The Federal Reserve System Chapter 14

Objectives How did the Panic of 1907 affect U.S. banking? How did the Panic of 1907 affect U.S. banking? What is the purpose of the Federal Reserve System? What is the purpose of the Federal Reserve System? How is the Fed organized? How is the Fed organized? What services does the Fed provide to banks? What services does the Fed provide to banks? How do economist measure the money supply? How do economist measure the money supply? Easy-money policy v. tight-money policy Easy-money policy v. tight-money policy How is monetary policy made? How is monetary policy made?

Central Bank Many of the founders were distrustful of a central bank Many of the founders were distrustful of a central bank The Second Bank of the United States had its charter expire under Andrew Jackson. The Second Bank of the United States had its charter expire under Andrew Jackson. No central bank was proposed again until the Panic of 1907 No central bank was proposed again until the Panic of 1907

Panic of 1907 Causes Causes No ability to expand the nation’s money supply No ability to expand the nation’s money supply The system of pyramided reserves failed The system of pyramided reserves failed

Money Supply Businesses and individuals competed for a fixed supply of funds available as loans Businesses and individuals competed for a fixed supply of funds available as loans When these were not available, withdrawals were made from savings accounts When these were not available, withdrawals were made from savings accounts “Runs” on banks would occur. “Runs” on banks would occur.

Pyramided Reserves Smaller banks deposit with larger banks who deposit with large commercial banks in New York, Chicago or San Francisco Smaller banks deposit with larger banks who deposit with large commercial banks in New York, Chicago or San Francisco Even small financial panics could cause serious “runs” on even the commercial banking houses. Even small financial panics could cause serious “runs” on even the commercial banking houses.

Federal Reserve 1908 – establishment of the National Monetary Commission 1908 – establishment of the National Monetary Commission Federal Proposed the establishment of a new central bank Federal Proposed the establishment of a new central bank Reserve Act passed in 1913 Reserve Act passed in 1913

Role of the Federal Reserve Fed supervises member banks Fed supervises member banks Holds cash reserves Holds cash reserves Moves money in and out of circulation Moves money in and out of circulation

Characteristics of the Fed There is no central bank. District banks carry on the policies There is no central bank. District banks carry on the policies The government owns no shares in the Fed—Congress does have oversight The government owns no shares in the Fed—Congress does have oversight Only nationally chartered banks are required to join the Federal Reserve System. Only nationally chartered banks are required to join the Federal Reserve System.

Organization National Level National Level Decisions made by the Board of Governors and Federal Open Market Committee Decisions made by the Board of Governors and Federal Open Market Committee District Level District Level 12 separate federal reserve banks 12 separate federal reserve banks

National Level The Board of Governors supervises policy and controls the supply of money The Board of Governors supervises policy and controls the supply of money There are 7 members on the board. They are nominated by the president and confirmed by the senate and serve a term of 14 years. There are 7 members on the board. They are nominated by the president and confirmed by the senate and serve a term of 14 years. The 7 members of the board and the president of the Federal Reserve Bank of New York are permanent members of the FOMC. The 7 members of the board and the president of the Federal Reserve Bank of New York are permanent members of the FOMC. The remaining 4 members are district federal reserve bank presidents who serve one rotating terms The remaining 4 members are district federal reserve bank presidents who serve one rotating terms

District Level 12 District Federal Reserve Banks each serving a particular geographic region. 12 District Federal Reserve Banks each serving a particular geographic region. There are 25 branch offices located throughout the country There are 25 branch offices located throughout the country All commercial banks are nationally chartered and belong to the Feds All commercial banks are nationally chartered and belong to the Feds Each district has a board of 9. Each district has a board of 9. The federal reserve district elect 6 members (3 may be bankers). The Board of Governors appoint the remaining 3 members. The federal reserve district elect 6 members (3 may be bankers). The Board of Governors appoint the remaining 3 members.

Federal Reserve Services to Banks Services offered by Fed Reserve Banks making your banking easier Services offered by Fed Reserve Banks making your banking easier The Fed clears checks The Fed clears checks 1. Mrs. Pacheco writes a check to Macy’s 1. Mrs. Pacheco writes a check to Macy’s 2. Macy’s deposits the check in their account with Bank of New York 2. Macy’s deposits the check in their account with Bank of New York 3. Bank of New York credits Macy’s account for the amount of the check and sends the check to the District Fed Reserve Bank of New York 3. Bank of New York credits Macy’s account for the amount of the check and sends the check to the District Fed Reserve Bank of New York 4. The Fed Reserve Bank of New York credits the Bank of New York and sends the check to Federal Reserve Bank in San Francisco 4. The Fed Reserve Bank of New York credits the Bank of New York and sends the check to Federal Reserve Bank in San Francisco 5. The Federal Reserve Bank in San Francisco credits the Federal Reserve Bank of New York for the value of the check and sends the check on to Mrs. Pacheco’s bank 5. The Federal Reserve Bank in San Francisco credits the Federal Reserve Bank of New York for the value of the check and sends the check on to Mrs. Pacheco’s bank 6. Mrs. Pacheco’s bank credit the Federal Reserve Bank in San Francisco and debits the amount of the check from her account 6. Mrs. Pacheco’s bank credit the Federal Reserve Bank in San Francisco and debits the amount of the check from her account

Loans to Banks Loans to Banks Federal Reserve Banks make loans to state or regional banks for the short term Federal Reserve Banks make loans to state or regional banks for the short term Often small banks need loans to cover short term increases in withdrawals Often small banks need loans to cover short term increases in withdrawals Sometimes the Fed make loans to help in times of national emergencies Sometimes the Fed make loans to help in times of national emergencies

Services to Government Serves as the Government’s Bank Serves as the Government’s Bank Depository of Revenues Depository of Revenues Provide a government checking account Provide a government checking account Keeps records of deposits and withdrawals and conducts purchase and sales of T-Bills Keeps records of deposits and withdrawals and conducts purchase and sales of T-Bills Acts as advisor to the executive and legislative branches Acts as advisor to the executive and legislative branches

The Federal Reserve acts as a “watchdog” over the 12 District Federal Reserve Banks The Federal Reserve acts as a “watchdog” over the 12 District Federal Reserve Banks The District Banks have bank examiners who audit member banks to ensure proper procedures and an adequate amount of cash is available to depositors The District Banks have bank examiners who audit member banks to ensure proper procedures and an adequate amount of cash is available to depositors Regulate bank mergers and charters of bank holding companies Regulate bank mergers and charters of bank holding companies

The Fed’s regulate the nation’s money supply The Fed’s regulate the nation’s money supply Paper money is printed by the Treasury Department’s Bureau of Engraving and Printing Paper money is printed by the Treasury Department’s Bureau of Engraving and Printing Coins are minted at the U.S. mints Coins are minted at the U.S. mints New Currency is placed in circulation to: New Currency is placed in circulation to: Replace worn out notes Replace worn out notes Increase the amount of money in circulation Increase the amount of money in circulation The Fed’s increase or decrease the money supply by trading in U.S. Securities The Fed’s increase or decrease the money supply by trading in U.S. Securities

Money Supply Economist determine how much money is in circulation by several means: Economist determine how much money is in circulation by several means: M1 M1 M2 M2 M3 and L M3 and L

M1 The simplest of the measures The simplest of the measures Considered in the measure are Considered in the measure are All of the currency in circulation All of the currency in circulation All deposits in checking accounts All deposits in checking accounts All Traveler’s checks All Traveler’s checks

M2 Is a broader and more encompassing measure of money Is a broader and more encompassing measure of money It includes everything in M1 and It includes everything in M1 and Money market accounts Money market accounts Money market mutual fund shares Money market mutual fund shares Savings accounts Savings accounts Certificates of Deposit that are less than $100,000. Certificates of Deposit that are less than $100,000.

M3 and L These are the most inclusive of the measures These are the most inclusive of the measures M3 include all aspects of M1 and M2 and M3 include all aspects of M1 and M2 and CDs over $100,00 CDs over $100,00 L include M1, M2 and M3 and L include M1, M2 and M3 and Savings bonds Savings bonds Short-term treasury securities Short-term treasury securities

Monetary Policy and Aggregate Demand Fed regulates the amount of money and credit available. Fed regulates the amount of money and credit available. Monetary policy effects the cost of credit via money supply Monetary policy effects the cost of credit via money supply Aggregate demand is the demand for all goods and services Aggregate demand is the demand for all goods and services

Easy Money Policy Designed to expand the money supply. This will Designed to expand the money supply. This will Increase jobs, aggregate demand Increase jobs, aggregate demand This policy is used to aid the economy during a recession This policy is used to aid the economy during a recession

Tight Money Policy Slows business growth and stabilizes the economy Slows business growth and stabilizes the economy Inflation may develop if there is too much money in circulation Inflation may develop if there is too much money in circulation Higher interest rates, reduced aggregate demand, decreased money supply Higher interest rates, reduced aggregate demand, decreased money supply

Components of Monetary Policy Open Market Operations Open Market Operations The buying and selling of government securities The buying and selling of government securities FOMC makes the decision to buy or sell securities FOMC makes the decision to buy or sell securities The Federal Reserve Bank of New York handles the transactions The Federal Reserve Bank of New York handles the transactions Selling – contracts money supply Selling – contracts money supply Buying – expands money supply Buying – expands money supply

Discount Rate is the interest rate that the Fed charges member banks Discount Rate is the interest rate that the Fed charges member banks Adjustments are done to encourage or discourage borrowing Adjustments are done to encourage or discourage borrowing The prime rate is the interest rate that commercial banks charge their best customers The prime rate is the interest rate that commercial banks charge their best customers

Reserve Requirement is the money that must be held by banks Reserve Requirement is the money that must be held by banks It is a percentage of a bank’s total net transaction accounts It is a percentage of a bank’s total net transaction accounts This percentage is on fluid accounts This percentage is on fluid accounts The Fed can increase or decrease the money supply by adjusting the reserve requirement The Fed can increase or decrease the money supply by adjusting the reserve requirement

The SEC can adjust the margin requirement to increase or decrease the money supply and investment The SEC can adjust the margin requirement to increase or decrease the money supply and investment As the margin increases, investment decreases As the margin increases, investment decreases

Credit Regulation is the power to regulate consumer credit during times of nation emergency Credit Regulation is the power to regulate consumer credit during times of nation emergency This power was revoked in This power was revoked in 1952.

Moral Suasion Moral Suasion The indirect method of the Fed exerting pressure on the economy The indirect method of the Fed exerting pressure on the economy Done through direct appeal to banking, congress and the public Done through direct appeal to banking, congress and the public The Fed can change the lending policies of banks. The Fed can change the lending policies of banks.

Policy Limitations Economic forecasting Economic forecasting Used to develop monetary policy based on educated guesses Used to develop monetary policy based on educated guesses Time Lags Time Lags Period of time between forecast and implementation of policy Period of time between forecast and implementation of policy Priorities and Trade Offs Priorities and Trade Offs Monetary policy can fight inflation or recession Monetary policy can fight inflation or recession Lack of Coordination Lack of Coordination Government agencies sometimes have agendas that differ from those of the Fed Government agencies sometimes have agendas that differ from those of the Fed Conflicting Opinion Conflicting Opinion Economists and government agencies often have different ideas about what will positively effect the economy Economists and government agencies often have different ideas about what will positively effect the economy