

two days of uninterrupted discussion, brainstorming

different ways to strengthen the U.S. economy. The

first action taken out of the meeting occurred the

following Tuesday when the Fed cut their target

interest rate to historic lows of between zero

and a quarter percentage point. The central bank

agreed to do everything in its power to help the

U.S. economy. The first step forward was to reduce

the Fed’s target interest rate—the overnight bank-

lending rate called the federal-funds rate—from 1%.

An additional lending rate, the discount rate, was

reduced to half a percentage point, something

that has not been seen since the 1940s. The Wall

Street Journal reported, “The cut was more than

many economists expected, and the statement that

came with it marked the latest signal by the Fed

and its chairman, Ben Bernanke, that the central

bank was prepared to take aggressive steps to

revive the economy.”

Fed Cuts Rates Near Zero

to Battle Slump

N O T A B L E E V E N T S F R O M T H E F I N A N C I A L C R I S I S

In a statement, the Fed confirmed that it

will “employ all available tools to promote the

resumption of sustainable economic growth and

to preserve price stability.” In a move that helped

bring down longer-term rates, the Fed explained

that it planned to keep interest rates “exception-

ally” low for some time. Lower borrowing costs to

businesses, financial institutions, or households will

generally, in times of normal economic stability,

help energize spending and borrowing in the econ-

omy. However, the current economy saw many of

these businesses and people overloaded with large

amounts of debt. According to The Wall Street

Journal, “A number of official borrowing rates—

such as rates on three-month Treasury bills—have

tumbled to near zero, a level they haven’t been

near since the Great Depression.”

Bernanke was heavily involved in the Fed’s

two-day discussion, lending his academic and

practical expertise associated with financial crises

and recovery. The Fed considered many rescue

steps and came to the decision to initiate much

of what Bernanke had experience instigating in

the past. There were, however, several risks

involved with following Bernanke’s plan of action:

potential, eventual higher inflation; exposure to

“political meddling” within the central bank; and

independent and group losses on loans. There

was also the possibility that the plan wouldn’t

deliver. In addition to Bernanke’s suggestions,

The Wall Street Journal reported that the Fed had

already begun an initiative to “lend directly to

damaged financial markets and companies—nearly

anyone with collateral. Its statement Tuesday said

those efforts could ‘sustain the size of the Federal

Reserve’s balance sheet at a high level.’” Fed

officials decided that, in the event that banks and

financial markets refuse to extend credit, the Fed

will “do part of the job for them.” .

Source: The Wall Street Journal, December 17, 2008,

p. A1, by Jon Hilsenrath. www.wsj.com

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106 Part 1 Introduction and Overview of Financial Markets

the size of the money supply and/or the level of interest rates (e.g., the fed funds rate).

When the Federal Reserve purchases securities, it pays for the securities by either writing

a check on itself or directly transferring funds (by wire transfer) into the seller’s account.

Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the

securities. This transaction increases the bank’s excess reserve levels. When the Fed sells

securities, it either collects checks received as payment or receives wire transfers of funds

from these agents (such as banks) using funds from their accounts at the Federal Reserve

Banks to purchase securities. This reduces the balance of the reserve account of a bank that

purchases securities. Thus, when the Federal Reserve sells (purchases) securities in the

open market, it decreases (increases) banks’ (reserve account) deposits at the Fed.

EXAMPLE 4–1 Purchases of Securities by the Federal Reserve

Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Trea-

sury securities. Traders at the FRBNY call primary government securities dealers of major

commercial and investment banks (such as Goldman Sachs and Morgan Stanley), 9 who

provide a list of securities they have available for sale, including the denomination, matu-

rity, and the price on each security. FRBNY traders then seek to purchase the target num-

ber of securities (at the desired maturities and lowest possible price) until they have

purchased the $500 million. The FRBNY then notifies its government bond department to

receive and pay the sellers for the securities it has purchased. The securities dealer sellers

(such as banks) in turn deposit these payments in their accounts held at their local Federal

Reserve Bank. As a result of these purchases, the Treasury securities account balance of

the Federal Reserve System is increased by $500 million and the total reserve accounts

maintained by these banks and dealers at the Fed is increased by $500 million. We illus-

trate these changes to the Federal Reserve’s balance sheet in Table 4–4 . In addition, there

is also an impact on commercial bank balance sheets. Total reserves (assets) of commercial

banks will increase by $500 million due to the purchase of securities by the Fed, and

demand deposits (liabilities) of the securities dealers (those who sold the securities) at their

banks will increase by $500 million. 10

We also show the changes to commercial banks’

balance sheets in Table 4–4 .

9. As of July 2013, there were 21 primary securities dealers trading, on average, $1.27 trillion of securities per day.

10. In reality, not all of the $500 million will generally be deposited in demand deposit accounts of commercial banks,

and commercial banks will not generally hold all of the $500 million in reserve accounts of Federal Reserve Banks. We

relax these simplifying assumptions and look at the effect on total reserves and the monetary base later in the chapter.

Change in Federal Reserve’s Balance Sheet

Assets Liabilities

Treasury securities + $500m. Reserve account of

securities dealers’ banks

+ $500m.

Change in Commercial Bank Balance Sheets

Assets Liabilities

Reserve accounts

at Federal Reserve

+ $500m. Securities dealers’ demand

deposit accounts at banks

+ $500m.

TABLE 4–4 Purchase of Securities in the Open Market

Note the Federal Reserve’s purchase of Treasury securities has increased the total

supply of bank reserves in the financial system. This in turn increases the ability of banks

to make new loans and create new deposits. For example, in March 2009 the Federal

Reserve announced that it would buy $300 billion of long-term Treasury securities over

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 107

the next six months in order to try and get credit flowing to the financial markets. This

program was eventually referred to as the Fed’s Quantitative Easing 1 (QE1) program.

The Fed generally conducts open market operations using short-term Treasury bills (to

set the fed funds rate) and generally does not intervene in long-term Treasury markets

(allowing the market to set long-term rates). In fact, the Fed had not purchased long-

term Treasury securities since the 1960s. In November 2010, the Fed followed up its

QE1 program with QE2, in which the Fed purchased $600 billion of long-term Trea-

sury securities between November 2010 and June 2011. In September 2012 the Fed

announced the beginning of QE3, an open-ended program involving the purchase of

$40 billion of Treasury securities per month. As of mid-year 2013, the Fed had purchased

over $1.5 trillion in Treasury securities as part of these programs. The results of the QE

programs can be seen on the Federal Reserve’s balance sheet in Table 4–3 . Treasury

securities totaled $1.80 trillion in 2013, up from $741 billion in 2007, while deposi-

tory institution reserves were $1.79 trillion in 2013, up from $21 billion in 2007. The

message to the financial markets from these actions was that the Fed was willing to do

whatever was necessary to stabilize the economy until it had sufficiently recovered from

the financial crisis.

EXAMPLE 4–2 Sale of Securities by the Federal Reserve

Suppose the FOMC instructs the FRBNY Trading Desk to sell $500 million of securities.

Traders at the FRBNY call government securities dealers who provide a list of securities

they are willing to buy, including the price on each security. FRBNY traders sell securi-

ties to these dealers at the highest prices possible until they have sold $500 million. The

FRBNY then notifies its government bond department to deliver the securities to, and

receive payment from, the buying security dealers. The securities dealers pay for these

securities by drawing on their deposit accounts at their commercial banks. As a result

of this sale, the Treasury securities account balance for the Federal Reserve System is

decreased by $500 million (reflecting the sale of $500 million in Treasury securities) and

the reserve accounts maintained at the Fed by commercial banks that handle these securi-

ties transactions for the dealers are decreased by $500 million. The changes to the Fed-

eral Reserve’s balance sheet would in this case have the opposite sign (negative) as those

illustrated in Table 4–4 . In addition, total reserves of commercial banks will decrease by

$500 million due to the purchase of securities from the Fed, and demand deposits of the

securities dealers at their banks will decrease by $500 million (reflecting the payments for

the securities by the securities dealers). Commercial banks’ balance sheet changes would

have the opposite sign as those illustrated in Table 4–4 for a purchase of securities.

Note that the Federal Reserve’s sale of Treasury or other government securities has

decreased the total supply of bank reserves in the financial system. This in turn decreases

the ability of banks to make loans and create new deposits.

While the Federal Reserve conducts most of its open market operations using Treasury

securities, other government securities can be used as well. For example, in addition to the

purchase of Treasury securities, the QE programs of the Federal Reserve also involved the

purchase of over $1 trillion Fannie Mae and Freddie Mac mortgage-backed securities and

bonds. The purchase of these securities is evident on the Fed’s balance sheet in Table 4–3 .

In 2013, the Fed’s holding of U.S. government agency securities was $1.14 trillion, up

from $0 in 2007. Treasury securities are used most, however, because the secondary mar-

ket for such securities is highly liquid and there is an established group of primary dealers

who also trade extensively in the secondary market. Thus, the Treasury securities market

can absorb a large number of buy and sell transactions without experiencing significant

price fluctuations.

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108 Part 1 Introduction and Overview of Financial Markets

The Discount Rate

The discount rate is the second monetary policy tool or instrument used by the Federal

Reserve to control the level of bank reserves (and thus the money supply or interest rates).

As defined above, the discount rate is the rate of interest Federal Reserve Banks charge on

loans to financial institutions in their district. The Federal Reserve can influence the level

and price of reserves by changing the discount rate it charges on these loans.

Specifically, changing the discount rate signals to the market and the economy that the

Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount

rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy. For

example, raising the discount rate signals that the Fed would like to see a tightening of

monetary conditions and higher interest rates in general (and a relatively lower amount of

borrowing). Lowering the discount rate signals a desire to see more expansionary mon-

etary conditions and lower interest rates in general.

For two reasons, the Federal Reserve has rarely used the discount rate as a monetary

policy tool. First, it is difficult for the Fed to predict changes in bank discount window

borrowing when the discount rate changes. There is no guarantee that banks will borrow

more (less) at the discount window in response to a decrease (increase) in the discount

rate. Thus, the exact direct effect of a discount rate change on the money supply is often

uncertain. The In the News box in this section demonstrates how in August 2007, the Fed’s

lowering of the discount rate to calm financial markets battered by deteriorating conditions

in the mortgage and other debt markets resulted in little effect on the borrowing by banks.

However, the Fed’s lowering of the fed funds rate less than a month later resulted in a surge

in discount window borrowing.

Second, because of its “signaling” importance, a discount rate change often has great

effects on the financial markets. For example, the unexpected decrease in the Fed’s dis-

count rate (to 0.50 percent) on December 16, 2008, resulted in a 359.61 point increase in

the Dow Jones Industrial Average, one of the largest one-day point gains in the history of

the Dow and one of a handful of up days during the height of the financial crisis. Moreover,

virtually all interest rates respond in the same direction (if not the same amount) to the

discount rate change. For example, Figure 4–3 shows the correlation in four major U.S.

interest rates (discount rate, prime rate [the rate banks charge to large corporations for

short-term loans], three-month CD rate, and three-month T-bill rate) from 1990 through

July 2013.

In general, discount rate changes are used only when the Fed wants to send a strong

message to financial markets to show that it is serious about wanting to implement new

monetary policy targets. For example, Federal Reserve Board members commented that

the December 16, 2008, discount rate change was taken in light of a deterioration in labor

market conditions and a decline in consumer spending, business investment, and industrial

production. Further, financial markets remained quite strained and credit conditions tight.

The Board commented that overall, the outlook for economic activity had weakened fur-

ther. Thus, this drop in the discount rate was intended to signal the Fed’s strong and per-

sistent intention to allow the money supply to increase and to stimulate economic growth.

The discount rate stayed at this historical low until February 2010, when the Fed raised the

rate to 0.75 percent.

Historically, discount window lending was limited to depository institutions (DIs) with

severe liquidity needs. The discount window rate, which was set below the fed funds rate,

was charged on loans to depository institutions only under emergency or special liquidity

situations (see Figure 4–3 , 1990–2002). However, in January 2003, the Fed implemented

changes to its discount window lending that increased the cost of borrowing but eased the

terms. Specifically, three lending programs are now offered through the Fed’s discount

window. Primary credit is available to generally sound depository institutions on a very

short-term basis, typically overnight, at a rate above the Federal Open Market Commit-

tee’s target rate for federal funds. Primary credit may be used for any purpose, including

financing the sale of fed funds. Primary credit may be extended for periods of up to a few

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109

Borrowing from the Federal Reserve’s discount win-

dow soared in recent days, which some analysts

said may have been the result of the Fed’s efforts

to restore overnight interest rates to the Fed’s

target level. Discount borrowing under the Fed’s pri-

mary credit program for banks surged to more than

$7.1 billion outstanding as of Wednesday, up from

about $1 billion a week earlier, the central banks

said yesterday. It was the highest level since the

day after the Sept. 11, 2001, terrorist attacks.

In August, as liquidity concerns mounted, the

Fed injected money into the nation’s banking system

Banks Flock to

Discount Window

I N T H E N E W S

in a bid to ease problems in some credit markets.

As a result, the federal funds rate regularly fell well

below the target rate of 5.25 percent. The Fed also

lowered the discount rate by a half percentage point

to 5.75 percent, in a bid to encourage banks to

borrow directly from the Fed. But the Fed had little

success in spurring the discount window borrowing.

Banks typically are reluctant to borrow from the

discount window because they view it as a source

of funding for distressed institutions. In addition, they

have been able to borrow funds more cheaply from

each other, at the federal funds rate . . .

The surge in discount borrowing comes ahead

of the Fed’s next policy meeting Tuesday. Fed offi-

cials are expected to cut the federal funds rate for

the first time in four years. Markets widely expect

at least a quarter point cut to 5 percent, though

some analysts say a half point cut is possible.

The smaller cut might have less effect on financial

markets because it would simply bring the new

target down to where interest rates had been in

recent weeks.

Source: The Wall Street Journal, September 14, 2007,

p. Cl, by Sudeep Reddy. www.wsj.com

Figure 4–3 Various U.S. Interest Rates

0

2

4

6

8

10

12

J a n -9

0

J a n -9

1

J a n -9

2

J a n -9

3

J a n -9

4

J a n -9

5

J a n -9

6

J a n -9

7

J a n -9

8

J a n -9

9

J a n -0

0

J a n -0

1

J a n -0

2

J a n -0

3

J a n -0

4

J a n -0

5

J a n -0

6

J a n -0

7

J a n -0

8

J a n -0

9

J a n -1

0

J a n -1

1

J a n -1

2

J a n -1

3

Year

Interest Rate

Prime

CD

Discount

T-bill

Source: Federal Reserve Board website, “Research and Data,” July 2013. www.federalreserve.gov

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110 Part 1 Introduction and Overview of Financial Markets

weeks to depository institutions in generally sound financial condition that cannot obtain

temporary funds in the financial markets at reasonable terms. Secondary credit is avail-

able to depository institutions that are not eligible for primary credit. It is extended on a

very short-term basis, typically overnight, at a rate that is above the primary credit rate.

Secondary credit is available to meet backup liquidity needs when its use is consistent

with a timely return to a reliance on market sources of funding or the orderly resolution of

a troubled institution. Secondary credit may not be used to fund an expansion of the bor-

rower’s assets. The Federal Reserve’s seasonal credit program is designed to assist small

depository institutions in managing significant seasonal swings in their loans and deposits.

Seasonal credit is available to depository institutions that can demonstrate a clear pattern

of recurring intrayearly swings in funding needs. Eligible institutions are usually located

in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer-

term funds from the discount window during periods of seasonal need so that they can

carry fewer liquid assets during the rest of the year and make more funds available for

local lending.

With the change, discount window loans to healthy banks would be priced at 1 per-

cent above the fed funds rate rather than below, as it generally was in the period preceding

January 2003. Note in Figure 4–3 the jump in the discount window rate in January 2003.

Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were

intended not to change the Fed’s use of the discount window to implement monetary pol-

icy, but to significantly increase the discount rate while making it easier to get a discount

window loan. By increasing banks’ use of the discount window as a source of funding,

the Fed hopes to reduce volatility in the fed funds market as well. The change also allows

healthy banks to borrow from the Fed regardless of the availability of private funds. Previ-

ously, the Fed required borrowers to prove they could not get funds from the private sector,

which put a stigma on discount window borrowing. With the changes, the Fed lends to all

banks, but the subsidy of below fed fund rate borrowing is gone.

The Fed took additional unprecedented steps, expanding the usual function of the dis-

count window, to address the financial crisis. While the discount window had traditionally

been available only to DIs, in the spring of 2008 (as Bear Stearns nearly failed) investment

banks gained access to the discount window through the Primary Dealer Credit Facility

(PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per

day from the Fed. The largest expansion of the discount window’s availability to all FIs

occurred in the wake of the Lehman Brothers’ failure, as a series of actions were taken in

response to the increasingly fragile state of financial markets.

During the financial crisis, the Fed also significantly reduced the spread (premium)

between the discount rate and the federal funds target to just one-quarter of a point, bring-

ing the discount rate down to one-half percent. With lower rates at the Fed’s discount

window and interbank liquidity scarce as many lenders cut back their lending, more finan-

cial institutions chose to borrow at the discount window. The magnitude and diversity of

nontraditional lending programs and initiatives developed during the crisis were unprec-

edented in Federal Reserve history. The lending programs were all designed to “unfreeze”

and stabilize various parts of the credit markets, with the overall goal that parties receiving

credit via these new Fed programs would, in turn, provide funding to creditworthy indi-

viduals and firms.

Reserve Requirements (Reserve Ratios)

The third monetary policy tool available to the Federal Reserve to achieve its monetary

targets is depository institution reserve requirements. As defined above, reserve require-

ments determine the minimum amount of reserve assets (vault cash plus bank deposits at

Federal Reserve Banks) that depository institutions must maintain by law to back trans-

action deposit accounts (e.g., demand deposits and interest-bearing checking accounts)

held as liabilities on their balance sheets. This requirement is usually set as a ratio of

transaction accounts—for example, 10 percent (see Chapter 13 for a detailed description

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 111

of the process used by depository institutions to calculate required reserves). A decrease in

the reserve requirement ratio means that depository institutions may hold fewer reserves

(vault cash plus reserve deposits at the Fed) against their transaction accounts (depos-

its). Consequently, they are able to lend out a greater percentage of their deposits, thus

increasing credit availability in the economy. As new loans are issued and used to finance

consumption and investment expenditures, some of these funds spent will return to deposi-

tory institutions as new deposits by those receiving them in return for supplying consumer

and investment goods to bank borrowers. In turn, these new deposits, after deducting the

appropriate reserve requirement, can be used by banks to create additional loans, and so

on. This process continues until the banks’ deposits have grown sufficiently large such that

banks willingly hold their current reserve balances at the new lower reserve ratio. Thus, a decrease in the reserve requirement results in a multiplier increase in the supply of bank

deposits and thus the money supply. The multiplier effect can be written as follows:

Change in bank deposits = (1/New reserve requirement)

× Increase in reserves created by reserve requirement change

Conversely, an increase in the reserve requirement ratio means that depository institu-

tions must hold more reserves against the transaction accounts (deposits) on their balance

sheet. Consequently, they are able to lend out a smaller percentage of their deposits than

before, thus decreasing credit availability and lending, and eventually, leading to a multiple

contraction in deposits and a decrease in the money supply. Now the multiplier effect is

written as:

Change in bank deposits = (1/New reserve requirement)

× Decrease in reserves created by reserve requirement change

EXAMPLE 4–3 Increasing the Money Supply by Lowering Banks’ Reserve Requirements on Transaction Accounts

City Bank currently has $400 million in transaction deposits on its balance sheet. The

current reserve requirement, set by the Federal Reserve, is 10 percent. Thus, City Bank

must have reserve assets of at least $40 million ($400 million  ×  0.10) to back its deposits.

In this simple framework, the remaining $360 million of deposits can be used to extend

loans to borrowers. Table 4–5 , Panel A, illustrates the Federal Reserve’s and City Bank’s

balance sheets, assuming City Bank holds all of its reserves at the Fed (i.e., City Bank has

no vault cash).

If the Federal Reserve decreases the reserve requirement from 10 percent to 5 percent,

City Bank’s minimum reserve requirement decreases by $20 million, from $40 million to

$20 million ($400 million  ×  0.05). City Bank can now use $20 million of its reserves at

its local Federal Reserve Bank (since these are now excess reserves that earn little interest)

to make new loans. Suppose, for simplicity, that City Bank is the only commercial bank

(in practice, the multiplier effect described below will work the same except that deposit

growth will be spread over a number of banks). Those who borrow the $20 million from

the bank will spend the funds on consumption and investment goods and services and

those who produce and sell these goods and services will redeposit the $20 million in

funds received from their sale at their bank (assumed here to be City Bank). We illustrate

this redeposit of funds in Figure 4–4 . As a result of these transaction deposits, City Bank’s

balance sheet changes to $420 million (shown in Panel B of Table 4–5 ). Because of the $20

million increase in transaction account deposits, City Bank now must increase its reserves

held at the Federal Reserve Bank by $1 million ($20 million  ×  0.05) but still has $19 mil-

lion in excess reserves with which to make more new loans from the additional deposits of

$20 million (see row 2 in Figure 4–4 ).

Assuming City Bank continues to issue new loans and that borrowers continue to

spend the funds from their loans, and those receiving the loanable funds (in exchange for

the sale of goods and services) redeposit those funds in transaction deposits at City Bank,

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112 Part 1 Introduction and Overview of Financial Markets

While the deposit multiplier effect has been illustrated here using the example of a

change in reserve requirements, it also holds when other monetary policy tools or instru-

ments are changed as well (e.g., open market operations). For example, suppose the FOMC

instructs the FRBNY Trading Desk to purchase $200 million in U.S. Treasury securities.

City Bank’s balance sheet will continue to grow until there are no excess reserves held by

City Bank (Panel C in Table 4–5 ). The resulting change in City Bank’s deposits will be:

Change in bank deposits = (1/0.05) × (40m - 20m) = $400m

For this to happen, City Bank must willingly hold the $40 million it has as reserves.

This requires City Bank’s balance sheet (and its deposits) to double in size as a result

of the reserve requirement decrease from 10 percent to 5 percent (i.e., $800  million

deposits  ×  0.05  =  $40 million).

Panel A: Initial Balance Sheets

Federal Reserve Bank

Assets Liabilities

Securities $ 40m. Reserve accounts $ 40m.

City Bank

Assets Liabilities

Loans $360m. Transaction deposits $400m.

Reserve deposits at Fed

(10% of deposits) 40m.

Panel B: Balance Sheet Immediately after Decrease in Reserve Requirement

Federal Reserve Bank

Assets Liabilities

Securities $ 21m. Reserve accounts $ 21m.

City Bank

Assets Liabilities

Loans $380m. Transaction deposits $420m.

Reserve deposits at Fed

(5% of deposits) 21m.

Cash

(from liquidated reserves) 19m.

Panel C: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement

Federal Reserve Bank

Assets Liabilities

Securities $ 40m. Reserve accounts $ 40m.

City Bank

Assets Liabilities

Loans $760m. Transaction deposits $800m.

Reserve deposits at Fed

(5% of deposits) 40m.

TABLE 4–5 Lowering the Reserve Requirement

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 113

If the reserve requirement is set at 10 percent, the $200 million open market purchase will

result in an increase in bank reserves of $200 million, and ultimately, via the multiplier

(1/0.1), an increase in bank deposits and the money supply of $2 billion:

1/0.1 × $200 million = $2,000 million = $2 billion

We have made some critical assumptions about the behavior of banks and

borrowers to simplify our illustration of the impact of a change in open market

operations and reserve requirements on bank deposits and the money supply.

In Example 4–3 we assume that City Bank is the only bank, that it converts all

(100 percent) of its excess reserves into loans, that all (100 percent) of these funds

are spent by borrowers, and that all are returned to City Bank as “new” transac-

tion deposits. If these assumptions are relaxed, the overall impact of a decrease in

the reserve requirement ratio, or increase in excess reserves from an open market

purchase, on the amount of bank deposits and the money supply will be smaller

than illustrated, albeit still a multiplier similar to that above, and the precise effect

of a change in the reserve base on the money supply is less certain. For example,

in Example 4–3, if only 90 percent of any funds lent by City Bank are returned to

the bank in the form of transaction deposits and 10 percent is held in cash, then the

resulting change in City Bank’s deposits will be:

Change in bank deposits = [1/(New reserve requirement + c)] × Change in reserves created by reserve requirement change

where c   =  the public’s cash-to-deposit ratio or preference for holding cash outside banks relative to bank deposits  =   0.1 (or 10/100). Thus, City Bank’s change in deposits  =   [1/

(0.05  +  0.1)]  ×  (40m  -  20m)  =  $133.33 million.

Nevertheless, as long as some portion of the excess reserves created by the decrease in

the reserve requirement are converted into loans and some portion of these loans after being

spent are returned to the banking system in the form of transaction deposits, a decrease in

reserve requirements will result in a multiple (that is, greater than one) increase in bank

deposits, the money supply, and credit availability.

D O Y O U U N D E R S T A N D :

5. What the major policy tools used by

the Federal Reserve to influence the

economy are?

6. What the impact is on credit

availability and the money supply

if the Federal Reserve purchases

securities?

7. Why the Federal Reserve is unique

in its ability to change the money

supply through monetary policy

tools?

Figure 4–4 Deposit Growth Multiplier

Producers of

Goods and

Services Receive

$20 Million

Producers of

Goods and

Services Receive

$19 Million

Banks Use

$20 Million in

Excess Reserves

to Make Loans

Borrowers Spend

$20 Million in

Loans on Goods

and Services

Producers

Redeposit

$20 Million in Bank

Producers

Redeposit

$19 Million in Bank

Bank Deposits

Increase by $20

Million: Assets

Increase; $1 Million

in Reserves and

$19 Million in Loans

Borrowers Spend

$19 Million in

Loans on Goods

and Services

Bank Deposits Increase

by $19 Million: Assets

Increase; $0.95 Million

in Reserve Deposits and

$18.05 Million in Loans

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114 Part 1 Introduction and Overview of Financial Markets

Conversely, if the Federal Reserve increases reserve requirement ratios, depository

institutions must convert some of the loans on their balance sheets back into reserves held

at their local Federal Reserve Bank. The overall result is that an increase in the reserve

requirements will result in a multiple decline in credit availability, bank deposits, and the

money supply (i.e., the multiplier effect described above will be reversed). Again, the over-

all effect on the money supply is not fully predictable.

Because changes in reserve requirements can result in unpredictable changes in the

money supply (depending on the amount of excess reserves held by banks, the willing-

ness of banks to make loans rather than hold other assets such as securities, and the pre-

dictability of the public’s willingness to redeposit funds lent at banks instead of holding

cash—that is, whether they have a stable cash-deposit ratio or not), the reserve requirement

is very rarely used by the Federal Reserve as a monetary policy tool.

THE FEDERAL RESERVE, THE MONEY SUPPLY, AND INTEREST RATES

As we introduced this chapter, we stated that the Federal Reserve takes steps to influence

monetary conditions—the money supply, credit availability, interest rates, and ultimately

security prices—so it can promote price stability (low inflation) and other macroeconomic

objectives. We illustrate this process in Figure 4–5 . Historically, the Fed has sought to

influence the economy by directly targeting the quantity of bank reserves in the market

based on the FOMC’s objectives for growth in the monetary base, and in turn the money

supply or interest rates. In this section, we take a look at the ultimate impact of monetary

policy changes on key economic variables. We also look at the Fed’s choice of whether to

target the money supply or interest rates in order to best achieve its overall macroeconomic

objectives.

LG 4-4

Figure 4–5 The Process of Monetary Policy Implementation

Open Market Operations

Discount Rate Changes

Reserve Requirement Ratio Changes

Monetary Policy Tools

Financial Markets

A n a ly

s is

a n d F

e e d b a c k

Objectives

Change in Bank Reserves

Change in Money Supply

Change in Credit Availability

Change in Interest Rates

Change in Borrowing

Change in Security Prices

Change in Foreign Exchange Rates

Price Stability

Economic Growth

Low Inflation

Full Employment

Sustainable Pattern of

International Trade

Money Supply

(bank reserves)

Interest Rates

(fed funds rate)

Targets

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 115

Effects of Monetary Tools on Various Economic Variables

The examples in the previous section illustrated how the Federal Reserve and bank balance

sheets change as a result of monetary policy changes. Table 4–6 goes one step further and

looks at how the money supply, credit availability, interest rates, and security prices are

affected by these monetary policy actions. To do this, we categorize monetary policy tool

changes into expansionary activities versus contractionary activities.

Expansionary Activities. We described above the three monetary policy tools that the Fed can use to increase the money supply: open market purchases of securities, discount

rate decreases, and reserve requirement ratio decreases. All else held constant, when the

Federal Reserve purchases securities in the open market, the reserve accounts of banks

increase. When the Fed lowers the discount rate, this generally results in a lowering of

interest rates in the economy. Finally, a decrease in the reserve requirements, all else con-

stant, results in an increase in bank reserves.

In two of the three cases (open market operations and reserve requirement changes),

an increase in reserves results in an increase in bank deposits and the money supply. One

immediate effect of this is that interest rates fall and security prices start to rise (see Chap-

ters 2 and 3). In the third case (a discount rate change), the impact of a lowering of inter-

est rates is more direct. Lower interest rates encourage borrowing from banks. Economic

agents spend more when they can get cheaper funds. Households, businesses, and govern-

ments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). House-

holds increase their purchases of durable goods (e.g., automobiles, appliances). State and

local government spending increases (e.g., new road construction, school improvements).

Finally, lower domestic interest rates relative to foreign rates can result in a drop in the

(foreign) exchange value of the dollar relative to other currencies. 11

As the dollar’s (for-

eign) exchange value drops, U.S. goods become relatively cheaper compared to foreign

goods. Eventually, U.S. exports increase. The increase in spending from all of these market

participants results in economic expansion, stimulates additional real production, and may

cause the inflation rate (defined in Chapter 2) to rise. Ideally, the expansionary policies

of the Fed are meant to be conducive to real economic expansion (economic growth, full

employment, sustainable international trade) without price inflation. However, when the

Fed undertakes expansionary activities, the resulting increase in demand for goods and

services tends to push wages and other costs higher and can lead to inflation. Indeed, price

stabilization (low inflation) can be viewed as the primary policy objective of the Fed.

Contractionary Activities. We also described three monetary policy tools that the Fed can use in a contractionary fashion: open market sales of securities, discount rate

increases, and reserve requirement ratio increases. All else constant, when the Federal

11. See the discussion of the interest rate parity theorem in Chapter 9.

Expansionary Activities (open market purchases

of securities, discount rate decreases, reserve requirement

ratio decreases)

Contractionary Activities (open market sales of securities,

discount rate increases, reserve requirement ratio

increases)

Impact on:

Reserves ↑  ↓ 

Money supply ↑  ↓ 

Credit availability ↑  ↓ 

Interest rates ↓  ↑ 

Security prices ↑  ↓ 

TABLE 4–6 The Impact of Monetary Policy on Various Economic Variables

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116 Part 1 Introduction and Overview of Financial Markets

Reserve sells securities in the open market, reserve accounts of banks decrease. When the

Fed raises the discount rate, interest rates generally increase in the open market, making

borrowing more expensive. Finally, an increase in the reserve requirement ratio, all else

constant, results in a decrease in excess reserves for all banks and limits the availability of

funds for additional loans.

In all three cases, interest rates will tend to rise. Higher interest rates discourage credit

availability and borrowing. Economic participants spend less when funds are expensive.

Households, businesses, and governments are less likely to invest in fixed assets. House-

holds decrease their purchases of durable goods. State and local government spending

decreases. Finally, an increase in domestic interest rates relative to foreign rates may result

in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar’s exchange

rate increases, U.S. goods become relatively expensive compared to foreign goods. Even-

tually, U.S. exports decrease.

Money Supply versus Interest Rate Targeting

Table 4–7 shows how the Federal Reserve has varied between its use of the money supply

and interest rates as the target variable used to control economic activity in the United States.

Panel A of Figure 4–6 illustrates the targeting of money supply, while Panel B of Figure 4–6

shows the targeting of interest rates. For example, letting the demand curve for money be

represented as M D in Panel A of Figure 4–6 , suppose the FOMC sets the target money sup- ply (currency and bank reserves) at a level that is consistent with 5 percent growth, line M S in Panel A of Figure 4–6 . At this M S level, the FOMC expects the equilibrium interest rate to be i * . However, unexpected increases or decreases in production, or changes in inflation, may cause the demand curve for money to shift up and to the right, M D

′

, or down and to

the left, M D � . Accordingly, interest rates will fluctuate between i ′ and i �. Thus, targeting the money supply can lead to periods of relatively high volatility in interest rates.

In Panel B of Figure 4–6 , suppose instead the FOMC targets the interest rate, i T   =   6 percent. If the demand for money falls, to M D � , interest rates will fall to i �  =  5 percent with no intervention by the Fed. In order to maintain the target interest rate, the FOMC has

to conduct monetary policy actions (such as open market sales of U.S. securities) to lower

bank reserves and the money supply (to M S ′

). This reduction in the money supply will

maintain the target interest rate at i T   =  6 percent. As should be obvious from these graphs and the discussion, the Federal Reserve can successfully target only one of these two vari- ables (money supply or interest rates) at any one moment. If the money supply is the target variable used to implement monetary policy, interest rates must be allowed to fluctuate

relatively freely. By contrast, if an interest rate (such as the fed funds rate) is the target,

then bank reserves and the money supply must be allowed to fluctuate relatively freely.

In the 1970s, the Fed, and then chairmen Arthur Burns and G. William Miller, imple-

mented its monetary policy strategy by targeting the federal funds rate. However, during

the 1970s, interest rates rose dramatically (see Figure 4–7 ). The Fed responded to these

interest rate increases by increasing the money supply, which led to historically high levels

of inflation (e.g., over 10 percent in the summer of 1979). With rapidly rising inflation,

Paul Volcker (chairman of the Federal Reserve Board from 1979 to 1987) felt that inter-

est rate targets were not doing an appropriate job in constraining the demand for money

Target Years

Fed funds rate targeted using bank

reserves to achieve target 1970–October 1979

Nonborrowed reserves targeted October 1979–October 1982

Borrowed reserves targeted October 1982–July 1993

Fed funds rate targeted (rate announced) July 1993–present

TABLE 4–7 Federal Reserve Monetary Policy Targets

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 117

(and the inflationary side of the economy). Thus, on October 6, 1979, the Fed

chose to completely refocus its monetary policy, moving away from interest rate

targets toward targeting the money supply itself, and in particular bank reserves—

so-called nonborrowed reserves, which are the difference between total reserves

and reserves borrowed through the discount window (see the earlier discussion in

this chapter).

Growth in the money supply, however, did not turn out to be any easier to

control. For example, the Fed missed its money supply growth rate targets in

each of the first three years in which reserve targeting was used. Further, in con-

trast to expectations, volatility in the money supply growth rate grew as well (see

Figure  4–7 ). Thus, in October 1982, the Federal Reserve abandoned its policy of

targeting nonborrowed reserves for a policy of targeting borrowed reserves (those

reserves banks borrow from the Fed’s discount window).

The borrowed reserve targeting system lasted from October 1982 until 1993,

when the Federal Reserve, and then chairman Alan Greenspan, announced that it

would no longer target bank reserves and money supply growth at all. At this time,

the Fed announced that it would use interest rates—the federal funds rate—as the

main target variable to conduct monetary policy (initially setting the target rate at a

Figure 4–6 Targeting Money Supply versus Interest Rates

Interest

Rate

Quantity of Money

(in billions of dollars)Ms

MD'

MD''

MD

Ms i' 5 8%

i * 5 6%

i'' 5 4%

Panel A: Targeting Money Supply

MsM s'

Quantity of Money

(in billions of dollars)Ms

MD'

MD''

MD

i T 5 6%

i'' 5 5%

M s'

Interest

Rate

Panel B: Targeting Interest Rates

D O Y O U U N D E R S T A N D :

8. What actions the Federal Reserve

can take to promote economic

expansion? Describe how each

affects money supply, credit

availability, interest rates, and

security prices.

9. What actions the Federal Reserve

can take to contract the U.S.

economy? Describe how each

affects money supply, credit

availability, interest rates, and

security prices.

10. Why the simultaneous targeting

of the money supply and interest

rates is sometimes impossible to

achieve?

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118 Part 1 Introduction and Overview of Financial Markets

constant 3 percent). A guiding principle used by the Fed to set short-term interest rates dur-

ing this period is the Taylor rule, a formula developed by economist John Taylor. The rule

states that short-term interest rates should be determined by three conditions: (1) where

actual inflation is relative to the Fed’s targeted level, (2) the extent to which the economy is

above or below its full employment level, and (3) what short-term interest rates should be

Figure 4–7 Federal Funds Rates and Annualized Money Supply Growth Rates, 1977–June 2013

0

2

4

6

8

10

12

14

16

18

20

A p

r- 7

7

A p

r- 7

9

A p

r- 8

1

A p

r- 8

3

A p

r- 8

5

A p

r- 8

7

A p

r- 8

9

A p

r- 9

1

A p

r- 9

3

A p

r- 9

5

A p

r- 9

7

A p

r- 9

9

A p

r- 0

1

A p

r- 0

3

A p

r- 0

5

A p

r- 0

7

A p

r- 0

9

A p

r- 1

1

A p

r- 1

3

Year

Federal Funds Rate

26

24

22

0

2

4

6

8

10

12

14

16

18

20

22

A p r-

7 9

A p r-

8 1

A p r-

8 3

A p r-

8 5

A p r-

8 7

A p r-

8 9

A p r-

9 1

A p r-

9 3

A p r-

9 5

A p r-

9 7

A p r-

9 9

A p r-

0 1

A p r-

0 3

A p r-

0 5

A p r-

0 7

A p r-

0 9

A p r-

1 1

A p r-

1 3

Year

Money Supply

Growth Rate

A p r-

7 7

Source: Federal Reserve Board website, “Research and Data,” June 2013. www.federalreserve.gov

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 119

to achieve full employment. The rule recommends that the Fed increase interest rates when

inflation is above its target or when the economy is above the full employment level and

decrease interest rates when inflation is below its target or when the economy is below the

full employment level. Although the Fed does not follow the Taylor rule unequivocally in

conducting monetary policy, the rule closely describes how monetary policy actually has

been conducted since 1993.

Under the current regime, and contrary to previous tradition such as in the 1970s, the

Fed simply announces whether the federal funds rate target has been increased, decreased,

or left unchanged after every monthly FOMC meeting—previously, the federal funds rate

change had been kept secret. This announcement is watched very closely by financial mar-

ket participants who react quickly to any change in the fed funds rate target. As a result of

this regime, there has been relatively small volatility in interest rates since the late 1980s

(see Figure 4–7 ).

INTERNATIONAL MONETARY POLICIES AND STRATEGIES

Central banks guide the monetary policy in virtually all countries. For example, the Euro-

pean Central Bank (ECB) is the central bank for the European Union, while the Bank of

England is the central bank of the United Kingdom. Like the Federal Reserve, these are

independent central banks whose decisions do not need to be ratified by the government.

In contrast, the People’s Bank of China, the Reserve Bank of India, and the Central Bank

of Brazil are less independent in that the government imposes direct political control over

the operations of these central banks. Independence of a central bank generally means that

the bank is free from pressure from politicians who may attempt to enhance economic

activity in the short term (e.g., around election time) at the expense of long-term economic

growth. Therefore, independent central banks operate with more credibility.

Regardless of their independence, in the increasingly global economy, central banks

around the world must work not only to guide the monetary policy of their individual

countries, but also to coordinate their efforts with those of other central banks. In this

section, we look at how central banks around the world took independent as well as coor-

dinated actions as they set their monetary policy during the financial crisis. For example,

as news spread that Lehman Brothers would not survive, FIs around the world moved to

disentangle trades made with Lehman. The Dow fell more than 500 points, the largest drop

in over seven years. By Wednesday, September 17, tension had mounted around the world.

Stock markets saw huge swings in value as investors tried to sort out who might survive

(markets from Russia to Europe were forced to suspend trading as stock prices plunged).

As the U.S. government debated a rescue plan, the financial crisis continued to

spread worldwide. During the last week of September and the first week of October 2008,

the German government guaranteed all consumer bank deposits and arranged a bailout of

Hypo Real Estate, the country’s second largest commercial property lender. The United

Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest

mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account.

Ireland guaranteed the deposits and debt of its six major financial institutions. Iceland

rescued its third largest bank with an $860 million purchase of 75 percent of the bank’s

stock and a few days later seized the country’s entire banking system. The Netherlands,

Belgium, and Luxembourg central governments together agreed to inject $16.37 billion

into Fortis NV (Europe’s first ever cross-border financial services company) to keep it

afloat. However, five days later this deal fell apart and the bank was split up. The Dutch

government bought all assets located in the Netherlands for approximately $23 billion.

The central bank in India stepped in to stop a run on the country’s second largest bank,

ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their

banking systems as banks’ reluctance to lend to each other and a run on Bank of East

Asia Ltd. led the Hong Kong Monetary Authority to inject liquidity into its banking sys-

tem. South Korean authorities offered loans and debt guarantees to help small and mid-

size businesses with short-term funding. Table 4–8 lists some other systemwide support

LG 4-5

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120 Part 1 Introduction and Overview of Financial Markets

TABLE 4–8 Central Bank Actions, September 2008–June 2009

Source: Bank for International Settlements, BIS Papers, No. 48, July 2009. www.bis.org

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 121

programs (e.g., on October 12, Australia committed an unspecified amount of funds to

guarantee the country’s bank liabilities) and bank-specific actions (e.g., on September 30,

the ECB and the French government pledged $3 billion to recapitalize Dexia, one of

France’s largest banks) taken by central governments during the heat of the crisis. All

of these actions were a result of the spread of the U.S. financial market crisis to world

financial markets.

Systemwide Rescue Programs Employed During the Financial Crisis

While the above mentioned actions by central banks represent steps taken by individual

countries, they were just a part of a coordinated effort by major countries to ease the mone-

tary conditions brought about by the financial crisis and avoid a deep worldwide recession.

At the heart of the efforts were 11 countries, which accounted for the bulk of the rescue

programs: Australia, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Swit-

zerland, the United Kingdom, and the United States. The central banks in these coun-

tries took substantive actions targeted at the balance sheets of financial institutions in their

countries. The programs can be categorized into four general areas: expansion of retail

deposit insurance, capital injections, debt guarantees, and asset purchases/guarantees. 12

Figure 4–8 summarizes deposit insurance coverage in various countries before versus after

the start of the financial crisis, and Table 4–9 provides a more detailed overview of the

commitments and outlays associated with capital injections, debt guarantees, and asset

purchases/guarantees made by various countries.

Expansion of retail deposit insurance. Increased retail bank deposit insurance cover- age was widely used during the crisis to ensure continued access to deposit funding. As

shown in Figure 4–8 , the amounts covered by deposit insurance varied substantially across

countries, with some countries extending unlimited guarantees of retail deposits.

Capital Injections. Direct injections of capital by central governments were the main mechanism used to directly support bank balance sheets. Governments increased banks’

capital by injecting combinations of common shares, preferred shares, warrants, subor-

dinated debt, mandatory convertible notes, or silent participations. These capital injec-

tions improved banks’ abilities to absorb additional losses and strengthened protection for

banks’ uninsured creditors. Further, because they relieved balance sheet constraints, the

capital injections allowed banks to increase their lending.

Countries varied in the capital instruments they used and the conditions of their capital

injections. Some countries (e.g., the United States) also imposed restrictions on executive

compensation and/or dividend payments to common stockholders. As seen in Table 4–9 ,

countries also varied in the amounts of capital injected into the banking system. The Neth-

erlands made commitments totaling 6.2 percent of the country’s GDP, the United Kingdom

made commitments worth 3.4 percent of its GDP, and Switzerland made commitments

worth 1.1 percent of its GDP.

Debt guarantees. As financial markets froze, so did the wholesale funding market used by banks to support lending activities. In response to these events, governments announced

state guarantees on bank wholesale debt. Specifically, governments provided explicit

guarantees against default on uninsured bank liabilities. These programs allowed banks to

maintain access to reasonably priced, medium-term funding. They also reduced liquidity

risk and lowered overall borrowing costs for banks.

Countries varied in the range of liabilities covered and the fee structures associated

with these programs (e.g., some charged a flat fee, while others linked fees to bank credit

default swap spreads). Further, as seen in Table 4–9 , countries committed significantly

larger amounts to the debt guarantee programs than to the capital injection programs.

12. For a detailed summary of each of these, see BIS Quarterly Review, December 2008, www.bis.org .

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122 Part 1 Introduction and Overview of Financial Markets

Figure 4–8 Deposit Insurance Coverage for Commercial Banks in Various Countries (USD equivalents, at current exchange rates, as of mid-September and early December 2008)

400,000 600,000 800,000 1,00,000200,0000

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Australia

Austria

Denmark

Germany

Hong Kong, China

Iceland

Ireland

Singapore

Slovak Republic

New Zealand

Norway

United States

Italy

Belgium

Greece

Luxembourg

Netherlands

Portugal

Spain

Mexico

Japan

France

Switzerland

Canada

United Kingdom

Czech Republic

Finland

Hungary

Poland

Sweden

Korea

Turkey

Russia

544,000

281,000

250,000

133,000

129,000

129,000

129,000

129,000

129,000

129,000

121,000

108,000

90,000

83,000

79,000

74,000

64,000

64,000

64,000

64,000

61,000

35,000

32,000

25,000

mid September 2008

early December 2008

Source: Financial Crisis: Deposit Insurance and Financial Safety Net Aspects, Organization for Economic Co-operation and Development working paper, December 2008, www.oecd.org

Many countries (e.g., Australia, Canada, Italy, and Switzerland) committed unspecified

amounts for debt guarantees, the Netherlands committed an amount totaling 33.6 percent

of the country’s GDP, the United Kingdom made commitments worth 17.2 percent of its

GDP, and Spain made commitments worth 9.1 percent of its GDP.

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123

TA B LE

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124 Part 1 Introduction and Overview of Financial Markets

Asset purchases or guarantees. Asset purchase programs removed distressed assets from bank balance sheets. Thus, bank liquidity was improved and capital relief was pro-

vided (particularly if purchase prices were higher than book values). Asset guarantee pro-

grams left the distressed assets with the banks. However, the central banks assumed part or

all of the risk of the portfolio of distressed or illiquid assets from the banks. Asset purchase

and guarantee programs were not used extensively. A main reason for this is that it was dif-

ficult to determine the price at which the central bank would purchase the distressed assets.

A purchase price set too close to par effectively amounted to a covert recapitalization of the

bank. Further, there was a debate regarding the range of eligible assets. To have a significant

and immediate impact on market confidence, the programs would have to cover all

distressed assets, which would require large programs. As seen in Table 4–9 , the

United Kingdom used asset guarantees extensively (commitments amounted to 33.4

percent of the country’s GDP). Beyond this, Germany committed an unspecified

amount for asset purchases and an amount totaling 8.0 percent of the country’s GDP

for asset guarantees, while the United States committed 1.0 percent of its GDP for

asset purchases and an amount totaling 2.5  percent of the country’s GDP for asset

guarantees.

Challenges Remain After the Crisis

While the worst of the financial crisis subsided in the United States in the last half of

2009, throughout the spring of 2010 Greece struggled with a severe debt crisis. Early on,

the European Central Bank (ECB) and some of the healthier European countries tried to

step in and assist the debt-ridden country. Specifically, in March 2010, the ECB, Ger-

many, and France began formulating a plan to bail out Greece with as much as $41 billion

in aid. However, in late April, Greek bond prices dropped dramatically as traders deter-

mined that a debt default was inevitable, even if the country received a massive bailout.

The selloff was the result of still more bad news for Greece, which showed that the 2009

budget deficit was worse than had been previously reported. As a result, politicians in

Germany began to voice opposition to a Greek bailout. Further, Moody’s Investors Ser-

vice downgraded Greece’s debt rating and warned that additional cuts could be on the

way. However, the ECB stated that it would continue to support Greece regardless of the

country’s credit rating.

The problems in the Greek bond market then spread to other European nations with

fiscal problems, such as Portugal, Spain, and Italy. As a result, in May the ECB, Euro-

zone countries, and the International Monetary Fund, seeking to halt a widening European

debt crisis that had now threatened the stability of the euro, agreed to extend to Greece

an unprecedented $147 billion rescue in return for huge budget cuts. Additional rescue

packages and promises of further austerity measures intended to cut the burgeoning Greek

deficit occurred through 2012. Yet the European debt crisis continued. While Greece had

not yet missed a bond payment, in March the International Swaps and Derivatives Asso-

ciation (ISDA) 13

declared that Greece had undergone a “restructuring credit event” which

triggered insurance policy payments. The restructuring event was a forced swap of old debt

held by some of its private bond holders for new debt. The swap forced a 74 percent haircut

on those creditors that held out, triggering the effective default.

At one point, Greece seemed unable to form a government and the leader of one

party rejected the country’s bailout commitments. It seemed increasingly conceivable

that Greece might have to leave the Euro zone. Economists estimated that a Greek exit

from the Euro zone would cost the European Union $1 trillion, or about 5 percent of the

Union’s annual economic output. Yet, the leaders of EU countries, particularly Germany

and France, continued to work to keep Greek reform on track and the EU together. Further,

the ECB stated that it would do whatever it took to protect the euro; the ECB prepared to

D O Y O U U N D E R S T A N D :

11. The monetary policy measures

taken by central banks to address

the recent worldwide financial crisis?

What were they?

13 The ISDA is the trade group that oversees the market for credit default swaps. Credit default swaps are essentially

insurance policies against bond defaults (see Chapter 10).

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