The Federal Reserve System Chapter 14 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

The Federal Reserve SystemChapter 14

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

14-2

The Federal Reserve System

• This chapter examines the mechanics of government control– How does the 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?

14-3

The Federal Reserve System

• The government must regulate bank lending if it wants to control the amount of money in the economy

• Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

14-4

Structure of the Fed

• The Federal Reserve was created in 1913 to avert recurrent financial crises

• Each of the twelve (12) Federal Reserve banks act as central banker for the private banks in their region

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Federal Reserve Banks

• Each regional Fed bank provides services:– Clearing checks between private banks– Holding bank reserves– Providing currency– Providing loans to private banks

14-6

The Board of Governors

• The seven-person Board of Governors sets monetary policy

• Each governor is appointed to a 14-year term by the President (with confirmation by the U.S. Senate)

• The President selects one of the governors to serve as chairman for a 4-year term

14-7

The Federal Open Market Committee (FOMC)

• The FOMC is a twelve member group (the seven governors along with five of the 12 regional Reserve bank presidents)

• The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes

14-8

Structure of the Federal Reserve System

Private banks

(depository institutions)

Federal Reserve banks(12 banks, 25 branches)

Boardof

Governors(7 members)

Federal Open Market Committee

(12 members)

Federal Advisory Council and other

committees

14-9

Monetary Tools

• The Federal Reserve controls the money supply using three policy instruments:– Reserve requirements– Discount rates– Open-market operations

14-10

Reserve Requirements

• Required reserves – The minimum amount of reserves a bank is required to hold

• By changing the reserve requirements, the Fed can directly alter the lending capacity of the banking system

Required required totalreserves reserve ratio deposits

14-11

Reserve Requirements

• By changing the reserve requirement, the Fed changes the level of excess reserves in the banking system

• Excess reserves: Bank reserves in excess of required reserves

Excess total requiredreserves reserves reserves

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Reserve Requirements

• The money multiplier determines how much in additional loans the banking system can make based on their excess reserves

Available lending capacity money

excess reservesof the banking system multiplier

1

Money multiplier

required reserve ratio

14-13

Reserve Requirements

• By raising the required reserve ratio, the Fed reduces lending capacity in the banking system

• A change in the reserve requirement causes a change in:– Excess reserves– The money multiplier– The lending capacity of the banking system

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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

Money multiplier 5 4

Unused lending capacity $ 50 billion $ 20 billion

Impact of an Increased Reserve Requirement

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The Discount Rate

• Excess reserves earn no interest, so banks have a profit incentive to keep their reserves as close to the required reserve level as possible

• Because banks continually seek to keep excess reserves at a minimum, they run the risk of falling below reserve requirements

14-16

Excess Reserves and Borrowings

Excess reserves represent unused lending capacity. Hence, banks strive to keep excess reserves at a minimum.

14-17

The Federal Funds Market

• A bank that finds itself short of reserves can turn to other banks for help

• Reserves borrowed from another bank are called federal funds

• Federal funds rate: The interest rate for interbank reserve loans

14-18

Sale of Securities

• Banks use some of their excess reserves to purchase government bonds

• A bank that is low on reserves can also sell securities

14-19

Discounting

• Discounting: Federal Reserve lending of reserves to private banks

• Discount rate: The rate of interest the Federal Reserve charges for lending reserves to private banks

• Changing the discount rate affects the cost and incentive for banks to borrow reserves

14-20

Open-Market Operations

• Open-market operations are the Fed’s principal mechanism for altering the reserves of the banking system

• The Fed’s open-market operations focus on the portfolio choices people make

14-21

Hold Money or Bonds?

• Portfolio decision: The choice of how (where) to hold idle funds

• People do not hold all their idle funds in transactions accounts or cash

• The Fed attempts to influence the choice by making bonds more or less attractive

14-22

Open Market Operations

Open market

operations

Fed BUYS bonds

Buyers spend

account balances

Sellers deposit

bond proceeds

BanksThe Fed

Fed SELLS bonds Reserves decrease

Reserves increase

The Public

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The Bond Market

• Bond: A certificate acknowledging a debt and the amount of interest to be paid each year until repayment; an IOU

• Bonds can be resold to someone else at any time

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Bond Yields

• Yield: The rate of return on a bond

• A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields

annual interest paymentYield

price paid for bond

14-25

Open Market Activity

• Open market operations: Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves

• By buying bonds, the Fed increases bank reserves

• By selling bonds, the Fed reduces bank reserves

14-26

An Open-Market Purchase

Federal OpenMarket Committee

Regional FederalReserve bank

Privatebank

Step 2: Bond seller deposits Fed check

Step 3: Bank deposits check at Fed bank, as

a reserve credit

Public

Step 1: FOMC purchases government bonds; pays

for bonds with Federal Reserve check

14-27

The Fed Funds Rate

• The federal funds rate is a highly visible signal of Federal Reserve open market operations

• If the Fed is pumping more reserves into the banking system, the federal funds rate will decline

• If the Fed is reducing bank reserves by selling bonds, the federal funds rate will increase

14-28

The Fed Funds Rate

• The Fed doesn’t actually set the federal funds rate

• The Fed it sets a target rate and then conducts open market operations to achieve it

• Other market interest rates tend to move in the same direction

14-29

Increasing the Money Supply

• To increase the money supply, the Fed can:– Lower reserve requirements– Reduce the discount rate– Buy bonds

14-30

Lowering Reserve Requirements

• Lowering reserve requirements is an expedient way of increasing the lending capacity of the banking system– Excess reserves in the banking system increase– Banks expand deposits through loans– The money supply increases

14-31

Lowering the Discount Rate

• Profitability of discounting depends on the difference between the discount rate and the interest rate banks charge on loans

• Lowering the discount rate increases this– Banks become more willing to borrow reserves– Banks make more loans, increasing the money

supply

14-32

Buying Bonds

• The Fed purchases bonds from bond sellers

• Sellers deposit proceeds of sales in banks

• Excess reserves increase

• The money supply increases as banks make additional loans

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Federal Funds Rate

• When the Fed starts bidding up bonds, bond yields and market interest rates start falling

• The federal funds rate also falls, giving individual banks incentive to borrow reserves

• This accelerates deposit (loan) creation

14-34

Decreasing the Money Supply

• To reduce the money supply, the Fed can:– Raise reserve requirements– Increase the discount rate– Sell bonds

14-35

Focus on Fed Funds Rate, not Money Supply

• The Fed has shifted from money-supply targets to interest rate targets

• The Fed will continue to use the federal funds rate as its primary barometer of monetary policy

The Federal Reserve SystemEnd of Chapter 14

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin