
This chapter addresses the following:
◦ How does government control the amount of money
in the economy?
◦ Which government agency is responsible for
exercising this control?
◦ How are banks and bond markets affected by the
government’s policies?


The fed’s control over the supply of money is
the key mechanism of monetary policy.
Monetary policy is the use of money and
credit controls to influence macroeconomic
activity.

Each of the twelve (12) Federal Reserve banks
act as a central banker for the private banks
in their region.

The Federal Reserve performs the following
services:
 Clears
checks between private banks
 Holds bank reserves.
 Provides currency to the public.
 Provides loans to private banks.


The Fed is controlled by a seven person Board
of Governors.
Each governor is appointed to a 14-year term
by the President (with confirmation by the
U.S. Senate).


The long term is intended to give the Fed a
strong measure of political independence.
The President selects one of the governors
to serve as chairman for a 4-year term.
Federal Open
Market
Committee
(12 members)
Board
of
Governors
(7 members)
Federal Reserve banks
(12 banks, 24 branches)
Private banks
(depository institutions)
Federal Advisory
Council and
other
committees

The Federal Reserve controls the money
supply using the following three policy
instruments:
◦ Reserve requirements
◦ Discount rates
◦ Open-market operations

The Fed requires banks to keep a minimum
amount of required reserves.
◦ Required reserves – The minimum amount of
reserves a bank is required to hold; equal to
required reserve ratio times transactions deposits.
Required reserves = required reserve ratio
X total deposits

The fed directly alters the lending capacity of
the banking system by changing the reserve
requirement.


By changing the reserve requirement, the Fed
changes the level of excess reserves in the
banking system.
Excess reserves are bank reserves in
excess of required reserves.
Excess reserves = Total reserves –
Required reserves

By raising the required reserve ratio, the Fed
can immediately reduce the lending capacity
of the banking system.

A change in the reserve requirement causes
changes in:
 Excess
reserves.
 The money multiplier.
 The lending capacity of the banking system.
Required Reserve Ratio
20 percent
25 percent
Total deposits
$100 billion
$100 billion
Total reserves
30 billion
30 billion
Required reserves
20 billion
25 billion
Excess reserves
10 billion
5 billion
5
4
$ 50 billion
$ 20 billion
Money multiplier
Unused lending capacity


Excess reserves earn no interest.
Banks have a tremendous profit incentive to
keep their reserves as close to their required
reserve level as possible.
7
Excess reserves
4
3
2
Borrowings at
Federal Reserve banks
1
1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000


The federal funds market is where a bank that
finds itself short of reserves can turn to other
banks for help.
The federal funds rate is the interest rate for
inter-bank reserve loans.

Reserves borrowed in this manner are called
“federal funds” and are lent for short periods
- usually overnight.


A bank that is low on reserves can also sell
securities.
Banks use some of their excess reserves to
purchase government bonds.


Discounting refers to the Federal Reserve
lending of reserves to private banks.
A bank can deal with a reserve shortage by
going to the Fed’s “discount window” to
borrow reserves directly.

The discount rate is the rate of interest the
Federal Reserve charges for lending reserves
to private banks.

By raising or lowering the discount rate, the
Fed changes the cost of money for banks and
the incentive to borrow reserves.

Open-market operations are the principal
mechanism for directly altering the reserves
of the banking system.


The portfolio decision is the choice of how
(where) to hold idle funds.
People do not hold all their idle funds in
transactions accounts or cash.


The Fed’s open-market operation focus on
the portfolio choices people make.
The Fed attempts to influence the choice by
making bonds more or less attractive, as
circumstances warrant.

When the Fed buys bonds from the public, it
increases the flow of deposits (reserves) to
the banking system.
Bond sales by the Fed reduce the flow.
 Likewise, when the Fed sells bonds, it
removes money from the banking system.

Buyers spend
Fed SELLS bonds
account balances
The Fed
Open
market
operations
The
Public
Banks
Sellers deposit
Fed BUYS bonds
Reserves
decrease
bond proceeds
Reserves
increase



Not all of us buy and sell bonds, but a lot of
consumers and corporations do.
A bond is a certificate acknowledging a debt
and the amount of interest to be paid each
year until repayment.
It is nothing more than an IOU.


The current yield paid on a bond is the rate of
return on a bond.
It is the annual interest payment divided by
the bond’s price.
Annual interest payment
Yield =
Price paid for bond

A principal objective of Federal Reserve open
market activity is to alter the price of bonds,
and therewith their yields.



The less you pay for a bond, the higher its
yield.
Federal Reserve open-market activity alters
the price of bonds, and their yields.
By doing so, the Fed makes bonds a more or
less attractive alternative to holding money.

Open market operations are Federal Reserve
purchases and sales of government bonds for
the purpose of altering bank reserves.


If the Fed offers to pay a higher price for
bonds, it will effectively lower bond yields
and market interest rates.
By buying bonds, the Fed increases bank
reserves.
Regional Federal
Reserve bank
Federal Open
Market Committee
Step 3: Bank deposits
check at Fed bank,
as a reserve credit
Step 1: FOMC purchases
government bonds; pays
for bonds with Federal
Reserve check
Private
bank
Step 2: Bond seller
deposits Fed check
Public



Fed funds rate act as a market signal of the
changing reserve flows.
If the Fed is pumping more reserves into the
banking system, the federal funds rate will
decline.
If the Fed is reducing bank reserve by selling
bonds, the federal funds rate will increase.


The volume of trading in U.S. government
securities exceeds $100 billion per day.
Each dollar in reserves represents
approximately $10 in potential lending due to
the money multiplier.