Chapter 14: The Federal Reserve System Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13e

14-2 The Federal Reserve System We examine how the government controls money creation and thus aggregate demand (AD). The core issues are – Which government agency is responsible for controlling the money supply? – What policy tools are used to control the amount of money in the economy? – How are banks and bond markets affected by the government’s policies?

14-3 Learning Objectives Describe how the Federal Reserve is organized Identify the Fed’s major policy tools Explain how open market operations work.

14-4 The Structure of the Fed The Fed was created in It consists of 12 Federal Reserve banks, which act as the central bank for private banks in their regions and perform the following services: – Clearing checks. – Holding bank reserves. – Providing currency. – Providing loans.

14-5 The Structure of the Fed The Fed Board of Governors is responsible for setting monetary policy. – Monetary policy: the use of money and credit controls to influence macroeconomic outcomes. Board members are appointed to a 14-year term, in a two-year stagger, to ensure a measure of political independence. One board member is appointed chairman for 4 years.

14-6 The Structure of the Fed The current Fed chairman is Ben Bernanke, serving his second 4-year term. The Federal Open Market Committee (FOMC) is responsible for the Fed’s daily activity in financial markets. – The FOMC meets monthly to review economic performance and to adjust monetary policy as needed.

14-7 Monetary Tools The Fed controls the money supply by using three policy tools: – Reserve requirements. – Discount rates. – Open market operations.

14-8 Reserve Requirements Private banks are required to keep a fraction of deposits “in reserve,” either as cash or on deposit at the regional Fed bank. By changing reserve requirements, the Fed can directly alter the lending capacity of the banking system.

14-9 Reserve Requirements Increase the reserve requirement and … – The amount of excess reserves decreases. – The money multiplier decreases. – The available lending capacity shrinks. Decrease the reserve requirement and … – The amount of excess reserves increases. – The money multiplier increases. – The available lending capacity expands. Available lending capacity = Excess reserves x Money multiplier

14-10 The Discount Rate Profit-seeking private banks earn income by making loans. – They try to fully lend out their excess reserves. At times, a bank might fall short of satisfying the reserve requirement. – It can borrow excess reserves overnight from another bank and pay interest: the federal funds rate. – It can borrow reserves overnight from the Fed and pay interest: the discount rate.

14-11 The Discount Rate Discount rate: the rate of interest the Fed charges for lending reserves to private banks. – If the discount rate is raised, borrowing reserves from the Fed becomes more expensive, and fewer reserves are borrowed. Fewer loans are made, decreasing the money supply. – If the discount rate is lowered, borrowing reserves from the Fed becomes less expensive, and more reserves are borrowed. More loans are made, increasing the money supply.

14-12 Open Market Operations This is the principal mechanism to directly alter the reserves of the banking system. Portfolio decision: the choice of how and where to hold idle funds. – There are several choices: cash, savings accounts, stocks, and bonds. The last three may generate additional income in the form of dividends or interest. Should you keep your idle funds in a savings account or purchase government bonds? – The Fed influences this decision by making bonds more or less attractive.

14-13 Open Market Operations If the public moves funds from savings to bonds, reserves fall, and vice versa. – When the Fed buys government bonds from the public, reserves increase, more loans can be made, and the money supply grows. – When the Fed sells government bonds to the public, reserves decrease, fewer loans can be made, and the money supply shrinks.

14-14 The Bond Market A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment. – It is an IOU. People buy bonds because they pay interest and are a safe investment. – Yield: the rate of return on a bond. Annual interest payment Yield = Price paid for the bond

14-15 The Bond Market Pay $1,000 for a bond that pays out $80 a year, and its yield is 0.08 or 8%. If its price fell to $900 in the bond market, its yield would increase to or 9%. The objective of open market operations is to alter the price of bonds, and also their yields, to make them more or less attractive as investments.

14-16 Open Market Activity The Fed can induce people to buy bonds by offering to sell them at a lower price. – When the public pays for the bonds, bank reserves fall. Fewer loans are made, and the money supply decreases (or its growth slows). The Fed can induce people to sell bonds by offering to buy them at a higher price. – When the Fed pays the public for the bonds, bank reserves rise. More loans are made, and the money supply increases.

14-17 The Fed Funds Rate The Fed funds rate: the interest rate one bank charges another for an overnight loan of excess reserves. – If the Fed increases reserves by buying bonds, the Fed funds rate falls. – If the Fed decreases reserves by selling bonds, the Fed funds rate rises. The Fed funds rate is a highly visible signal of Federal Reserve open market operations.

14-18 Increasing the Money Supply To increase the money supply, the Fed can – Lower reserve requirements. – Reduce the discount rate. – Buy bonds in open market operations.

14-19 Decreasing the Money Supply To decrease the money supply, the Fed can – Raise reserve requirements. – Increase the discount rate. – Sell bonds in open market operations.

14-20 The Economy Tomorrow Is the Fed losing control? – Since 1980, all depository institutions have had to satisfy Fed reserve requirements. – Traditional banks have declined in number and are replaced by multifunction financial services firms. Controlling these large units is more complicated than controlling single-purpose banks. – Finance is global. Foreign banks hold dollars. This makes it more difficult to control the size of the money supply.

14-21 The Economy Tomorrow Is the Fed losing control? – Because of these changes, the Fed shifted away from targeting the money supply to targeting interest rates. This is easier and faster to track. Interest rates are of more immediate concern in investment and consumption decisions. – Thus the Fed most likely will use the federal funds rate as its primary barometer of monetary policy in the economy tomorrow.

14-22 Revisiting the Learning Objectives Describe how the Federal Reserve is organized. – There are 12 regional Federal Reserve banks. – The Board of Governors sets general policy. – The chairman is the spokesperson for monetary policy. – The Federal Open Market Committee (FOMC) implements policy strategy.

14-23 Revisiting the Learning Objectives Identify the Fed’s major policy tools. – The Fed controls the size and growth of the money supply by regulating loan activity of private banks. – The three tools are Altering the reserve requirement. Altering discount rates. Buying or selling government bonds in open market operations.

14-24 Revisiting the Learning Objectives Explain how open market operations work. – When the Fed buys bonds, it pays the seller, and bank reserves increase. More loans can be made, and the money supply grows. – When the Fed sells bonds, the buyer pays the Fed, and bank reserves decrease. Fewer loans can be made, and the money supply shrinks (or grows slower).