Transcript Chapter 1

Chapter 4: Functions of the Fed.
Chapter 4: Functions of the Fed.
Chapter Outline:
• Organization of the Fed.
• Monetary Policy Tools.
• Global Monetary Policy.
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The Federal Reserve System
• The Federal Reserve System (the Fed) is
the central bank of the United States.
Organization of the Fed
• Federal Reserve District Banks.
• Member Banks.
• Board of Governors.
• Federal Open Market Committee (FOMC)
• Advisory Committees.
Organization of the
Federal Reserve System
The Federal Reserve System
Organization of the Federal
Reserve System
• Federal Reserve System created by action of the U.S.
Congress in 1913
• Prior to 1913, U.S. had no Central Banking System
• Occasional Financial Panics (1880’s, 1890’s, and
finally, 1907) – Public demanded that government
take steps to prevent such panics
• The Federal Reserve System to become the “lender
of last resort” should commercial banks begin to
fail
Organization of the Federal
Reserve System
• Each of the Twelve Federal Reserve District
Banks are owned by the member commercial
District Banks in their District.
• Fed is a quasi public-private enterprise, not
controlled by the President or Congress.
The Board of Governors
• Seven Members appointed by the President &
Confirmed by the Senate
• Appointed for a single fourteen year term
• A Board positions is scheduled for replacement every
two years
• Oftentimes, however, board members do not remain
for the full term, giving a sitting president opportunity
to choose several board members during his term of
office
Independence of the Board of
Governors
• The only control a sitting president has over the Board
of Governors is the opportunity to fill positions as
terms expire
• Once a Board member has received Senate
confirmation, he is not subject to the control of either
the President or the Congress
• This gives the Board both independence and
tremendous power
Federal Open Market Committee
(FOMC)
• The Federal Open Market Committee (FOMC)
sets goals regarding the money supply and interest
rates and directs the operations of the Open Market
Desk in New York.
• The Open Market Desk is an office in the New
York Federal Reserve Bank from which
government securities are bought and sold by the
Fed.
Functions of the Federal Reserve
• Conduct Monetary Policy
• First and Foremost, maintain price stability
• Secondly, to promote full employment and
economic growth
• Serve as a lender of last resort to commercial banks
within the District
• Issue Currency
• Provide Banking Services to the U.S. Government
• Supervise and regulate our financial institutions
(Banks)
Monetary Policy Tools
• Open Market Operations.
• Adjustments in the discount rate.
• Adjustments in the reserve requirement ratio.
Open Market Operations
• Open market operations is the purchase and sale
by the Fed of government securities in the open
market; a tool used to expand or contract the
amount of reserves in the system and thus the
money supply.
• Open market operations is by far the most
significant tool of the Fed for controlling the
supply of money.
Open Market Operations
• An open market purchase of securities
by the Fed results in an increase in
reserves and an increase in the supply
of money.
Open Market Operations
• An open market sale of securities by the
Fed results in a decrease in reserves
and a decrease in the supply of money.
Tools of Monetary Policy Open
Market Transactions
 If the Fed wishes to stimulate the economy it will purchase U.S.
Government Securities in the bond market (U.S. Treasury
Notes) – Raises bond prices; reduces interest rates
• Cash flows from the Fed to sellers of bonds; sellers deposit cash in their
banks, thereby increasing the nations deposits and the excess reserves of
the banking industry
• If the Fed wishes to restrain the economy it will buy U.S.
Government Securities in the bond market (U.S. Treasury
Notes) – Lowers bond prices; increases interest rates
• Cash flows from the banks to buyers of bonds and ultimately to the Fed,
thereby reducing the deposit accounts and restricting the ability of
commercial banks to loan money
Open Market Operations
• Fed Use of the Repurchase Agreements.
• The effect of the Open Market Operations on Interest
Rate.
• Open Market Operations in Response to the Crash.
• Open Market Operations in Response to the Weak
U.S. Economy.
• Open Market Operations in Response to the September
11 Attacks.
The Discount Rate
• The discount rate is the interest rate that banks pay
to the Fed to borrow from it.
• Bank borrowing from the Fed leads to an increase in
the money supply.
• The higher the discount rate, the higher the cost of
borrowing, and the less borrowing banks will want to
do.
The Required Reserve Ratio
• The required reserve ratio establishes a link
between the reserves of the commercial banks and
the deposits (money) that commercial banks are
allowed to create.
• If the Fed wants to increase the money supply, the
Fed can decrease the required reserve ratio, which
allows the bank to create more deposits by
making loans.
Tools of Monetary Policy Changing
the Reserve Requirements
• The Fed’s Ultimate Weapon, but rarely used
• Generally, the Fed has not changed reserve requirements but
once a decade or so
• The limits for checking deposits are between 8-14%
• Use of this tool would be perceived as a reaction to
extraordinary events
• Fed will be very cautious and publicize its intentions well in
advance
• Last time required reserves changed – 1980 – resulted in a
credit crunch that plunged the economy into the worst recession
since the Great Depression
Tools of Monetary Policy
Summary
• To Restrain the Economy
• Raise the Fed Funds and Discount Rates
• Sell U.S. Government Securities on the Open Market
 Declining Securities Values and Increasing Bond Yield Rates
• Raise the Reserve Requirements
• To Stimulate the Economy
• Lower the Fed Funds and Discount Rates
• Buy U.S. Government Securities on the Open Market
 Increasing Securities Values and Decreasing Bond Yield Rates
• Lower the Reserve Requirements
The Fed’s Effectiveness in Fighting
Inflation & Recession
• The Fed has a much harder time igniting the economic engine
• Although it is true, the Fed can lower interest rates, increase the
banks’ deposits, but . . .
• It cannot force a broke man (business) to borrow
• Good risks in prosperous times become poor risks in
recessionary times
• Fed ability to stimulate is often compared to the problem of
trying to push a string – no matter how much effort you give it,
it just doesn’t move much
Fed Tools for Regulating
the Money Supply
Global Monetary Policy
• A Single Eurozone Monetary Policy.
• Impact of the Euro on Monetary Policy.
• Variations in the Value of the Euro.
• Global Central Bank Coordination.
Conclusions
• Fiscal Policy and Monetary Policy should mesh
• Fed is given primary praise or criticism for
management of the economy, but
• The Fed is still only one set of variables in an ocean of
variables
• The direction of the economy itself must be considered
• New innovations, globalization, and demographics
create fundamental forces that weigh heavily on the
economy and its future
End of Chapter 4