The Federal Reserve System Chapter 14 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve System • This chapter examines the mechanics of government control – How does the 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? 14-2 The Federal Reserve System • The government must regulate bank lending if it wants to control the amount of money in the economy • Monetary policy: The use of money and credit controls to influence macroeconomic outcomes 14-3 Structure of the Fed • The Federal Reserve was created in 1913 to avert recurrent financial crises • Each of the twelve (12) Federal Reserve banks act as central banker for the private banks in their region 14-4 Federal Reserve Banks • Each regional Fed bank provides services: – – – – Clearing checks between private banks Holding bank reserves Providing currency Providing loans to private banks 14-5 The Board of Governors • The seven-person Board of Governors sets monetary policy • 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 14-6 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 14-7 Structure of the Federal Reserve System Federal Open Market Committee (12 members) Board of Governors Federal Advisory Council and other committees (7 members) Federal Reserve banks (12 banks, 25 branches) Private banks (depository institutions) 14-8 Monetary Tools • The Federal Reserve controls the money supply using three policy instruments: – Reserve requirements – Discount rates – Open-market operations 14-9 Reserve Requirements • Required reserves – The minimum amount of reserves a bank is required to hold • By changing the reserve requirements, the Fed can directly alter the lending capacity of the banking system Required required total reserves reserve ratio deposits 14-10 Reserve Requirements • By changing the reserve requirement, the Fed changes the level of excess reserves in the banking system • Excess reserves: Bank reserves in excess of required reserves Excess total required reserves reserves reserves 14-11 Reserve Requirements • The money multiplier determines how much in additional loans the banking system can make based on their excess reserves 1 Money multiplier required reserve ratio Available lending capacity money excess reserves of the banking system multiplier 14-12 Reserve Requirements • By raising the required reserve ratio, the Fed reduces lending capacity in the banking system • A change in the reserve requirement causes a change in: – Excess reserves – The money multiplier – The lending capacity of the banking system 14-13 Impact of an Increased Reserve Requirement Required Reserve Ratio 20 percent 25 percent Total deposits $100 billion $100 billion Total reserves 30 billion 30 billion Required reserves 20 billion 25 billion Excess reserves 10 billion 5 billion 5 4 $ 50 billion $ 20 billion Money multiplier Unused lending capacity 14-14 The Discount Rate • Excess reserves earn no interest, so banks have a profit incentive to keep their reserves as close to the required reserve level as possible • Because banks continually seek to keep excess reserves at a minimum, they run the risk of falling below reserve requirements 14-15 Excess Reserves and Borrowings Excess reserves represent unused lending capacity. Hence, banks strive to keep excess reserves at a minimum. 14-16 The Federal Funds Market • A bank that finds itself short of reserves can turn to other banks for help • Reserves borrowed from another bank are called federal funds • Federal funds rate: The interest rate for interbank reserve loans 14-17 Sale of Securities • Banks use some of their excess reserves to purchase government bonds • A bank that is low on reserves can also sell securities 14-18 Discounting • Discounting: Federal Reserve lending of reserves to private banks • Discount rate: The rate of interest the Federal Reserve charges for lending reserves to private banks • Changing the discount rate affects the cost and incentive for banks to borrow reserves 14-19 Open-Market Operations • Open-market operations are the Fed’s principal mechanism for altering the reserves of the banking system • The Fed’s open-market operations focus on the portfolio choices people make 14-20 Hold Money or Bonds? • Portfolio decision: The choice of how (where) to hold idle funds • People do not hold all their idle funds in transactions accounts or cash • The Fed attempts to influence the choice by making bonds more or less attractive 14-21 Open Market Operations Fed SELLS bonds Buyers spend account balances The Fed Open market operations The Public Banks Sellers deposit Fed BUYS bonds Reserves decrease bond proceeds Reserves increase 14-22 The Bond Market • Bond: A certificate acknowledging a debt and the amount of interest to be paid each year until repayment; an IOU • Bonds can be resold to someone else at any time 14-23 Bond Yields • Yield: The rate of return on a bond annual interest payment Yield price paid for bond • A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields 14-24 Open Market Activity • Open market operations: Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves • By buying bonds, the Fed increases bank reserves • By selling bonds, the Fed reduces bank reserves 14-25 An Open-Market Purchase Regional Federal Reserve bank Federal Open Market Committee Step 3: Bank deposits check at Fed bank, as a reserve credit Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check Private bank Step 2: Bond seller deposits Fed check Public 14-26 The Fed Funds Rate • The federal funds rate is a highly visible signal of Federal Reserve open market operations • If the Fed is pumping more reserves into the banking system, the federal funds rate will decline • If the Fed is reducing bank reserves by selling bonds, the federal funds rate will increase 14-27 The Fed Funds Rate • The Fed doesn’t actually set the federal funds rate • The Fed it sets a target rate and then conducts open market operations to achieve it • Other market interest rates tend to move in the same direction 14-28 Increasing the Money Supply • To increase the money supply, the Fed can: – Lower reserve requirements – Reduce the discount rate – Buy bonds 14-29 Lowering Reserve Requirements • Lowering reserve requirements is an expedient way of increasing the lending capacity of the banking system – Excess reserves in the banking system increase – Banks expand deposits through loans – The money supply increases 14-30 Lowering the Discount Rate • Profitability of discounting depends on the difference between the discount rate and the interest rate banks charge on loans • Lowering the discount rate increases this – Banks become more willing to borrow reserves – Banks make more loans, increasing the money supply 14-31 Buying Bonds • • • • The Fed purchases bonds from bond sellers Sellers deposit proceeds of sales in banks Excess reserves increase The money supply increases as banks make additional loans 14-32 Federal Funds Rate • When the Fed starts bidding up bonds, bond yields and market interest rates start falling • The federal funds rate also falls, giving individual banks incentive to borrow reserves • This accelerates deposit (loan) creation 14-33 Decreasing the Money Supply • To reduce the money supply, the Fed can: – Raise reserve requirements – Increase the discount rate – Sell bonds 14-34 Focus on Fed Funds Rate, not Money Supply • The Fed has shifted from money-supply targets to interest rate targets • The Fed will continue to use the federal funds rate as its primary barometer of monetary policy 14-35 The Federal Reserve System End of Chapter 14 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.