The Federal Reserve System

The Federal Reserve The Federal Reserve (the Fed), created in 1913, is the central bank for the United States. The Federal Reserve is responsible for the creation of a stable monetary climate for the entire U.S. economy. It controls the money supply of the U.S. Serves as a “banker’s bank” or “lender of last resort” for U.S. banks Regulates the banking sector In short, the Federal Reserve is responsible for the conduct of U.S. monetary policy.

The Fed and the Treasury The U.S. Treasury: Is concerned with the finances of the federal government Issues bonds to the general public to finance the budget deficits of the federal government Does not determine the money supply The Federal Reserve: Is concerned wit the monetary climate of the economy Does not issue bonds Is responsible for the control of the money supply and the conduct of monetary policy

The Federal Reserve System Federal Reserve Board of Governors 7 members appointed by the president, with the consent of the U.S. Senate The Board of Governors is at the center of Federal Reserve operations. The board sets all the rates and regulations for the depository institutions. 12 Federal Reserve District Banks (25 branches) Open Market Committee Board of Governors & 5 Federal Reserve Bank Presidents (alternating terms, New York Bank always represented). The seven members of the Board of Governors also serve on the Federal Open Market Committee (FOMC). Commercial Banks Savings & Loans Credit Unions Mutual Savings Banks The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities. The Public: Households & businesses

The Federal Reserve Districts 10 Kansas City 9 Minneapolis San Francisco 12 7 Chicago 1 Boston 4 Cleveland 2 New York Philadelphia 3 5 Richmond Washington, D.C. (Board of Governors) St. Louis 8 Atlanta 6 11 Dallas The map indicates the 12 Federal Reserve districts and the cities in which the district banks are located. Each district bank monitors the commercial banks in their region and assists them with the clearing of checks. The Board of Governors of the Federal Reserve System is located in Washington D.C.

The Independence of the Fed The independence of the Federal Reserve system is designed to strengthen the ability of the Fed to pursue monetary policy in a stabilizing manner. Fed independence stems from: The lengthy terms of the members of the Board of Governors (14 years), and, The fact that the Fed’s revenues are derived from interest on the bonds that it holds rather than allocations from Congress.

Four Tools The Fed has four major tools that it can use to control the money supply: Reserve requirements Setting the fraction of assets that banks must hold as reserves (vault cash or deposits with the Fed), against their checking deposits Open market operations The buying and selling of U.S. government securities and other assets in the open market Extensions of Loans Control the volume of loans to banks and other financial institutions Interest paid on bank reserves Setting the interest rate paid to banks on reserves held at the fed

Reserve Requirements When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply. When the raises the required reserve ratio, it has the opposite effect, contracting the money supply. The Fed very rarely changes the reserve requirements for deposits, because the effect it can have on the money supply is harder to quantify than just dividing by the ratio.

Open Market Operations Open Market Operations: The buying and selling of U.S. Treasury bonds and other financial assets by the Fed. This is the primary tool used by the Fed to control the money supply. Note: the U.S. Treasury bonds held by the Fed are part of the national debt.

Open Market Operations Open Market Operations: The buying and selling of U.S. Treasury bonds and other financial assets by the Fed. When the Fed buys bonds the money supply expands because: Bond sellers acquire money Bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans When the Fed sells bonds the money supply contracts because: Bond buyers exchange money for bonds Bank reserves decline, causing them to extend fewer loans

Extension of Loans Historically, member banks have borrowed from the Fed primarily to meet temporary shortages of reserves. The discount rate is the interest rate the Fed charges for short-term loans needed to meet reserve requirements. Other things constant, an increase in the discount rate will reduce borrowing from the Fed and thereby exert a restrictive impact on the money supply. Conversely, a lower discount rate will make it cheaper for banks to borrow from the Fed and exert an expansionary impact on the supply of money.

The Federal Funds Rate The Fed is not the only one who can lend money to a bank in need of reserves. Other banks can loan the money at their own interest rate, which is set by usual market forces. Ex. If Bank of America sees some great investment opportunities, but doesn’t have enough in their excess reserves to make the loan, they can call up Wells Fargo and take out a loan themselves. The market in which banks lend to each other is a private loanable funds market called the federal funds market. The interest rate at which these banks lend to each other is called the federal funds rate.

The Federal Funds Rate Announcements after the regular meetings of the Federal Open Market Committee often focus on the Fed’s target for the federal funds rate. The Fed controls the federal funds rate through open market operations. The Fed can reduce the federal funds rate by buying bonds, which will inject additional reserves into the banking system. The Fed can increase the federal funds rate by selling bond, which drains reserves from the banking system. While the media often focuses on the Fed’s target funds rate, open market operations are used to control this interest rate.

Interest on Reserves The Fed began paying banks interest on their reserves in October 2008. As of year-end 2009, the Fed was paying member banks an interest rate equal to the target federal funds rate on both required and excess reserves. The payment of interest on reserves provides the Fed with another tool it can use to control the money supply.

Summary of Fed Tools Federal Reserve Policy Expansionary Monetary Policy Restrictive Monetary Policy 1. Reserve Requirements Reduce reserve requirements because this will create additional excess reserves and induce banks to extend more loans, which will expand the money supply. Raise reserve requirements because this will reduce the excess reserves of banks and induce them to make fewer loans, which will contract the money supply. 2. Open Market Operations Purchase additional U.S. Securities and other assets, which will increase the money supply and also expand the reserves available to banks. Sell U.S. securities and other assets, which will decrease the money supply and also contract the reserves available to banks. 3. Extension of Loans Extend more loans because this will increase bank reserves, encouraging banks to make more loans and expand the money supply. Extend fewer loans because this will decrease bank reserves, discourage bank loans, and reduce the money supply. 4. Interest Paid on Excess Bank Reserves Reduce the interest paid on excess reserves because this will induce banks to hold less reserves and extend more loans, which will expand the money supply. Increase the interest paid on excess reserves because this will induce banks to hold more reserves and extend fewer loans, which will contract the money supply.