Chapter 4 Functions of the Fed Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline Organization of the Fed Monetary policy tools Impact of technical factors on funds Fed control of the money supply Monetary Control Act of 1980 Global monetary policy

Organization of the Fed The Fed has five major components: Federal Reserve district banks Member banks Board of Governors Federal Open Market Committee (FOMC) Advisory committees

Organization of the Fed (cont’d) Federal Reserve district banks There are 12 Federal Reserve district banks The NY bank is the most important Commercial banks that become members of the Fed must purchase stock in their district banks Pays a maximum dividend of 6% annually Each district bank has nine directors Six elected by member banks; three appointed by the Board of Governors The nine directors appoint the president of the district bank District banks clear checks, replace old currency, provide loans to depository institutions, and conduct research

Organization of the Fed (cont’d) Member banks All national banks are required to be members of the Fed State-chartered banks are not required to be members About 35% of all banks are members

Organization of the Fed (cont’d) Board of Governors The Board of Governors consists of seven members Each member is appointed by the President of the U.S. and confirmed by the Senate Members serve 14-year terms Reduces political pressure Terms are staggered so that one term expires in every even-numbered year Main roles: Regulate commercial banks Control monetary policy

Organization of the Fed (cont’d) Federal Open Market Committee (FOMC) The FOMC consists of the seven members of the Board of Governors plus the presidents of five Fed district banks NY plus four others on a rotating basis Goals: promote high employment, economic growth, and price stability Achieved through control of the money supply Decisions on changes in monetary policy are forwarded to the Trading Desk (Open Market Desk) at the NY Fed district bank

Organization of the Fed (cont’d) Advisory committees The Federal Advisory Council consists of one member from each district Makes recommendations to the Fed about economic and banking issues The Consumer Advisory Council consists of up to 30 members Represents the financial institutions industry and its consumers The Thrift Institutions Advisory Council consists of representatives of savings banks, S&Ls, and credit unions Offers views on issues specifically related to thrift institutions

Integration of Federal Reserve Components Board of Governors Regulates member banks and BHCs Sets reserve requirements Advisory Committee Federal Open Market Committee Conducts open market operations Supervision Federal Reserve District Banks Clear checks Replace old currency Provide loans to depository institutions

Monetary Policy Tools Open market operations The FOMC meets 8 times a year At each meeting, the target money supply growth level and interest rate level are determined FOMC meeting agenda Members receive the Beige Book two weeks prior to the meeting Meeting is attended by the Board of Governors, the 12 presidents of the district banks, and staff members Staff members begin with presentations about current economic conditions and recent economic trends Next, each FOMC member can offer recommendations about whether monetary growth and interest rate target levels should be changed Last, voting members vote on monetary policy and interest rates

Monetary Policy Tools (cont’d) Open market operations (cont’d) Communication to the Trading Desk The FOMC’s decision on target money supply levels is forwarded to the Trading Desk at the NY district bank through a policy directive FOMC objectives are specified in a target range for the money supply growth The FOMC also specifies a desired target for the federal funds rate The federal funds rate is the rate charged by banks on short-term loans to each other

Monetary Policy Tools (cont’d) Open market operations (cont’d) Role of the Trading Desk The manager of the Trading Desk instructs traders on the amount of government securities to buy or sell in the secondary market This is called open market operations The Trading Desk continuously conducts open market operations in response to ongoing changes in bank deposit levels

Monetary Policy Tools (cont’d) Open market operations (cont’d) Fed purchase of securities Traders at the Trading Desk call government securities dealers to purchase securities Dealers provide a list of securities for sale Traders purchase those that are most attractive The total funds of commercial banks increase by the dollar amount of securities purchased by the Fed A loosening of the money supply To force a decline in the Fed funds rate, the Trading Desk can also purchase Treasury securities The Fed funds rate will decline along with other interest rates

Monetary Policy Tools (cont’d) Open market operations (cont’d) Fed sale of securities To decrease the money supply, traders sell government securities to government securities dealers Sold to the dealer submitting the highest bid As dealers pay, their account balances are reduced and the total amount of funds at commercial banks is reduced A tightening of the money supply To force an increase in the Fed funds rate, the Trading Desk can also sell Treasury securities

Monetary Policy Tools (cont’d) Open market operations (cont’d) Fed use of repurchase agreements Used to increase the aggregate level of bank funds for only a few days The Trading Desk trades repurchase agreements rather than government securities Purchases Treasury securities with an agreement to sell back the securities at a specified date in the near future Often used during holidays to correct temporary imbalances

Monetary Policy Tools (cont’d) Open market operations (cont’d) How open market operations affect interest rates When the Fed uses open market operations to increase bank funds, interest rates are affected because: The fed funds rate may decline Banks with excess funds may offer new loans at a lower interest rate Banks may lower interest rates on deposits The yield on Treasury securities may decline

Monetary Policy Tools (cont’d) Open market operations (cont’d) How open market operations affect interest rates (cont’d) As yields on bank deposits and Treasuries decline, investors look for alternative securities The yields on the alternative investments will decline as more money is invested in them The reduction in yields on debt securities lowers the cost of borrowing for the issuers of debt securities Can encourage potential expenditures

Monetary Policy Tools (cont’d) Open market operations (cont’d) Dynamic vs. defensive open market operations Dynamic operations are implemented to increase or decrease the level of funds Defensive operations offset the impact of other conditions that affect the level of funds

Monetary Policy Tools (cont’d) Open market operations (cont’d) Open market operations in response to the Crash Stock prices declined by 22 percent on October 19, 1987 The Fed loosened the money supply to provide liquidity The Fed monitored bank deposits to ensure there was no run on deposits The Fed monitored credit relationships between commercial banks and securities firms Open market operations in response to the weak economy in 2001 The Fed increased money supply growth to stimulate the economy Businesses did not respond to lower interest rates

Monetary Policy Tools (cont’d) Open market operations (cont’d) Open market operations in response to the September 11 attack on the United States The FOMC decided to add liquidity to the banking system to prevent a banking crisis The FOMC left the federal funds rate target unchanged On September 17, the FOMC reduced the federal funds target rate by 50 basis points just before markets reopened

Monetary Policy Tools (cont’d) Adjusting the discount rate To increase the money supply, the Fed can authorize a reduction in the discount rate Encourages depository institutions to borrow from the Fed To decrease the money supply, the Fed can increase the discount rate Discouraged borrowing from the Fed

Monetary Policy Tools (cont’d) Adjusting the discount rate (cont’d) In January 2003 the Fed classified its loans as primary or secondary credit Primary credit can be used for any purpose but it available only to financially sound institutions Secondary credit is provided to banks that do not qualify for secondary credit Contains a risk premium above the discount rate

Monetary Policy Tools (cont’d) Adjusting the discount rate (cont’d) Recently, the Fed has often adjusted the discount rate to keep it in line with changes in the targeted federal funds rate In January 2003, the Fed set the discount rate at a level above the federal funds rate Loans from the Fed serve as a backup source of funds The discount rate no longer serves as a signal about the Fed’s monetary policy

Monetary Policy Tools (cont’d) Adjusting the reserve requirement ratio The reserve requirement ratio is the proportion of bank deposits that must be held as reserves Set by the Board of Governors Historically set between 8 and 12 percent Currently 10 percent of transaction accounts Sometimes changed to adjust the money supply A reduction increases the proportion of bank deposits that can be lent out

Monetary Policy Tools (cont’d) Adjusting the reserve requirement ratio (cont’d) How reserve requirement adjustments affect money growth An initial increase in demand deposits as a result of loosening the money supply multiplies into (1/reserve requirement ratio) A higher ratio causes an initial injection to multiply by a smaller amount

Monetary Policy Tools (cont’d) Comparison of monetary policy tools The most frequent monetary policy tool is open market operations Open market operations can be used without signaling the Fed’s intentions and can be easily reversed Adjustments in the discount rate only work if depository institutions respond to the adjustment Adjustments in the reserve requirement ratio can cause erratic shifts in the money supply

Impact of Technical Factors on Funds The volume of funds can change without the Fed’s intervention because of: Federal Reserve float The amount of checks credited to banks’ funds that have not yet been collected Currency in circulation Staff at the NY Fed and the Board of Governors provide daily forecasts of how technical factors will affect the level of funds

Fed Control of the Money Supply The Fed must decide what form of money to manipulate The optimal form of money should: Be controllable by the Fed Have a predictable impact on economic variables

Fed Control of the Money Supply (cont’d) M1 includes currency held by the public and checking deposits M1 is the most narrow form of money M2 includes everything in M1 plus savings accounts and small time deposits, money market deposit accounts (MMDAs), and other items M3 includes everything in M2 plus large time deposits and other items

Fed Control of the Money Supply (cont’d) Limitations of controlling money supply It may be difficult for the Fed to simultaneously control money supply growth and the federal funds rate In October 1979 it focused primarily on the money supply In the last several years, the Fed focused on maintaining the federal funds rate within a narrow target range In 2000, the Fed reduced its focus on the use of specific money supply target ranges M2 remains in the Index of Leading Economic Indicators

Monetary Control Act of 1980 The Depository Institutions Deregulations and Monetary Control Act (DIDMCA) of 1980 had two objectives: To deregulate some aspects of the depository institutions industry To enhance the Fed’s ability to control the money supply

Monetary Control Act of 1980 (cont’d) DIDMCA mandates that all depository institutions be subject to the same reserve requirements imposed by the Fed Applies to member and nonmember banks All depository institutions must report their deposit levels promptly to the Fed Improves the Fed’s knowledge of the current level of deposits in the banking system DIDMCA allowed all depository institutions that offer transaction accounts to have access to the discount window

Global Monetary Policy Central banks of other countries use open market operations, reserve requirement adjustment, and adjustments in the interest rate they charge on loans The Fed must consider economic conditions in other major countries when assessing the U.S. economy Coordinating monetary policy may be difficult because of conflicts of interest

Global Monetary Policy (cont’d) A single Euro zone monetary policy On June 1, 2002, the euro replaced the currencies of 12 European countries The European Central Bank (ECB) sets monetary policy for all participating countries Objective is to control inflation and to stabilize the value of the euro Impact of the euro on monetary policy The interest rate offered on government securities must be similar across participating countries The euro prevents any single country from using a unique monetary policy

Global Monetary Policy (cont’d) Global central bank coordination Sometimes central banks of various countries coordinate efforts for a common cause After September 11, 2001, central banks of various countries injected money into the banking system to provide more liquidity On September 17, 2001, several central banks reduced their interest rates Sometimes central banks have conflicting objectives If two countries attempt to weaken their currencies simultaneously, the exchange rate is subject to conflicting forces