1. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-1 McGraw-Hill/Irwin Chapter Four The Federal Reserve System, Monetary Policy, and Interest Rates

2. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-2 McGraw-Hill/Irwin Why Fed, Why the US? Federal Reserve is a Central Bank. Central Banks have similar duties all over the world. They are the operators of monetary policy and responsible from monetary actions. Without knowing a little from central banking, financial system can not be understood. We could study only SAMA but you would not know anything about a central bank whose policies are directly related with you (as Riyal is pegged to USD) ! By FED as a example, we study and learn how central banks work.... Studying a more sophisticated system will make you understand the simple ones easily, but not the vice verca. Federal Reserve is a Central Bank. Central Banks have similar duties all over the world. They are the operators of monetary policy and responsible from monetary actions. Without knowing a little from central banking, financial system can not be understood. We could study only SAMA but you would not know anything about a central bank whose policies are directly related with you (as Riyal is pegged to USD) ! By FED as a example, we study and learn how central banks work.... Studying a more sophisticated system will make you understand the simple ones easily, but not the vice verca.

3. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-3 McGraw-Hill/Irwin The Federal Reserve -Central Bank of the US- Founded by Congress under the Federal Reserve Act in 1913 after 1907 banking panic. Subject to oversight (مراقبة) by Congress under its authority to coin money ( To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures, Constitution, Art1, Sec. 8 ) An independent central bank–its decisions do not have to be ratified (approved) by the President Founded by Congress under the Federal Reserve Act in 1913 after 1907 banking panic. Subject to oversight (مراقبة) by Congress under its authority to coin money ( To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures, Constitution, Art1, Sec. 8 ) An independent central bank–its decisions do not have to be ratified (approved) by the President

4. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-4 McGraw-Hill/Irwin Functions of the Federal Reserve It is one of the most powerful economic bodies in the world. Even the hint of a change in interest rate policy by the Fed can have an impact on markets around the world. 1.Conduct monetary policy 2.Supervise and regulate depository institutions 3.Maintain financial system stability 4.Provide payment and other financial services to the U.S. government, the public, FIs, and foreign official institutions Main goals of central bank? Economic growth, high level of employment, stable prices, moderate long term debt. It is one of the most powerful economic bodies in the world. Even the hint of a change in interest rate policy by the Fed can have an impact on markets around the world. 1.Conduct monetary policy 2.Supervise and regulate depository institutions 3.Maintain financial system stability 4.Provide payment and other financial services to the U.S. government, the public, FIs, and foreign official institutions Main goals of central bank? Economic growth, high level of employment, stable prices, moderate long term debt.

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-5 McGraw-Hill/Irwin Structure of the Federal Reserve Each Reserve Bank acts as a desository institution for the banks in the district. As of their assets the biggests are New York, Chicago and S. Francisco. Each Reserve bank has its own nine member Board of Directors that supervise it. 6 are elected by member banks and 3 are appointed by FED Reserve Board of Governors. These mem bers appoint the president of their Fed. Each Reserve Bank acts as a desository institution for the banks in the district. As of their assets the biggests are New York, Chicago and S. Francisco. Each Reserve bank has its own nine member Board of Directors that supervise it. 6 are elected by member banks and 3 are appointed by FED Reserve Board of Governors. These mem bers appoint the president of their Fed.

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-6 McGraw-Hill/Irwin Structure of the Federal Reserve Divided into 12 Federal Reserve districts, each with a main Federal Reserve Bank Federal Reserve Banks operate under the general supervision of the a 7 member Board of Governors of the Federal Reserve in Washington DC The Office of the Comptroller of the Currency (OCC) charters national banks, which are members of the Federal Reserve System (FRS) –Banks are either nationally chartered or state chartered. If they meet the standarts set by the FRS state chartered banks (those not chartered by the OCC) can also elect to become FRS members. FRS member banks “own” the 12 Federal Reserve Banks Divided into 12 Federal Reserve districts, each with a main Federal Reserve Bank Federal Reserve Banks operate under the general supervision of the a 7 member Board of Governors of the Federal Reserve in Washington DC The Office of the Comptroller of the Currency (OCC) charters national banks, which are members of the Federal Reserve System (FRS) –Banks are either nationally chartered or state chartered. If they meet the standarts set by the FRS state chartered banks (those not chartered by the OCC) can also elect to become FRS members. FRS member banks “own” the 12 Federal Reserve Banks

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-7 McGraw-Hill/Irwin Structure of the Federal Reserve Fed stocks, are not publicly traded and pays a predetermined divident (max 6 pct annually) holding over 80 percent of the total assets in the US banking system40 pcnt of all US banks ( holding over 80 percent of the total assets in the US banking system ) are currently members of the FRS. FED is a nonprofit organization. However, their main income comes from: –Interest earned on government securities acquired in the course of FR open market transactions. –Interest earned on reserves that banks are required to deposit at the Fed. –Fees from the provision of payment and other services to member depository institutions. Fed stocks, are not publicly traded and pays a predetermined divident (max 6 pct annually) holding over 80 percent of the total assets in the US banking system40 pcnt of all US banks ( holding over 80 percent of the total assets in the US banking system ) are currently members of the FRS. FED is a nonprofit organization. However, their main income comes from: –Interest earned on government securities acquired in the course of FR open market transactions. –Interest earned on reserves that banks are required to deposit at the Fed. –Fees from the provision of payment and other services to member depository institutions.

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-8 McGraw-Hill/Irwin Board of Governors of the FRS Seven member board headquartered in Washington, DC President appoints and Senate confirms members to nonrenewable 14-year terms President appoints and Senate confirms Chairman and vice-chairman to renewable 4-year terms This board of governors formulates and conducts monetary policy and supervises and regulates banks Seven member board headquartered in Washington, DC President appoints and Senate confirms members to nonrenewable 14-year terms President appoints and Senate confirms Chairman and vice-chairman to renewable 4-year terms This board of governors formulates and conducts monetary policy and supervises and regulates banks

9. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-9 McGraw-Hill/Irwin Federal Open Market Committee (FOMC) FOMC consists of 12 members –seven members of the Board of Governors –the president of the Federal Reserve Bank of NY –the presidents of four other Federal Reserve Banks (on a rotating basis) FOMC is the monetary policy-making body of the FRS Policies seek to promote –full employment, economic growth, price stability, and a sustainable pattern of international trade FOMC consists of 12 members –seven members of the Board of Governors –the president of the Federal Reserve Bank of NY –the presidents of four other Federal Reserve Banks (on a rotating basis) FOMC is the monetary policy-making body of the FRS Policies seek to promote –full employment, economic growth, price stability, and a sustainable pattern of international trade

10. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-10 McGraw-Hill/Irwin Federal Open Market Committee (FOMC) The FOMC sets ranges for growth of monetary aggregates and the fed funds rate, and also directs FR operations in FX markets Open market operations are the main policy tool used to achieve monetary targets –involve the purchase and sale of U.S. government and federal agency securities –are implemented by the Federal Reserve Board Trading Desk of the New York Federal Reserve Bank The FOMC sets ranges for growth of monetary aggregates and the fed funds rate, and also directs FR operations in FX markets Open market operations are the main policy tool used to achieve monetary targets –involve the purchase and sale of U.S. government and federal agency securities –are implemented by the Federal Reserve Board Trading Desk of the New York Federal Reserve Bank

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-11 McGraw-Hill/Irwin Federal Open Market Committee (FOMC) FOMC is required to meet at least for times each year in Washington DC. But, eight regularly scheduled meeting have been held each year since 1980. After each meeting FOMC release the Beige Book, summarizes information on current economic conditions by Federal Reserve districts. These meetings and their reports are the most closely watched economic meetings in the world. FOMC is required to meet at least for times each year in Washington DC. But, eight regularly scheduled meeting have been held each year since 1980. After each meeting FOMC release the Beige Book, summarizes information on current economic conditions by Federal Reserve districts. These meetings and their reports are the most closely watched economic meetings in the world.

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-12 McGraw-Hill/Irwin

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-13 McGraw-Hill/Irwin Functions of Federal Reserve Banks Assist in the conduct of monetary policy –set and change the discount rate (must be approved by the Board of Governors) –make discount window loans to depository institutions Supervise and regulate FRS member banks –conduct examinations and inspections of member banks –issue warnings when banking activity is unsafe or unsound –approve bank mergers and acquisitions Provide government services –act as the commercial banks of the U.S. Treasury Assist in the conduct of monetary policy –set and change the discount rate (must be approved by the Board of Governors) –make discount window loans to depository institutions Supervise and regulate FRS member banks –conduct examinations and inspections of member banks –issue warnings when banking activity is unsafe or unsound –approve bank mergers and acquisitions Provide government services –act as the commercial banks of the U.S. Treasury

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-14 McGraw-Hill/Irwin Federal Reserve Banks Issue new currency (provide liquidity Y2K+9/11) –collect and replace currency in circulation as necessary Clear checks –act as a central clearing system for U.S. banks –clear ~25% of all checks written in the U.S. (15 billion yearly) Provide wire transfer services –Fedwire –Automated Clearinghouse (ACH) Perform banking sector and economic research –used in the formulation of monetary policy Issue new currency (provide liquidity Y2K+9/11) –collect and replace currency in circulation as necessary Clear checks –act as a central clearing system for U.S. banks –clear ~25% of all checks written in the U.S. (15 billion yearly) Provide wire transfer services –Fedwire –Automated Clearinghouse (ACH) Perform banking sector and economic research –used in the formulation of monetary policy

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-15 McGraw-Hill/Irwin Balance Sheet of the Federal Reserve The conduct of monetary policy is through the changes in the assets and liabilities. (major determinants of the size of the nation’s money supply) Major assets –Treasury securities %86.5 ( Op.Mark ) –Treasury currency %4.2 –gold (certificates) and foreign exchange %3.5 –loans to domestic banks %0.0 (thru disc. wind.) Major liabilities –Reserves % 2 Required Excess (no interest is paid) –currency in circulation % 84.7 IOUs outside the banks. –currency in circulation + reserves (in Fed+in bank vaults) = money base The conduct of monetary policy is through the changes in the assets and liabilities. (major determinants of the size of the nation’s money supply) Major assets –Treasury securities %86.5 ( Op.Mark ) –Treasury currency %4.2 –gold (certificates) and foreign exchange %3.5 –loans to domestic banks %0.0 (thru disc. wind.) Major liabilities –Reserves % 2 Required Excess (no interest is paid) –currency in circulation % 84.7 IOUs outside the banks. –currency in circulation + reserves (in Fed+in bank vaults) = money base SDR Certificates% 0.2 Federal Reserve float% 0.0 Security repurchase agreements %3.7 US goverment agency securities %0.0 Miscellaneous assets % 1.9 Vaulth Cash of commercial banks % 4.6 Deposits due to federal goverment %0.5 Equity % 1.9

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-16 McGraw-Hill/Irwin

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-17 McGraw-Hill/Irwin Monetary Policy Monetary policy affects the macroeconomy by influencing the supply and demand for excess bank reserves –influences the money supply and the level of short-term and long-term interest rates –affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices Monetary policy affects the macroeconomy by influencing the supply and demand for excess bank reserves –influences the money supply and the level of short-term and long-term interest rates –affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-18 McGraw-Hill/Irwin Monetary Policy Open market operations –Policy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York –Trading Desk manager buys or sells U.S. Treasury securities in the over-the-counter (OTC) market, which keeps the fed funds rate (the interest rate on short term funds transferred between financial institutions, usually for a period of one day) near its desired target – (after 9/11 FED decreased fed funds 11 times!!) Open market operations –Policy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York –Trading Desk manager buys or sells U.S. Treasury securities in the over-the-counter (OTC) market, which keeps the fed funds rate (the interest rate on short term funds transferred between financial institutions, usually for a period of one day) near its desired target – (after 9/11 FED decreased fed funds 11 times!!)

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-19 McGraw-Hill/Irwin Monetary Policy Open market operations (cont’d) –FRBNY acts through the Trading Desk to implement policy directives each business day –operations may be permanent or temporary –For payment either cheque or wire system is used. –may use repurchase agreements for temporary increases or decreases in excess reserves Open market operations (cont’d) –FRBNY acts through the Trading Desk to implement policy directives each business day –operations may be permanent or temporary –For payment either cheque or wire system is used. –may use repurchase agreements for temporary increases or decreases in excess reserves

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-20 McGraw-Hill/Irwin Monetary Policy The discount rate is the rate Federal Reserve Banks charge on loans to depository institutions in their district The Federal Reserve rarely uses the discount rate as a policy tool –discount rate changes are strong signals of the Federal Reserves intentions: raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general. (there will be less borrowing) –there is no guarantee that banks will borrow The discount rate is the rate Federal Reserve Banks charge on loans to depository institutions in their district The Federal Reserve rarely uses the discount rate as a policy tool –discount rate changes are strong signals of the Federal Reserves intentions: raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general. (there will be less borrowing) –there is no guarantee that banks will borrow

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-21 McGraw-Hill/Irwin Monetary Policy

22. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-22 McGraw-Hill/Irwin Monetary Policy Discount window rates: –Primary credit: sound depository institutions on a very short term basis. –Secondary credit: depository institutions that are not eligible for primary credit, the rate is above the primary credit. –Seasonal credit: available to depository institutions that can demonstrate a clear pattern of recurring intrayearly swings in funding needs; tourist, agriculture. Discount window rates: –Primary credit: sound depository institutions on a very short term basis. –Secondary credit: depository institutions that are not eligible for primary credit, the rate is above the primary credit. –Seasonal credit: available to depository institutions that can demonstrate a clear pattern of recurring intrayearly swings in funding needs; tourist, agriculture.

23. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-23 McGraw-Hill/Irwin Monetary Policy Reserve requirements are the reserve assets depository institutions must keep to “back” transaction deposits –reserve assets include vault cash and deposits at Federal Reserve Banks The multiplier effect Reserve requirements are the reserve assets depository institutions must keep to “back” transaction deposits –reserve assets include vault cash and deposits at Federal Reserve Banks The multiplier effect

24. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-24 McGraw-Hill/Irwin Monetary Policy

25. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-25 McGraw-Hill/Irwin Monetary Policy Deposit multiplier effect also holds when other monetary policy tools or instruments are changed as well. For Instance, FOMC instructs the FRBNY to purchase 200 million USD open market purchase. If the reserve requirement is 10 pct: 1/.1X$200 million = 2,000 million = 2 billion What if not a complete circle available : Change in money supply = 1/(new reserve req.+c)x change in reserves. C is the public’s cash to deposit ratio or preference for holding cash outside banks relative to bank deposits. Deposit multiplier effect also holds when other monetary policy tools or instruments are changed as well. For Instance, FOMC instructs the FRBNY to purchase 200 million USD open market purchase. If the reserve requirement is 10 pct: 1/.1X$200 million = 2,000 million = 2 billion What if not a complete circle available : Change in money supply = 1/(new reserve req.+c)x change in reserves. C is the public’s cash to deposit ratio or preference for holding cash outside banks relative to bank deposits.

26. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-26 McGraw-Hill/Irwin Monetary Policy Expansionary monetary policy –open market purchases of securities by the Fed –discount rate decreases –reserve requirement ratio decreases Contractionary monetary policy –open market sales of securities by the Fed –discount rate increases –reserve requirement ratio increases Expansionary monetary policy –open market purchases of securities by the Fed –discount rate decreases –reserve requirement ratio decreases Contractionary monetary policy –open market sales of securities by the Fed –discount rate increases –reserve requirement ratio increases

27. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-27 McGraw-Hill/Irwin Money Supply versus Interest Rate Targeting Federal reserve can target either money supply or interest at any one moment. If the money supply is the target variable, interest rates must be allowed to fluctuate relatively freely. If the interest rate is the target, then bank reserves and the money supply must be allowed to fluctuate relatively freely. With Greenspan the Fed now uses interest rates –fed funds rate- as the main target variable to guide monetary policy. Federal reserve can target either money supply or interest at any one moment. If the money supply is the target variable, interest rates must be allowed to fluctuate relatively freely. If the interest rate is the target, then bank reserves and the money supply must be allowed to fluctuate relatively freely. With Greenspan the Fed now uses interest rates –fed funds rate- as the main target variable to guide monetary policy.

28. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-28 McGraw-Hill/Irwin Money Supply versus Interest Rate Targeting Interest Rate Quantity of Money i’=8% i*=6% i’’=4% MSMS M D’ M D’’ MDMD Interest Rate Quantity of Money i T = 6% i’’= 5% M S’ MSMS M D’ MDMD M D’’ MSMS Interest rates will flactuate between i’ and i’’ If the demant changes so the rate. To turn back target we have to change Ms level using monetary tools.

29. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-29 McGraw-Hill/Irwin International Monetary Policy The Federal Reserve generally allows foreign exchange rates to fluctuate freely 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 The Federal Reserve generally allows foreign exchange rates to fluctuate freely 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

30. ©2009, The McGraw-Hill Companies, All Rights Reserved 4-30 McGraw-Hill/Irwin Major Foreign Central Banks The Bank of Japan –loose monetary policy is fueling an economic recovery The European Central Bank –recently switched from targeting the money supply to targeting inflation The People’s Bank of China –interest rates are becoming a more important policy tool as China moves to a market oriented financial system The Bank of Japan –loose monetary policy is fueling an economic recovery The European Central Bank –recently switched from targeting the money supply to targeting inflation The People’s Bank of China –interest rates are becoming a more important policy tool as China moves to a market oriented financial system