Chapter 14 The Federal Reserve
System
• The Federal Reserve Act of 1913 created the
Federal Reserve System
– To provide for the establishment of Federal reserve
banks, to furnish an elastic currency, to afford
means of rediscounting commercial paper, to
establish a more effective supervision of banking in
the United States, and for other purposes
– First United States Bank [ 1791 - 1811]
– Second United States Bank [ 1816 - 1836]
• The charters of both were allowed to lapse
– The 1907 bank crises caused the public to demand
the government do something to keep this from
happening again
• The Federal Reserve has five main jobs
– Conduct monetary policy which is, by far, the most
important job
• Monetary policy is the control of the rate of growth of the
money supply to foster relatively full employment, price
stability, and a satisfactory rate of economic growth
– Serve as lender of last resort to commercial banks,
savings banks, savings and loan associations, and
credit unions
– Issue currency
– Provide banking services to the U.S. government
– Supervise and regulate our financial institutions
The Federal Reserve District
Banks
• Each Federal Reserve District Bank is owned
by the several hundred member banks in that
district
– A commercial bank becomes a member by buying
stock in the Federal Reserve District Bank
– So, the Fed is a quasi public-private enterprise, not
controlled by the President or Congress
• Effective control is really exercised by the Federal Reserve
Board of Governors in Washington, D.C.
The Federal Reserve System
• Board of Governors
– Seven members
– Appointed by President
– Confirmed by Senate
• Sets reserve requirements
• Supervises and regulates
member banks
• Establishes and
administers regulations
• Oversees Federal Reserve
Banks
• 12 District Banks
• Propose discount rates
• Hold reserve balances
for member institutions
• Lends reserves
• Furnish currency
• Collects & clears checks
• Handle U.S. government
debt & cash balances
Federal Open Market Committee (Board of Governors plus 5 Reserve
Bank Presidents. This committee directs open market operations which
is the primary instrument of monetary policy
Legal Reserve Requirements
• The focal point of the Federal Reserve’s
control of our money supply is legal
reserve requirements
– Every financial institution in the country is
legally required to hold a certain percentage
of its deposits on reserve, either in the form
of deposits at its Federal Reserve District
Bank or in its own vaults
Legal Reserve Requirements
• Technical Term Meanings
– Required Reserves (RR) is the minimum
amount of vault cash and deposits (RD) at
the Federal Reserve District Bank that must
be held (kept on the books) by the financial
institution
– Actual Reserves (RD) is what the bank is
holding (on the books)
– Excess Reserves = Actual Reserves - Required
Reserves
• ER = RD - RR
What About Negative Excess
Reserves?
• If actual reserves (RD) are less than
Required Reserves (RR), the excess
Reserves (ER) are negative
– If a bank does find itself short, it will usually
borrow reserves from another bank that
does have excess reserves. These are called
federal funds and the interest rate charge is
called the federal funds rate
– A bank may also borrow reserves (RD) from
its Federal Reserve District Bank at its
discount window
Primary and Secondary
Reserves
• A bank’s primary reserves are its vault cash
and its deposits at the the Federal District
Bank
– These reserves pay no interest, therefore the
banks try to hold no more than the Federal
Reserve requires
Primary and Secondary
Reserves
• Every bank holds secondary reserves,
mainly in the form of very short-term U.S.
government securities
– Treasury bills, notes, certificates, and bonds
(that will mature in less than a year) are
generally considered a bank’s secondary
reserves
– These can be quickly converted to cash without
loss if a bank suddenly needs money
Deposition Expansion
Hypothetical Deposit Expansion with 10 Percent Reserve Requirement
Deposits
(thousands)
Reserves
$100.0
$10.0
$ 90.0
9.0
$ 81.0
8.1
$ 72.9
7.29
$ 65.61
6.661
$ 59.05
5.904
$ 53.541
5.354
$ 48.186
4.819
$ 43.368
4.337
$ 39.031
3.903
* To save space the rest of the calculations are omitted
$1,000.00
100.00
Deposit Expansion Multiplier
(DEM)
1
DEM =
Reserve Ratio
Assume a RR of 10%
1
DEM =
.10
= 10
Assume a RR of 25%
DEM =
1
.25
When RR decreases
When RR increases
DEM increases
DEM decreases
=4
Three Modifications of the
Deposit Expansion Multiplier
• Not every dollar of deposit expansion will
actually be redeposited again and lent out
repeatedly
– Some people may choose to hold or spend
some money as currency
• It is also possible that some banks will
carry excess reserves
– This is not likely in times of high inflation
Three Modifications of the
Deposit Expansion Multiplier
• There are leakages of dollars to foreign
countries
– This is caused mainly by our foreign trade
imbalance
• The Deposit Expansion Multiplier is, in
reality, quite a bit lower than if we based
it solely on the reserve ratio
– If the reserve ration tells us it is 10, perhaps
it’s only 6
Cash, Checks, and Electronic
Money
• Increasingly, money is changing hands
electronically
– Today, more than $1.7 trillion a day is
transferred electronically
– About $600 billion of these transfers are carried
out by the Federal Reserve’s electronic network
– About $1.1 trillion are done by the Clearing
House Interbank Payment System (CHIPS)
which is owned by 11 big New York Banks
Cash, Checks, and Electronic
Money
• Does all this mean that we are well on our way
to a checkless, cashless society?
– Yes and no
– We still carry out nearly 85 percent of our monetary
transactions in cash
– When the total dollars actually spent is considered,
cash covers less than 1 percent of the total value
– Electronic transfers account for five out of every six
dollars that move in the economy
The Tools of Monetary Policy
• The most important job of the Fed is to
control the rate of growth of the money
supply
• This effort focuses on the reserves held by
financial institutions
– The most important policy tool to do this is
open-market operations
How Open-Market Operations
Work
• Open-Market operations are the buying and
selling of U.S. government securities
– U.S. government securities are treasury bills, notes,
certificates, and bonds
– The Fed buys and sells securities that have already
been marketed by the treasury
• The total value of all outstanding U.S. government
securities is more than $4.0 trillion. This is our national
debt
– What open market operations consist of, then, is the
buying and selling of chunks of the national debt
The Federal Open-Market
Committee (FOMC)
• Open-market operations are conducted
by the Federal Open-Market Committee
(FOMC)
– This committee consist of 12 people
• Eight permanent members – the board of
Governors and the president of the New York
Federal Reserve District Bank
• The other four are presidents of the other 11
Federal Reserve District Banks
– They serve on a rotating basis
The Federal Open-Market
Committee (FOMC)
• The FOMC meets about once every six
weeks to decide what policy to follow
– To fight recessions, the FOMC buys
securities
• This increases the rate of growth of the money
supply
– To fight inflation, the FOMC sells securities
• This decreases the rate of growth of the money
supply
Borrowing Reserve Deposits
• The discount rate is the interest rate paid by
member banks when they borrow reserve
deposits (RD) at their Federal Reserve District
Bank
• The federal funds rate is the interest rate banks
charge each other for borrowing reserve
deposits (RD) from each other
– This is higher than the discount rate
• Banks borrow to maintain their required
reserves (RR)
– Banks tend to borrow reserve deposits from each
other because they may not like to call attention to
the fact they are having to borrow reserve deposits
Changing Reserve
Requirements
• The Federal Reserve Board has the
power to change reserve requirements
within the legal limits of 8 and 14 percent
for checkable deposits
– Changing reserve requirements is the
ultimate weapon and is rarely used
Changing Reserve
Requirements
• To fight inflation, before the Board would
take the drastic step of raising reserve
requirements
– The District Banks would raise the discount
rate
– The FOMC will be actively selling securities
– Credit will be getting tighter
– The chairman will be publicly warning that
the banks are advancing too many loans
Changing Reserve
Requirements
• If the money supply is still growing too rapidly
– the Fed reaches for its biggest stick and raises
reserve requirements
– This weapon is so rarely used because it is simply
too powerful
– If the reserve requirement on demand deposits were
raised by just one half of 1 percent, the nation’s
banks and thrift institutions would have to come up
with nearly $4 billion in reserves
• This would drastically reduce the nation’s money supply
Summary: The Tools of
Monetary Policy
• To fight recession, the Fed will
– Lower the discount rate
– Buy securities on the open market
– Lower reserve requirements
• This would be done only as a last resort
• To fight inflation, the Fed will
– Raise the discount rate
– Sell securities on the open market
– Raise reserve requirements
• This would be done only as a last resort