1 Chapter 5 The Federal Reserve

2 The Federal Reserve (the Fed) The U.S. Central Bank I.The Role of the Federal Reserve System A.The purpose is to control the supply of money through Monetary Policy to achieve: 1. stable prices 2. Full employment 3. Economic growth a)Regulation of supply of credit b)Regulation of money in economy

3 The Federal Reserve (the Fed) B.Tools of monetary policy 1. Primary tool a) Open markets operations 2. Secondary tool a) Discount rate b) Reserve Requirements 3. Fed uses these tools to a) Expand/contract supply of money C.Easy monetary policy 1. Increase the supply of money/credit to expand income and unemployment D. Tight monetary policy 1. Contract the supply of money/credit to help fight inflation

4 The Federal Reserve (the Fed) E.Other Functions of the Fed 1. Supervises depository institutions a) Bank regulations b) Periodic examinations of banks c) Bank loans, expenses, earnings 2. Supervises check clearing 3. Serves as a depository institution a) Member banks b) US Treasury c) Foreign central banks 4. Changes the supply of money a) Reserves

5 Structure of the Federal Reserve A. Board of Governors 1. Controlling body of the Fed 2. Members are appointed by President of US 3. Confirmation from Senate year staggered term B. Districts Districts a) Federal Reserve Bank in each district 2. Managed by nine directors a) 3 of whom are appointed by Board of Governors C. Federal Open Market Committee (FOMC) 1. Part of the Fed that establishes and executes monetary policy

6 Structure of the Federal Reserve

7 D.Important components of the Federal Reserve System 1. Board of Governors a) Appoints three of the nine directors of district reserve banks b) Composes a majority of the FOMC c) Regulatory authority over commercial banks 2. District reserve banks 3. Member banks 4. Federal Open Market Committee (FOMC)

8 Structure of the Federal Reserve

9 Expansion of Money and Credit A. Bankers ability to lend comes from investors 1. Depositors 2. Creditors 3. Owners (CDs or bank stock) B. Process of loan creation 1. Cash is always deposited in a demand deposit 2. Banks hold no excess reserves a) All excess reserves are loaned out b) Must be a sufficient amount of borrowers to consume excess reserves C. Holding of Cash 1. Example, if I keep cash in my house and do not deposit it in a bank, I am interfering with the act of increasing money supply and credit

10 Expansion of Money and Credit D.Depositing of Cash 1. Example, if I deposit $100 and the reserve requirement is 10%, the bank must keep $10 on reserve, and the excess ($90) can be loaned out which will increase credit and money supply

11 Multiple Epansion of the Supply of Money New Demand Deposits Cumulative New Credit Cumulative Required Reserves Excess Reserves 1st bank$100.00$0.00$10.00$ nd bank rd bank Final round0$900.00$ Initial Dep: $100Reserve Req: 10%

12 Expansion of Money and Credit E.Lending 1. Example, if a bank grants a borrower a loan of $90, what effect does it have on the following? a) A depositor – No effect (1)The depositor can demand money at any time b) The bank (1) The bank acquires the asset (loan) and the liability of the demand deposit c) The borrower (1) The borrower acquires an asset (money) and the liability of paying back the bank

13 Cash Withdrawals and the Reduction in Reserves A. If a bank is low on reserves because of excessive withdrawals, the bank must somehow increase the diminished reserves B. Federal Funds Market 1. Market in which banks borrow and lend excess reserves 2. Short term borrowing 3. If a bank lacks sufficient reserves against deposits, it can borrow from a commercial bank 4. If a bank has excess reserves, it can loan the reserves to a bank that needs them

14 Cash Withdrawals and the Reduction in Reserves C.Federal Funds Rate 1. Interest rate charged by banks on overnight loans of reserves 2. Interest rate used when banks borrow from other banks 3. Established by the demand and supply of funds available in the federal funds market D. Discount Rate 1. The interest rate charged when banks borrow from the Federal Reserve 2. Federal Reserve sets the Discount Rate E. The supply of money and credit will contract if banks are not willing to borrow from the Federal Reserve

15 Federal Funds Rate

16 The Tools of Monetary Policy A. The reserves of commercial banks are an important component of the financial system B. The control of the supply of money rests with the Federal Reserve 1. It is through the impact on banks reserves that the Fed is able to affect interest rates and the economy

17 The Tools of Monetary Policy C.Three primary tools for affecting reserves 1. Reserve requirement 2. Discount rate 3. Open market operations D. Other Tools 1. Credit Controls a) Real Estate b) Consumer Loans 2. Margin Requirements

18 Reserve Requirement A. Maintaining reserves against deposit liabilities B. Any change in reserves alters a banks ability to lend C. Reserve requirements are rarely used as a monetary policy tool

19 Discount Rate A. A change in the discount rate will either stimulate increased borrowing or decrease the willingness to borrow B. The Fed may increase or decrease the Discount Rate… 1. They cannot force banks to borrow more or borrow less

20 Open Market Operations(OMO) A. Buying and selling of US Treasury securities by the Federal Reserve B. Alters the supply of money in circulation C. Alters the reserves of the banking system D. Fed does not directly buy and sell securities to the general public 1. Transactions are negotiated by private US government securities dealers

21 Open Market Operations(OMO) E.If the Fed wants to expand the supply of money… 1.Purchase securities F. If the Fed wants to contract the supply of money… 1. Sell securities

22 The Impact of Fiscal Policy on Credit Markets A. Fiscal Policy 1. Taxation, expenditures, and debt management by the Federal government B. Deficit 1.Disbursements exceeding receipts C. Surplus 1. Receipts exceeding disbursements

23 The Impact of Fiscal Policy on Credit Markets D. If the Federal government runs a deficit, it may obtain funds to finance the deficit by borrowing from: 1.General public 2.Banks 3.Federal Reserve 4.Foreign investors E. If the Federal government runs a surplus, it may retire debt held by: 1.General public 2.Banks 3.Federal Reserve 4.Foreign investors

24 Impact of an Inflationary Economic Environment on Credit Markets A. Inflation 1. General increase in prices with special emphasis on increases in consumer prices 2. Prices a) What consumers pay to obtain goods and services 3. General a) Does not mean that all prices are rising b) Prices of most goods and services are rising

25 Impact of an Inflationary Economic Environment on Credit Markets B.Consumer Price Index 1. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services C. Deflation 1. General decline in prices D. Recession 1. Period of at least six months of increased unemployment and negative economic growth