Chapter 16 The Structure of Central BanksThe Federal Reserve by zlt20671

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									ECON 333 L1
Week 5, T4, Fall 2009

Chapter 16 The Structure of Central Banks:The Federal Reserve and the European
Central Bank

I. The Structure of the Federal Reserve System
      1. The Federal Reserve Act, passed in 1913 and amended several times since
         then, establishes a system that is composed of three branches with
         overlapping responsibilities.
      2. There is are the twelve regional Federal Reserve Banks, distributed
         throughout the country; a central governmental agency, the Board of
         Governors, located in Washington, D.C.; and the Federal Open Market
         Committee.
      3. In addition, a series of advisory committees makes recommendations to the
         Board and the regional Banks.
      4. Finally, there are the commercial banks that are members of the system.
      5. This complex structure diffuses power in a way that is typical of the U.S.
         government, creating a system of checks and balances that reduces the
         tendency for power to concentrate at the center.
      6. All national banks (chartered by the federal government) are required to
         belong to the Federal Reserve System, and state banks have the option to join
         (though less than 20 percent do because of the cost involved).
      7. Members and nonmembers alike must hold non-interest bearing reserve
         deposits at the Fed, so there is no real distinction between them.


   A. The Federal Reserve Banks
       1. The Federal Reserve Bank of New York is the largest of the twelve regional
          Federal Reserve Banks.
       2. The geographical lines that define the Banks’ districts were drawn in 1914 and
          represent the population density at the time and the decision that no district
          should coincide with a single state.
       3. This arrangement has two purposes: to ensure that every district contains as
          broad a mixture of economic interests as possible and that no person or group
          can obtain preferential treatment from the Reserve Bank.
       4. Reserve Banks are part public and part private; they are owned by the
          commercial banks in their districts and are overseen by the Board of
          Governors.
       5. The Board of Directors of each bank is comprised of representatives of
          banking, other business leaders, and those who represent the public interest.



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       Of the nine members on each board, six are elected by the commercial bank
       members and three are appointed by the Board of Governors.
   6. Each Reserve Bank has a President who is appointed for a five-year term by
       the Bank’s Board of Directors (with the approval of the Board of Governors).
   7. The Reserve Banks conduct the day-to-day business of the central bank,
       serving as both the government’s bank and the bankers’ bank.
   8. As the bank for the U.S. government they issue new currency, maintain the
       U.S. Treasury’s bank account, and manage the U.S. Treasury’s borrowings.
   9. As the bankers’ bank they hold deposits for the banks in their districts, operate
       and ensure the integrity of a payments network, make funds available to
       commercial banks in the district through “discount loans,” supervise and
       regulate financial institutions in the district, and collect and make data
       available on business conditions.
   10. In addition to these duties the Federal Reserve Bank of New York provides
       services to foreign central banks and to certain international organizations that
       hold accounts there; it is also the System’s point of contact with financial
       markets.
   11. Finally, the Reserve Banks play an important part in formulating monetary
       policy, both through their responsibilities on the FOMC and through their
       participation in setting the discount rate.


B. The Board of Governors
    1. The seven members of the Board are appointed by the President and
       confirmed by the U.S. Senate for 14-year terms, which are staggered (typically
       one new member is appointed every two years).
    2. These long terms are intended to protect the Board from political pressure, as
       is the fact that the terms are staggered so that one begins every two years.
    3. The Board has a Chairman and a Vice Chairman, appointed by the President
       from among the seven governors for four-year renewable terms.
    4. The duties of the Board are to: set the reserve requirement, approve or
       disapprove the discount rate recommendations made by the Federal Reserve
       Banks, administer consumer credit protection laws, approve bank mergers,
       supervise and regulate the regional Reserve Banks, regulate and supervise
       the banking system (along with the Reserve Banks), analyze financial and
       economic conditions, and collect and publish statistics about the system’s
       activities and the economy at large.


C. The Federal Open Market Committee
   1. The FOMC is the group that sets interest rates to control the availability of
      money and credit to the economy.


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2. Made up of the seven Governors, the President of the NY Fed, and four
    Reserve Bank Presidents, it is chaired by the Chairman of the Board of
    Governors.
3. The FOMC controls the federal funds rate, the rate banks charge each other
    on overnight loans of excess deposits at the Fed.
4. The FOMC meets eight times a year, although in extraordinary times it can
    meet more often.
5. The primary purpose of a meeting is to decide on the target interest rate and
    produce a policy directive, which tells the NY Fed how to conduct purchases
    and sales of Treasury securities in order to meet the FOMC’s goals.
6. Prior to each meeting participants receive the beige book (a compilation of
    anecdotal information about current business activity), the green book (the
    Board staff’s economic forecast for the next few years) and the blue book (a
    discussion of financial markets and current policy options).
7. An FOMC meeting is a formal proceeding that can be divided into three parts:
    reports by the staff, and two rounds of discussion by the meeting participants.
8. Reports by the staff include presentations by the System Open Market
    Account Manager (reporting on financial market conditions and actions taken
    to maintain the target interest rate since the last meeting); the Director of the
    Division of International Finance (commenting on recent international
    economic developments); and the Director of the Division of Research and
    Statistics at the Federal Reserve Board (presenting the staff’s forecast from
    the green book).
9. The ensuing round of discussion is called the economic go-round. One at a
    time committee members describe their view of the economic outlook, and
    then the Chair speaks at the end.
10. Next, the Director of Monetary Affairs describes the policy options (from the
    blue book). Committee members again comment on the options, with the
    Chair speaking last.
11. Finally there is a vote taken, with the Chair voting first, the Vice Chair second,
    and then the committee members (in alphabetical order).
12. The Chair of the Federal Reserve is the FOMC’s most powerful member; to
    have an impact on policy, governors or Reserve Bank presidents must build
    support for their positions through their statements at the meeting and in public
    speeches.
13. However, while the Chair is very powerful, the committee structure does
    provide an important check on that person’s power.




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II.     Assessing the Federal Reserve System’s Structure
          A. Independence from Political Influence
             1. The Fed controls its own budget, which is an important criterion for central
                bank independence.
             2. The Fed does occasionally come under political attack, especially when it
                believes it must raise interest rates.


          B. Decision Making by Committee
             1. The Fed meets this criterion for independence because the FOMC is a
                committee.
             2. The chair may dominate policy decisions, but the fact that there are 12 voting
                members provides an important safeguard against arbitrary action by a single
                individual.


          C. Accountability and Transparency
             1. The FOMC releases huge amounts of information to the public.
             2. However, there is no regular press conference or real questioning of the chair
                on the FOMC’s current policy stance.
             3. Moreover, some information is released well after the fact of the meeting.
             4. Also, the Committee’s refusal to state its objectives clearly and concisely
                hampers communication.


          D. Policy Framework
             1. The Congress of the United States has set the Fed’s objectives, but the
                statement is vague enough that the Fed can essentially set its own goals.
             2. Many people have argued that the system should be replaced by one in which
                the FOMC’s objectives are made clear and the Committee announce a
                specific numerical objective for consumer price inflation over some horizon.


III.   The European Central Bank
          A. Organizational Structure
             1. The Eurosystem mirrors the structure of the Federal Reserve in that there is
                an Executive Board (like the Board of Governors), the National Central Banks
                (like the regional Federal Reserve Banks) and the Governing Council (which,
                like the FOMC, formulates monetary policy).
             2. The Executive Board has a President and Vice President who play the same
                role as the Chairman and Vice Chairman of the Fed.
             3. The ECB and the NCBs together perform the traditional operational functions
                of a central bank; they use interest rates to control the availability of money



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        and credit in the economy, are responsible for the smooth operation of the
        payments system, and issue currency.
   4.   The NCBs continue to serve as bankers to the banks and governments in their
        countries.
   5.   Unlike the Fed, the ECB does not supervise and regulate financial institutions.
        Also, the implementation of monetary policy is not centralized and the ECB’s
        budget is controlled by the NCBs and not vice versa.
   6.   The focus of the ECB’s activity is on the control of money and credit in the
        Eurosystem.
   7.   The Governing Council meets monthly and decisions are made by consensus;
        no formal votes are taken, because votes may get in the way of good policy.
   8.   The ECB’s independence is protected by long terms of office, the fact that the
        ECB’s financial interest must remain separate from any policy organization,
        and by the provision in the Treaty of Masstricht that the Governing Council
        cannot take instructions from any government.
   9.   As the number of members in the Eurosystem has increased, the Governing
        Council has adopted a rotating system for voting like that used by the FOMC.


B. Accountability and Transparency
   1. The most important aspect of the ECB’s communication strategy concerns
      statements about the Governing Council’s policy deliberations; unlike the
      FOMC there is a news conference at which questions are taken and the
      transcript is posted on the website immediately.
   2. The primary problem with ECB communications is that there often are a
      number of conflicting opinions expressed.
   3. But indications are that the system is working and that there is accountability.


C. The Price Stability Objective and Monetary Policy Strategy
   1. The Treaty of Maastricht states that the primary objective of the ECB is to
      maintain price stability.
   2. The ECB’s strategy has been to numerically define price stability and to focus
      on a broad-based assessment of the outlook for future prices, with money
      playing a prominent role.
   3. Price stability is defined as inflation of close to 2 percent, based on a
      euro-area wide measure of consumer prices called the Harmonized Index of
      Consumer Prices (similar to the U.S. CPI).
   4. The economically large countries matter much more than the small ones,
      which affects the dynamics of the Governing Council’s policy making.
   5. However, evidence suggests that the ECB is doing the job it is supposed to do.



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Conceptual Problems

 1. What are the Federal Reserve’s goals? How are Fed officials held accountable for
     meeting them?
 Answer: The goals of the Federal Reserve, as set by Congress are to “maintain long
 run growth of the monetary and credit aggregates commensurate with the economy's
 long run potential to increase production, so as to promote effectively the goals of
 maximum employment, stable prices, and moderate long-term interest rates." The
 Fed’s officials release large amounts of information in order to maintain accountability.
 After each of the meetings of the FOMC, the target interest rate is released
 immediately, along with a brief statement. Minutes and transcripts of the meetings
 are also eventually made public. Members of the FOMC give public speeches and
 the chair reports to Congress and twice a year.

 3. Some people have argued that the high inflation of the late 1970s was a
 consequence of the fact that Federal Reserve Board Chairman Arthur Burns did what
 President Richard Nixon wanted him to do. Explain the connection.
 Answer: Because politicians are elected for relatively short terms, they favor
 expansionary monetary policy that will boost growth in the short run. However, this
 will eventually lead to higher inflation. This is why it is important for the central bank
 to be independent.


 4. *How did the political climate in the early 1900’s influence the structure of the
 Federal Reserve System?
 Answer: The reluctance to centralize power is evident in the complex structure of
 the Federal Reserve System. The combination of the Board of Governors in
 Washington D.C. and the Federal Reserve Banks serving various districts diffuses
 power away from the center and creates a system of checks and balances.

 5. While the Chair of the Federal Reserve Board has only one of 12 votes on the
 FOMC, he is never in the minority. What gives him the power to control the
 Committee?
 Answer: The Chair controls the staff of the Board of Governors that produces the
 material distributed to the Committee members prior to the meeting; he controls the
 agenda of the meeting; he controls when people speak; and he is the first to make a
 policy recommendation.


     6. What are the goals of the ECB? How are its officials held accountable for
        meeting them?
 Answer: The primary goal of the ECB is to maintain price stability, which the ECB
 defines as inflation of less than, but close to, two percent using the Harmonized Index
 of Consumer Prices. Like the Federal Reserve, the ECB is held accountable
 through releases of information, including the target interest rate along with an

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explanatory statement, reports to the European Parliament, and public speeches.

    8. Do you think the FOMC has an easier or a harder time agreeing on monetary
       policy than the Governing Council of the ECB? Why?
Answer: The presence of national biases is likely to make agreement among
members of the Governing Council of the ECB more difficult. By contrast, the
Federal Reserve has very little regional bias. Also, a group of 12 (the number of
voting FOMC members) is likely to have an easier time coming to a decision than a
group of 18 (the current number of ECB Governing Council members).


   9. *What are the two most important factors in ensuring that power is
      decentralized in the Eurosystem?
Answer: The ECB’s budget is controlled by the national central banks and the
executive board members are always a minority on the Governing Council.




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Chapter 17 The Central Bank Balance Sheet and the Money Supply Process

 I. The Central Bank’s Balance Sheet
      1. The central bank engages in numerous financial transactions, all of which
         cause changes in its balance sheet.
      2. Central banks publish their balance sheets regularly; the Fed and the ECB do
         so weekly. Publication is a crucial part of transparency.


  A. Assets
  1. The central bank’s balance sheet shows three basic assets: securities, foreign
     exchange reserves, and loans.
  2. Securities: the primary assets of most central banks; independent central banks
     determine the quantity of securities that they purchase. For the U.S. Federal
     Reserve, these are primarily U.S. Treasury securities.
  3. Foreign Exchange Reserves: the central bank’s and government’s balances of
     foreign currency and are held as bonds issued by foreign governments. These
     reserves are used in foreign exchange market interventions.
  4. Loans are extended to commercial banks. There are several kinds. Discount
     loans are the loans the Fed makes when commercial banks need short-term
     cash.
  5. Through its holdings of U.S. Treasury securities the Fed controls the federal funds
     rate and the availability of money and credit.


  B. Liabilities
  1. There are three major liabilities: currency, the government’s deposit account,
     and the deposit accounts of the commercial banks.
  2. The first two items represent the central bank in its role as the government’s bank,
     and the third shows it as the bankers’ bank.
  3. Currency: nearly all central banks have a monopoly on the issuance of currency,
     and currency is the principal liability of the Fed.
  4. Government’s account: the central bank provides the government with an
     account into which it deposits funds (primarily tax revenues) and from which it
     writes checks and makes electronic payments.
  5. Reserves: Commercial bank reserves consist of cash in the bank’s own vault
     and deposits at the Fed, which function like the commercial bank’s checking
     account.
  6. Central banks run their monetary policy operations through changes in banking
     system reserves.




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   C. The Importance of Disclosure
      1. The balance sheet published by the central bank is probably the most
         important information that it makes public; it is an essential aspect of central
         bank transparency.


   D. The Monetary Base
      1. Currency in the hands of the public and the reserves of the banking system
          are the two components of the monetary base, also called high-powered
          money.
      2. The central bank can control the size of the monetary base and therefore the
          quantity of money.


II. Changing the Size and Composition of the Balance Sheet
       The central bank controls the size of its balance sheet. Policymakers can enlarge
          or reduce their assets and liabilities at will.
       The central bank can buy things, like a bond, and create liabilities to pay for them.
          It can increase the size of its balance sheet as much as it wants.
       There are four specific types of transactions which can affect the balance sheets
          of both the central bank and the banking system: (1) an open market
          operation, in which the central bank buys or sells a security; (2) a foreign
          exchange intervention, in which the central bank buys or sells foreign currency
          reserves; (3) the central bank’s extension of a discount loan to a commercial
          bank; and (4) the decision by an individual to withdraw cash from a bank.
       Open market operations, foreign exchange interventions, and discount loans all
          affect the size of the central bank’s balance sheet and they change the size of
          the monetary base; cash withdrawals by the public create shifts among the
          different components of the monetary base, changing the composition of the
          central bank’s balance sheet but leaving its size unaffected.
       One simple rule will help in understanding the impact of each of these four
          transactions on the central bank’s balance sheet: When the value of an asset
          on the balance sheet increases, either the value of another asset decreases
          (so that the net change is zero) or the value of a liability rises by the same
          amount (and similarly for an increase in liabilities).


   A. Open Market Operations
      1. OMO is when the Fed buys or sells securities in financial markets.
      2. These purchases and sales have a straightforward impact on the Fed’s
         balance sheet: its assets and liabilities increase by the amount of a purchase,
         and the monetary base increases by the same amount.


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      3. In terms of the banking system’s balance sheet, the purchase has no effect on
         the liabilities, and results in two counterbalancing changes on the asset side,
         so the net effect there is zero.
      4. For an open market sale the effects would be the same but in the opposite
         direction.


   B. Foreign Exchange Intervention
      1. The impact of a foreign exchange purchase is almost identical to that of an
         open market purchase: the Fed’s assets and liabilities increase by the same
         amount, as does the monetary base.
      2. If the Fed buys from a commercial bank, the impact again is like the open
         market purchase, except the assets involved are different.


   C. Discount Loans
      1. The Fed does not force commercial banks to borrow money; the banks ask for
         loans and must provide collateral, usually a U.S. Treasury bond.
      2. When the Fed makes a loan it creates an asset and a matching increase in its
         reserve liabilities.
      3. The extension of credit to the banking system raises the level of reserves and
         expands the monetary base.
      4. The banking system balance sheet shows an increase in assets (reserves)
         and an increase in liabilities (the loan).


   D. Cash Withdrawal
      1. Cash withdrawals affect only the composition, not the size, of the monetary
         base.
      2. When people withdraw cash they force a shift from reserves to currency on the
         Fed’s balance sheet.
      3. The withdrawal reduces the banking system’s reserves, which is a decrease in
         its assets, and if the funds come from a checking account, there is a matching
         decrease in liabilities.
      4. On the Fed’s balance sheet both currency and reserves are liabilities, so there
         is just a change between the two with a net effect of zero.


III. The Deposit Expansion Multiplier
     A. Deposit Creation in a Single Bank
        1. If the Fed buys a security from a bank, the bank has excess reserves, which it
           will seek to lend.
        2. The loan replaces the securities as an asset on the bank’s balance sheet.



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   B. Deposit Expansion in a System of Banks
      1. However, the loan that the bank made was spent and as the checks cleared,
         reserves were transferred to other banks.
      2. The banks that receive the reserves will seek to lend their excess reserves,
         and the process continues until all of the funds have ended up in required
         reserves.
      3. Assuming no excess reserves are held and that there are no changes in the
         amount of currency held by the public, the change in deposits will be the
         inverse of the required deposit reserve ratio (rD) times the change in required
         reserves, or ∆D = (1/rD) ∆RR
      4. The term (1/rD) represents the simple deposit expansion multiplier.
      5. A decrease in reserves will generate a deposit contraction in a multiple amount
         too.


IV. The Monetary Base and the Money Supply
    Deposit Expansion with Excess Reserves and Cash Withdrawals
       The simple deposit expansion multiplier was derived assuming no excess
          reserves are held and that there is no change in currency holdings by the
          public. These assumptions are now relaxed.
       The desire of banks to hold excess reserves and the desire of account holders to
          withdraw cash both reduce the impact of a given change in reserves on the
          total deposits in the system; the two factors operate in the same way as an
          increase in the reserve requirement.


The Arithmetic of the Money Multiplier
      1. The amount of excess reserves a bank holds depends on the costs and
          benefits of holding them, where the cost is the interest foregone and the
          benefit is the safety from having the reserves in case there is an increase in
          withdrawals.
      2. The higher the interest rate, the lower banks’ excess reserves will be; the
          greater the concern over possible deposit withdrawals, the higher the excess
          reserves will be.
      3. Similarly, the decision of how much currency to hold depends on the costs and
          benefits, where the cost is the interest foregone and the benefit is the lower
          risk and greater liquidity of currency.
      4. As interest rates rise cash becomes less desirable, but if the riskiness of
          alternative holdings rises or liquidity falls, then it becomes more desirable.
      5. Deriving the money multiplier tells us that the quantity of money in the
          economy depends on the monetary base, the reserve requirement, the desire
          by banks to hold excess reserve and the desire by the public to hold currency.


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      6. The quantity of money changes directly with the base, and for a given amount
         of the base, an increase in either the reserve requirement or the holdings of
         excess reserves will decrease the quantity of money.
      7. But currency holdings affect both the numerator and the denominator of the
         multiplier, so the effect is not immediately obvious. Logic tells us that an
         increase in currency decreases reserves and so decreases the money supply.


   The Limits of the Central Bank’s Ability to Control the Quantity of Money
      1. There is no tight link between the monetary base and the quantity of money.
      2. In places like the United States, Europe, and Japan, the link between the
         central bank’s balance sheet and the quantity of money circulating in the
         economy has become too weak and unpredictable to be exploited for policy
         purposes.
      3. The problem is that the money multiplier is too variable.
      4. Therefore, modern central banks keep an eye on trends in money growth
         since that is what ultimately determines inflation. For short-run policy, interest
         rates have become the monetary policy tool of choice.


Conceptual Problems
  1. Follow the impact of a $100 cash withdrawal through the entire banking system,
     assuming that the reserve requirement is 10 percent and that banks have no
     desire to hold excess reserves.
   Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A) needs
   to increase its reserves by $90 in order to meet the required reserve ratio. To raise
   the $90, Bank A will sell $90 of securities to someone. The deposit account of the
   person who purchased the securities will fall by $90, as will the reserve balance of his
   bank, Bank B. Bank B now needs to increase its reserves by $81 in order to meet
   the reserve requirements so it will sell $81 of securities. This continues until
   deposits contract by $100/0.1 = $1000.

   2. Compute the impact on the money multiplier of an increase in desired currency
      holdings from 10 percent to 15 percent of deposits when the reserve requirement
      is 10 percent of deposits, and banks’ desired excess reserves are 3 percent of
      deposits.
   Answer:
                                                                    1 + 1.1
   When desired currency holdings = 10% of deposits, m =                        = 1.71
                                                               1.1 + 0.1 + 0.03


                                                                   1 + 1.15
   When desired currency holdings = 15% of deposits, m =                         = 1.68
                                                               1.15 + 0.1 + 0.03


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3. Consider an open market purchase by the Fed of $3 billion of Treasury bonds.
   Show the impact of the purchase on the bank from which the Fed bought the
   securities. Then, using the assumptions in problem 2, compute the impact on
   M1.
Answer: The bank’s securities fall by $3 billion and reserves rise by $3 billion.
Assuming that the required reserve ratio is 10 percent, the bank does not want to
hold extra reserves, and the public does not wish to hold currency, the value of
deposits will rise by $30 billion.

4. *Why is currency circulating in the hands of the nonbank public considered a
   liability of the central bank?
Answer: Currency issued by the central bank is effectively an IOU to the holder of the
currency. The central bank is obliged to pay back the holder of the currency. If the
currency is backed by gold, for example, the central bank is obliged to exchange gold
for currency. With fiat money, however, the central bank is obliged only to exchange
currency for more currency.

5. The U.S. Treasury maintains accounts at commercial banks. What would be the
   consequences if the Treasury shifted funds from one of those banks to the Fed?


Answer: The balance sheet for the bank would reflect a decrease in reserves and a
decrease in deposits. The decrease in reserves would also appear on the Fed’s
balance sheet; however, it would be balanced by an increase in the government’s
account. The consequences would be a decline in the quantity of money.


6. In an effort to diversify, the Central Bank of China has decided to exchange some
   of its dollar reserves for euros. Follow the impact of this move on the U.S.
   banking system's balance sheet, the Federal Reserve's balance sheet, and the
   European Central Bank’s balance sheet. What is the impact on the U.S. and
   Chinese monetary bases?
Answer: The decision by a foreign central bank to sell dollars moves the dollars into
the U.S. commercial banking system, increasing U.S. commercial bank reserves and
thus the U.S. monetary base. The balances sheets of the various central banks are
unaffected, as is the Chinese monetary base.


7. Suppose the Fed buys $1 billion in Japanese yen, paying in dollars. What is the
   impact on the monetary base? What would the Fed need to do to keep the
   monetary base from changing following the purchase?
Answer: On the Fed’s balance sheet, currency and foreign reserves would both rise
by $1 billion; the monetary base would increase by $1 billion. If the Fed wished to

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keep its balance sheet from changing (performing what is called a “sterilized
intervention”) it could then sell $1 billion in securities.

8. List the factors that you suspect may have caused the Federal Reserve to lose
   control of the quantity of money in the economy. Explain your reasoning.
Answer: Financial and technological innovations have had an impact on the various
components of the money multiplier. The increasing variability and unpredictability of
the money multiplier has weakened the link between the monetary base and the
money supply. Some factors that have contributed to the changing value of the
money multiplier include the introduction of ATM machines, rising use of credit cards,
and increased availability of relatively liquid financial instruments, such as money
market mutual funds; all of these have reduced the currency-to-deposit ratio. The
practice of “sweeping” balances from checking accounts into savings accounts each
weekend has rendered the reserve requirement irrelevant.

9. *Explain how an absence of understanding in the US of the relationship between
   the central bank’s balance sheet and the money supply contributed to the Great
   Depression.
Answer: During the Great Depression, the central bank was increasing the monetary
base at a significant rate. Conditions in the economy, however, meant that the money
multiplier was declining and so the overall impact was a fall in quantity of money.
This contributed to the contraction of the economy.




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