2. Chapter 12 Roles and Services of the Federal Reserve & Other Central Banks Around the World McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

3.  Learning Objectives   To explore the many roles and functions of the central banks around the world.  To see how and why the Federal Reserve System came to be established as the U.S. central bank.  To examine how the Federal Reserve System is organized to carry out the many tasks it must perform. 12-3

4.  Learning Objectives   To discover how important central bank independence from the dictates of governments is in carrying out effective money and credit policy.  To understand the concept of legal reserves and how the Federal Reserve System influences the level and growth of legal reserves and, ultimately, deposits and loans. 12-4

5. Introduction  A central bank is a government agency that monitors the operation of its financial system and controls the growth of the nation’s money supply.  Central banks are “bankers’ banks.” They communicate with commercial banks and securities dealers in carrying out their essential public policy functions.  The U.S. central bank is the Federal Reserve System. 12-5

6. The Roles of Central Banks  Control of the money supply  Linked to economic activity  Linked to price inflation  Stabilizing the money and capital markets  Fostering their development  Ensuring a stable flow of funds  Lender of last resort  Lend to financial institutions  Particularly those subject to liquidity pressure  Supervisor of the banking system 12-6

7. The Roles of Central Banks  Maintaining and improving the payments mechanism - a smoothly functioning and efficient payments mechanism is vital for business and commerce 12-7

8. What is Money?  Money is a financial asset  Medium of exchange – funds used to purchase goods, services, and other financial assets  Highly liquid store of value – Carry readily accessible purchasing power through time  Unit of account – track transactions and balances in terms of money 12-8

9. The World’s Leading Central Banks 12-9

10. The Goals of Central Banking  Central banking in the U.S. and most other nations is directed toward the goals of:  Achieving maximum sustainable output and employment  Promoting stable prices  Recent emphasis has been on long-run price stability  A growing list of nations have set inflation- rate targets or target ranges 12-10

11. The Goals of Central Banking  The central bank is able to influence the economy’s progress  Influence interest rates  Influence the growth of the money supply  However, the goals often conflict  Trade-offs have to be accepted 12-11

12. The Channels Through Which Central Banks Work Policy tools of the central bank Volume & growth of borrowing & spending by the public on domestic & foreign consumer & capital goods & services Economic goals: A stable price level and low inflation Sustainable economic growth Maximum employment Cost & availability of credit Size & growth of the money supply Market value of the public’s security holdings Currency exchange rates Public expectations regarding security prices, interest rates, currency prices, money supply & credit availability Market interest rates Level & growth of reserves in the banking system 12-12

13. History of the Federal Reserve System  The U.S. was one of the last major nations in the Western hemisphere to permanently charter a central bank  U.S. public officials were hesitant to do so  Feared that a strong central bank with would restrict the availability of credit  A series of crises plagued the U.S. financial system in the late 19 th and early 20 th centuries 12-13

14. Problems in the Early U.S. Banking System  Prior to the Civil War, the states controlled the banking system  Many did a poor job  The high failure rate among poorly capitalized and ill-managed banks resulted in heavy losses  The 1863 National Banking Act  Created a dual banking system  State and federal governments charter banks  Competition between regulatory agencies sometimes led to actions detrimental to public interest 12-14

15. Problems in the Early U.S. Banking System  New national bank notes proved to be unresponsive to the nation’s growing need for a money  The process of clearing and collecting checks was also too slow and expensive  Many banks charged a check redemption fee  There were recurring liquidity crises too  Massive sell-offs of bank-held securities  Led to panic selling by other investors 12-15

16. Creation of the Federal Reserve System  The Federal Reserve Act was signed in 1913  Twelve Federal Reserve banks were chartered  They opened for business as World War I began in Europe 12-16

17. The Early Structure of the Federal Reserve  The first Federal Reserve System was quite different that of today  The chief policy tool was the discount rate  Rate charged on loans of reserves to eligible banks  Each Reserve bank had the authority to set its own discount rate  The Federal Reserve banks were also given authority to issue their own paper notes to serve as a circulating currency 12-17

18. The Early Structure of the Federal Reserve  A supervisory board of seven members had been set up in Washington, D.C.  However regional Reserve banks were key  They possessed the essential monetary tools  They made the key policy decisions  Slowly, forces combined to amend the original Federal Reserve Act  Economic  Financial  Political 12-18

19. Goals and Policy Tools of the Fed  The Great Depression brought about a concentration of power within the Fed  The seven-member Board of Governors in Washington, D.C., became the central administrative and policymaking group  The Federal Open Market Committee was created  Oversee the conduct of open market operations  These rapidly became the Fed’s main policy tool 12-19

20. How the Fed is Organized Today Board of Governors (7 members appointed by the president) 2,700 member banks of the system Supervise Manager of the System Open Market Account Supervise 12 Federal Reserve banks & 25 branch banks (reserve bank presidents appointed by Board of Governors) Supervise Federal Open Market Committee (12 voting members) Serve 12-20

21. How the Fed is Organized Today  In principle, the Board of Governors is independent of both legislative and executive branches of the federal government  Independence is supported by terms of office much longer than the president’s (up to 14 years)  Appointed by president  Approved by the senate  Also supported by the fact that the Fed is self-supporting 12-21

22. How the Fed is Organized Today 12-22

23. How the Fed is Organized Today  The Fed has extensive powers  Sets reserve requirements on deposits held by depository institutions  Sets the discount rate on loans to depository institutions  Sets margin requirements on the public’s purchase of securities  Provides leadership in the conduct of open market operations  Regulatory control over financial holding companies and foreign banks 12-23

24. How the Fed is Organized Today  When the Federal Open Market Committee (FOMC) has reached a consensus on the appropriate future course for monetary policy  A directive is given to the manager of the System Open Market Account (SOMA)  The SOMA manager is a vice president of the Federal Reserve Bank of New York 12-24

25. How the Fed is Organized Today There is a Federal Reserve bank in each of the twelve districts Source: Board of Governors of the Federal Reserve System 12-25

26. How the Fed is Organized Today  Each Reserve bank houses a research division that studies regional economic and financial developments, and reports its findings to the Board of Governors and to the FOMC.  The Reserve banks also provide the securities needed for open market sales, and take their pro rata share of security purchases made by the Federal Reserve System. 12-26

27. How the Fed is Organized Today Source: Board of Governors of the Federal Reserve System 12-27

28. How the Fed is Organized Today  Member banks of the Federal Reserve System  National banks, which are required to join the system  State-chartered banks that agree to conform to the Fed’s rules  Member banks at year-end 2000  2,230 national banks  Just under 1,000 state-chartered banks are members of the Federal Reserve System  More than 5,000 nonmember banks 12-28

29. Roles of the Federal Reserve System Today  Collecting and clearing checks and other means of payment (through an electronic network known as the FEDWIRE)  Issuing currency and coin  Maintaining a sound banking and financial system  Serving as a lender of last resort (through the discount window of Reserve banks)  Supervising member banks 12-29

30. Roles of the Federal Reserve System Today  Serving as the Federal government’s fiscal agent, by holding the Treasury’s checking account and by maintaining reasonable stability in the government securities market  Providing information to the public, through statistical releases and research reports  Carrying out monetary policy, through the use of various tools 12-30

31. The Key Focus of Central Bank Monetary Policy  Regulating money and credit conditions to strengthen the economy  Most central banks target market interest rates  To impact market rates, central banks usually make use of their control over the volume of reserves available to the banking system  These reserves are the raw material out of which depository institutions create credit and cause the money supply to grow 12-31

32. The Key Focus of Central Bank Monetary Policy  The total supply of reserves can be changed  Through open market operations  By making loans to depository institutions through the central bank’s discount window  By changing the legal reserve requirements applicable to deposits held by depository institutions 12-32

33. Reserve Composition  Legal reserves in the U.S. consist of the  Amount of deposits each institution keeps with the Federal Reserve bank in its district  Plus the amount of currency and coin held in its vault Total legal reserves = Required reserves + Excess reserves 12-33

34. The Deposit Multiplier  The banking system can create more deposit money by using its excess reserves to make loans and purchase securities  The deposit multiplier indicates the dollar volume of deposits and loans that the banking system can create for each new dollar of excess legal reserves 12-34

35. The Deposit Multiplier  The Federal Reserve sets required reserves  A percentage of banks’ total transaction deposits Required Reserves = RR d x Transaction Deposits  RR d is the Federal Reserve’s reserve requirement ratio 12-35

36. The Deposit Multiplier  Banks may also choose to hold some excess reserves  Protective cushion  Meet unexpected withdrawals Excess Reserves = EXR x Transaction Deposits  EXR is the excess reserve ratio  The amount of excess reserves that the bank wants to hold for each one dollar of transaction accounts 12-36

37. The Deposit Multiplier  Then total reserves in the banking system are: Total Reserves = RR d x Transaction Deposits + EXR x Transaction Deposits = (RR d + EXR) x Transaction Deposits = (RR d + EXR) x Transaction Deposits 12-37

38. The Deposit Multiplier  So one dollar of reserves supports _____1____ _____1____ (RR d + EXR) (RR d + EXR) dollars in transaction deposits 12-38

39. The Deposit Multiplier  When new excess reserves are injected into the system: Maximum Volume of New Deposits and Loans = Deposit Multiplier  Excess Reserves = Deposit Multiplier  Excess Reserves  In the real world however, leakages of funds from the banking system greatly reduce the size of the deposit multiplier 12-39

40. Money Multiplier  Central bankers usually more interested in the money multiplier  Defines the relationship between a measure of the money supply that is closely related to spending and income (M2) in the economy to the total reserve base  Closely related to deposit multiplier  Currency and coin holdings impact reserves held by depository institutions  If the public holds less currency, the excess is typically redeposited 12-40

41. Money Multiplier  Develop idea of monetary base  Legal reserves plus currency and coin held by the public Monetary Base = Legal Bank Reserves + Currency in the Hands of the Public  Monetary base is important  It is most of the liabilities of the central bank  Can be closed controlled through the use of open market operations 12-41

42. Money Multiplier  Monetary base  Also known as high-powered money  Linked to M2 through the money multiplier M2 = Money Multiplier x Monetary Base M2 = Money Multiplier x Monetary Base  Can derive an expression for the money multiplier from the formula 12-42

43. Money Multiplier  Monetary base can be expressed as  CD is the currency-deposit ratio 12-43

44. Money Multiplier  So it is possible to estimate the money supply from transaction deposits M2 = (1 + CD + LA) x Transaction Deposits  Where LA is the desired ratio of liquid savings assets to transaction deposits that households wish to maintain 12-44

45. Money Multiplier  And the money multiplier is: Money Multiplier = __1 + CD + LA Money Multiplier = __1 + CD + LA. RRd + EXR + CD RRd + EXR + CD 12-45

46. Markets on the Net  Answers.com at www.answers.com/topic/lender-of-last-resort www.answers.com/topic/lender-of-last-resort and www.answers.com/topic/high-powered-money www.answers.com/topic/high-powered-moneywww.answers.com/topic/high-powered-money  Bank of England at www.bankofengland.co.uk www.bankofengland.co.uk  Bank of International Settlements at www.bis.org www.bis.org  Bank of Japan at www.boj.or.jp www.boj.or.jp  BanxCorp at banx.com banx.com 12-46

47. Markets on the Net  Board of Governors of the Federal Reserve System at www.federalreserve.gov www.federalreserve.gov  Center for the Study of Central Banks at www.law.nyu.edu/centralbankscenter www.law.nyu.edu/centralbankscenter  European Central Bank www.ecb.int www.ecb.int  Fed 101 at www.federalreserveeducation.org/Fed101 www.federalreserveeducation.org/Fed101  Federal Open Market Committee at www.federalreserve.gov/fomc www.federalreserve.gov/fomc 12-47

48. Markets on the Net  Federal Reserve at www.federalreserve.gov www.federalreserve.gov  Federal Reserve Bank of Kansas City at www.kc.frb.org www.kc.frb.org  Federal Reserve Bank of Minneapolis at www.mpls.frb.org www.mpls.frb.org  Federal Reserve Bank of New York at www.ny.frb.org www.ny.frb.org  Federal Reserve Bank of St. Louis at www.stls.frb.org/research www.stls.frb.org/research 12-48

49. Markets on the Net  Federal Reserve Releases at www.federalreserve.gov/releases www.federalreserve.gov/releases  Federal Reserve Services at www.frbservices.org www.frbservices.org  Investopedia.com at www.investopedia.com/terms/l/lender oflastresort.asp www.investopedia.com/terms/l/lender oflastresort.asp www.investopedia.com/terms/l/lender oflastresort.asp  Reserve Bank of New Zealand at www.rbnz.govt.nz www.rbnz.govt.nz 12-49

50. Chapter Review  Introduction to central banking  The roles of central banks in the economy and financial system  Control of the money supply to avoid damaging Inflation  Stabilizing the money and capital markets  Lender of last resort  Supervisor of the banking system  Maintaining and improving the payments mechanism 12-50

51. Chapter Review  Goals and channels of central banking  Central banks’ goals  Challenges in achieving central bank goals  The channels through which central banks work  History of the Federal Reserve System  Problems in the early U.S. banking system  Creation of the Federal Reserve System  The early structure of the Fed  Goals and policy tools of the Fed 12-51

52. Chapter Review  How the Fed is organized today  The board of governors  The Federal Open Market Committee  The Federal Reserve banks  The member banks of the Federal Reserve System 12-52

53. Chapter Review  Roles of the federal reserve system today  The clearing and collection of checks and other payments media  Issuing currency & coin and related services  Maintaining a sound banking and financial system  Serving as the federal government’s fiscal agent  Providing information to the public  Carrying out monetary policy 12-53

54. Chapter Review  The key focus of central bank monetary policy: Interest rates, reserves and money  Reserve composition and the deposit & money multipliers  The deposit multiplier  The money multiplier 12-54