The Federal Reserve and Monetary Policy

Structure of the Federal Reserve 1.Board of Governors – Located in Washington, DC – 7 members appointed by the president & approved by the Senate – 14 year terms – Chair must be reappointed every 4 years (and most often is)

Copy and answer: Why are members of the Board of Directors appointed for such long terms? (HINT: Think about Supreme Court Justices!)

Structure of the Federal Reserve 2.Twelve Federal Reserve Banks – Each serves a different region (Federal Reserve district) – Serve the supervisory role for that district – Each has its own board of directors chosen from bankers and businesspeople in that region – NY Federal Reserve Bank carries out the Fed’s open-market operations

Copy and answer: Decisions about monetary policy are made by the Federal Open Market Committee, which consists of: the Board of Governors the New York Fed president Four other regional bank presidents (rotating) Why don’t other members of the government serve on this committee? (HINT: Consider the reasons for the “pseudo- governmental nature of the Fed!)

Functions of the Federal Reserve 1.Provide Financial Services – “Banker’s bank” that holds reserves, clears checks, provides cash, and transfers funds for commercial banks – Also acts as banker and fiscal agent for the U.S. government and other large institutions; in fact, the U.S. Treasury’s checking account is with the Fed!

Functions of the Federal Reserve 2.Supervise & Regulate the Banking System – The regional Federal Reserve banks examine and regulate commercial banks in their district, ensuring their compliance with laws – including those regarding reserve requirements – The Board of Governors provides overall supervision of the system

Functions of the Federal Reserve 3.Maintain Stability of the Financial System – The Fed is charged with maintaining a safe and stable monetary and financial system – As part of this function, the Fed provides liquidity to financial institutions through loans (discount window) that ensure soundness

Functions of the Federal Reserve 4.Conduct Monetary Policy – Utilizes reserve requirements, discount rate, and open-market operations to control the monetary base (and therefore, the money supply and interest rates) – The most popular tool of monetary policy is open- market operations

Tools of Monetary Policy 1.Reserve Requirements – Banks that fail to maintain reserve requirements on average for a two-week period face penalties – Banks borrow from other banks with excess reserves at the federal funds rate, which is determined by supply and demand in the fed funds market – Fed hasn’t made significant change to the reserve requirement since 1992

Copy and answer: How would changes to the reserve requirement tighten or loosen the money supply?

Tools of Monetary Policy 2.Discount Rate – Banks can borrow from the Fed via the discount window – The discount rate is the rate the Fed charges, and it is normally set 1% above the fed funds rate to discourage use of Fed funds (and encourage interbank lows)

Copy and answer: How would changes to the discount rate (i.e., reducing the gap between the fed funds rate and discount rate to just.25% as the Fed did in 2008) tighten or loosen the money supply?

Tools of Monetary Policy 3.Open-Market Operations – The Fed has assets and liabilities AssetsLiabilities Government debtMonetary base (Treasury bills – short term(Currency in circulation + govt bonds of less than 1 yr.)bank reserves) – Fed buys or sells Treasury bills, usually through commercial banks – Credits the commercial banks’ Fed reserve account with the value of T-bills it purchased (in purchases) or debits the banks’ account (in sales)

Copy and answer: How would open-market operations tighten or loosen the money supply?

Fed Policy Actions All Fed policy actions impact the monetary base, but have impacts on the money supply and interest rates All Fed policy actions are aimed at obtaining a target interest rate For open-market transactions, money credited to banks’ reserve accounts is simply “created” – increasing the monetary base

Copy and answer: Why is it important to factor in the money multiplier when we consider the impact of Fed policy actions? Does it apply to the use of all three tools?