1. The Federal Reserve System, Monetary Policy and Interest Rates
Chapter 4

2. Federal Reserve Central bank of US
Founded by Congress under Federal Reserve Act, 1913
Independent
Decisions do not have to be ratified by President or any executive branch of US govt.
Required to work under the overall objectives of economic and financial policies established by the US govt.

3. Functions of FRS 1. Conducting monetary policy
controls the supply of money, to ensure price stability and general trust in the currency.
2. Supervising and regulating depository institutions
3. Maintaining the stability of the financial system
stable financial system is one in which financial intermediaries,
markets and market infrastructure facilitate the smooth flow of funds between savers and investors and, by doing so, help promote growth in economic activity
4. Providing payment and other financial services to the US govt., the public, financial institutions and foreign official institutions.

4. Objectives of Federal Reserve System (FRS)
Economic growth in line with economy’s potential to expand
High level of employment
Stable prices
Moderate long-term interest rates

5. Structure of FRS
Federal Reserve System consists of 12 Federal Reserve Banks located in major cities throughout the United States and a seven-member Board of Governors located in Washington, D.C
Carry out functions for the central banking system
Depository for bank in the district

6. Structure of FRS
Federal reserve banks under the general supervision of Board of governors of the Federal Reserve based in Washington D C
Each bank has 9 member board of directors
Six elected by member banks in the district – 3 of which professional bankers and 3 business men
3 appointed by the Federal Reserve Board of Governors who are prohibited from being employees, officers or stockholders of member banks

7. Structure of FRS
Commercial banks that become members of FRS are required to buy stock in their Federal Reserve district bank
Federal Reserve Banks are quasi public, part private, part govt.
Stocks are not publicly traded
Pays predetermined dividend at a maximum rate of 6%

8. Board of Governors of FRS
Seven member board headquartered in Washington, DC
President appoints and Senate confirms members to nonrenewable 14-year terms
President appoints and Senate confirms Chairman and vice-chairman to renewable 4-year terms
Formulates and conducts monetary policy and supervises and regulates banks

9. FEDERAL OPEN MARKET COMMITTIE
committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
FOMC consists of 12 members
seven members of the Board of Governors
the president of the Federal Reserve Bank of NY
the presidents of four other Federal Reserve Banks (on a rotating basis)
Chairman of the Board of Governors is the Chair of FOMC
Required to meet at least 4 times each year

10. Federal Open Market Committee
The main responsibilities of FOMC are to formulate policies seek to promote full employment, economic growth, price stability, and a sustainable pattern of international trade
In each meeting of FOMC, Beige book is released
Beige book contains information on current economic conditions by Federal Reserve district.
FOMC accomplishes this by setting guidelines regarding open market operations.

11. Open market Operation
Open market operation refers to the buying or selling of government securities in the open market in order to expand or contract the supply of money in the banking system, facilitated by the federal reserve.
Purchase of securites inject money in the banking system and stimulate growth
While sales of securites to the banks will shrink the fund that bank hold and contract the economy.

12. when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed.
When the Federal Reserve’s purchase of Treasury securities has increased the total sup- ply of bank reserves in the financial system. This in turn increases the ability of banks to make new loans and create new deposits
When that the Federal Reserve’s sale of Treasury or other government securities has decreased the total supply of bank reserves in the financial system. This in turn decreases the ability of banks to make loans and create new deposits.

13. Other Responsibilities
Sets ranges for the growth of monetary aggregates
Sets the federal funds rate
Monitoring reserve requirements and discount rate

14. Some Functions performed by federal reserve banks
Assistance in the conduct of monetary policy
Primary responsibility of Federal Reserve System is to influence the monetary (and financial) condition in US financial markets and thus the economy.
This process is done in several ways.
1. Federal Open Market Committee determines monetary policy with respect to the open market sale and purchase of government

15. Some Functions performed by federal reserve banks
Assistance in the conduct of monetary policy
2. Set and change the discount rate (must be approved by the Board of Governors)
Discount rate – interest rate on loans made by Federal Reserve Banks to depository institutions

16. Some Functions performed by federal reserve banks
New currency issue
Collection and replacement of currency from circulation
Check clearing
Central check clearing system for US banks
Route interbank checks to depository institutions on which they are written
Transfer the appropriate funds from one bank to another

17. Some Functions performed by federal reserve banks
Wire transfer services
Federal Reserve Banks and their member banks are linked electronically through Federal Reserve Communications Systems
Allows transfer of funds and securities
Research activities
Gather, analyze and interpret economic data and developments in the banking sector as well as the economy

18. Balance Sheet of the Federal Reserve
Liabilities.
The major liabilities on the Fed’s balance sheet are currency in circulation and reserves
currency in circulation: Currency in circulation is currency that is physically used to conduct transactions between consumers and businesses rather than stored in a bank.
Reserve: Depository institutions’ vault cash plus reserves deposited at Federal Reserve Banks.
Their sum is often referred to as the Fed’s monetary base or money base
monetary base
Currency in circulation and reserves (depository institution reserves and vault cash of commercial banks) held by the Federal Reserve.
changes in these accounts are the major determinants of the size of the nation’s money supply

19. Liabilities
1.Reserves.
All banks have an account at the Fed in which they hold deposits.
Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes.
an increase in reserves leads to an increase in the level of deposits and hence in the money supply.
Total reserves can be classified into two categories:
(1) required reserves reserves that the Fed requires banks to hold by law
(2) excess reserves additional reserves over and above required reserves that banks choose to hold themselves
Banks typically have low incentive to maintain excess reserves because cash earns the rate of return of zero.
under normal circumstances, banks minimize their excess reserves and lend out money to clients rather than holding cash in their vaults.
Bank reserves decrease during periods of economic expansion and increase during recessions.

20. Liabilities
Required reserve a portion of customer transaction accounts
Required reserve ratio expands or contracts with the level of transaction accounts and with the required reserve ratio set by Federal Reserve
Banks typically have low incentive to maintain excess reserves because cash earns the rate of return of zero.
under normal circumstances, banks minimize their excess reserves and lend out money to clients rather than holding cash in their vaults.
Bank reserves decrease during periods of economic expansion and increase during recessions.

21. Liabilities - Reserves
No interest
Banks try to keep reserves to the minimum
Excess reserves may be lent by banks to other banks that do not have sufficient reserves to meet their required level

22. Liabilities
2. Currency Outside Banks. The second largest liability, in terms of percent of total liabilities and equity, of the Federal Reserve System is currency in circulation

23. Monetary Policy Tools
Banks with excess reserve held in the vault or on deposit at Federal Reserve earn no interest
They lend overnight to banks who need reserve at fed funds rate for one day
Fed funds rate: The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate
which is used in the United States to guide monetary policy.
The fed funds rate is a function of the supply and demand for federal funds among banks

24. Monetary Policy
Monetary policy affects the macro economy by influencing the supply and demand for excess bank reserves
influences the money supply and the level of short-term and long-term interest rates
affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices

25. Assets The major assets on the Federal Reserve’s balance sheet are:
Treasury and government agency (i.e., Fannie Mae, Freddie Mac) securities
Treasury currency
gold and foreign exchange

26. Assets U.S. Government Agency Securities.
This account grew as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac

27. Assets Treasury Securities
The Fed’s open market operations involve the buying and selling of these securi- ties. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply.

28. Assets
Gold and Foreign Exchange and Treasury Currency: Treasury gold certificates redeemable for gold
Loans to Domestic Banks
depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window
the Fed implemented changes to its discount window lending policy that increased the cost of discount window borrowing but eased the requirements on which depository institutions can borrow. As part of this change, the discount window rate was increased so that it would be higher than the fed funds rate

29. Discount Rate
Discount rate is the rate Federal Reserve Banks charge on loans to depository institutions in their district
The Federal Reserve rarely uses the discount rate as a policy tool
changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy
For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general.

30. Discount Rate
the Federal Reserve has rarely used the discount rate as a monetary policy tool for two reasons:
First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes.
There is no guarantee that FIs will borrow more (less) at the discount window in response to a decrease (increase) in the discount rate.
Thus, the exact direct effect of a discount rate change on the money supply is often uncertain.

31. Discount Rate
Second because of its “signaling” importance, a discount rate change often has great effects on the financial markets.
For example, the unexpected decrease in the Fed’s dis- count rate (to 0.50 percent) on December 16, 2008, resulted in a point increase in the Dow Jones Industrial Average, one of the largest one-day point gains in the history

32. Monetary Policy Expansionary monetary policy
open market purchases of securities by the Fed
discount rate decreases
reserve requirement ratio decreases
Contractionary monetary policy
open market sales of securities by the Fed
discount rate increases
reserve requirement ratio increases