1. The Federal Reserve System
Chapter 14

2. Introduction This chapter addresses the following:
How does government control the amount of money in the economy?
Which government agency is responsible for exercising this control?
How are banks and bond markets affected by the government’s policies?

3. Introduction
The government must regulate bank lending if it wants to control the amount of money in the economy.

4. Introduction
The fed’s control over the supply of money is the key mechanism of monetary policy.
Monetary policy is the use of money and credit controls to influence macroeconomic activity.

5. Structure of the Fed
A series of bank failures resulted in a severe financial panic in 1907 – millions of depositors lost their savings.
Congress passed the Federal Reserve Act in 1913 to avert recurrent financial crises.

6. Federal Reserve Banks
Each of the twelve (12) Federal Reserve banks act as a central banker for the private banks in their region.

7. 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.

8. 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).

9. The Board of Governors
The long term is intended to give the Fed a strong measure of political independence.
The President selects one of the governors to serve as chairman for a 4-year term.

10. 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).

11. The Federal Open Market Committee (FOMC)
The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes.

12. Structure of the Federal Reserve System
Private banks
(depository institutions)
Federal Reserve banks
(12 banks, 24 branches)
Board of
Governors
(7 members)
Federal Open Market Committee (12 members)
Federal Advisory Council and other committees

13. Monetary Tools
The Federal Reserve controls the money supply using the following three policy instruments:
Reserve requirements
Discount rates
Open-market operations

14. 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.

15. Required reserves = required reserve ratio X total deposits
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; equal to required reserve ratio times transactions deposits.
Required reserves = required reserve ratio X total deposits

16. Reserve Requirements
The fed directly alters the lending capacity of the banking system by changing the reserve requirement.

17. Excess reserves = Total reserves – Required reserves
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.
Excess reserves = Total reserves – Required reserves

18. Reserve Requirements
The money multiplier determines how much in additional loans the banking system can make based on their excess reserves.
Available lending capacity of the banking system = excess reserves X money multiplier

19. 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.

20. Reserve Requirements
By raising the required reserve ratio, the Fed can immediately reduce the lending capacity of the banking system.

21. Reserve Requirements
A change in the reserve requirement causes c change in:
Excess reserves.
The money multiplier.
The lending capacity of the banking system.

22. Impact of an Increased Reserve Requirement

23. 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.

24. Excess Reserves and Borrowings7
1930 4 3 2 1
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
Borrowings at
Federal Reserve banks
Excess reserves

25. The Federal Funds Market
The federal funds market is where a bank that finds itself short of reserves can turn to other banks for help.
The federal funds rate is the interest rate for inter-bank reserve loans.

26. The Federal Funds Market
Reserves borrowed in this manner are called “federal funds” and are lent for short periods - usually overnight.

27. 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.

28. Discounting
Discounting refers to the Federal Reserve lending of reserves to private banks.
A bank can deal with a reserve shortage by going to the Fed’s “discount window” to borrow reserves directly.

29. Discounting
The discount rate is the rate of interest the Federal Reserve charges for lending reserves to private banks.

30. Discounting
By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

31. Open-Market Operations
Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

32. 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.

33. 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.

34. 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.

35. Open Market Operations
The Fed
The Public
Banks
Buyers spend account balances
Fed SELLS bonds
Open market operations
Reserves decrease
Sellers deposit bond proceeds
Reserves increase
Fed BUYS bonds

36. The Bond Market
Not all of us buy and sell bonds, but a lot of consumers and corporations do.

37. The Bond Market
A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment.
It is nothing more than an IOU.

38. The Bond Market
Like other markets, the bond market exists whenever and however bond buyers and sellers get together.

39. 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.

40. Bond Yields
A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields.

41. Open Market Activity
The less you pay for a bond, the higher its yield.
Federal Reserve open-market activity alters the price of bonds, and their yields.
By doing so, the Fed makes bonds a more or less attractive alternative to holding money.

42. Open Market Activity
Open market operations are Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves.

43. 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.

44. Open-Market Purchases
Regional Federal
Reserve bank
Federal Open
Market Committee
Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check
Step 3: Bank deposits check at Fed bank, as a reserve credit
Private
bank
Public
Step 2: Bond seller deposits Fed check

45. Open-Market Sales
By selling bonds, the Fed reduces bank reserves.

46. The Fed Funds Rate
Fed funds rate act as a market signal of the changing reserve flows.

47. The Fed Funds Rate
If the Fed is pumping more reserves into the banking system, the federal funds rate will decline.

48. The Fed Funds Rate
If the Fed is reducing bank reserve by selling bonds, the federal funds rate will increase.

49. 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.

50. Increasing the Money Supply
To increase the money supply, the Fed can:
Lower reserve requirements.
Reduce the discount rate.
Buy bonds.

51. Lowering Reserve Requirements
This will increase the banking system’s excess reserves with which they will increase the money supply through deposit creation (loans).

52. 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.

53. Lowering the Discount Rate
The effectiveness of lowering the discount rate depends primarily on the difference in the new discount rate and the rate that banks charge their loan customers.

54. 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.

55. 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.

56. Decreasing the Money Supply
To reduce the money supply, the Fed can:
Raise reserve requirements.
Increase the discount rate.
Sell bonds.

57. Is the Fed Losing Control?
The Fed’s control over the money supply is far from complete.

58. Monetary Control Act
Before 1980, the Fed’s control of the money supply was not only incomplete - it was weakening.

59. Monetary Control Act
Only one-third of all commercial banks were members of the Federal Reserve System and subject to its regulations.

60. Monetary Control Act
Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980.

61. Monetary Control Act The principal objectives of the Act were:
The Monetary Control Act subjected all commercial banks, S&Ls, savings banks and most credit unions to Fed regulation.
To extend the Fed’s control of the money supply.
To encourage greater competition in the banking industry.

62. 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.

63. Decline of Traditional Banks
Thirty percent of all consumer loans are now made through credit cards.
Insurance companies and pension funds also make loans.

64. Decline of Traditional Banks
Foreign banks, corporations, and pension funds may also extend credit to American businesses.

65. Focus on Fed Funds Rate, not Money Supply
The Fed has shifted from money-supply targets to interest targets.

66. The Federal Reserve System
End of Chapter 14