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ECON302: Money, Banking, And Financial Markets

Unit 4: Central Banking   *A central bank is commonly known as a lender of last resort, or as a “bankers’ bank.”  Most developing countries have a central bank that controls the credit system. These central banks exercise control by setting short-term interest rates (that is, the rates at which loans of last resort are made).  Central banks may also control the money supply by requiring participating banks to keep a percentage of their holdings in reserve.  Typically, central banks issue bank notes (in the United States, the Treasury creates the currency), act as the government’s bank, accept deposits, and make loans to commercial banks.  The United States’ central bank, known as the Federal Reserve System, was established in 1913 by an act of Congress; unlike most other central banks, the Federal Reserve is privately owned by banks in each of its twelve districts.  Far from being above reproach, however, some economists (among them Milton Friedman, John Kenneth Galbraith, and Ben Bernanke) have argued that the policies of the Federal Reserve were largely responsible for bringing about the Great Depression of 1929.  This unit will review the structure and origins of central banks, as well as the various instruments at its disposal.

The recession of 2009 has its roots in the malfunctions of the financial institutions of several major economies.  The use of derivatives and other financial products, the question of asymmetric information, and the role of banks (especially central banks) make this a timely topic.  Unfortunately, at the time of this course’s development, there are few textbook descriptions of its causes, the extent of its damage, or the proposals developed for its ultimate resolution.  Nevertheless, this unit will prove critical to a thorough understanding of the current controversies.  *

Unit 4 Time Advisory
This unit should take you 15 hours to complete.

☐    Subunit 4.1: 2.0 hours

☐    Subunit 4.2: 2.5 hours

☐    Subunit 4.3: 2.5 hours

☐    Subunit 4.4: 2.0 hours

☐    Subunit 4.5: 3.0 hours

☐    Assessments: 3 hours

Unit4 Learning Outcomes
Upon successful completion of this unit, the student will be able to:
- Explain the role of central banks in the economy.

  • Discuss the structure of the  Federal Reserve System (The U.S. central bank).
  • Explain how the central bank controls the money supply.
  • Identify the goals of monetary policy.
  • Explain what monetary policy targeting is and why the central bank might choose one target over another.
  • Explain how monetary policy affects the targets and the goals.

4.1 Structure of the Central Banks and the Federal Reserve System   Note: Until the creation of the European Central Bank, one could say that the Federal Reserve System had the most unusual structure of any central bank.  This subunit describes the unique structure of the Federal Reserve System and its evolution since 1913.  Although the Federal Reserve has been granted a high degree of independence, a clearer understanding of its decisions requires that one acknowledge the political and bureaucratic forces influencing its behavior.  This section describes the institutional structure of the Federal Reserve, the European Central Bank and other foreign central banks.  Knowing the institutional structure of a central bank will help you to understand who controls the central bank, what motivates its behavior, and who holds the reigns of power within the central bank.  A key feature of the institutional structure of a central bank is the degree to which it is independent of political pressures from government officials outside of the central bank.  This section examines the advantages and disadvantages of central bank independence.

  • Reading: Pearson Education Canada's version of Frederic S. Mishkin’s “Chapter 14: Structure of the Central Banks and the Federal Reserve System” Lecture Notes Link: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 14: Structure of the Central Banks and the Federal Reserve System” Lecture Notes (Microsoft PowerPoint)
     
    Instructions: When you click on the link above, you will be directed to a webpage that lists links to lecture notes on specific chapters from Mishkin's The Economics of Money, Banking, and Financial Markets.  Click on the "Chapter 14 " link to download the presentation. Please read all of the slides for Chapter 14 for information that covers sections 4.1.1-4.1.6.
     
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Money and Banking: “Chapter 13: Central Bank Form and Function” Link: Money and Banking: “Chapter 13: Central Bank Form and Function” (PDF)

    Instructions: Please note this reading will address the topics in sections 4.1.1-4.1.6.  When you click on the link above, you will be directed to Chapter 13 “Central Bank Form and Function” of the on-line book Money and Banking.  Please read Chapter 13 in its entirety.
     
    Terms of Use: The text was adapted by The Saylor Foundation under a Creative Commons-Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensee.

  • Web Media: YouTube: The Ludwig von Mises Institute’s “Money, Banking, and the Federal Reserve” Link: YouTube: The Ludwig von Mises Institute’s “Money, Banking, and the Federal Reserve

    Also available in:
    iTunes U
     
    Instructions: Please note this video contains information relevant to sections 4.1.1-4.1.6.  When you click on the link above, you will be directed to the video “Money, Banking, and the Federal Reserve” posted on YouTube by misesmedia. Please watch the video (42:09 minutes) in its entirety.
     
    Note on the Media: This video, rich in the history of American economics and featuring several famous economists, clearly describes the role of the Federal Reserve.  However, this film is not without its criticisms of the importance of curbing America’s central bank.  This video was created by Ludwig von Mises Institute based on the Austrian School pedagogy of economics and libertarian political and social theory.
     
    Terms of Use: The video above is licensed under a Creative Commons Attribution 3.0 United States License.  It is attributed to the Ludwig von Mises Institute.  The original version can be found here http://www.youtube.com/watch?v=Qe5c7ik4srU.

  • Reading: The Federal Reserve Board's "Chapter 1: Overview of the Federal Reserve System: Background and Structure" Link: The Federal Reserve Board's "Chapter 1: Overview of the Federal Reserve System: Background and Structure" (PDF)

    Instructions: Please read this entire chapter from The Federal Reserve System: Purposes and Functions.  

    Terms of Use: This material is in the Public Domain.

4.1.1 Origins of the Federal Reserve System   4.1.2 Formal Structure of the Federal Reserve System   4.1.3 The FOMC Meeting   4.1.4 Informal Structure of the Federal Reserve System   4.1.5 Structure and Independent of Foreign Central Banks   4.1.6 Explaining Central Bank Behavior   - Assessment: Pearson Education: Frederic S. Mishkin’s “Chapter 15: Structure of the Central Banks and the Federal Reserve System”: “Multiple Choice Quiz” Link: Pearson Education: Frederic S. Mishkin’s “Chapter 15: Structure of the Central Banks and the Federal Reserve System”: “Multiple Choice Quiz” (HTML)
 
Instructions: This quiz will assess what you have learned in subunits 4.1.1-4.1.6.  When you click on the link above, you will be directed to Frederic S. Mishkin’s “Chapter 15: Structure of the Central Banks and the Federal Reserve System” multiple choice quiz.  After you finish the 15 questions of the quiz, please click “Submit Answers for Grading” to assess your quiz.
 
Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

4.2 Multiple Deposit Creation and the Money Supply Process   Note: This subunit describes the money supply process.  Bank deposits are by far the largest component of the money supply.  The focus of this section is on how banks create deposits and how deposit creation affects the money supply.  Movements in the money supply influence us all by affecting the health of the economy; thus, it is important to understand how the money supply is determined.  Because deposits at banks (and other depository institutions) comprise the largest component of the money supply, understanding how these deposits are created is the first step in understanding the money supply process.

  • Reading: Pearson Education Canada's version of Frederic S. Mishkin’s Lecture Notes on “Chapter 15: Multiple Deposit Creation and the Money Supply Process” Link: Pearson Education Canada’s version of Frederic S. Mishkin’s Lecture Notes on Chapter 15: Multiple Deposit Creation and the Money Supply Process (Microsoft PowerPoint)
     
    Instructions:  When you click on the link above, you will be directed to a webpage that lists links to lecture notes on specific chapters from Mishkin's The Economics of Money, Banking, and Financial Markets.  Click on the "Chapter 15" link to download the presentation. Please read all of the slides for Chapter 16 for information that covers sections 4.2.1-4.2.4.

      
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Money and Banking: “Chapter 14: The Money Supply Process” Link: Money and Banking: “Chapter 14: The Money Supply Process” (PDF)

    Instructions: Please note this reading will address the subjects in sections 4.2.1-4.2.4.  When you click on the link above, you will be directed to Chapter 14 “The Money Supply Process” of an on-line book Money and Banking.  Please read Chapter 14 in its entirety.

    Terms of Use: The text was adapted by The Saylor Foundation under a Creative Commons-Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensee.

  • Web Media: Google Videos: Paul Grignon’s “Money As Debt” Link: Google Videos: Paul? Grignon’s “Money As Debt” (Adobe Flash)
      
    Instructions: When you click on the link above, you will be directed to Paul? Grignon Video Sessions on “Money As Debt”.  Please watch this video (47:10 minutes) in its entirety to learn about the topics covered in sections 4.2.1-4.2.4.
     
    Note on the Media: This video, narrated by Paul Grignon, will explain the creation and distribution of money, providing historical context of how different types of currency were used in trade, as well as how money used to be financed by silver and gold but is now financed by debt.  This video was originally produced by Moonfire Studio and is now hosted on the Google Videos website.
     
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Lecture: The Khan Academy's "Money and Banking 3: Fractional Reserve Banking" Link: The Khan Academy's "Money and Banking 3: Fractional Reserve Banking" (Khan Academy). 

    Intructions: Please watch the entire video lecture (11:48).

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  This video was created by Salman Khan for the Khan Academy.

  • Lecture: The Khan Academy's "Money and Banking 4: Money Multiplier and the Money Supply" Link: The Khan Academy's "Money and Banking 4: Money Multiplier and the Money Supply" (YouTube).

    Instructions: Please watch the entire video lecture (11:07).

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  This video was created by Salman Khan for the Khan Academy.

4.2.1 Four Players in the Money Supply Process   4.2.2 The Fed’s Balance Sheet   4.2.3 Control of the Monetary Base   4.2.4 Multiple Deposit Creation   - Reading: Pearson Education: Frederic S. Mishkin’s Multiple Choice Quiz on “Chapter 16: Multiple Deposit Creation and the Money Supply Process” Link: Pearson Education: Frederic S. Mishkin’s Multiple Choice Quiz on “Chapter 16: Multiple Deposit Creation and the Money Supply Process” (HTML)
 
Instructions: This quiz will assess what you have learned in sections 4.2.1-4.2.4.  When you click on the link above, you will be directed to Frederic S. Mishkin’s Multiple Choice Quiz on “Chapter 16: Multiple Deposit Creation and the Money Supply Process”. After you finish the 15 questions of the quiz, please click “Submit Answers for Grading” to make an assessment.
 
Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

4.3 Determination of the Money Supply   Note: The section developed a simple model of multiple deposit creation. That model illustrated the process of multiple deposit creation but was lacking in two respects. It assumed that depositors hold no currency and banks hold no excess reserves. This section relaxes those assumptions in order to derive a more realistic money multiplier. After deriving a more realistic money multiplier, this section describes the sources of movement in the monetary base, the money multiplier and the money supply. Throughout this section, money (M) is defined as M1 which is currency plus checkable deposits. This section incorporates depositor and bank behavior into the monetary process, presenting a more realistic model of the money supply process. The analysis is separated into three steps. First, because the Fed's control of the monetary base is more precise than its control over reserves, the model links changes in the money supply to changes in the monetary base. Next, the money multiplier, a ratio that relates the change in the money supply to a given change in the monetary base, is derived. Third, factors determining the money multiplier are examined.

  • Reading: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 16: Determination of the Money Supply” Lecture Notes Link: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 16: Determination of the Money Supply” Lecture Notes (Microsoft PowerPoint)
     
    Instructions: When you click on the link above, you will be directed to a webpage that lists links to lecture notes on specific chapters from Mishkin's The Economics of Money, Banking, and Financial Markets.  Click on the "Chapter 16" link to download the presentation. Please read all of the slides for Chapter 16 for information that covers sections 4.3.1-4.3.3.

      
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Money and Banking: “Chapter 15: The Money Supply and the Money Multiplier” Link: Money and Banking: “Chapter 15: The Money Supply and the Money Multiplier” (PDF)

    Instructions: This reading will address the topics in sections 4.3.1-4.3.3.  When you click on the link above, you will be directed to Chapter 15 “The Money Supply and the Money Multiplier” of an on-line book Money and Banking.  Please read Chapter 15 in its entirety.

    Terms of Use: The text was adapted by The Saylor Foundation under a Creative Commons-Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensee.

  • Web Media: Bukisa’s version of Khan Academy’s “Learn about Banking 4: Multiplier Effect and the Money Supply” Link: Bukisa’s version of Khan Academy’s “Learn about Banking 4: Multiplier Effect and the Money Supply” (YouTube)
     
    Also available in:
     
    iTunes U
     
    Instructions: When you click on the link above, you will be directed to the video titled “Learn about Banking 4: Multiplier Effect and the Money Supply,” which will cover the topics in sections 4.3.1-4.3.3.  Please watch this video (11:06 minutes) in its entirety.
     
    Note on the Media: With a conversational tone, the narrator of this video will review definitions of money supply and the multiplier effect.  Please note that the video uses a made-up example of money supply for farmers from the previous video in this series; however, the narrator will revisit the example and set up the situation again for this video.
     
    Terms of Use: This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License. It is attributed to the Khan Academy and the original version can be found here.

4.3.1 The Money Supply Model and the Money Multiplier   4.3.2 Factors That Determine the Money Multiplier   4.3.3 Additional Factors That Determine the Money Supply   - Assessment: Pearson Education: Frederic S. Mishkin’s Multiple Choice Quiz on “Chapter 17: Determination of the Money Supply” Link: Pearson Education: Frederic S. Mishkin’s Multiple Choice Quiz on “Chapter 17: Determination of the Money Supply” (HTML)
 
Instructions: This quiz will assess what you have learned in sections 4.3.1-4.3.3.  When you click on the link above, you will be directed to Frederic S. Mishkin’s “Chapter 17: Determination of the Money Supply” multiple choice quiz. After you finish the 15 questions of the quiz, please click “Submit Answers for Grading” to redirect to the answer key.
 
Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

4.4 Tools of Monetary Policy   Note: This section examines how the Federal Reserve uses its three policy tools—open market operations, changes in discount lending, and changes in reserve requirements—to manipulate the money supply and interest rates.  The Fed uses three tools to manipulate the money supply and interest rates: open market operations, discount lending, and reserve requirements.  This subunit looks at how the Fed uses these tools to influence the market for reserves and the federal funds rate.  The section ends with a discussion of the tools of monetary policy used by other central banks besides the Federal Reserve.

  • Reading: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 17: Tools of Monetary Policy” Lecture Notes Link: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 17: Tools of Monetary Policy” Lecture Notes (Microsoft PowerPoint)
     
    Instructions: When you click on the link above, you will be directed to a webpage that lists links to lecture notes on specific chapters from Mishkin's The Economics of Money, Banking, and Financial Markets.  Click on the "Chapter 17" link to download the presentation. Please read all of the slides for Chapter 17 for information that covers sections 4.4.1-4.4.4.
     
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Money and Banking: “Chapter 16: Monetary Policy Tools” Link: Money and Banking: “Chapter 16: Monetary Policy Tools” (PDF)

    Instructions: Please note this reading covers sections 4.4.1-4.4.4.  When you click on the link above, you will be directed to Chapter 16 “Monetary Policy Tools” of an on-line book Money and Banking. Please read Chapter 16 in its entirety.

    Terms of Use: The text was adapted by The Saylor Foundation under a Creative Commons-Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensee.

  • Lecture: Yale University: Professor Robert J. Shiller’s “Lecture 16: The Evolution and Perfection of Monetary Policy” Link:  Yale University: Professor Robert J. Shiller’s “Lecture 16: The Evolution and Perfection of Monetary Policy

    Also available in: 
    iTunes U
    Quicktime (Low bandwidth/slow connection) 
    MP3 format 
    Transcript (HTML)
     
    Instructions: When you click on the link above, you will be directed to Robert J. Shiller’s lecture 16 “The Evolution and Perfection of Monetary Policy.”  To download this video, you will need to click on the Flash icon or the QuickTime icon in the lower right corner of the webpage.  Please watch the video in its entirety for information on the topics covered in sections 1.3.1-1.3.4.  You may also choose to listen to the audio version (mp3) or to read the transcript (html format).  
     
    Note on the Media: Lecturer, Robert J. Shiller, is the Arthur M. Okun Professor of Economics at Yale University.  This video lecture was created for his Financial Markets course.
     
    Terms of Use: Robert Shiller, Financial Markets (Yale University: Open Yale Courses), http://oyc.yale.edu (Accessed March 2, 2011).  License: Creative Commons BY-NC-SA 3.0. The original version can be found here.

  • Lecture: The Khan Academy's "Money and Banking 13: Open-Market Operations" Link: The Khan Academy's "Money and Banking 13: Open-Market Operations," (YouTube) 

    Instructions: Please watch the video lecture (13:22). 

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  This video was created by Salman Khan for the Khan Academy.

  • Lecture: The Khan Academy's "Money and Banking 14-15: Federal Funds Rate" Link: The Khan Academy's "Money and Banking 14: Federal Funds Rate" (YouTube) and "Money and Banking 15: More on the Federal Funds Rate" (YouTube).

    Instructions: Please watch both video lectures (23:58). 

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  This video was created by Salman Khan for the Khan Academy.

  • Lecture: The Khan Academy's "Money and Banking: Discount Rate" Link: The Khan Academy's "Money and Banking: Discount Rate" (YouTube). 

    Instructions: Please watch the video lecture (13:22).

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  This video was created by Salman Khan for the Khan Academy.

4.4.1 The Market for Reserves and the Federal Funds Rate   4.4.2 Open Market Operations   4.4.3 Discount Policy   4.4.4 Reserve Requirements   - Assessment: Pearson Education: Frederic S. Mishkin’s “Chapter 18: Tools of Monetary Policy”: “Multiple Choice Quiz” Link: Pearson Education: Frederic S. Mishkin’s “Chapter 18: Tools of Monetary Policy”: “Multiple Choice Quiz” (HTML)
 
Instructions: This quiz will assess what you have learned in subunits 4.4.1-4.4.4.  When you click on the link above, you will be directed to Frederic S. Mishkin’s multiple choice quiz on “Chapter 18: Tools of Monetary Policy.”  After you finish the 15 questions of the quiz, please click “Submit Answers for Grading” to check your answers.
 
Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

4.5 Conduct of Monetary Policy: Goals and Targets   Note: This subunit examines how central banks use the monetary policy tools to achieve their policy goals and objectives.  The first part of the section discusses the important goals that central banks attempt to achieve through their conduct of monetary policy and regulatory duties.  The general operating strategy employed by central banks to achieve these goals is presented in the second part of the section.  The third part ties together the first two parts by examining the Fed’s past policy procedures.  This historical perspective provides important insights when it comes to assessing current and future monetary policy actions.  The subunit concludes with a brief discussion of the Taylor rule as a guide for setting the federal funds rate.

  • Reading: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 18: Conduct of Monetary Policy: Goals and Targets" Lecture Notes Link: Pearson Education Canada’s version of Frederic S. Mishkin’s “Chapter 18: Conduct of Monetary Policy: Goals and Targets" Lecture Notes (Microsoft PowerPoint)
     
    Instructions: When you click on the link above, you will be directed to a webpage that lists links to lecture notes on specific chapters from Mishkin's The Economics of Money, Banking, and Financial Markets.  Click on the "Chapter 18" link to download the presentation. Please read all of the slides for Chapter 18 for information that covers sections 4.5.1-4.5.5.
     
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Money and Banking: “Chapter 17: Monetary Policy Targets and Goals” Link: Money and Banking: “Chapter 17: Monetary Policy Targets and Goals” (PDF)

    Instructions: When you click on the link above, you will be directed to “Chapter 17: Monetary Policy Targets and Goals” of an on-line book Money and Banking.  Please read Chapter 17 in its entirety for information outlined in sections 4.5.1-4.5.5.
     
    Terms of Use: The text was adapted by The Saylor Foundation under a Creative Commons-Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensee.

     

  • Reading: *Macroeconomics – Theory Through Applications* Link: Macroeconomics – Theory Through Applications (PDF)
     
    Instructions: Read Section 10.3, on pages 273 to 280. Focus on the topic of inflation targeting.
     
    Terms of Use: This text was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work’s original creator or licensee.

  • Reading: The Federal Reserve Board's "Chapter 3: The Implementation of Monetary Policy" Link: The Federal Reserve Board's "Chapter 3: The Implementation of Monetary Policy" (PDF).

    Instructions: Please read this entire chapter from The Federal Reserve System: Purposes and Functions.

    Terms of Use: This materical is in the Public Domain.

  • Reading: The Federal Reserve Board's "Chapter 2: Monetary Policy and the Economy" Link: The Federal Reserve Board's "Chapter 2: Monetary Policy and the Economy" (PDF)

    Instructions: Please read this entire chapter from The Federal Reserve System: Purposes and Functions.

    Terms of Use: This materical is in the Public Domain.

4.5.1 Goals of Monetary Policy   4.5.2 Central Bank Strategies: The Use of Targets   4.5.3 Choosing the Targets   4.5.4 Fed Policy Procedures   4.5.5 The Taylor Rule, NAIRU, and the Philips Curve   - Assessment: Pearson Education: Frederic S. Mishkin’s “Chapter 19: What Should Central Banks Do? Monetary Policy Goals, Strategy, and Tactics”: “Multiple Choice Quiz” Link: Pearson Education: Frederic S. Mishkin’s “Chapter 19: What Should Central Banks Do? Monetary Policy Goals, Strategy, and Tactics”: “Multiple Choice Quiz” (HTML)
 
Instructions: This quiz will assess what you have learned in sections 4.5.1-4.5.5.  When you click on the link above, you will be directed to Frederic S. Mishkin’s multiple choice quiz on “Chapter 19: What Should Central Banks Do? Monetary Policy Goals, Strategy, and Tactics.”  After you finish the 15 questions of the quiz, please click “Submit Answers for Grading” to redirect to the answer key.
 
Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.