1. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Reserve System Chapter 14

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure of the Fed The government must regulate bank lending if it wants to control the amount of money in the economy. If the Federal Reserve didn’t exist, the supply of money would be determined by individual banks.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Reserve Banks The Federal Reserve was created in 1913 to avert recurrent financial crises. Each of the twelve (12) Federal Reserve banks act as a central banker for the private banks in their region.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Reserve 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.

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 President selects one of the governors to serve as chairman for a 4-year term.

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Open Market Committee (FOMC) The FOMC is a twelve member group (the seven governors along with five of the 12 regional Reserve bank presidents). The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes.

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure of the Federal Reserve System Private banks (depository institutions) Federal Reserve banks (12 banks, 25 branches) Board of Governors (7 members) Federal Open Market Committee (12 members) Federal Advisory Council and other committees

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Tools The Federal Reserve controls the money supply using the following three policy instruments: –Reserve requirements –Discount rates –Open-market operations

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Tools The money supply (M1) includes currency held by the public, plus balances in transactions accounts. The M2 money supply includes M1 plus balances in most savings accounts and money market mutual funds.

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements The money multiplier determines how much in additional loans the banking system can make based on their excess reserves.

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves. It is equal to 1 ÷ required reserve ratio.

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements By raising the required reserve ratio, the Fed can immediately reduce the lending capacity of the banking system.

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements A change in the reserve requirement causes c change in: –Excess reserves. –The money multiplier. –The lending capacity of the banking system.

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Impact of an Increased Reserve Requirement

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves and Borrowings Excess Reserves Borrowings at Federal Reserve banks

19. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Funds Market Reserves borrowed by one bank from another are called federal funds. Federal funds are lent for short periods, usually overnight. The federal funds rate is the interest rate for inter-bank reserve loans.

20. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

21. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Discounting Discounting refers to the Federal Reserve lending of reserves to private banks. The discount rate is the rate of interest the Federal Reserve charges for lending reserves to private banks.

22. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Discounting By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

23. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Open-Market Operations Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

24. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

25. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

26. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Hold Money or Bonds 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.

27. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Open Market Operations Open market operations Fed BUYS bonds Buyers spend account balances Sellers deposit bond proceeds Fed SELLS bonds Reserves decrease Reserves increase

28. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bond Market A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment. The bond market exists whenever and however bond buyers and sellers get together.

29. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

30. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Bond Yields A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields. The less you pay for a bond, the higher its yield.

31. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Open Market Activity Open market operations are Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves. Federal Reserve open-market activity alters the price of bonds, and their yields.

32. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

33. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Open-Market Purchases Federal Open Market Committee Regional Federal Reserve bank Private bank Step 2: Bond seller deposits Fed check Step 3: Bank deposits check at Fed bank, as a reserve credit Public Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check

34. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Open-Market Sales By selling bonds, the Fed reduces bank reserves.

35. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Fed Funds Rate 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.

36. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

37. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Increasing the Money Supply To increase the money supply, the Fed can: –Lower reserve requirements. –Reduce the discount rate. –Buy bonds.

38. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Lowering Reserve Requirements This will increase the banking system’s excess reserves with which they will increase the money supply through deposit creation (loans).

39. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Lowering the Discount Rate This makes the cost of borrowing reserves from the Federal Reserve cheaper for banks. The new borrowed (excess) reserves will be used to make more loans - thus increasing the money supply.

40. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Buying Bonds By purchasing bonds, the Fed places money in bank reserves (via bond sellers). The banks will then increase the money supply even more through additional loans.

41. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Funds Rate When market interest rates fall due to Fed bond purchases, individual banks have an incentive to borrow any excess reserves available to increase loan creation.

42. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Decreasing the Money Supply To reduce the money supply, the Fed can: –Raise reserve requirements. –Increase the discount rate. –Sell bonds.

43. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Is the Fed Losing Control? The Fed’s control over the money supply is far from complete.

44. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Control Act Before 1980, the Fed’s control of the money supply was not only incomplete - it was weakening. Only one-third of all commercial banks were members of the Federal Reserve System and subject to its regulations.

45. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Control Act The principal objectives of the Depository Institutions Deregulation and Monetary Control Act of 1980 are: –To extend the Fed’s control of the money supply. –To encourage greater competition in the banking industry.

46. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Decline of Traditional Banks As the Fed’s control of the banks was increasing, the banks themselves were declining in importance due to competition from “non-bank” financial institutions.

47. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Focus on Fed Funds Rate, not Money Supply The Fed has shifted from money-supply targets to interest targets. The Fed will continue to use the federal funds rate as its primary barometer of monetary policy.

48. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Reserve System End of Chapter 14