CHAPTER 4 The Fed and Monetary Policy © 2003 South-Western/Thomson Learning

Chapter Objectives n Identify the Fed’s role in monetary policy n Describe the tools the Fed uses to influence monetary policy n Explain how changes in regulation in the 1980s affected the Fed and monetary policy

Federal Reserve System: Third U. S. Central Bank n First Bank of the United States (1791–1811) n Second Bank of the United States (1816–1836) n Federal Reserve System (1913–)

Structure of the Federal Reserve System n 12 Fed District Banks n Member Commercial Banks n 7 Members of Board of Governors n 14 year terms for Governors n 12 Open Market Committee (FOMC) Members n Advisory Committees to Fed from private sector

Functions of the Federal Reserve System n Effect Monetary Policy n U.S. Central Bank In International Area n Fiscal Agent of U.S. Treasury n Facilitate Efficient Payments System n Regulate Banks and Bank Holding Co. n Enforce Consumer Credit Laws

Organization of the Federal Reserve n Federal Reserve District Banks l 12 districts l Districts divided by population at 1912–13 l District bank size related to economic wealth of district l District banks owned by private member banks l Board of Directors of district banks u Three appointed by Board of Governors u Three professional bankers u Three business persons in district

Organization of the Federal Reserve n Member Banks l Must meet requirements of the Federal Reserve Board of Governors to be a member bank l Nationally chartered banks must be member banks l State chartered banks may be member banks l 35% of banks controlling 70% of all deposits are members

Organization of the Federal Reserve n Board of Governors l 7 individuals appointed by the U.S. president and confirmed by the Senate l U.S. president appoints one of the 7 chair whose 4-year term is renewable l Offices in Washington, D.C. l Serve nonrenewable 14-year terms l Independence of Federal Reserve u Staggered terms of Governors u Budget separate from Congress

Organization of the Federal Reserve n Board of Governors has two main functions: n Regulate commercial banks l Supervise and regulate member banks and bank holding companies l Oversight of 12 Fed district banks l Establish consumer finance regulations after Congressional legislation

Organization of the Federal Reserve n Establish and effect monetary policy l Direct control over two tools of monetary policy u Set reserve requirements u Approve discount rate set by district banks l Indirect control in a third area u Governors are members of the Federal Open Market Committee

Organization of the Federal Reserve n Federal Open Market Committee (FOMC) meets every 6 weeks l 12 members u 7 from the Board of Governors u President of the New York Fed u 4 other district bank presidents appointed on a rotating basis u Other presidents participate but do not vote on monetary policy matters

Organization of the Federal Reserve n Federal Open Market Committee (FOMC) l Monetary policy goals of: u high employment u price stability u economic growth l Make monetary policy decisions to achieve goals l Forward decisions to N.Y. Fed open market desk n Advisory committees from private sector also are a part of overall structure of the Fed

Fed’s Influence on Economy n Fed influences liquidity (supply of loanable funds) in money market to influence: Liquidity, Money Supply and Interest Rates Business and Consumer Borrowing/Spending Goals of Growth Price Stability Job Growth

Tools of Monetary Policy Tools of Monetary Policy Open Market Op. Reserve Req. Discount Rate

How Fed Controls Money Supply n Banks must maintain reserves as percent of deposits n Reserves kept as deposits in Fed (plus vault cash) n Fed controls level of member bank reserve deposits in Fed n Fed influences bank deposit portion of money supply

Monetary Policy Tools n Open market operations involve the purchase or sale of government securities based on FOMC directives sent to N.Y. Fed Trading Desk n Open market purchase of government securities: l Purchase securities from government securities dealers l Increase bank deposits and bank reserves, money market liquidity and, in time… l Increases the money supply

Exhibit 4.4 a a a $100 million $90 million $81 million $10 million $9.0 million $8.1 million Increase in deposits at banks Required reserves held on new deposits Funds received from new deposits that can be lent out $90 million $81 million $72.9 million

Monetary Policy Tools n Open market operations and interest rates l Most rates are market determined but Fed influences federal funds interest rate l Fed purchase of securities results in an injection of additional funds into the bank system u Shifts supply of federal funds to the right u Lowers federal funds rate u Lower rates spread to other money market securities l More funds available for money market and bank lending

Monetary Policy Tools n Adjusting the discount rate l Depository institutions borrow from Fed for three reasons: u Adjustment credit for short-term reserve deficiencies u Seasonal credit to agricultural banks u Extended credit for longer-term liquidity problems of problem banks l Lower discount rate u More bank borrowing from Fed, bank reserves expand, money supply increases

Monetary Policy Tools n Adjusting the reserve requirement ratio l Proportion of deposits at depository institutions set aside to meet their reserve requirements l Increase in lending or expansion limited by ($) reserves bank must hold the meet reserve requirements (%) l Total dollar expansion effect as follows: Dollar amount of open market Fed purchase or discount loan × 1 RR

Comparison of Policy Tools n Increasing the money supply l Open market operation purchase of securities via the Trading Desk in the secondary market l Discount rate lowered to encourage borrowing at the discount window l Reserve requirements lowered

Comparison of Policy Tools n Decreasing the money supply l Open market operation sale of securities via the Trading Desk in the secondary market l Discount rate raised to encourage borrowing at the discount window l Reserve requirements raised

Monetary Policy Deposit Expansion Provides n Excess Reserves to Lend n Loan/Deposit Expansion n Loans Finance Spending n Potential Expansion = Added $ Reserves  1/Required Reserve Ratio

Limiting Factors to Deposit Expansion n Banks may not lend excess reserves n Public may not re-deposit payments In expansion process (cash drains) n Lowers deposit expansion multiplier n Other fed functions impact member bank reserve level

Federal Reserve Policy Emphasis n Money Supply Growth n Interest Rate Levels n Price Level Changes n Real Economic Activity

Monetary Control Act of 1980 n To regain more control over the money supply the MCA required all depository institutions to l Meet the same reserve requirements l Hold noninterest-bearing reserves l Promptly report deposit levels to the Fed n Other provision of the MCA allowed all depository institutions l To offer transaction accounts l Access to the discount window

Global Monetary Policy n Each country has its own central bank and often industrialized countries have banks with similar goals n Integration in the global economy means the Fed must consider conditions in other countries when looking at the U.S. economy n Central banks try to work together but conflicts of interest can make cooperation difficult at times

Global Monetary Policy n A single European monetary policy l Euro replaced national currencies of 11 countries in January 1999 l National currencies withdrawn and replaced by euro by June 1, 2002 l Countries of the 15 in the European Union needed to meet economic criteria and chose to join l Created a European Central Bank