Chapter 3

The Federal Reserve System (FED)

The Beginning Severe nationwide financial panics led

Congress to pass the Federal Reserve Act in 1913, setting up the Federal Reserve System.

The Federal Reserve Act divided the United States into 12 Federal Reserve districts, each of which has a Federal Reserve Bank in one city to conduct discount lending.

Formal Structure The Federal Reserve System (Fed) is the

central bank of the United States (created by Congress in 1913) that regulates the banking system and determines monetary policy. The original purpose of the Fed was to provide an elastic currency and to act as lender of last resort. The Banking Reform Acts of 1933 and 1935 broadened the powers of the Fed to promote the overall health and stability of the economy.

Functions of the FED Bank’s Bank

Lender of the last resort Conducts monetary policy Supervises, examines and regulates the

financial system Provides financial services

Issues new currency and clears checks U.S. Governments bank

Organization Federal Reserve Banks

Facts Each district bank has a board of directors

consisting of three bankers (Class A directors), three leaders in industry, commerce, and agriculture (Class B directors), and three public interest directors (Class C directors).

Class A and B directors are elected by member banks and Class C directors are appointed by the Fed’s Board of Governors.

Subject to the Board’s approval, the nine directors of a Federal Reserve Bank elect the president of that bank.

The 12 Federal Reserve banks carry out duties related to the Fed’s roles in the payments system, monetary control, and financial regulation.

12 Districts each has branches

Each has 9 directors who appoint a President

Each has an advisory Board of 9 members 3 from the local banking community 3 from local community 3 from the local community chosen by the

Board of Governors in Washington New York is the most important 5 Serve on the FOMC

New York and 4 others

Functions: Day to day operations Issues new currency Evaluates mergers and applications Collects data within their districts Conducts research Conducts monetary policy Appoints commercial bankers to sit on the Federal

Advisory Council Bank’s Bank

Collects and Clears checks Automated Clearing house Fedwire Makes loans to banks in their districts Examines banks

U.S. Governments bank

Member banks (3000 of 8178 commercial banks)

All national banks must be members State banks may join All banks and depository institutions

(20000) (as of 1987) must hold reserves in the FED and follow the rules

Board of Governors Seven members appointed by the President and

confirmed by the Senate to 14 year terms Chairman – second most important person in the world

Term is for 4 years (as is the vice chairman) Establish monetary policy

Sets Reserve Requirement – percentage of deposits that must be held in the FED

Set Discount Rate Determines and reviews discount rates and policy

Sits on FOMC Determines Open Market Operations – buying and

selling securities to the banks Determines Federal Funds Rate

Appoints 3 directors to the district banks

Federal Open Market Committee Meets 8 times a year- about every 6 weeks

Directs open market operations The meeting

Boardroom on the second floor of the BOG in Washington

9:00 am on Tuesday Attendance Agenda Go through “the books” Discuss the target (FFR) and goals (full employment,

price stability and economic growth Discuss the state of the economy Votes on policy Announcement 2:15 ET (Tuesday or Wednesday)

Issues FOMC Directive – written instructions to the Head of the Trading Desk of the New York District Bank

The Books Green – 2 year forecast Blue – Monetary aggregates Beige – Produced by the districts

Covers conditions in each district and overall economic conditions

Policy Tools Open Market Operations (the buy and selling of government

securities to change reserves): are the most important monetary policy tool. They are executed by the New York Fed.

Discount Rate: Changes in the primary credit rate and the secondary credit rate (the rates depository institutions are charged to borrow reserves from the Fed) are a highly publicized but less important monetary policy tool. Increases (decreases) in the discount rate raise (lower) the cost of borrowing reserves from the Fed. In recent years, the primary credit rate has been set one percent above another key short-term rate on which the Fed exerts a great deal of influence and the secondary credit rate one and a half percent higher.

Reserve Requirement: The Fed may also change the required reserve ratio (the fraction of deposit liabilities which must be held as required reserves). The ratio is increased to limit depository institution’s ability to make more loans. The ratio is decreased to allow depository institutions to make more loans.

The Fed does not use this tool often but rather relies more heavily on open market operations to change reserves.

Informal Structure Independent of the government Still under political pressure because

Congress, which writes the laws, can change its mind at any time

Members are driven by their power and prestige

Chairman has a lot of power Says it acts in the public interest

Independence of the FED For

Must remain unbiased Must look to the long run not short run of

politics Against

Undemocratic to allow and unsupervised and unaccountable organization

Makes it difficult to coordinate fiscal and monetary policy

The political issue of the Fed’s independence arises because of the public’s negative reaction to Fed policy.

The main argument for Fed independence is that monetary policy is too important and technical to be determined by politicians.

Opponents of Fed independence claim that in a democracy elected officials should make public policy.