Ch. 13: The Federal Reserve System Del Mar College John Daly ©2003 South-Western Publishing, A Division of Thomson Learning

The Federal Reserve System There are 12 Federal Reserve Districts; each District has a Federal Reserve Bank with its own president.

The Fed’s Structure There is a seven-member board of governors that coordinates and controls the activities of the Federal Reserve System. Each governor serves a fourteen year term. A governor is appointed every other year, so no one president can “stack” the Fed. The major policy making group within the Fed is the Federal Open Market Committee. Open Market Operations is the buying and selling of government securities by the Fed.

Functions of the Federal Reserve System Control the Money Supply. Supply the economy with paper money. Provide check- clearing services. Hold depository institutions’ reserves.

Functions of The Federal Reserve System Supervise Member Banks Serve as the government’s banker Serve as the lender of last resort Serve as a fiscal agent for the Treasury.

The Check-Clearing Process

Q & A The president of which Federal Reserve District Bank holds a permanent seat on the Federal Open Market Committee (FOMC)? What is the most important responsibility of the Fed? What does it mean to say the Fed acts as “lender of last resort”?

Fed Tools For Controlling the Money Supply: Open Market Operations The main “thing” the Fed buys and sells is U.S. government securities, which are bonds the government originally sold to investors when it needed to borrow funds. The Fed buys and sells such securities in the financial market, it is said to be engaged in open market operations.

Open Market Purchases Consider an open market purchase of government securities by the Fed. The Fed receives the securities from a bank, and the bank’s reserves increase by the amount the purchase (remember Reserves = Bank deposits at the Fed + Vault Cash). When the banks have a reserve increase and no other bank has a similar decline, the money supply expands through a process of increased loans and checkable deposits.

Open Market Sales Open market sales refer to Fed sales of government securities to banks and others. In one of these sales, a bank buys securities from the Fed and the money is taken from the reserves of the bank. This decreases the money supply by having the bank reduce total loans outstanding, which reduces the total volume of checkable deposits and money in the economy.

Open Market Operations

The Required-Reserve Ratio The Fed can also influence the money supply by changing the required-reserve ratio. An increase in the required-reserve ratio leads to a decrease in the money supply, and a decrease in the required-reserve ratio leads to an increase in the money supply.

The Discount Rate There are two major places a bank can go to acquire a loan: the federal funds market or the Fed. The bank will pay an interest rate for this loan, and the rate it pays for the loan in the federal funds market is the federal funds rate. The rate it pays for the loan from the Fed is called the discount rate. When a bank borrows money from the Fed’s discount window, its reserves increase while the reserves of no other bank decrease; meaning, the money supply increases.

The Spread Between the Discount Rate and the Federal Funds Rate The bank may borrow from the higher Federal Funds Rate. Here are some reasons why: 1.The bank may know that the Fed is hesitant to extend loans to banks that want to take advantage of profit- making opportunities. 2.The bank doesn’t want to deal with the Fed bureaucracy that regulates it, particularly if Fed officials interpret a request for a loan as mismanagement. 3.The bank realizes that acquiring a loan from the Fed is a privilege and not a right, and doesn’t want to abuse the privilege.

Discount Rate Vs. Federal Funds Rate If the discount rate is significantly lower than the federal funds rate, most banks will borrow from the Fed. An increase in the discount rate relative to the federal funds rate reduces bank borrowings from the Fed.

Which Tool Does the Fed Prefer to Use? The Fed can use open market operations, the required-reserve ratio, or the discount rate to influence the money supply. The Fed prefers to us Open Market Operations. Open market operations are flexible Open market operations can be reversed Open market operations can be implemented quickly

Fed Monetary Tools & their Effects on the Money Supply

Q & A What is the difference between the federal funds rate and the discount rate? If bank A borrows $10 million from bank B, what happens to the reserves in bank A? In the banking system? If bank A borrows $10 million from the Fed, what happens to the reserves in bank A? In the banking system?