1. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-1 Chapter Four The Federal Reserve System, Monetary Policy, and Interest Rates

2. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-2 Major Duties and Responsibilities of the Federal Reserve System Conducting monetary policy Supervising and regulating depository institutions Maintaining the stability of the financial system Providing payment and other financial services to the U.S. government, the public, FIs and foreign official institutions Conducting monetary policy Supervising and regulating depository institutions Maintaining the stability of the financial system Providing payment and other financial services to the U.S. government, the public, FIs and foreign official institutions

3. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-3 Structure of the Federal Reserve System 12 FR Banks plus 10 branches located in major U.S. cities A 7-member Board of Governors in Washington, DC The Federal Open Market Committee (FOMC) 12 FR Banks plus 10 branches located in major U.S. cities A 7-member Board of Governors in Washington, DC The Federal Open Market Committee (FOMC)

4. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-4 Functions Performed by the Federal Reserve Banks Assistance in the Conduct of Monetary Policy Supervision and Regulation Government Services New Currency Issue Check Clearing Wire Transfer Services Research Services Assistance in the Conduct of Monetary Policy Supervision and Regulation Government Services New Currency Issue Check Clearing Wire Transfer Services Research Services

5. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-5 Locations of FR Banks and Branches Banks located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco and St. Louis Branches located in Baltimore, Birmingham, Buffalo, Charlotte, Cincinnati, Denver, Detroit, El Paso, Helena, Houston, Jacksonville, Little Rock, Los Angeles, Louisville, Memphis, Miami, Nashville, Oklahoma City, Omaha, Pittsburgh, Portland Salt Lake City, San Antonio, Seattle Banks located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco and St. Louis Branches located in Baltimore, Birmingham, Buffalo, Charlotte, Cincinnati, Denver, Detroit, El Paso, Helena, Houston, Jacksonville, Little Rock, Los Angeles, Louisville, Memphis, Miami, Nashville, Oklahoma City, Omaha, Pittsburgh, Portland Salt Lake City, San Antonio, Seattle

6. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-6 Board of Governors Headquartered in Washington, DC Each of 7 members appointed by the President of the United States and confirmed by the Senate Board members serve nonrenewable 14-year terms President designates two members to chairman and vice- chairman for four year terms Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks Chairman advises President on economic policy and serves as spokesperson for the FR system Headquartered in Washington, DC Each of 7 members appointed by the President of the United States and confirmed by the Senate Board members serve nonrenewable 14-year terms President designates two members to chairman and vice- chairman for four year terms Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks Chairman advises President on economic policy and serves as spokesperson for the FR system

7. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-7 Federal Open Market Committee (FOMC) The major monetary policy-making body of the FR System Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade Open market operations—the purchase and sale of U.S. government and federal agency securities Sets ranges for growth of monetary aggregates and directs the FR in foreign exchange markets The major monetary policy-making body of the FR System Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade Open market operations—the purchase and sale of U.S. government and federal agency securities Sets ranges for growth of monetary aggregates and directs the FR in foreign exchange markets

8. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-8 Balance Sheet of the Federal Reserve (in billions of dollars, 2002) Assets Liabilities and Equity Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5 SDR certificates 2.2 Vault cash of commercial banks 47.3 Treasury currency 33.2 Deposits due to federal government 7.1 Federal Reserve Float 0.0 Deposits due to rest of the world 0.1 FR loans to domestic banks 0.0 Currency outside banks 596.2 Security repurchase agreements 50.3 Miscellaneous liabilities 7.8 U.S. Treasury securities 551..7 FR Bank stock 7.2 U.S. government securities 0.0 Miscellaneous assets 20.3 Total assets $683.2 Total liabilities and equity $683.2 Assets Liabilities and Equity Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5 SDR certificates 2.2 Vault cash of commercial banks 47.3 Treasury currency 33.2 Deposits due to federal government 7.1 Federal Reserve Float 0.0 Deposits due to rest of the world 0.1 FR loans to domestic banks 0.0 Currency outside banks 596.2 Security repurchase agreements 50.3 Miscellaneous liabilities 7.8 U.S. Treasury securities 551..7 FR Bank stock 7.2 U.S. government securities 0.0 Miscellaneous assets 20.3 Total assets $683.2 Total liabilities and equity $683.2

9. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-9 Objective of Monetary Policy To influence the amount of reserve in the banking system… which affects interest rates and availability of credit and… ultimately affects the levels of employment, output, prices and inflation To influence the amount of reserve in the banking system… which affects interest rates and availability of credit and… ultimately affects the levels of employment, output, prices and inflation

10. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-10 Monetary Policy Tools Open Market Operations –primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates The Discount Rate –the rate of interest FR Banks charge on emergency loans to depository institutions Reserve Requirements –determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities Open Market Operations –primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates The Discount Rate –the rate of interest FR Banks charge on emergency loans to depository institutions Reserve Requirements –determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities

11. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-11 Impact of Monetary Policy on Various Economic Variables Expansionary Activities Contractionary Activities Impact on Reserves Credit availability Money supply Interest rates Security prices

12. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-12 Alternate Monetary Policy Foci Interest Rate Quantity of Money (in billions) i’=8% i*=6% i’’=4% MSMS M D’ M D’’ MDMD Interest Rate Quantity of Money (in billions) i* = 6% i’’= 5% M S’ MSMS M D’ MDMD M D’’

13. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4-13 International Monetary Policies and Strategies Foreign Exchange Intervention –commitments between countries about the institutional aspects of their intervention in the foreign exchange markets –similar to open market purchases and sales of Treasury securities Foreign Exchange Intervention –commitments between countries about the institutional aspects of their intervention in the foreign exchange markets –similar to open market purchases and sales of Treasury securities