1. The Federal Reserve System

2. 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.

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

4. Federal Reserve Banks Clears checks between private 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. 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).

6. 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.

7. 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

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

9. 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

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

11. 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

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

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

14. Impact of an Increased Reserve Requirement

15. 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.

16. 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

17. 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.

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

19. 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.

20. 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.

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

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

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

24. 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. 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. Hold Money or Bonds Bond sales by the Fed reduce the flow.
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.
Likewise, when the Fed sells bonds, it removes money from the banking system.

27. 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

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

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

31. 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.

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

33. 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.

34. 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

35. The Fed Funds Rate
Fed funds rate act as a market signal of the changing reserve flows.
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. 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. Is the Fed Losing Control?