The Federal Reserve System

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.

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 Clears checks between private 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.

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

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

Reserve Requirements Excess reserves. The money multiplier. A change in the reserve requirement causes changes 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 Bond sales by the Fed reduce the flow. 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. Likewise, when the Fed sells bonds, it removes money from the banking system.

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. 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.

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

The Fed Funds Rate Fed funds rate act as a market signal of the changing reserve flows. If the Fed is pumping more reserves into the banking system, the federal funds rate will decline. 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.

Is the Fed Losing Control?