Chapter 4 Central Banks' Objectives; Structure of the Fed

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest

Rates

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Structure of the Federal Reserve System(The Fed)

• The Fed is the central bank of U.S.A banker’s bankA government’s bank

Decentralized system• 12 Federal Reserve Banks (FRBs)• Board of Governors of the Federal Reserve System• Federal Open Market Committee (FOMC)• Member banks

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The Fed’s Main Responsibilities• Formulate and conduct monetary policy

through the FOMC.• Regulate commercial banks. • Serve as the lender of last resort.• Provide payment and other financial services

Goals: Foster economic growth (low unemployment); stable and low price level

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Structure of the Fed (cont.)

• 12 districts Each district has its own district Federal Reserve Bank (FRB). http://www.federalreserve.gov/otherfrb.htmEach FRB has its own president, and a 9-member Board of directors.

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Federal Reserve Banks

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Federal Reserve Bank Functions: General

• Issue new currency and remove damaged currency

• Clear checks• Perform bank examinations• Collect and examine data on local business

conditions• Liaison between local community and the Federal

Reserve System• Lender to member banks• Evaluate bank mergers and expansions

http://kansascityfed.org/aboutus/fed-and-you.cfm

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The FRB of New York

• The New York Fed houses the open market desk. All of the Feds open market operations are directed through this trading desk.

• The chairman of New York Fed is the only permanent member of the FOMC, serving as the vice-chairman of the committee.

• Being in NYC, the New York Fed is responsible for oversight of some of the largest financial institutions headquartered in Manhattan and the surrounding area.

Structure of the Fed (cont.)• Board of Governors in D.C.

7 governors, non-renewable 14-year term, appointed by the U.S. President and confirmed by the Senate.

Chair serves a 4 year term but can be reappointed

Independence of the Fed

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Structure of the Fed (cont.)Federal Open Market Committee (FOMC)•12 members (7 Board of governors+5 Presidents of district FRBs); The chairman of the FOMC is the chairman of the Board of the Governors.•Who makes actual decision for the Fed? _______.•How often does the FOMC meet? 8 times per year + emergent meetings if needed.http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm•Make decisions regarding open market operations, to influence the monetary base and interest rate. •FOMC Statement.

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FOMC statement

• Committee’s view of current economic conditions.• Risk of attaining the dual objectives• Decisions

Current target for the federal funds rate

The point is to be as transparent as possible regarding the path of policies for the next few months.

• Voting

Monetary Policy Tools

• Open Market Operation• Discount Rate• Reserve Requirement

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Money• M0 (Monetary base): Currency & coins,

reserves• M1: currency& coins + demand deposits

(checking accounts)• M2: ___+ time deposits (savings accounts)

• In this class: Money=currency in circulation + deposits

Monetary base 12

Open Market Operations

• Open Market Operations: the Fed buys or sells U.S. government securities.

• Process8:30-9:00am, open market staff members figure out the demand for reserve9:00-9:20am formulate a plan (buy or sell, how much)9:20am a daily conference call By about 10:00am transactions are done (electronic trading)

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Federal (Fed) Funds Rate• The Federal (Fed) Funds Rate: interest rate depository

institutions in US charge when they lend reserves to each other overnight.

• Depository institutions and the reserve requirement Depository institutions: legally allowed to accept deposits

from customers. Commercial banks, credit unions,

savings associations, etc. Reserve requirement: A certain percentage of customers’

deposits as reserves. • 200m deposits Required reserves Total reserves Bank A 20m 30m Bank B 20m 15m

Market (effective) Fed Funds Rate vs.Target Fed Funds Rate

• Market Fed Funds Ratewww.federalreserve.gov/releases/h15/updateDetermined in the market, not controlled by the Fed. demand and supply of

federal funds in the market• Target Fed Funds Rate

The target interest rate at which banks make overnight loans to each other.FOMC announces it at its statement.

•

Source: http://research.stlouisfed.org/

How Does the Fed Influence Market Fed Funds Rate?

• By influencing reserves Add reserves ↓ market fed funds rate

or

Drain reserves ↑ market fed funds rate

• Practice Question:The Fed can lower market fed funds rate by

____(buying/selling) securities, thereby ____(↑ / ↓ ) reserves.

Why should we care the federal funds rate?

• Market interest rate and the Federal Funds rate are positively related.

• The Federal Funds rate ↓ => Market interest rate ↓

↑ ↑

Discount Policy• Discount lending, Discount rate

The Fed lends to commercial banks. The interest rate charged by the Fed when financial

institutions borrow from it.• Lender of last resort

To provide liquidity to banks, eliminate bank panics, and stabilize the financial systemCost: moral hazard problem, take extra risk, especially for large commercial banks (“too big to fail”)

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Operations of the Discount Window• Primary Credit

to sound banks, very short-term.Primary discount rate is usually 100 basis points above the target federal funds rate. As a ceiling for market federal funds rate.

• Secondary Credit only if the bank can’t borrow from others

50 basis points above the primary discount rate• Seasonal Credit

Market interest rate.banks with a lot of farmers’ loans and deposits

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Reserve Requirements

• Reserve Ratio Requirement: portion (expressed as a percent) of depositors' balances that banks are required to deposit as reserves with the Fed or to hold as cash.

• Change in reserve ratio affects the quantity of money and credit availability in the economy.

• Reserve requirement have a large – really, too large – impact on the level of deposits.

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Money MultiplierWhat determines the money supply?• Example 1: I have $100, and put it under

my mattress.

• M increases by how much.

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Money Multiplier (cont.)• Example 2: I have $100. (the starting point)

I’m going to deposit $100 in a bank (the 1st bank). (The bank wants to make profit by putting loans out).

• Suppose the bank loans $90 to Jamie, Jamie buys a coat from Macy’s and Macy’s deposits $90 in its bank (the 2nd bank).

• The 2nd bank loans $81 to Steve, Steve buys a cabinet from Walmart, Walmart puts $81 in its bank (the 3rd bank).

• The 3rd Bank loans $72 to Kim, Kim puts $72 under his mattress. 22

Money Multiplier (cont.)• In example 2: money supply increases by

how much?• M=currency + deposits

Currency increases by ____; Deposits by ____• Multiplier: 1/required reserve ratio.

• Scenario 2: private sector created money. When people deposits funds, and when banks lend funds, M increases. 23

What Determines Money Supply?

1) Government prints money

2) How much households deposit and how much banks lend.

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Federal Reserve Bank Functions: Monetary Policy

• Five of the 12 bank presidents vote in the Federal Open Market Committee

• “Establish” the discount rate at which member banks may borrow from the Federal Reserve Bank (subject to BOG review), decide which banks can obtain discount loans from the Federal Reserve Bank.

• Elect one member to the Federal Advisory Council

Board of Governors

• Sets the reserve requirement.• All Board members are members of the

FOMC.• Effectively sets the discount rate. • Serve in an advisory capacity to the President

of the United States, and represent the U.S. in foreign economic matters.

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Member Banks

• National banks (banks chartered by the Office of the Comptroller of the Currency) are required to be members.

• State commercials banks may elect to join. • By 1987, all depository institutions were

required to maintain reserves (member or nonmember banks), have access to the discount window and Fed check clearing service.