Federal Reserve System (ch7 & 8) -- Fin331 1 Federal Reserve System Overview of Federal Reserve System (central banking) Structure of Federal Reserve Fed Practice –Monetary Policies –Targets and Goals –Use of Target to achieve goals

Federal Reserve System (ch7 & 8) -- Fin331 2 Overview of Fed Tradeoff between benefits and costs of having a regulated banking system –particularly, preventing bank run Started in 1913, 12 regional Federal Reserve banks (the system consists of 12 districts) quasi-public

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4 Structure of Federal Reserve Board of Governors 12 Federal Reserve Banks FOMC Federal Advisory Council 3600 Member Commercial Banks

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6 Terminology Reserve requirement -- all banks are required to hold an account at the Fed discount lending -- the Fed provides reserves to the banking system by making discount loans to banks open market operation -- the central bank’s purchase or sale of bonds in the open market

Federal Reserve System (ch7 & 8) -- Fin331 7 Board of Governors Governors are appointed by the US president Governors serve one nonrenewable 14-year term Chairman’s term is 4-year Actively involved in conduct of monetary policy Set reserve requirement and control discount rate by “review and determination” process … Has substantial regulatory functions: approves bank mergers and the activities of foreign banks in the US

Federal Reserve System (ch7 & 8) -- Fin331 8 Federal Reserve Banks Clear checks Issue new currency Withdraw damaged currency from circulation Evaluate proposed mergers and applications for banks to expand their activities Administer and make discount loans to banks in their district Act as liaisons Examine bank holding companies and state-chartered member banks Conduct research related to monetary policy

Federal Reserve System (ch7 & 8) -- Fin331 9 Federal Reserve Districts

Federal Reserve System (ch7 & 8) -- Fin Member banks All national banks (commercial banks charted by the Office of Comptroller of the Currency) are required Currently, 1/3 commercial banks are members Before 1980, only member banks were required to keep reserve After 1980, all depository institutions became subject to the same requirement

Federal Reserve System (ch7 & 8) -- Fin FOMC Meets eight times a year Makes decisions regarding the conduct of open market operations -- purchase or sale of bonds in the open market to determine changes in reserves and interest rate

Federal Reserve System (ch7 & 8) -- Fin Factors making Fed independent 1. Members of Board have long terms 2. Fed is financially independent Factors making Fed dependent 1.Congress can amend Fed legislation 2.President appoints Chairmen and Board members and can influence legislation Overall: Fed is quite independent

Federal Reserve System (ch7 & 8) -- Fin The Federal Reserve’s Balance Sheet AssetsLiabilities Government Securities Discount Loans Currency in Circulation Reserves Monetary Base: (1) Currency in Circulation; (2) reserve

Federal Reserve System (ch7 & 8) -- Fin Impact of Monetary Policies on Balance Sheet Open Market Purchase from Bank The Banking System The Fed Assets Liabilities Assets Liabilities Securities Securities Reserves - $100 + $100 + $100 Reserves + $100 Result: Reserve  $100, Money Base  $100

Federal Reserve System (ch7 & 8) -- Fin Open Market Purchase from Public Public The Fed Assets Liabilities Assets Liabilities Securities Securities Reserves - $100 + $100 +$100 Deposits + $100 Banking System Assets Liabilities Reserves Deposits + $100 + $100 Result: R  $100, MB  $100

Federal Reserve System (ch7 & 8) -- Fin Discount Loans Banking System The Fed Assets Liabilities Assets Liabilities Reserves Discount Discount loan Reserves + $100 loan + $100 + $100 + $100 Result: R  $100, MB  $100

Federal Reserve System (ch7 & 8) -- Fin Reserves and Federal Funds Rate Federal Funds Rate: the interest rate on overnight loans of reserves from one bank to another.

Federal Reserve System (ch7 & 8) -- Fin Market for Reserves and the Fed Funds Rate 1. Demand curve slopes down because i ff , ER  and R d up 2. Supply curve slopes down because i ff , DL , R s  3. Equilibrium i ff where R d = R s

Federal Reserve System (ch7 & 8) -- Fin Response to Open Market Operation 1. Open market purchase, R s shifts to right and i ff  2. i d , DL , R s shifts to right and i ff 

Federal Reserve System (ch7 & 8) -- Fin Response to Change in Required Reserves 1. RR , R d shifts to right, i ff 

Federal Reserve System (ch7 & 8) -- Fin Specific Tools of Monetary Policies A. Open Market Operations 1. Dynamic: Meant to change Reserves 2. Defensive: Meant to offset other factors affecting Reserves, typically uses repos

Federal Reserve System (ch7 & 8) -- Fin B. Discount Loans 3 Types 1. Adjustment Credit (primary credit; standby lending facility) 2. Seasonal Credit 3. Extended Credit (secondary credit) Lender of Last Resort 1.To prevent banking panics FDIC fund not big enough 2.To prevent nonbank financial panics Example: 1987 stock market crash

Federal Reserve System (ch7 & 8) -- Fin C. Reserve Requirement Those deposits in an account at the Fed plus currency that is physically held by banks All depository institutions, including commercial banks, savings and loan associations, mutual saving banks and credit unions are subject to the same requirement All checkable deposits In 1999, required reserve is 3% of bank’s first $49.3 million of checkable deposits and 10% if checkable deposits over $49.3m

Federal Reserve System (ch7 & 8) -- Fin C. Reserve Requirements (cont’d) Advantages 1. Powerful effect Disadvantages 1. Small changes have very large effect on M s 2. Raising causes liquidity problems for banks 3. Frequent changes cause uncertainty for banks 4. Tax on banks

Federal Reserve System (ch7 & 8) -- Fin Goals of Monetary Policy 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict

Federal Reserve System (ch7 & 8) -- Fin Central Bank Strategy

Federal Reserve System (ch7 & 8) -- Fin Use of Targets Money Supply Target Interest Rate Target

Federal Reserve System (ch7 & 8) -- Fin Money Supply Target 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i ' and i ''

Federal Reserve System (ch7 & 8) -- Fin Interest Rate Target 1. M d fluctuates between M d' and M d'' 2. To set i-target at i*, M s fluctuates between M ' and M '’