1. Chapter 4 The Overseer: The Federal Reserve System Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. 2 Organizational Structure of the System The Federal Reserve System was created by Congress in 1913 –created as a central bank that could lend funds to commercial banks during emergencies to help them avoid insolvency and bankruptcy lender of last resort

3. 3 Organizational Structure of the System In the midst of the Great Depression, it was clear that the Federal Reserve was not able to handle bank failures –in the Banking Reform Acts of 1933 and 1935, Congress provided many of the additional policy tools and regulation the Fed needed the most significant change involved the Fed’s purpose and objectives

4. 4 Organizational Structure of the System The Fed’s new responsibilities involved efforts to attain the nation’s economic an financial goals –foster a smooth-running, efficient, competitive financial system –promote the overall health and stability of the economy through its ability to influence the availability and cost of money and credit

5. 5 Organizational Structure of the System The core of the Federal Reserve System in the Board of Governors –7 members appointed by the President with the consent of the U.S. Senate –the full term of a member is 14 years arranged so that 1 expires every 2 years –1 member is appointed as chair and 1 is appointed as vice-chair term is 4 years chair is the “official spokesperson” for the Fed

6. 6 Organizational Structure of the System The nation is divided into 12 districts –each district is served by a Reserve Bank the 3 largest are New York, Chicago, and San Francisco the 12 Reserve Banks have a total of 26 branches –member commercial banks within a district elect 6 of the 9 directors of the Reserve Bank the other 3 are appointed by the Board of Governors

7. 7 Organizational Structure of the System

8. 8 The Federal Open Market Committee (FOMC) is the principal policy-making body within the Federal Reserve System –formulates policy and oversees its implementation –12 members 7 members of the Board of Governors 5 of the 12 District Bank presidents (1 is always the president of the New York District Bank) –by tradition, the chair has been the Fed chair

9. 9 Organizational Structure of the System The FOMC meets in Washington 8 times per year (approximately every 6 weeks) –issue a policy directive which sets forth the operating instructions to the Federal Reserve Bank of New York regarding the conduct of monetary policy the Fed uses the New York District Bank because New York is the center of the U.S. financial system economists, financial investors, and portfolio managers follow the operations of the New York District Bank closely

10. 10 The Organizational Structure of the Federal Reserve System Board of Governors Seven members appointed by the president of the United States and confirmed by the Senate for 14-year terms. One of the seven governors is appointed chair by the President of the United States and confirmed by the Senate for a 4-year term. The Board of Governors appoints three of the nine directors to each Reserve Bank. Twelve Federal Reserve Banks Each with nine directors who appoint the Reserve Bank president and other officers of the Reserve Banks. Federal Open Market Committee (FOMC) Seven members of the Board of Governors plus the president of the New York Fed and presidents of four other Reserve Banks. Nearly 5,000 Member Commercial Banks Elect six of the nine directors to each Reserve Bank.

11. 11 The Functions of the Fed FUNCTIONS OF THE FED Actions taken to improve the health of the economy Formulates Monetary Policy Actions taken to ensure the safety and soundness of the financial system Facilitates the Payments Mechanisms Actions taken to ensure the safe and efficient transfer of funds including check clearing and providing sufficient currency and coin Supervises and Regulates the Financial System Maintains the Treasury’s transactions account Acts as Federal Agent for the U.S. Government

12. 12 2 objectives –to ensure that sufficient money and credit are available to allow the economy to expand along its long-term potential growth trend with little or no inflation –to minimize the fluctuations around the long- run trend Formation and Implementation of Monetary Policy

13. 13 The Fed takes actions to affect the cost and availability of funds in the financial system Its decisions may, in turn, affect the spending, producing, borrowing, lending, pricing, and hiring decisions made in the rest of the economy Formation and Implementation of Monetary Policy

14. 14 Promoting the safety and soundness of depository institutions –forming specific rules that govern banking behavior –ensuring that banks are operated prudently and in accordance with statutes and regulations Truth in Lending Act Fair Credit Billing Act Equal Credit Opportunity Act Community Reinvestment Act Supervision and Regulation of the Financial System

15. 15 Developing and maintaining safe and efficient means for transferring funds –providing currency and coin –clearing checks Facilitation of the Payments Mechanism

16. 16 The Check-Clearing System check canceled Mary’s bank Dad’s bank Dad receives and deposits check check deposited Mary writes check to Dad check Federal Reserve Bank check forwarded

17. 17 Furnishes banking services to the government –maintains the U.S. Treasury transactions account –clears Treasury checks –issues and redeems government securities –acts as the fiscal agent of the government in financial transactions with foreign governments and foreign central banks Operation as Fiscal Agent for the Government

18. 18 The Fed’s Major Policy Tools Open Market Operations The Discount Rate Reserve Requirements

19. 19 Open Market Operations The most important monetary policy tool available to the Fed These involve the buying and selling of U.S. government securities by the Fed –when the Fed buys securities, reserves rise –when the Fed sells securities, reserves fall changes in reserves affect the ability of depository institutions to make loans and to extend credit thus, changes in reserves also affect the money supply

20. 20 The Discount Rate The Fed operates a discount window through which depository institutions can borrow reserves from the Fed –in January 2003, a new policy was implemented that established three credit programs for discount window borrowing primary secondary seasonal

21. 21 The Primary Credit Program Loans are made to depository institutions that are in a healthy and sound financial condition for a very short time –usually overnight –the primary credit rate is set 1 percent above another key short-term interest rate on which the Fed exerts a great deal of influence When we refer to the “discount rate”, we are generally talking about the primary credit rate

22. 22 The Secondary Credit Program Short-term loans are made to depository institutions that are having financial difficulties –the secondary credit rate is generally set ½ percent higher than the primary credit rate

23. 23 The Seasonal Credit Program Seasonal credit is extended to a small number of depository institutions that have recurring seasonal funding needs –banks in agricultural or seasonal resort communities –the seasonal credit rate is an average of various market rates

24. 24 The Discount Rate Prior to 2003, changes in the discount rate often lagged changes in other interest rates Now the discount rate automatically changes in response to changes in other short-term rates

25. 25 The Discount Rate Changes in the discount rate can have several possible effects on depository institution behavior and the economy –alters the cost of borrowing reserves from the Fed The Fed urges depository institutions to borrow from the Fed only when other alternatives are not available –should be temporary and not persistent

26. 26 The Discount Rate In cases where the safety and solvency of the institution exist, the Fed stands ready to serve as lender of last resort –its main concern is to minimize the risk to the public interest and the financial system wants to preserve the public’s confidence in the safety and soundness of the country’s depository institutions

27. 27 Reserve Requirements The Fed requires depository institutions to hold required reserves equal to a proportion of checkable deposit liabilities –if the Fed wants to encourage bank lending, it could lower the required reserve ratio can have a powerful effect on the supply of money and the cost and availability of credit The Fed does not change the required reserve ratio very often

28. 28 Division of Responsibility within the Federal Reserve System

29. 29 The Independence of the Fed Congress established the Fed as an independent agency to shield it from the political process –14-year terms of the members of the board ensure that they do not have to defend their policies to Congress or the President –the Fed does not depend on Congress for its funding –the Fed is exempt from many of the provisions of the Freedom of Information Act

30. 30 The Independence of the Fed The Fed is not completely outside of government –in the short run, the Fed does not take orders from anyone in the executive or legislative branch of government –in the long run, Congress can pass new laws that the Fed must obey

31. 31 The Independence of the Fed Ever since the Fed was created, there has been a debate concerning the desirability of its independence –the degree to which the Fed should alter its policy in response to “suggestions” from Congress or the President the more responsive the Fed is, the less independent it will be

32. 32 The Independence of the Fed Those who support independence do so on the grounds that anything less will inject politics into monetary policy operations –politicians may be short-run maximizers, only interested in getting elected and reelected

33. 33 The Independence of the Fed Those who do not support independence argue that the independence of the Fed is inconsistent with democracy –the President and Congress are held accountable for economic conditions they should have all policy tools available to them monetary policy should be controlled by people directly responsible to the electorate

34. 34 The Independence of the Fed Opponents of the Fed’s independence would like to see reforms –a change in the status of Reserve Bank presidents on the FOMC bank presidents represent the interests of the banking community and not the public at large –a broadening of the authority of the General Accounting Office (GAO) to audit the Fed the deliberations regarding monetary policy, the transactions directed by the FOMC, and the transactions involving foreign exchange operations

35. 35 The Independence of the Fed In response to concerns about too much Fed autonomy, the Fed has become more open in recent years –releases edited minutes of its deliberations a few weeks after the FOMC meets –several policy changes are announced immediately after FOMC meetings

36. 36 Summary of Major Points The Federal Reserve System was established by an act of Congress in 1913 –the original Federal Reserve Act was modified and strengthened in 1933 and 1935 following the economic and financial collapse of the Great Depression

37. 37 Summary of Major Points The Fed is charged with regulating and supervising the operation of the financial system so as to promote a smooth- running, efficient, competitive financial system and with promoting the overall health and stability of the economy through its ability to influence the availability and cost of money and credit

38. 38 Summary of Major Points The Board of Governors, located in Washington, D.C., is the core of the Federal Reserve System –it is composed of seven members appointed by the president, with the approval of the Senate, for 14-year terms the terms are staggered so that one expires every two years –the President appoints one of the governors as chair for a four-year term

39. 39 Summary of Major Points The country is divided into 12 districts –each district is served by a Reserve Bank located in a large city within the district –the framers of the original Federal Reserve Act hoped to decentralize policy-making authority within the Fed through the creation of Reserve Banks

40. 40 Summary of Major Points The Federal Open Market Committee (FOMC) is the chief policy-making body within the Fed –it is composed of 12 members the 7 members of the Board of Governors 5 of the 12 presidents of the Reserve Banks –the president of the New York Federal Reserve Bank is a permanent voting member –the other four slots rotate yearly among the remaining 11 Reserve Bank presidents

41. 41 Summary of Major Points The Fed’s functions can be classified into four main areas –formulating and implementing monetary policy –supervising and regulating the financial system –facilitating the payments mechanism –acting as a fiscal agent for the government

42. 42 Summary of Major Points The FOMC directs open market operations, the major tool for implementing monetary policy –these operations involve the buying or selling of government securities –these operations affect the volume of reserves in the banking system as well as interest rates when the Fed buys securities, bank reserves rise this encourages bankers to expand loans and the money supply

43. 43 Summary of Major Points The FOMC meets eight times each year in closed meetings in Washington –policy changes are announced immediately after the meetings –the minutes of the meetings are released to the public immediately after the next FOMC meeting they contain the policy directive, which is the set of instructions regarding the conduct of open market operations

44. 44 Summary of Major Points The New York Fed, located at the center of the nation’s financial markets, executes open market operations on behalf of the FOMC and the entire Federal Reserve System

45. 45 Summary of Major Points In January 2003, the Fed established primary, secondary, and seasonal credit rates for discount window borrowing of reserves from the Fed –the primary credit rate is for short-term borrowing by healthy financial institutions –the secondary credit rate is the rate charged for borrowing reserves by troubled depository institutions

46. 46 Summary of Major Points In exceptional circumstances, the Fed is prepared to serve as a lender of last resort –to preserve the public’s confidence in the safety and soundness of the financial system, the Fed will lend for an extended period to an institution experiencing severe difficulties

47. 47 Summary of Major Points The Fed requires depository institutions to hold reserve assets equal to a proportion of each dollar of its deposit liabilities –the Fed’s required reserve ratio specifies the proportion

48. 48 Summary of Major Points There is an ongoing debate as to whether the Fed should continue to operate as an independent government agency –the Fed and others argue that independence is essential to the pursuit of economic stability –opponents argue that such independence is inconsistent with our democratic form of government –others observe that Congress and the President find the Fed a convenient scapegoat when the economy deteriorates