The Federal Reserve
System
Ch 13 - Pg 254-258
Ch 15 - All
Chap 13, 15 Vocabulary
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Monetary policy
Open-market
operations (OMO)
Reserve ratio
Discount rate
Easy money policy
Tight money policy
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Velocity of money
Federal Funds Rate
Prime interest rate
Federal Reserve
System
Board of Governors
FOMC
Federal Reserve
Banks
Monetary Policy
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Central banks (The Fed, Bank of
Japan, ECB, Bank of England…)
manage monetary policies. Their
task is to promote full employment,
maintain price stability, and
encourage long-run economic
through control of Monetary Policy,
or by managing the money supply
and interest rates.
Independence of the Central Banks
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Studies have shown that the more
independent (less government
intervention) a Central Bank is, then
the better the bank is able to control
inflation.
The Federal Reserve is an
independent government agency.
The Federal Reserve System
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The Federal Reserve System was
created in 1913 following a series of
financial panics in the United States.
Congress created the Federal Reserve
to be a central bank, serving as a
banker’s bank.
The Federal Reserve Act of 1913 created
the “Fed”
One of the Fed’s primary jobs was to
serve as a lender of last resort—lending
funds to banks that suffered from panic
runs.
The Structure of the Federal Reserve
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The United States was divided into 12 Federal
Reserve districts, each of which has a Federal
Reserve Bank.
The Structure of the Federal
Reserve (Continued)
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The structure of the Federal Reserve today
consists of three distinct subgroups:
• Federal Reserve District Banks (12)
 El Paso is in the 11th Federal Reserve
District (the Dallas Fed). El Paso has one
of the three branch banks managed by the
Dallas Federal Reserve Bank.
• The Board of Governors (7 members)
• The Federal Open Market Committee (the
most important policy making component
of the Federal Reserve)
The Structure of the Federal
Reserve (Continued)
The Structure of the Federal Reserve
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The matter of central bank independence from
political authorities is a lively debate among
economists.
Monetary discipline (policy) is important for
the performance of the economy. Countries
with greater central independence tend to
have lower inflation rates.
The Federal Reserve is a “quasi public”
banking system
• The district banks are privately owned but “publicly
controlled”
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Owned by member banks (banks within the
district who have elected to join the Fed)
Controlled by Board of Governors
The Structure of the Federal Reserve
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The Board of Governors of the Federal
Reserve is the true seat of power over the
monetary system.
Headquartered in Washington, DC, the 7
members of the board are appointed for
staggered 14-year terms by the President and
must be confirmed by the Senate.
The chairperson serves a four-year term and is
the principal spokesperson for monetary policy in
the U.S. What he says is carefully observed, or
anticipated, by financial markets. A tool of
monetary policy is that of “moral suasion”.
The current Chairman is Ben Bernanke
The Structure of the Federal Reserve
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The Federal Open Market Committee
(FOMC) is a 12-person board consisting of
the 7 members of the Board of Governors,
the president of the New York Federal
Reserve Bank, plus the presidents of four
other regional Federal Reserve Banks.
These four presidents serve on a rotating
basis.
The FOMC meets 8 times a year to
determine appropriate monetary policy.
The FOMC is the major policy-making
group within the Federal Reserve system.
Functions of the Federal
Reserve System
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Control the Money Supply through open
market operations (buying and selling
government securities)
Supply the economy with paper money.
Provide check-clearing services.
Hold depository institutions’ reserves
• It is the banker’s bank. All banking
institutions MUST maintain an account at
the Federal Reserve District Bank.
• A crucial function to managing the money
supply
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. Holds the Government’s
“checking account”.
Monetary Policy Chap. 15
Tools For Controlling the Money Supply
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1. Open Market Operations: Buying and Selling
U.S. Government Securities in the Financial Markets.
This is the # 1 tool the Fed relies upon to manage
the money supply.
2. Sets the Reserve Requirement: The reserves
which banks must maintain either in their vaults or on
deposit at their district’s Federal Reserve Bank
3. Sets the Discount Rate: The rate at which
member banks can borrow from the Fed.
4. ? Moral Suasion: Speeches and comments by Fed
officials that attempt to influence the economy.
5. During the last financial crisis, the Fed used
Quantative Easing (QE) to increase the money
supply. They bought outstanding government bonds.
Which Tool Does the Fed Prefer
to Use?
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The Fed prefers Open Market
Operations because:
• Open market operations
• Open market operations
• Open market operations
implemented quickly
• Open market operations
the New York Fed bank.
are flexible
can be reversed
can be
are used daily by
How Open Market Purchases
Affect the Money Supply
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Assume Fed purchases securities from a
bank.
The Fed receives the securities from a bank,
and the bank’s excess 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.
“Buying Bonds = Bigger Bucks”
How Open Market Sales Affect the
Money Supply
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Assume the Fed sells securities to a
bank.
To pay for the securities, the Fed
takes excess reserves from the bank.
Because of the decrease in the bank’s
reserves, the bank reduces potential
loans, which reduces the potential
volume of checkable deposits and the
money supply.
“Selling Bonds = Smaller Bucks”
Open Market Operations
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.
This tool is infrequently used by the Fed as it
cause a disruption to daily banking operations.
For example, if the Fed raised the reserve
requirement, banks may need to call in loans
to meet their reserve requirement.
The Discount Rate
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A bank can borrow from the Fed at
the Discount Rate. It is a
“collateralized” loan (i.e. bank must
provide collateral – bonds)
Discount Rate: The interest rate a
bank pays for a loan from the Fed.
 When a bank borrows money from the Fed, the
potential money supply increases because its
reserves increase while the reserves of no other
bank decrease.
The Federal Funds Rate
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The interest rate refers to the
Federal Funds Rate set by the
FOMC
The Fed Funds rate is the most
important interest rate as it
influences many other interest rates
such as the Prime Rate.
The prime rate is what commercial
banks use to lend to their best
customers; also it affects other
lending rates.
Fed Funds Rate (contd)
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The Fed Funds rate defined: It is the rate at
which banks borrow overnight from other
banks to meet their reserve requirements
should their reserves fall short.
The Fed Funds Rate serves as a “target rate”
to regulate the money supply. On a daily
basis the Fed Funds Rate may increase or
decrease slightly as demands for money
increase or decrease in our economy. For
example, a natural disaster may increase the
demand for money.
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Fed Funds Rate
• http://www.dallasfed.org/data/data/rmf
edfun.htm
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Prime Rate
• http://www.dallasfed.org/data/data/rm
bkprim.htm
Why do banks need overnight
loans?
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Banks are like any other business in that they
seek to maximize profits. Banks make a profit by
loaning out as much of their excess reserves as
possible and charging interest to the borrower. If,
in the course of business, they have loaned out
all excess reserves and do not have enough
money to satisfy the required reserve ratio, then
they must either borrow from the Fed’s discount
window, or most likely borrow from each other in
the Fed Funds market at the Federal Funds Rate.
Fed Actions to Counter Inflation
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Tight (or Contractionary) Money
Policy
• To counter inflation (inflationary Gap on
the SRAS/AD graph)
• Fed attempts to reduce Aggregate
Demand
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Contract money supply
•Sell bonds, raise reserve requirement, raise
discount rate
Inflationary Gap
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An inflationary gap exists when equilibrium
occurs beyond full employment output.
PL
LRAS
SRAS
P
AD
YF Y
GDPR
Fed Actions to Counter a
Recession
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Easy (or Expansionary) Money Policy
• To counter recession (Recessionary
Gap) or downturn of the economy.
Expands money supply
• Fed attempts to increase Aggregate
Demand
• Buy bonds, lower reserve requirement, lower
discount rate
Recessionary Gap
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A recessionary gap exists when equilibrium
occurs below full employment output.
SRAS
LRAS
PL
P
AD
Y
YF
GDPR
Fed Monetary Tools & Their
Effects on the Money Supply
Federal Reserve and Interest
Rates
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An open market
• An open market sale shifts
purchase shifts the
the supply of money to the
supply of money to the
left and leads to higher
right and leads to
interest rates.
lower interest rates.
Interest Rates, Investment, and
Output
Open
market
purchase
Money
supply
increases
Interest
rates
fall
Investment
spending
rises
Increase
in GDP
MS MS1
i%
i%
Graphing Expansionary
Monetary Policy
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i
i
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MD
Q
Q1
1. Money Supply
Increases;
2. Interest Rate
Decreases,
3. Investment
Increases,
AD & GDP Increases
and Unemployment
(Y) decreases.
i1
ID

QM
I
P
IG
LRAS
PL
P1
I1
SRAS
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
i1
AD

Y
YF
AD1
GDPR
How Monetary Policy Affects
International Trade
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International trade and movements of
financial funds across countries are
affected by interest rates and exchange
rates.
The exchange rate is the rate at which
one currency trades for another country’s
currency.
A decrease in the value of a currency is
called depreciation. An increase in the
value of a currency is called appreciation.
We will see this topic again in Chapter 37.
But remember the value is determined by
the laws of supply and demand.
Canadian $ price of U.S. dollar
THE MARKET FOR CURRENCY
P
1.25
EXCHANGE
RATE: .97 CD = $1 USD
S
S1
Can. $$
depreciates
.97 p
p1
As Interest rate
decreases, money
supply increases
(S1) and the $
depreciates and C$
appreciates.
Can. $
appreciates
.80
D
Q
Quantity of U.S. $
Q1
Q
How Monetary Policy Affects
International Trade
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Lower interest rates brought on by
the Fed will cause the dollar to
depreciate. This will ultimately
change the demand and supply of
goods and services around the
globe because it will make U.S.
goods cheaper than foreign goods.
open
market
bond
purchase
increase
in money
supply
fall in
interest
rates
fall in
exchang
e rate
increase
in net
exports
increase
in GDP
Monetary Policy Challenges for the Fed
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Stabilization policies are intended
to move the economy closer to full
employment or potential output.
In practice, however, it is very
difficult to accomplish this goal.
Lags in monetary policy:
Normally it takes approximately 18
months for interest rate changes
to fully work their way through the
economy.
Strengths/Weaknesses of
Monetary Policy
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Strengths
• Speed and flexibility
• “No” political pressures
• Managing the money supply is the key to
managing the economy
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Weaknesses
• Fed cannot “force” loans. It is easier to slow
inflation than correct a recession
• Velocity,or often we spend money may change
• Change in interest rates may not affect
investment
Monetary Policy
Recession
Inflation
Open Market Ops.
Fed buys bonds
Fed sells bonds
Reserve Requirement
Lower
increase
Discount Rate
Lower
raise
Remember, monetary policy does not affect Fiscal
Policy; i.e. government spending and taxing.
They should complement each other but the Fed
is independent of the President and Congress
and there have been instances when fiscal and
monetary policies have moved in different
directions.
The Financial Crisis of 2008
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Subprime (remember the Prime Rate)
lending during the U.S. housing bubble of the
mid-2000s spread through the financial
system.
When the bubble burst, massive losses by
banks and non-bank financial institutions led
to widespread collapse in the financial system.
To prevent another Great Depression, the Fed
and the U.S. Treasury expanded lending to
bank and nonbank institutions, provided
capital through the purchase of bank shares,
and purchased private debt.
The Financial Crisis of 2008
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Because much of the crisis originated
in nontraditional bank institutions, the
crisis of 2008 indicated that a wider
safety net and broader regulation are
needed in the financial sector.
The 2008 Crisis and the Fed
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Fed officials believed that this change in standard
operating procedure was necessary to stave off an
even more severe financial crisis.
Usually, the Fed invests only in U.S. government debt,
which is considered a very safe asset; the same could
not be said of many of the loans made during 2008.
Normally, the Federal Reserve holds almost no assets
other than U.S. Treasury bills.
In response to the 2008 financial crisis, however, the
Fed created an alphabet soup of special “facilities” to
lend money to troubled financial institutions, leading
to a dramatic shift in its balance sheet. For example,
the Fed bought stock in General Motors to keep this
company out of bankruptcy.