Chapter-07-notes - Finance 3700 Financial Markets and...

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Unformatted text preview: Finance 3700 Financial Markets and Institutions Fall 2007 Lecture Notes CHAPTER 7 Central Banks and the Federal Reserve System © Sven Thommesen 2 What is a Central Bank – and why do we need one? Historically, the functions of a central bank have been: • to lend money to the government (the King); • to act as a “lender of last resort” (LLR) to the banking system; • more recently (after we ditched the gold standard): carrying out monetary policy through manipulation of bank reserves; • to regulate the banking system (as one of several institutions doing that). • Of these, the key function which is used to argue for the establishment of a central bank in the first place is in its role as a lender of last resort . In our banking system, based on fractional reserves , banks are constantly illiquid. (As we have said before, in the process of asset transformation, they “borrow short and lend long.”) Without an LLR, an otherwise sound bank can run out of liquid funds (cash reserves), causing a panic among its customers. A bank run may ensue, which puts the bank out of business. Sometimes, just the rumor that a bank is in trouble will cause a bank run! A central bank, as LLR, can lend new funds into existence to tide a bank over. The knowledge that this is so helps prevent bank runs from getting started in the first place. Æ In this context, discuss: where does the central bank get its money? • Note that the lender-of-last-resort function is vastly more important in a banking system based on fractional reserves than in a 100%-reserve system. • In today’s economy with a fiat monetary standard , the regulatory and money manipulation functions are now extremely important. Without a central bank it would be much more difficult to manipulate the money supply as part of monetary policy! The Federal Reserve System • The Fed acts as the Central Bank of the United States, operating as a “ lender of last resort ” for banks in trouble. • The Fed carries out monetary policy on behalf of the U.S. government, using the tools at its disposal (interest rates, the money supply, regulations). • The Fed regulates how banks do their business, along with the FDIC and the OCC. • Indirectly, the Fed lends money to the government (the Treasury) by monetizing budget deficits through open market operations. 3 Some history: the Fed • was founded in 1913 by an act of Congress; • is nominally a private corporation, owned by its member banks which are shareholders in the system; • all 2,409 nationally chartered banks are required to be members of the Fed • state chartered banks can choose; of the 6,266 such banks, 1,001 are members of the Fed • thus about 40% of all commercial banks are members of the Federal Reserve system • all banks, whether members or not, are subject to Fed regulations Peculiarities of U.S. banking history: • A fear of centralized power (and a central bank does have a lot of influence) • A distrust of East Coast moneyed interests (whom a central bank surely would represent)...
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Chapter-07-notes - Finance 3700 Financial Markets and...

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