Chapter 4: Functions of the Fed.

1-2

Chapter 4: Functions of the Fed.

Chapter Outline:

• Organization of the Fed.

• Monetary Policy Tools.

• Global Monetary Policy.

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 theFederal 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 Regulatingthe 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