CHAPTER

44The Fed and Monetary Policy

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Identify the Fed’s role in monetary policy Describe the tools the Fed uses to influence

monetary policy Explain how changes in regulation in the

1980s affected the Fed and monetary policy

Federal Reserve System: Third U. S. Federal Reserve System: Third U. S. Central BankCentral Bank

First Bank of the United States (1791–1811)

Second Bank of the United States

(1816–1836)

Federal Reserve System (1913–)

Structure of the Federal Reserve SystemStructure of the Federal Reserve System

12 Fed District Banks Member Commercial Banks 7 Members of Board of Governors 14 year terms for Governors 12 Open Market Committee (FOMC)

Members Advisory Committees to Fed from private

sector

Functions of the Federal Reserve SystemFunctions of the Federal Reserve System

Effect Monetary Policy U.S. Central Bank In International Area Fiscal Agent of U.S. Treasury Facilitate Efficient Payments System Regulate Banks and Bank Holding Co. Enforce Consumer Credit Laws

Organization of the Federal ReserveOrganization of the Federal Reserve

Federal Reserve District Banks 12 districts Districts divided by population at 1912–13 District bank size related to economic wealth of

district District banks owned by private member banks Board of Directors of district banks

Three appointed by Board of Governors Three professional bankers Three business persons in district

Organization of the Federal ReserveOrganization of the Federal Reserve

Member Banks Must meet requirements of the Federal Reserve

Board of Governors to be a member bank Nationally chartered banks must be member banks State chartered banks may be member banks 35% of banks controlling 70% of all deposits are

members

Organization of the Federal ReserveOrganization of the Federal Reserve

Board of Governors 7 individuals appointed by the U.S. president and

confirmed by the Senate U.S. president appoints one of the 7 chair whose

4-year term is renewable Offices in Washington, D.C. Serve nonrenewable 14-year terms Independence of Federal Reserve

Staggered terms of Governors Budget separate from Congress

Organization of the Federal ReserveOrganization of the Federal Reserve

Board of Governors has two main functions: Regulate commercial banks

Supervise and regulate member banks and bank holding companies

Oversight of 12 Fed district banks Establish consumer finance regulations after

Congressional legislation

Organization of the Federal ReserveOrganization of the Federal Reserve

Establish and effect monetary policy

Direct control over two tools of monetary policy Set reserve requirements Approve discount rate set by district banks

Indirect control in a third area Governors are members of the Federal Open Market

Committee

Organization of the Federal ReserveOrganization of the Federal Reserve

Federal Open Market Committee (FOMC) meets every 6 weeks 12 members

7 from the Board of Governors President of the New York Fed 4 other district bank presidents appointed on a rotating

basis Other presidents participate but do not vote on monetary

policy matters

Organization of the Federal ReserveOrganization of the Federal Reserve

Federal Open Market Committee (FOMC) Monetary policy goals of:

high employment price stability economic growth

Make monetary policy decisions to achieve goals Forward decisions to N.Y. Fed open market desk

Advisory committees from private sector also are a part of overall structure of the Fed

Fed’s Influence on EconomyFed’s Influence on Economy

Fed influences liquidity (supply of loanable funds) in money market to influence:

Liquidity,Money Supply

andInterest Rates

Business and ConsumerBorrowing/Spending

Goals of Growth

Price StabilityJob Growth

Tools of Monetary PolicyTools of Monetary Policy

Tools ofMonetary

Policy

OpenMarket Op.

Reserve Req. Discount Rate

How Fed Controls Money SupplyHow Fed Controls Money Supply

Banks must maintain reserves as percent of deposits

Reserves kept as deposits in Fed (plus vault cash)

Fed controls level of member bank reserve deposits in Fed

Fed influences bank deposit portion of money supply

Monetary Policy ToolsMonetary Policy Tools

Open market operations involve the purchase or sale of government securities based on FOMC directives sent to N.Y. Fed Trading Desk

Open market purchase of government securities: Purchase securities from government securities

dealers Increase bank deposits and bank reserves, money

market liquidity and, in time… Increases the money supply

Exhibit 4.4Exhibit 4.4

$100 million

$90 million

$81 million

$10 million

$9.0 million

$8.1 million

Increase indepositsat banks

Required reservesheld on

new deposits

Funds received fromnew deposits that

can be lent out

$90 million

$81 million

$72.9 million

Monetary Policy ToolsMonetary Policy Tools

Open market operations and interest rates Most rates are market determined but Fed

influences federal funds interest rate Fed purchase of securities results in an injection of

additional funds into the bank system Shifts supply of federal funds to the right Lowers federal funds rate Lower rates spread to other money market securities

More funds available for money market and bank lending

Monetary Policy ToolsMonetary Policy Tools

Adjusting the discount rate Depository institutions borrow from Fed for three

reasons: Adjustment credit for short-term reserve deficiencies Seasonal credit to agricultural banks Extended credit for longer-term liquidity problems of

problem banks

Lower discount rate More bank borrowing from Fed, bank reserves expand,

money supply increases

Monetary Policy ToolsMonetary Policy Tools

Adjusting the reserve requirement ratio Proportion of deposits at depository institutions

set aside to meet their reserve requirements Increase in lending or expansion limited by ($)

reserves bank must hold the meet reserve requirements (%)

Total dollar expansion effect as follows:

Dollar amount of open marketFed purchase or discount loan ×

1

RR

Comparison of Policy ToolsComparison of Policy Tools

Increasing the money supply Open market operation purchase of securities via

the Trading Desk in the secondary market Discount rate lowered to encourage borrowing at

the discount window Reserve requirements lowered

Comparison of Policy ToolsComparison of Policy Tools

Decreasing the money supply Open market operation sale of securities via the

Trading Desk in the secondary market Discount rate raised to encourage borrowing at the

discount window Reserve requirements raised

Monetary Policy Deposit Expansion Monetary Policy Deposit Expansion ProvidesProvides

Excess Reserves to Lend Loan/Deposit Expansion Loans Finance Spending Potential Expansion = Added $ Reserves

1/Required Reserve Ratio

Limiting Factors to Deposit ExpansionLimiting Factors to Deposit Expansion

Banks may not lend excess reserves Public may not re-deposit payments In

expansion process (cash drains) Lowers deposit expansion multiplier Other fed functions impact member bank

reserve level

Federal Reserve Policy EmphasisFederal Reserve Policy Emphasis

Money Supply Growth Interest Rate Levels Price Level Changes Real Economic Activity

Monetary Control Act of 1980Monetary Control Act of 1980

To regain more control over the money supply the MCA required all depository institutions to Meet the same reserve requirements Hold noninterest-bearing reserves Promptly report deposit levels to the Fed

Other provision of the MCA allowed all depository institutions To offer transaction accounts Access to the discount window

Global Monetary PolicyGlobal Monetary Policy

Each country has its own central bank and often industrialized countries have banks with similar goals

Integration in the global economy means the Fed must consider conditions in other countries when looking at the U.S. economy

Central banks try to work together but conflicts of interest can make cooperation difficult at times

Global Monetary PolicyGlobal Monetary Policy

A single European monetary policy Euro replaced national currencies of 11 countries

in January 1999 National currencies withdrawn and replaced by

euro by June 1, 2002 Countries of the 15 in the European Union needed

to meet economic criteria and chose to join Created a European Central Bank