Chapter 5
The Federal
Reserve
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The Federal Reserve (the Fed)
The U.S. Central Bank
I.The Role of the Federal Reserve System
A. The purpose is to control the supply of
money through Monetary Policy to
achieve:
1. stable prices
2. Full employment
3. Economic growth
a)Regulation of supply of credit
b)Regulation of money in economy
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The Federal Reserve (the Fed)
B. Tools of monetary policy
1. Primary tool
a) Open markets operations
2. Secondary tool
a) Discount rate
b) Reserve Requirements
3. Fed uses these tools to
a) Expand/contract supply of money
C. Easy monetary policy
1. Increase the supply of money/credit to expand income
and unemployment
D. Tight monetary policy
1. Contract the supply of money/credit to help fight inflation
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The Federal Reserve (the Fed)
E. Other Functions of the Fed
1. Supervises depository institutions
a) Bank regulations
b) Periodic examinations of banks
c) Bank loans, expenses, earnings
2. Supervises check clearing
3. Serves as a depository institution
a) Member banks
b) US Treasury
c) Foreign central banks
4. Changes the supply of money
a) Reserves
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Structure of the Federal Reserve
A. Board of Governors
1.
2.
3.
4.
Controlling body of the Fed
Members are appointed by President of US
Confirmation from Senate
14 year staggered term
B. Districts
1. 12 Districts
a) Federal Reserve Bank in each district
2. Managed by nine directors
a) 3 of whom are appointed by Board of Governors
C. Federal Open Market Committee (FOMC)
1. Part of the Fed that establishes and executes
monetary policy
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Structure of the Federal Reserve
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Structure of the Federal Reserve
D. Important components of the Federal
Reserve System
1. Board of Governors
a) Appoints three of the nine directors of district reserve
banks
b) Composes a majority of the FOMC
c) Regulatory authority over commercial banks
2. District reserve banks
3. Member banks
4. Federal Open Market Committee (FOMC)
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Structure of the Federal Reserve
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Expansion of Money and Credit
A. Bankers ability to lend comes from investors
1. Depositors
2. Creditors
3. Owners (CDs or bank stock)
B. Process of loan creation
1. Cash is always deposited in a demand deposit
2. Banks hold no excess reserves
a) All excess reserves are loaned out
b) Must be a sufficient amount of borrowers to consume excess
reserves
C. Holding of Cash
1. Example, if I keep cash in my house and do not
deposit it in a bank, I am interfering with the act of
increasing money supply and credit
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Expansion of Money and Credit
D. Depositing of Cash
1. Example, if I deposit $100 and the reserve
requirement is 10%, the bank must keep $10 on
reserve, and the excess ($90) can be loaned out which
will increase credit and money supply
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Multiple Epansion of the Supply of Money
Initial Dep: $100
Reserve Req: 10%
New
Demand
Deposits
Cumulative
New
Credit
Cumulative
Required
Reserves
$100.00
$0.00
$10.00
$90.00
2nd bank
90.00
90.00
19.00
81.00
3rd bank
81.00
171.00
27.10
72.90
0
.
.
$900.00
.
.
$100.00
1st bank
.
.
Final round
.
.
Excess
Reserves
.
.
0
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Expansion of Money and Credit
E. Lending
1. Example, if a bank grants a borrower a loan of
$90, what effect does it have on the following?
a) A depositor – No effect
(1)The depositor can demand money at any time
b) The bank
(1) The bank acquires the asset (loan) and the liability
of the demand deposit
c) The borrower
(1) The borrower acquires an asset (money) and the
liability of paying back the bank
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Cash Withdrawals and the Reduction in
Reserves
A. If a bank is low on reserves because of
excessive withdrawals, the bank must
somehow increase the diminished reserves
B. Federal Funds Market
1. Market in which banks borrow and lend
excess reserves
2. Short term borrowing
3. If a bank lacks sufficient reserves against
deposits, it can borrow from a commercial bank
4. If a bank has excess reserves, it can loan the
reserves to a bank that needs them
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Cash Withdrawals and the Reduction in
Reserves
C. Federal Funds Rate
1. Interest rate charged by banks on overnight loans
of reserves
2. Interest rate used when banks borrow from other
banks
3. Established by the demand and supply of funds
available in the federal funds market
D.
Discount Rate
1. The interest rate charged when banks borrow from
the Federal Reserve
2. Federal Reserve sets the Discount Rate
E.
The supply of money and credit will
contract if banks are not willing to borrow
from the Federal Reserve
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Federal Funds Rate
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The Tools of Monetary Policy
A. The reserves of commercial banks are an
important component of the financial
system
B. The control of the supply of money rests
with the Federal Reserve
1. It is through the impact on banks reserves that
the Fed is able to affect interest rates and the
economy
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The Tools of Monetary Policy
C. Three primary tools for affecting reserves
1. Reserve requirement
2. Discount rate
3. Open market operations
D.
Other Tools
1. Credit Controls
a) Real Estate
b) Consumer Loans
2. Margin Requirements
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Reserve Requirement
A. Maintaining reserves against deposit
liabilities
B. Any change in reserves alters a banks
ability to lend
C. Reserve requirements are rarely used as a
monetary policy tool
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Discount Rate
A. A change in the discount rate will either
stimulate increased borrowing or decrease
the willingness to borrow
B. The Fed may increase or decrease the
Discount Rate…
1. They cannot force banks to borrow more or
borrow less
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Open Market Operations(OMO)
A. Buying and selling of US Treasury
securities by the Federal Reserve
B. Alters the supply of money in
circulation
C. Alters the reserves of the banking
system
D. Fed does not directly buy and sell
securities to the general public
1. Transactions are negotiated by private US
government securities dealers
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Open Market Operations(OMO)
E. If the Fed wants to expand the supply
of money…
1.Purchase securities
F.
If the Fed wants to contract the
supply of money…
1. Sell securities
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The Impact of Fiscal Policy on
Credit Markets
A. Fiscal Policy
1. Taxation, expenditures, and debt management
by the Federal government
B. Deficit
1.Disbursements exceeding receipts
C. Surplus
1. Receipts exceeding disbursements
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The Impact of Fiscal Policy on
Credit Markets
D.
If the Federal government runs a deficit, it
may obtain funds to finance the deficit by
borrowing from:
1.General public
2.Banks
3.Federal Reserve
4.Foreign investors
E.
If the Federal government runs a surplus, it
may retire debt held by:
1.General public
2.Banks
3.Federal Reserve
4.Foreign investors
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Impact of an Inflationary Economic
Environment on Credit Markets
A. Inflation
1. General increase in prices with special
emphasis on increases in consumer prices
2. Prices
a) What consumers pay to obtain goods and services
3. General
a) Does not mean that all prices are rising
b) Prices of most goods and services are rising
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Impact of an Inflationary Economic
Environment on Credit Markets
B. Consumer Price Index
1. The Consumer Price Index (CPI) is a
measure of the average change over time in
the prices paid by urban consumers for a
market basket of consumer goods and
services
C.
Deflation
1. General decline in prices
D.
Recession
1. Period of at least six months of increased
unemployment and negative economic
growth
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