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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
Federal Reserve System (ch7 & 8) -- Fin331 2
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
Federal Reserve System (ch7 & 8) -- Fin331 3
Federal Reserve System (ch7 & 8) -- Fin331 4
Structure of Federal Reserve
Board of Governors
12 Federal Reserve Banks
FOMC
Federal Advisory Council
3600 Member Commercial Banks
Federal Reserve System (ch7 & 8) -- Fin331 5
Federal Reserve System (ch7 & 8) -- Fin331 6
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
Federal Reserve System (ch7 & 8) -- Fin331 7
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 System (ch7 & 8) -- Fin331 8
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 System (ch7 & 8) -- Fin331 9
Federal Reserve Districts
Federal Reserve System (ch7 & 8) -- Fin331 10
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
Federal Reserve System (ch7 & 8) -- Fin331 11
FOMC
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
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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
Federal Reserve System (ch7 & 8) -- Fin331 13
The Federal Reserve’s Balance Sheet
Assets Liabilities
Government Securities
Discount Loans
Currency in Circulation
Reserves
Monetary Base: (1) Currency in Circulation; (2) reserve
Federal Reserve System (ch7 & 8) -- Fin331 14
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
Federal Reserve System (ch7 & 8) -- Fin331 15
Open Market Purchase from Public
Public The Fed
Assets Liabilities Assets Liabilities
Securities Securities Reserves
- $100 + $100 +$100
Deposits
+ $100
Banking System
Assets Liabilities
Reserves Deposits
+ $100 + $100 Result: R $100, MB $100
Federal Reserve System (ch7 & 8) -- Fin331 16
Discount Loans
Banking System The Fed
Assets Liabilities Assets Liabilities
Reserves Discount Discount loan Reserves
+ $100 loan + $100 + $100 + $100
Result: R $100, MB $100
Federal Reserve System (ch7 & 8) -- Fin331 17
Reserves and Federal Funds Rate
Federal Funds Rate: the interest rate on overnight loans of reserves from one bank to another.
Federal Reserve System (ch7 & 8) -- Fin331 18
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
Federal Reserve System (ch7 & 8) -- Fin331 19
Response to Open Market Operation
1. Open market purchase, Rs shifts to right and iff
2. id , DL , Rs shifts to right and iff
Federal Reserve System (ch7 & 8) -- Fin331 20
Response to Change in Required Reserves
1. RR , Rd shifts to right, iff
Federal Reserve System (ch7 & 8) -- Fin331 21
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
Federal Reserve System (ch7 & 8) -- Fin331 22
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
Federal Reserve System (ch7 & 8) -- Fin331 23
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
Federal Reserve System (ch7 & 8) -- Fin331 24
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
Federal Reserve System (ch7 & 8) -- Fin331 25
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
Federal Reserve System (ch7 & 8) -- Fin331 26
Central Bank Strategy
Federal Reserve System (ch7 & 8) -- Fin331 27
Use of Targets
Money Supply Target
Interest Rate Target
Federal Reserve System (ch7 & 8) -- Fin331 28
Money Supply Target
1. Md fluctuates between Md' and Md''
2. With M-target at M*, i fluctuates between i ' and i ''
Federal Reserve System (ch7 & 8) -- Fin331 29
Interest Rate Target
1. Md fluctuates between Md' and Md''
2. To set i-target at i*, Ms fluctuates between M ' and M '’