The Federal Reserve System Chapter 14

Introduction This chapter addresses the following: How does government control the amount of money in the economy? Which government agency is responsible for exercising this control? How are banks and bond markets affected by the government’s policies?

Introduction The government must regulate bank lending if it wants to control the amount of money in the economy.

Introduction The fed’s control over the supply of money is the key mechanism of monetary policy. Monetary policy is the use of money and credit controls to influence macroeconomic activity.

Structure of the Fed A series of bank failures resulted in a severe financial panic in 1907 – millions of depositors lost their savings. Congress passed the Federal Reserve Act in 1913 to avert recurrent financial crises.

Federal Reserve Banks Each of the twelve (12) Federal Reserve banks act as a central banker for the private banks in their region.

Federal Reserve Banks The Federal Reserve performs the following services: Clears checks between private banks Holds bank reserves. Provides currency to the public. Provides loans to private banks.

The Board of Governors The Fed is controlled by a seven person Board of Governors. Each governor is appointed to a 14-year term by the President (with confirmation by the U.S. Senate).

The Board of Governors The long term is intended to give the Fed a strong measure of political independence. The President selects one of the governors to serve as chairman for a 4-year term.

The Federal Open Market Committee (FOMC) The FOMC is a twelve member group (the seven governors along with five of the 12 regional Reserve bank presidents).

The Federal Open Market Committee (FOMC) The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes.

Structure of the Federal Reserve System Private banks (depository institutions) Federal Reserve banks (12 banks, 24 branches) Board of Governors (7 members) Federal Open Market Committee (12 members) Federal Advisory Council and other committees

Monetary Tools The Federal Reserve controls the money supply using the following three policy instruments: Reserve requirements Discount rates Open-market operations

Monetary Tools The money supply (M1) includes currency held by the public, plus balances in transactions accounts. The M2 money supply includes M1 plus balances in most savings accounts and money market mutual funds.

Required reserves = required reserve ratio X total deposits Reserve Requirements The Fed requires banks to keep a minimum amount of required reserves. Required reserves – The minimum amount of reserves a bank is required to hold; equal to required reserve ratio times transactions deposits. Required reserves = required reserve ratio X total deposits

Reserve Requirements The fed directly alters the lending capacity of the banking system by changing the reserve requirement.

Excess reserves = Total reserves – Required reserves Reserve Requirements By changing the reserve requirement, the Fed changes the level of excess reserves in the banking system. Excess reserves are bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves

Reserve Requirements The money multiplier determines how much in additional loans the banking system can make based on their excess reserves. Available lending capacity of the banking system = excess reserves X money multiplier

Reserve Requirements The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves. It is equal to 1 ÷ required reserve ratio.

Reserve Requirements By raising the required reserve ratio, the Fed can immediately reduce the lending capacity of the banking system.

Reserve Requirements A change in the reserve requirement causes c change in: Excess reserves. The money multiplier. The lending capacity of the banking system.

Impact of an Increased Reserve Requirement

The Discount Rate Excess reserves earn no interest. Banks have a tremendous profit incentive to keep their reserves as close to their required reserve level as possible.

Excess Reserves and Borrowings 7 1930 4 3 2 1 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Borrowings at Federal Reserve banks Excess reserves

The Federal Funds Market The federal funds market is where a bank that finds itself short of reserves can turn to other banks for help. The federal funds rate is the interest rate for inter-bank reserve loans.

The Federal Funds Market Reserves borrowed in this manner are called “federal funds” and are lent for short periods - usually overnight.

Sale of Securities A bank that is low on reserves can also sell securities. Banks use some of their excess reserves to purchase government bonds.

Discounting Discounting refers to the Federal Reserve lending of reserves to private banks. A bank can deal with a reserve shortage by going to the Fed’s “discount window” to borrow reserves directly.

Discounting The discount rate is the rate of interest the Federal Reserve charges for lending reserves to private banks.

Discounting By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

Open-Market Operations Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

Portfolio Decisions The portfolio decision is the choice of how (where) to hold idle funds. People do not hold all their idle funds in transactions accounts or cash.

Hold Money or Bonds The Fed’s open-market operation focus on the portfolio choices people make. The Fed attempts to influence the choice by making bonds more or less attractive, as circumstances warrant.

Hold Money or Bonds When the Fed buys bonds from the public, it increases the flow of deposits (reserves) to the banking system. Bond sales by the Fed reduce the flow.

Open Market Operations The Fed The Public Banks Buyers spend account balances Fed SELLS bonds Open market operations Reserves decrease Sellers deposit bond proceeds Reserves increase Fed BUYS bonds

The Bond Market Not all of us buy and sell bonds, but a lot of consumers and corporations do.

The Bond Market A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment. It is nothing more than an IOU.

The Bond Market Like other markets, the bond market exists whenever and however bond buyers and sellers get together.

Bond Yields The current yield paid on a bond is the rate of return on a bond. It is the annual interest payment divided by the bond’s price.

Bond Yields A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields.

Open Market Activity The less you pay for a bond, the higher its yield. Federal Reserve open-market activity alters the price of bonds, and their yields. By doing so, the Fed makes bonds a more or less attractive alternative to holding money.

Open Market Activity Open market operations are Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves.

Open-Market Purchases If the Fed offers to pay a higher price for bonds, it will effectively lower bond yields and market interest rates. By buying bonds, the Fed increases bank reserves.

Open-Market Purchases Regional Federal Reserve bank Federal Open Market Committee Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check Step 3: Bank deposits check at Fed bank, as a reserve credit Private bank Public Step 2: Bond seller deposits Fed check

Open-Market Sales By selling bonds, the Fed reduces bank reserves.

The Fed Funds Rate Fed funds rate act as a market signal of the changing reserve flows.

The Fed Funds Rate If the Fed is pumping more reserves into the banking system, the federal funds rate will decline.

The Fed Funds Rate If the Fed is reducing bank reserve by selling bonds, the federal funds rate will increase.

Volume of Activity The volume of trading in U.S. government securities exceeds $100 billion per day. Each dollar in reserves represents approximately $10 in potential lending due to the money multiplier.

Increasing the Money Supply To increase the money supply, the Fed can: Lower reserve requirements. Reduce the discount rate. Buy bonds.

Lowering Reserve Requirements This will increase the banking system’s excess reserves with which they will increase the money supply through deposit creation (loans).

Lowering the Discount Rate This makes the cost of borrowing reserves from the Federal Reserve cheaper for banks. The new borrowed (excess) reserves will be used to make more loans - thus increasing the money supply.

Lowering the Discount Rate The effectiveness of lowering the discount rate depends primarily on the difference in the new discount rate and the rate that banks charge their loan customers.

Buying Bonds By purchasing bonds, the Fed places money in bank reserves (via bond sellers). The banks will then increase the money supply even more through additional loans.

Federal Funds Rate When market interest rates fall due to Fed bond purchases, individual banks have an incentive to borrow any excess reserves available to increase loan creation.

Decreasing the Money Supply To reduce the money supply, the Fed can: Raise reserve requirements. Increase the discount rate. Sell bonds.

Is the Fed Losing Control? The Fed’s control over the money supply is far from complete.

Monetary Control Act Before 1980, the Fed’s control of the money supply was not only incomplete - it was weakening.

Monetary Control Act Only one-third of all commercial banks were members of the Federal Reserve System and subject to its regulations.

Monetary Control Act Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980.

Monetary Control Act The principal objectives of the Act were: The Monetary Control Act subjected all commercial banks, S&Ls, savings banks and most credit unions to Fed regulation. To extend the Fed’s control of the money supply. To encourage greater competition in the banking industry.

Decline of Traditional Banks As the Fed’s control of the banks was increasing, the banks themselves were declining in importance due to competition from “non-bank” financial institutions.

Decline of Traditional Banks Thirty percent of all consumer loans are now made through credit cards. Insurance companies and pension funds also make loans.

Decline of Traditional Banks Foreign banks, corporations, and pension funds may also extend credit to American businesses.

Focus on Fed Funds Rate, not Money Supply The Fed has shifted from money-supply targets to interest targets.

The Federal Reserve System End of Chapter 14