Chapter 4

The Federal Reserve

System, Monetary Policy,
and Interest Rates

Structure of the Federal Reserve

System
(The Fed)

The Fed is the central bank of U.S.

A bankers bank
A governments bank

Decentralized system
12 Federal Reserve Banks (FRBs)
Board of Governors of the Federal Reserve System
Federal Open Market Committee (FOMC)
Member banks
2

The Feds Main

Responsibilities

Formulate and conduct monetary policy

through the FOMC.
Regulate commercial banks.
Serve as the lender of last resort.
Provide payment and other financial
services
Goals: Foster economic growth (low
unemployment); stable and low price level
3

Structure of the Fed (cont.)

12 districts Each district has its own
district Federal Reserve Bank (FRB).
http://www.federalreserve.gov/otherf
rb.htm
Each FRB has its own president, and
a 9-member Board of directors.

Federal Reserve Banks

7-5

Federal Reserve Bank Functions:

General
Issue new currency and remove
damaged currency
Clear checks
Perform bank examinations
Collect and examine data on local business
conditions
Liaison between local community and the
Federal Reserve System
Lender to member banks
Evaluate bank mergers and expansions

http://kansascityfed.org/aboutus/fed-and-you.c
fm
7-6

The FRB of New York

The New York Fed houses the open market
desk. All of the Feds open market
operations are directed through this trading
desk.
The chairman of New York Fed is the only
permanent member of the FOMC, serving as
the vice-chairman of the committee.
Being in NYC, the New York Fed is
responsible for oversight of some of the
largest financial institutions headquartered
in Manhattan and the surrounding area.
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Structure of the Fed (cont.)

Board of Governors in D.C.
7 governors, non-renewable 14-year term,
appointed by the U.S. President and
confirmed by the Senate.
Chair serves a 4 year term but can be
reappointed
Independence of the Fed

Structure of the Fed (cont.)

Federal Open Market Committee (FOMC)
12 members (7 Board of governors+5 Presidents
of district FRBs); The chairman of the FOMC is the
chairman of the Board of the Governors.
Who makes actual decision for the Fed? _______.
How often does the FOMC meet?
8 times per year + emergent meetings if
needed.
http://www.federalreserve.gov/monetarypolicy/fom
ccalendars.htm
Make decisions regarding open market
operations, to influence the monetary base and
interest rate.
FOMC Statement.
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FOMC statement
Committees view of current economic conditions.
Risk of attaining the dual objectives
Decisions
Current target for the federal funds rate
The point is to be as transparent as possible regarding
the path of policies for the next few months.
Voting

Monetary Policy Tools

Open Market Operation
Discount Rate
Reserve Requirement

11

Money
M0 (Monetary base): Currency & coins,
reserves
M1: currency& coins + demand deposits
(checking accounts)
M2: ___+ time deposits (savings accounts)
In this class:
Money=currency in circulation + deposits
Monetary base
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Open Market Operations

Open Market Operations: the Fed buys or
sells U.S. government securities.
Process
8:30-9:00am, open market staff members figure
out the demand for reserve
9:00-9:20am formulate a plan (buy or sell, how
much)
9:20am a daily conference call
By about 10:00am transactions are done
(electronic trading)
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Federal (Fed) Funds

Rate
The Federal (Fed) Funds Rate: interest rate

depository institutions in US charge when they lend

reserves to each other overnight.
Depository institutions and the reserve requirement
Depository institutions: legally allowed to accept
deposits from customers.
Commercial banks, credit
unions, savings associations, etc.
Reserve requirement: A certain percentage of
customers deposits as reserves.
200m deposits
Required reserves
Total
reserves
Bank A
20m
30m
Bank B
20m
15m

Market (effective) Fed Funds Rate vs.

Target Fed Funds Rate
Market Fed Funds Rate
www.federalreserve.gov/releases/h15/update
Determined in the market, not controlled by the Fed. demand and
supply of federal funds in the market
Target Fed Funds Rate
The target interest rate at which banks make overnight loans to each
other.
FOMC announces it at its statement.

Source: http://research.stlouisfed.org/

How Does the Fed Influence

Market Fed Funds Rate?
By influencing reserves
Add reserves
market fed funds rate

or
Drain reserves

market fed funds rate

Practice Question:
The Fed can lower market fed funds rate by
____(buying/selling) securities, thereby
____( / ) reserves.

Why should we care the

federal funds rate?
Market interest rate and the Federal Funds
rate are positively related.
The Federal Funds rate => Market interest
rate

Discount Policy
Discount lending, Discount rate
The Fed lends to commercial banks.
The interest rate charged by the Fed when
financial institutions borrow from it.
Lender of last resort
To provide liquidity to banks, eliminate bank
panics, and stabilize the financial system
Cost: moral hazard problem, take extra risk,
especially for large commercial banks (too
big to fail)
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Operations of the Discount

Window
Primary Credit
to sound banks, very short-term.
Primary discount rate is usually 100 basis
points above the target federal funds rate. As
a ceiling for market federal funds rate.
Secondary Credit
only if the bank cant borrow from others
50 basis points above the primary discount
rate
Seasonal Credit
Market interest rate.
banks with a lot of farmers loans and deposits
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Reserve Requirements
Reserve Ratio Requirement: portion
(expressed as a percent) of depositors'
balances that banks are required to deposit
as reserves with the Fed or to hold as cash.
Change in reserve ratio affects the quantity
of money and credit availability in the
economy.
Reserve requirement have a large really,
too large impact on the level of deposits.

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Money Multiplier
What determines the money
supply?
Example 1: I have $100, and put
it under my mattress.
M increases by how much.

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Money Multiplier (cont.)

Example 2: I have $100. (the starting
point)
Im going to deposit $100 in a bank (the
1st bank). (The bank wants to make
profit by putting loans out).
Suppose the bank loans $90 to Jamie,
Jamie buys a coat from Macys and
Macys deposits $90 in its bank (the 2 nd
bank).
The 2nd bank loans $81 to Steve, Steve
buys a cabinet from Walmart, Walmart
puts $81 in its bank (the 3 rd bank).
The 3rd Bank loans $72 to Kim, Kim puts
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Money Multiplier (cont.)

In example 2: money supply increases
by how much?
M=currency + deposits
Currency increases by ____; Deposits by
____
Multiplier: 1/required reserve ratio.
Scenario 2: private sector created
money. When people deposits funds, and
when banks lend funds, M increases.
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What Determines Money

Supply?
1) Government prints money
2) How much households deposit
and how much banks lend.

24

Federal Reserve Bank Functions:

Monetary Policy
Five of the 12 bank presidents vote in the
Federal Open Market Committee
Establish the discount rate at which
member banks may borrow from the Federal
Reserve Bank (subject to BOG review),
decide which banks can obtain discount
loans from the Federal Reserve Bank.
Elect one member to the Federal Advisory
Council
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Board of Governors
Sets the reserve requirement.
All Board members are members of
the FOMC.
Effectively sets the discount rate.
Serve in an advisory capacity to the
President of the United States, and
represent the U.S. in foreign
economic matters.
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Member Banks
National banks (banks chartered by the
Office of the Comptroller of the Currency)
are required to be members.
State commercials banks may elect to
join.
By 1987, all depository institutions were
required to maintain reserves (member or
nonmember banks), have access to the
discount window and Fed check clearing
service.
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