Federal Reserve System (ch7 & 8) -- Fin331 1 Federal Reserve System Overview of Federal Reserve...

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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

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

Structure of Federal Reserve

Board of Governors

12 Federal Reserve Banks

Federal Advisory Council

3600 Member Commercial Banks

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

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 BanksClear 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 Districts

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

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

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

The Federal Reserve’s Balance Sheet

Assets Liabilities

Government Securities

Discount Loans

Currency in Circulation

Reserves

Monetary Base: (1) Currency in Circulation; (2) reserve

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

Open Market Purchase from Public

Public The Fed

Securities Securities Reserves

- $100 + $100 +$100

Deposits

+ $100

Banking System

Assets Liabilities

Reserves Deposits

+ $100 + $100 Result: R $100, MB $100

Discount Loans

Banking System The Fed

Reserves Discount Discount loan Reserves

+ $100 loan + $100 + $100 + $100

Result: R $100, MB $100

Reserves and Federal Funds Rate

Federal Funds Rate: the interest rate on overnight loans of reserves from one bank to another.

Market for Reserves and the Fed Funds Rate

1. Demand curve slopes down because iff , ER and Rd up

2. Supply curve slopes down because iff , DL , Rs

3. Equilibrium iff where Rd = Rs

Response to Open Market Operation

1. Open market purchase, Rs shifts to right and iff

2. id , DL , Rs shifts to right and iff

Response to Change in Required Reserves

1. RR , Rd shifts to right, iff

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

B. Discount Loans3 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

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

C. Reserve Requirements (cont’d)

Advantages1. Powerful effect

Disadvantages1. Small changes have very large effect on Ms

2. Raising causes liquidity problems for banks

3. Frequent changes cause uncertainty for banks

4. Tax on banks

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

Central Bank Strategy

Use of Targets

Money Supply Target

Interest Rate Target

Money Supply Target

1. Md fluctuates between Md' and Md''

2. With M-target at M*, i fluctuates between i ' and i ''

Interest Rate Target

1. Md fluctuates between Md' and Md''

2. To set i-target at i*, Ms fluctuates between M ' and M '’

Federal Reserve System (ch7 & 8) -- Fin331 1 Federal Reserve System Overview of Federal Reserve...

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