The Federal Reserve System, Monetary Policy and Interest Rates Chapter 4

Federal Reserve Central bank of US Founded by Congress under Federal Reserve Act, 1913 Independent Decisions do not have to be ratified by President or any executive branch of US govt. Required to work under the overall objectives of economic and financial policies established by the US govt.

Functions of FRS 1. Conducting monetary policy controls the supply of money, to ensure price stability and general trust in the currency. 2. Supervising and regulating depository institutions 3. Maintaining the stability of the financial system stable financial system is one in which financial intermediaries, markets and market infrastructure facilitate the smooth flow of funds between savers and investors and, by doing so, help promote growth in economic activity 4. Providing payment and other financial services to the US govt., the public, financial institutions and foreign official institutions.

Objectives of Federal Reserve System (FRS) Economic growth in line with economy’s potential to expand High level of employment Stable prices Moderate long-term interest rates

Structure of FRS Federal Reserve System consists of 12 Federal Reserve Banks located in major cities throughout the United States and a seven-member Board of Governors located in Washington, D.C Carry out functions for the central banking system Depository for bank in the district

Structure of FRS Federal reserve banks under the general supervision of Board of governors of the Federal Reserve based in Washington D C Each bank has 9 member board of directors Six elected by member banks in the district – 3 of which professional bankers and 3 business men 3 appointed by the Federal Reserve Board of Governors who are prohibited from being employees, officers or stockholders of member banks

Structure of FRS Commercial banks that become members of FRS are required to buy stock in their Federal Reserve district bank Federal Reserve Banks are quasi public, part private, part govt. Stocks are not publicly traded Pays predetermined dividend at a maximum rate of 6%

Board of Governors of FRS Seven member board headquartered in Washington, DC President appoints and Senate confirms members to nonrenewable 14-year terms President appoints and Senate confirms Chairman and vice-chairman to renewable 4-year terms Formulates and conducts monetary policy and supervises and regulates banks

FEDERAL OPEN MARKET COMMITTIE committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks. FOMC consists of 12 members seven members of the Board of Governors the president of the Federal Reserve Bank of NY the presidents of four other Federal Reserve Banks (on a rotating basis) Chairman of the Board of Governors is the Chair of FOMC Required to meet at least 4 times each year

Federal Open Market Committee The main responsibilities of FOMC are to formulate policies seek to promote full employment, economic growth, price stability, and a sustainable pattern of international trade In each meeting of FOMC, Beige book is released Beige book contains information on current economic conditions by Federal Reserve district. FOMC accomplishes this by setting guidelines regarding open market operations.

Open market Operation Open market operation refers to the buying or selling of government securities in the open market in order to expand or contract the supply of money in the banking system, facilitated by the federal reserve. Purchase of securites inject money in the banking system and stimulate growth While sales of securites to the banks will shrink the fund that bank hold and contract the economy.

when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed. When the Federal Reserve’s purchase of Treasury securities has increased the total sup- ply of bank reserves in the financial system. This in turn increases the ability of banks to make new loans and create new deposits When that the Federal Reserve’s sale of Treasury or other government securities has decreased the total supply of bank reserves in the financial system. This in turn decreases the ability of banks to make loans and create new deposits.

Other Responsibilities Sets ranges for the growth of monetary aggregates Sets the federal funds rate Monitoring reserve requirements and discount rate

Some Functions performed by federal reserve banks Assistance in the conduct of monetary policy Primary responsibility of Federal Reserve System is to influence the monetary (and financial) condition in US financial markets and thus the economy. This process is done in several ways. 1. Federal Open Market Committee determines monetary policy with respect to the open market sale and purchase of government

Some Functions performed by federal reserve banks Assistance in the conduct of monetary policy 2. Set and change the discount rate (must be approved by the Board of Governors) Discount rate – interest rate on loans made by Federal Reserve Banks to depository institutions

Some Functions performed by federal reserve banks New currency issue Collection and replacement of currency from circulation Check clearing Central check clearing system for US banks Route interbank checks to depository institutions on which they are written Transfer the appropriate funds from one bank to another

Some Functions performed by federal reserve banks Wire transfer services Federal Reserve Banks and their member banks are linked electronically through Federal Reserve Communications Systems Allows transfer of funds and securities Research activities Gather, analyze and interpret economic data and developments in the banking sector as well as the economy

Balance Sheet of the Federal Reserve Liabilities. The major liabilities on the Fed’s balance sheet are currency in circulation and reserves currency in circulation: Currency in circulation is currency that is physically used to conduct transactions between consumers and businesses rather than stored in a bank. Reserve: Depository institutions’ vault cash plus reserves deposited at Federal Reserve Banks. Their sum is often referred to as the Fed’s monetary base or money base monetary base Currency in circulation and reserves (depository institution reserves and vault cash of commercial banks) held by the Federal Reserve. changes in these accounts are the major determinants of the size of the nation’s money supply

Liabilities 1.Reserves. All banks have an account at the Fed in which they hold deposits. Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes. an increase in reserves leads to an increase in the level of deposits and hence in the money supply. Total reserves can be classified into two categories: (1) required reserves reserves that the Fed requires banks to hold by law (2) excess reserves additional reserves over and above required reserves that banks choose to hold themselves Banks typically have low incentive to maintain excess reserves because cash earns the rate of return of zero. under normal circumstances, banks minimize their excess reserves and lend out money to clients rather than holding cash in their vaults. Bank reserves decrease during periods of economic expansion and increase during recessions.

Liabilities Required reserve a portion of customer transaction accounts Required reserve ratio expands or contracts with the level of transaction accounts and with the required reserve ratio set by Federal Reserve Banks typically have low incentive to maintain excess reserves because cash earns the rate of return of zero. under normal circumstances, banks minimize their excess reserves and lend out money to clients rather than holding cash in their vaults. Bank reserves decrease during periods of economic expansion and increase during recessions.

Liabilities - Reserves No interest Banks try to keep reserves to the minimum Excess reserves may be lent by banks to other banks that do not have sufficient reserves to meet their required level

Liabilities 2. Currency Outside Banks. The second largest liability, in terms of percent of total liabilities and equity, of the Federal Reserve System is currency in circulation

Monetary Policy Tools Banks with excess reserve held in the vault or on deposit at Federal Reserve earn no interest They lend overnight to banks who need reserve at fed funds rate for one day Fed funds rate: The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate which is used in the United States to guide monetary policy. The fed funds rate is a function of the supply and demand for federal funds among banks

Monetary Policy Monetary policy affects the macro economy by influencing the supply and demand for excess bank reserves influences the money supply and the level of short-term and long-term interest rates affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices

Assets The major assets on the Federal Reserve’s balance sheet are: Treasury and government agency (i.e., Fannie Mae, Freddie Mac) securities Treasury currency gold and foreign exchange

Assets U.S. Government Agency Securities. This account grew as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac

Assets Treasury Securities The Fed’s open market operations involve the buying and selling of these securi- ties. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply.

Assets Gold and Foreign Exchange and Treasury Currency: Treasury gold certificates redeemable for gold Loans to Domestic Banks depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window the Fed implemented changes to its discount window lending policy that increased the cost of discount window borrowing but eased the requirements on which depository institutions can borrow. As part of this change, the discount window rate was increased so that it would be higher than the fed funds rate

Discount Rate Discount rate is the rate Federal Reserve Banks charge on loans to depository institutions in their district The Federal Reserve rarely uses the discount rate as a policy tool changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general.

Discount Rate the Federal Reserve has rarely used the discount rate as a monetary policy tool for two reasons: First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. There is no guarantee that FIs will borrow more (less) at the discount window in response to a decrease (increase) in the discount rate. Thus, the exact direct effect of a discount rate change on the money supply is often uncertain.

Discount Rate Second because of its “signaling” importance, a discount rate change often has great effects on the financial markets. For example, the unexpected decrease in the Fed’s dis- count rate (to 0.50 percent) on December 16, 2008, resulted in a 359.61 point increase in the Dow Jones Industrial Average, one of the largest one-day point gains in the history

Monetary Policy Expansionary monetary policy open market purchases of securities by the Fed discount rate decreases reserve requirement ratio decreases Contractionary monetary policy open market sales of securities by the Fed discount rate increases reserve requirement ratio increases