Ch. 12: The Federal
Reserve System
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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The Federal Reserve
System: Definitions
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Federal Reserve System: the central
bank of the United States.
Board of Governors: the governing body
of the Fed.
Federal Open Market Committee
(FOMC): the 12 member policymaking
group within the Fed. It has the authority
to conduct open market operations.
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The Federal Reserve
System: Definitions

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Open Market Operations: the
buying and selling of government
securities by the Fed.
Monetary Policy: changes in the
money supply, or in the rate of change
of the money supply, to achieve
particular macroeconomic goals.
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Exhibit 1: Federal Reserve Districts
and Federal Reserve Bank Locations
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The Board of Governors of
The Federal Reserve
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Coordinates and controls the activities of the
Federal Reserve System.
7 Members.
14 Year Terms.
Appointed by the President with Senate
approval.
A governor is appointed every other year.
President designates one member as
President for a 4 year term.
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The Federal Open Market
Committee of the Federal
Reserve
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The major policy making group within the
Fed is the Federal Open Market Committee.
Authority to Conduct Open Market
Operations (Buying and Selling of Federal
Securities).
12 Members
– 7 Board of Governors
– 5 District Bank Presidents (including New York)
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Functions of the Federal
Reserve System

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Control the Money
Supply.
Supply the economy
with paper money.
Provide check-clearing
services.
Hold depository
institutions’ reserves.
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Functions of The Federal
Reserve System
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Supervise Member
Banks.
Serve as the
government’s
banker.
Serve as the lender
of last resort.
Serve as a fiscal
agent for the
Treasury.
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Exhibit 2: The CheckClearing Process
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Self-Test
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The president of which Federal
Reserve District Bank holds a
permanent seat on the Federal Open
Market Committee (FOMC)?
What is the most important
responsibility of the Fed?
What does it mean to say the Fed acts
as “lender of last resort”?
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Fed Tools For Controlling the
Money Supply: Open Market
Operations
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Open Market Operations: Buying and
Selling U.S. Government Securities in the
Financial Markets
U.S. Securities: bonds and bond-like
securities issued by the U.S. Treasury.
Open Market Purchase: The buying of
government securities by the Fed
Open Market Sale: The selling of
government securities by the Fed.
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Open Market Purchases

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Assume Fed purchases securities from a
bank.
The Fed receives the securities from a bank,
and the bank’s reserves increase by the
amount of the purchase (Reserves = Bank
deposits at the Fed + Vault Cash).
When the banks have a reserve increase
and no other bank has a similar decline, the
money supply expands through a process of
increased loans and checkable deposits.
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Open Market Sales
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Assume the Fed sells securities to a bank.
To pay for the securities, the Fed takes
reserves from the bank.
Because of the decrease in the bank’s
reserves, the bank reduces total loans
outstanding, which reduces the total volume
of checkable deposits and the money
supply.
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Exhibit 3: Open Market
Operations
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The Required-Reserve
Ratio
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The Fed can also influence the money
supply by changing the required-reserve
ratio.
An increase in the required-reserve ratio
leads to a decrease in the money supply
A decrease in the required-reserve ratio
leads to an increase in the money supply.
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The Discount Rate
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A bank can borrow from the federal funds
market or from the Fed.
Federal Funds Rate: The interest rate a
bank pays for a loan in the federal funds
market.
Discount Rate: The interest rate a bank
pays for a loan from the Fed.
When a bank borrows money from the Fed,
the money supply increases because its
reserves increase while the reserves of no
other bank decrease.
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The Spread Between the
Discount Rate and the Federal
Funds Rate
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Banks may believe that the Fed is
hesitant to extend loans to take
advantage of profit-making opportunities.
The bank may not want to deal with the
Fed bureaucracy that regulates it.
The bank realizes that acquiring a loan
from the Fed is a privilege and not a
right, and doesn’t want to abuse the
privilege.
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Discount Rate Vs. Federal
Funds Rate
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If the discount rate is
significantly lower than
the federal funds rate,
most banks will borrow
from the Fed.
An increase in the
discount rate relative
to the federal funds
rate reduces bank
borrowings from the
Fed.
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Which Tool Does the Fed
Prefer to Use?
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Tools which can be used to influence the
money supply:
– open market operations
– the required-reserve ratio
– the discount rate
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The Fed prefers Open Market Operations
– Open market operations are flexible
– Open market operations can be reversed
– Open market operations can be implemented
quickly
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Exhibit 4: Fed Monetary Tools
& Their Effects on the Money
Supply
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Self-Test
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How does the money supply change as a result of
(a) an increase in the discount rate, (b) an open
market purchase, (c) an increase in the required
reserve ratio?
What is the difference between the federal funds
rate and the discount rate?
If bank A borrows $10 million from bank B, what
happens to the reserves in bank A? In the banking
system?
If bank A borrows $10 million from the Fed, what
happens to the reserves in bank A? In the banking
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system?
Coming Up (Ch. 13):
Money and the Economy
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