The Federal Reserve System and Open Market operations Flashcards
What is the Federal Reserve System?
The Federal Reserve acquires its unique powers through its ability to issue money.
The Fed is both the government’s bank and the banker’s bank.
Why do large private banks keep their own accounts at the Fed?
In part because some banks are required to hold accounts with the Federal reserve and in part because other banks and financial institutions want a safe and convenient place to hold their money.
Name the 4 most important assets that serve as means of payment in the United States:
- Currency - paper bills and coins
- Total reserves - held by banks at the Fed
- Checkable deposits - your checking or debit account
- Savings deposits - money market mutual funds, and small time deposits
What’s a liquid asset?
A liquid asset is an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments.
Economists have created many definitions of the money supply. Name the three most important ones:
- The monetary base
- M1
- M2
Explain the monetary base
Currency and total reserves held at the Fed
Explain M1
Currency plus checkable deposits
Explain M2
M1 plus savings deposits, money market mutual funds, and small-time deposits
What’s fractional reserve banking?
When you open a bank account, the teller doesn’t take your money and puts it into a box labelled with your name. Instead the bank holds a fraction of your account balance in reserve.
What’s a ‘reserve ratio’?
The reserve ratio, RR, is the ratio of reserves to deposit.
Explain how RR works
If 1$ in cash is held in reserve for every $10 of deposits, the reserve ratio is 1/10.
How is the reserve ratio determined by a bank?
The reserve ratio is determined primarily by how liquid banks wish to be.
What’s a ‘money multiplier’?
Inverse of the reserve ratio. The money multiplier is the ratio of deposits to reserves. It is the amount with which the money supply expands with each dollar increase in reserves.
What is the money multiplier used for?
Tells us how much deposits expand with each dollar increase in reserve.
Give an example of the money multiplier.
If the MM is 10, then an increase in reserves of $1000 will lead to an increase in deposits of $10000.
How is the change in money supply calculated? (RR and MM)
Change of Money supply = Change of reserves x Money multiplier
How can de fed control the money supply?
- Open market operations - the buying and selling of U.S. government bonds on the open market
- Discount rate lending and the term auction facility- Federal reserve lending to banks and other financial institutions
- Paying interest on reserves held by banks at the Fed
Explain an ‘Open market operation’
If the fed wants to change the money supply, it usually does so by buying or selling government bonds.
What’s quantitative easing?
When the Fed buys longer-term government bonds or other securities
What’s quantitative tightening
When the Fed sells longer-term government bonds or other securities
Define the federal funds rate
The Federal funds rate is simply the overnight rate for a loan from one major bank to another.
What’s the problem of solvency crisis?
Solvency crisis is a potential problem that occurs when banks become insolvent, leaning the value of a bank’s loans falls so far that the bank can no longer pay back its depositors.
What’s a liquidity crisis
If all the depositors want their money back at the same time.
Explain the Term Auction Facility
The Term Auction Facility had the Fed announce that it wanted to inject a certain quantity of reserves into banks; those funds were then auctioned until the rate was low enough that banks would borrow the money.
Explain the discount rate
The discount rate sets an interest rate and then the Fed waits to see how many banks want to borrow.
What’s an issue with the discount rate?
Banks may not borrow, for fear of admitting to the market that they are in a weak position.
Explain payment of interest on reserves
The Fed can vary the rate of interest that it pays banks on reserves held at the Fed
Explain Systematic risk
Systematic risk simply means that the failure of one financial institution can bring down another institution as well, just as if a chain of dominoes were collapsing.
Explain the problem of moral hazard
Moral hazard occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out
Who controls the Fed?
The Fed has a seven-member board of governors, who are appointed by the president and confirmed by the senate.
How long are governors (of the fed) appointed for?
Governors are appointed for 14-year terms and cannot be reappointed. This means a single president will rarely appoint a majority of the board.
How is the chairperson of the Fed appointed?
The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years.
If the economy is growing faster than its long-run potential growth rate, what should the Fed do to bring the real growth rate back to the long-run potential rate?
Raise the discount rate
