1. Money and Capital Markets 13 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu The Roles and Services of The Federal Reserve & Other Central Banks Around The World

2.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 2  Learning Objectives   To explore the many roles and functions of the central banks around the world.  To see how and why the Federal Reserve System came to be established as the U.S. central bank.  To examine how the Federal Reserve System is organized to carry out the many tasks it must perform.

3.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 3  Learning Objectives   To discover how important central bank independence from the dictates of governments is in designing and carrying out an effective central banking (monetary) policy.  To understand the concept of legal reserves and how the Federal Reserve System influences the level and growth of legal reserves.

4.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 4 Introduction  A central bank is a government agency that monitors the operation of its financial system and controls the growth of its money supply.  Central banks are “bankers’ banks.” They communicate with commercial banks and securities dealers in carrying out their essential public policy functions.  The U.S. central bank is the Federal Reserve System.

5.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 5 The Roles of Central Banks  Control of the money supply, which is closely linked to economic activity and price inflation  Stabilizing the money and capital markets, by fostering their development and ensuring a stable flow of funds through them  Lender of last resort for financial institutions squeezed by severe liquidity pressures  Supervisor of the banking system

6.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 6 The Roles of Central Banks  Maintaining and improving the payments mechanism - a smoothly functioning and efficient payments mechanism is vital for business and commerce

7.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 7 The Goals of Central Banking  Central banking in the U.S. and in most other nations is directed toward four major goals:  Full employment of resources  Reasonable stability in the general price level of all goods and services  Sustained economic growth  A stable balance-of-payments position for the nation vis-à-vis the rest of the world

8.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 8 The Goals of Central Banking  Through its influence over interest rates and the growth of the money supply, the central bank is able to influence the economy’s progress toward each of the goals.  However, the goals often conflict and trade- offs have to be accepted.

9.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 9 The Channels Through Which Central Banks Work Policy tools of the central bank Volume & growth of borrowing & spending by the public on domestic & foreign consumer & capital goods & services Economic goals: Full employment A stable price level Sustainable economic growth A stable balance-of- payments position Cost & availability of credit Size & growth of the money supply Market value of the public’s security holdings Currency exchange rates Public expectations regarding security prices, interest rates, currency prices, money supply & credit availability Market interest rates Level & growth of reserves in the banking system

10.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 10 The History of the Federal Reserve System  The U.S. was one of the last major nations in the Western hemisphere to permanently charter a central bank.  U.S. public officials were hesitant to do so for fear that a central bank with great financial power will restrict the availability of credit.  However, a series of crises plagued the U.S. financial system in the late 19 th and early 20 th centuries.

11.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 11 Problems in the Early U.S. Banking System  Prior to the Civil War, the states controlled the banking system and many did a poor job.  The high failure rate among poorly capitalized and ill-managed banks resulted in substantial losses for unlucky depositors.  The 1863 National Banking Act created a dual banking system, but competition between federal and state bank regulatory agencies sometimes led to actions detrimental to public interest.

12.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 12 Problems in the Early U.S. Banking System  The new national bank notes proved to be unresponsive to the nation’s growing need for a money or cash medium.  The process of clearing and collecting checks was also too slow and expensive, and many banks charged a check redemption fee.  There were recurring liquidity crises too, when the massive sell-offs of bank-held securities led to panic selling by other investors.

13.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 13 Creation of the Federal Reserve System  The Federal Reserve Act was signed in 1913. Twelve Federal Reserve banks were chartered and they opened for business as World War I began in Europe.

14.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 14 The Early Structure of the Fed  The first Federal Reserve System was quite different from the Fed of today.  The chief policy tool was the discount rate charged on loans of reserves to eligible banks, and each Reserve bank had the authority to set its own discount rate.  The Federal Reserve banks were also given authority to issue their own paper notes to serve as a circulating currency.

15.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 15 The Early Structure of the Fed  Hence, although a supervisory board of seven members had been set up in Washington, D.C., the regional Reserve banks possessed the essential monetary tools and made the key policy decisions during the Fed’s early years.  Then slowly, economic, financial, and political forces combined to amend the original Federal Reserve Act and remake the character and methods of the central bank.

16.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 16 Goals and Policy Tools of the Fed  The Great Depression brought about a concentration of power within the Fed.  The seven-member Board of Governors in Washington, D.C., became the central administrative and policymaking group.  In addition, the Federal Open Market Committee was created to oversee the conduct of open market operations, which rapidly became the Fed’s main policy tool.

17.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 17 How the Fed is Organized Board of Governors (7 members appointed by the president) 3,200 member banks of the system Supervise Manager of the System Open Market Account Supervise 12 Federal Reserve banks & 25 branch banks (reserve bank presidents appointed by Board of Governors) Supervise Federal Open Market Committee (12 voting members) Serve

18.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 18 How the Fed is Organized  In principle, the Board of Governors is independent of both legislative and executive branches of the federal government.  This independence is supported by terms of office much longer than the president’s (up to 14 years), and by the fact that the Fed is self- supporting (it reported operating income of $34 billion in 2000).

19.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 19 How the Fed is Organized  When the Federal Open Market Committee (FOMC) has reached a consensus on the appropriate future course for monetary policy, a directive is given to the manager of the System Open Market Account (SOMA)  The SOMA manager is a vice president of the Federal Reserve Bank of New York.

20.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 20 How the Fed is Organized There is a Federal Reserve bank in each of the twelve districts. Source: Board of Governors of the Federal Reserve System

21.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 21 How the Fed is Organized  Each Reserve bank houses a research division that studies regional economic and financial developments, and reports its findings to the Board of Governors and to the FOMC.  The Reserve banks also provide the securities needed for open market sales, and take their pro rata share of security purchases made by the Federal Reserve System.

22.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 22 How the Fed is Organized  The member banks of the Federal Reserve System consist of national banks, which are required to join the system, and state-chartered banks that agree to conform to the Fed’s rules.  At year-end 2000, there are 2,230 national banks and just under 1,000 state-chartered banks registered as members of the Federal Reserve System, compared to more than 5,000 nonmember banks.

23.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 23 Roles of the Federal Reserve System Today  Collecting and clearing checks and other means of payment (through an electronic network known as the FEDWIRE)  Issuing currency and coin  Maintaining a sound banking and financial system, by serving as a lender of last resort (through the discount window of each Reserve bank) and by supervising member banks

24.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 24 Roles of the Federal Reserve System Today  Serving as the Federal government’s fiscal agent, by holding the Treasury’s checking account and by maintaining reasonable stability in the government securities market  Providing information to the public, through statistical releases and research reports  Carrying out monetary policy, through the use of various tools

25.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 25 The Key Focus of Central Bank Monetary Policy  In regulating money and credit conditions to strengthen the economy, most central banks target market interest rates.  To impact market rates, central banks usually make use of their control over the volume of reserves available to the banking system.  These reserves are the raw material out of which depository institutions create credit and cause the money supply to grow.

26.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 26 The Key Focus of Central Bank Monetary Policy  The total supply of reserves can be changed  through open market operations,  by making loans to depository institutions through the central bank’s discount window, and  by changing the legal reserve requirements applicable to deposits held by depository institutions.

27.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 27 The Composition of Reserves for Depository Institutions  Legal reserves in the U.S. consist of the amount of deposits each institution keeps with the Federal Reserve bank in its district plus the amount of currency and coin held in its vault.  Total legal reserves = Required reserves + Excess reserves

28.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 28 The Deposit Multiplier  As a whole, the banking system can create more deposit money by using its excess reserves to make loans and purchase securities.  The deposit multiplier indicates how many dollars of deposits can result from an injection of new excess reserves into the system.  Transaction deposit multiplier = 1. Reserve requirement on transaction deposits

29.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 29 The Deposit Multiplier  Maximum volume of new deposits and loans = Deposit multiplier  Excess reserves  Central bankers are usually more interested in a related concept known as the money multiplier, which defines the relationship between the size of the money supply and the size of the total reserve base available to depository institutions.

30.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 30 Money and Capital Markets in Cyberspace  Most central banks maintain comprehensive websites. Visit, for example,  http://www.federalreserve.gov/ http://www.federalreserve.gov/  http://www.ecb.int/ http://www.ecb.int/  http://www.bankofengland.co.uk/ http://www.bankofengland.co.uk/  http://www.boj.or.jp/en/ http://www.boj.or.jp/en/  http://www.bis.org/cbanks.htm http://www.bis.org/cbanks.htm

31.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 31 Chapter Review  Introduction  The Roles of Central Banks in the Economy and Financial System  Control of the Money Supply  Stabilizing the Money and Capital Markets  Lender of Last Resort  Supervisor of the Banking System  Maintaining and Improving the Payments Mechanism

32.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 32 Chapter Review  The Goals and Channels of Central Banking  The History of the Federal Reserve System  Problems in the Early U.S. Banking System  Creation of the Federal Reserve System  The Early Structure of the Fed  Goals and Policy Tools of the Fed  How the Fed is Organized

33.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 33 Chapter Review  Roles of the Federal Reserve System Today  The Clearing and Collection of Checks and Other Means of Payment  Issuing Currency and Coin  Maintaining a Sound Banking and Financial System  Serving as the Federal Government’s Fiscal Agent  Providing Information to the Public  Carrying Out Monetary Policy

34.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 34 Chapter Review  The Key Focus of Central Bank Monetary Policy: Interest Rates, Reserves and Money  The Composition of Reserves for Depository Institutions  The Deposit Multiplier  The Money Multiplier