Macroeconomics
Unit 14
The Federal Reserve
The Top Five Concepts
Introduction
This unit discusses the role of the Federal Reserve. Did you
know that the Federal Reserve is responsible for determining
the rates that most of the banks use to establish their rates for
savings accounts, time deposits and loans?
The impact of changes in Federal Reserve policy on banks,
businesses and consumers is also discussed.
Finally, a simple calculation to determine the yield on a bond is
discussed.
Concept 1: Federal Reserve Structure
The Federal Reserve System consists of 12 Federal Reserve
Banks located throughout the United States.
Regional Federal Reserve Banks provide services to private
banks in their area.
Four main services are provided: check clearing, holding bank
reserves, providing currency and coins, and providing loans to
private banks.
Concept 1: Federal Reserve Structure
The Federal Reserve System is governed by its Board of
Governors.
The board of governors consists of 7 members appointed by
the U.S. president to 14-year terms.
The U.S. president selects one governor to be the chair.
The chair serves a four-year term and can be reappointed. The
current chair of the Federal Reserve is Ben Bernanke who
recently replaced Alan Greenspan as chair.
Concept 1: Federal Reserve Structure
The Federal Reserve also contains a group called the Federal
Open Market Committee.
This group has 12 members consisting of the Federal Reserve
Bank governors (7) plus 5 of the 12 regional Federal Reserve
Bank presidents.
The committee is responsible for directing Federal Reserve
transactions in the money market (buying and selling
securities). They also determine the amount of reserves that
private banks are required to maintain.
Monetary Tools
The Federal Reserve can change the supply of money using
one or more of the following policy instruments:
Changing bank reserve requirements (reserve ratio).
Changing bank discount and federal funds rates.
Through open market operations – the buying and selling of
government securities.
Concept 2: Reserve Requirements
By changing the reserve ratio, the Federal Reserve can
increase or decrease the supply of money available to banks
for lending activity.
If the banking system has total deposits of $100 billion, and the
reserve ratio is .20, then the banks have required reserves of
($100 billion X .20) $20 billion.
Excess reserves are calculated based upon the amount of
additional deposits banks have to lend after the reserve
requirement is met.
Concept 2: Reserve Requirements
Excess reserves = Total reserves – required reserves.
Any dollar amount of reserves being held by a bank that is over
the required reserve amount is excess reserves.
In our example, $100 billion of total reserves (deposits) exists in
the banking system. The required reserve ratio is .20. The
required reserve equals .20 X $100 billion = $20 billion.
Excess reserves = $100 billion - $20 billion = $80 billion.
Concept 2: Reserve Requirements
Federal Reserve policy is concerned with what happens to
bank excess reserves.
If the $80 billion was used for loans, we can calculate the total
economic effect using the money multiplier.
Money multiplier = 1/required reserve ratio.
1/.20 = 5
5 X $80 billion = $400 billion increase in the money supply.
Concept 2: Reserve Requirements
Federal Reserve policy can increase or decrease the reserve
requirement.
By changing the reserve requirement, the Federal Reserve can
increase or decrease the supply of money.
If the reserve ratio is increased, banks have less money to
lend. The supply of money is reduced.
If the reserve ratio is decreased, banks have more money to
lend. The supply of money is increased.
Impact of an Increased Reserve Requirement
Notice that when the reserve ratio increases, excess reserves
decline.
Required Reserve Ratio
.20
.25
Total deposits
$100 billion
$100 billion
Total reserves
30 billion
30 billion
Total loans
70 billion
70 billion
Required reserves
20 billion
25 billion
Excess reserves
10 billion
5 billion
5
4
$ 50 billion
$ 20 billion
Money multiplier
Total unused lending capacity
Concept 2: Reserve Requirement
Changes in the reserve requirement cause a change in the
following:
• Excess reserves.
• The money multiplier.
• The lending capacity of the banking system.
Banks will try to keep their excess reserves to a minimum in
order to improve their profitability. If significant excess reserves
and the bank is unable to loan them, most banks will purchase
government securities to provide some additional income.
Concept 3: The Discount Rate
At times banks may need to borrow money from the Federal
Reserve in order to meet minimum reserve requirements.
If a bank borrows money from the Federal Reserve to cover
reserve requirements, it borrows at the discount rate.
The discount rate is the rate of interest the Federal Reserve
charges for lending reserves to private banks.
The discount rate is determined by current Federal Reserve
policy.
Concept 3: The Discount Rate
Banks may also borrow money from other banks to meet
reserve requirements. When loans of this type occur, the funds
are borrowed at the federal funds rate of interest. The federal
funds rate is the interest rate for interbank reserve loans.
The federal funds rate is controlled by the Federal Reserve
through its Open Market Committee. Additional information
about the federal funds rate and the discount rate can be
obtained at http://www.federalreserve.gov/policy.htm.
Click on the links for the discount rate and open market
operations.
Concept 3: The Discount Rate
If the Federal Reserve wishes to increase the supply of money,
it can lower the discount and federal funds rates. This causes
the rates that banks charge for loans to fall and increases
lending activity.
If the Federal Reserve wishes to decrease the supply of
money, it can raise the discount and federal funds rates. This
causes the cost of banks loans to rise which reduces the
demand for loans.
Rate changes also make it more or less expensive for banks to
borrow money to cover reserve requirements.
Concept 4: Open Market Operations
The third tool of monetary policy implemented by the Federal
Reserve is called Open Market Operations.
Open Market Operations are one of the primary tools used to
directly alter the reserves of the banking system.
Open Market Operations is the process where the Federal
Reserve makes federal government bonds more or less
attractive as an investment to the private sector, including
banks.
Concept 4: Open Market Operations
The Federal Reserve is one of the U.S. government’s largest
bond holders. Bonds can be bought and sold in the open
market.
Prices of bonds are determined by their interest rates and the
price paid for the bond.
If the Federal Reserve lowers its price on government bonds it
would like to sell, this will increase the demand for bonds and
reduce bank deposits. Why? Individuals and businesses are
attracted to federal government securities when they are sold at
a discount price.
Concept 4: Open Market Operations
If the Federal Reserve buys government bonds at higher
prices, the demand for them by other market participants
(individuals, businesses) is reduced and more funds remain in
the banking system. This activity by the Federal Reserve
lowers bond yields and market interest rates while increasing
the supply of money.
Therefore, if the Federal Reserve sells an increasing number of
bonds because of a price reduction, it is reducing the supply of
money. Why? Because individuals and businesses will take
their bank deposits and buy the securities. This reduces the
amount of bank deposits available for deposit creation.
Concept 4: Open Market Operations
To summarize:
If the Federal Reserve wishes to increase the supply of money,
it buys more federal government securities on the open market.
Government securities investors are willing to sell because the
Federal Reserve buys the securities at attractive premium
prices.
If the Federal Reserve wishes to decrease the supply of
money, it sells more federal government securities on the open
market. Government securities investors are willing to buy
more securities because the Federal Reserve sells the
securities at attractive discount prices.
Concept 4: Open Market Operations
If the money supply is increased by the actions of the Federal
Reserve, the desired effect is to shift the aggregate demand
curve to the right.
If the money supply is decreased by the actions of the Federal
Reserve, the desired effect is to shift the aggregate demand
curve to the left.
Concept 4: Open Market Operations
Bond prices are determined by the
interest rate and cost of the bond.
Often the yield is an important calculation
used to determine the value of a bond.
The yield is the annual rate of return on
a bond calculated by taking the annual
interest payment and dividing it by the
bond’s price.
Concept 5: Bond Yield
Yield = annual interest payment / price paid for the bond
For example:
A $1000 face value bond, with a 4% interest rate. Annual
interest payment = .04 X 1000 = $40.
If the bond was purchased for $900, what is its yield?
Yield = 40/900 = 4.4%
Notice that we do not use the face value of the bond to
calculate the yield – we use the cost of the bond.
Bond Yield
Bonds can also be bought and sold for more than their face
value.
For example, a $1000 bond with a 6% interest rate.
Annual interest payment = .06 X 1000 = $60
If this bond was bought for $1100, what is its yield?
Yield = 60/1100 = 5.5%
Once again we use the cost or purchase price of the bond to
calculate its yield.
Bond Yield
Why would someone buy a bond for more than its issue price
or face value?
Usually this occurs when the interest rate being paid on the
bond is higher than the current market rates for similar bonds.
When this occurs the bonds with higher interest rates become
more costly to purchase (demand for these bonds is higher)
thereby reducing the yield on the bonds to current market rates.
Federal Reserve Policy Choices Summary
• To increase the supply of money the Federal Reserve can:
– Lower reserve requirement.
– Lower discount and federal funds rates.
– Buy more government bonds.
• To decrease the supply of money the Federal Reserve can:
– Increase reserve requirement.
– Increase discount and federal funds rates.
– Sell more government bonds.
Monetary Control Act of 1980
Prior to 1980, the Federal Reserve did not have authority or
control over all banks.
Upon passage of the Monetary Control Act of 1980, the
Federal Reserve obtained control over all banks, savings and
loans, savings banks, and most credit unions. All institutions
are required to comply with the new Federal Reserve reserve
requirements.
The act also permitted banks to begin diversifying into other
financial services to compete with other non-bank entities. It
also gave all banks access to the Federal Reserve’s discount
window.
Summary
• Federal Reserve System.
• Federal Open Market Committee.
• Reserve requirement.
• Discount and federal funds rate.
• Open market operations.
• Monetary policy options.
• Monetary Control Act of 1980.
More information about the Federal Reserve and its
operations is available at:
http://www.stls.frb.org/publications/pleng/default.html