The Federal Reserve System

2. The Federal Reserve System • We examine how the government controls money creation and thus aggregate demand (AD). • The core issues are • Which government agency is responsible for controlling the money supply? • What policy tools are used to control the amount of money in the economy? • How are banks and bond markets affected by the government’s policies?

3. Learning Objectives • 14-01. Describe how the Federal Reserve is organized. • 14-02. Identify the Fed’s major policy tools. • 14-03. Explain how open market operations work.

4. The Structure of the Fed • The Fed was created in 1913. • It consists of 12 Federal Reserve banks, which act as the central bank for private banks in their regions and perform the following services: • Clearing checks. • Holding bank reserves. • Providing currency. • Providing loans.

5. The Structure of the Fed • The Fed Board of Governors is responsible for setting monetary policy. • Monetary policy: the use of money and credit controls to influence macroeconomic outcomes. • Board members are appointed to a 14-year term, in a two-year stagger, to ensure a measure of political independence. • One board member is appointed chairman for 4 years.

6. The Structure of the Fed • The current Fed chairman is Ben Bernanke, serving his second 4-year term. • The Federal Open Market Committee (FOMC) is responsible for the Fed’s daily activity in financial markets. • The FOMC meets monthly to review economic performance and to adjust monetary policy as needed.

7. Monetary Tools • The Fed controls the money supply by using three policy tools: • Reserve requirements. • Discount rates. • Open market operations.

8. Reserve Requirements • Private banks are required to keep a fraction of deposits “in reserve,” either as cash or on deposit at the regional Fed bank. • By changing reserve requirements, the Fed can directly alter the lending capacity of the banking system.

9. Reserve Requirements Available lending capacity = Excess reserves x Money multiplier • Increase the reserve requirement and … • The amount of excess reserves decreases. • The money multiplier decreases. • The available lending capacity shrinks. • Decrease the reserve requirement and … • The amount of excess reserves increases. • The money multiplier increases. • The available lending capacity expands.

10. The Discount Rate • Profit-seeking private banks earn income by making loans. • They try to fully lend out their excess reserves. • At times, a bank might fall short of satisfying the reserve requirement. • It can borrow excess reserves overnight from another bank and pay interest: the federal funds rate. • It can borrow reserves overnight from the Fed and pay interest: the discount rate.

11. The Discount Rate • Discount rate: the rate of interest the Fed charges for lending reserves to private banks. • If the discount rate is raised, borrowing reserves from the Fed becomes more expensive, and fewer reserves are borrowed. Fewer loans are made, decreasing the money supply. • If the discount rate is lowered, borrowing reserves from the Fed becomes less expensive, and more reserves are borrowed. More loans are made, increasing the money supply.

12. Open Market Operations • This is the principal mechanism to directly alter the reserves of the banking system. • Portfolio decision: the choice of how and where to hold idle funds. • There are several choices: cash, savings accounts, stocks, and bonds. The last three may generate additional income in the form of dividends or interest. • Should you keep your idle funds in a savings account or purchase government bonds? • The Fed influences this decision by making bonds more or less attractive.

13. Open Market Operations • If the public moves funds from savings to bonds, reserves fall, and vice versa. • When the Fed buys government bonds from the public, reserves increase, more loans can be made, and the money supply grows. • When the Fed sells government bonds to the public, reserves decrease, fewer loans can be made, and the money supply shrinks.

14. The Bond Market • A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment. • It is an IOU. • People buy bonds because they pay interest and are a safe investment. • Yield: the rate of return on a bond. Annual interest payment Yield = Price paid for the bond

15. The Bond Market • Pay $1,000 for a bond that pays out $80 a year, and its yield is 0.08 or 8%. • If its price fell to $900 in the bond market, its yield would increase to 0.089 or 9%. • The objective of open market operations is to alter the price of bonds, and also their yields, to make them more or less attractive as investments.

16. Open Market Activity • The Fed can induce people to buy bonds by offering to sell them at a lower price. • When the public pays for the bonds, bank reserves fall. Fewer loans are made, and the money supply decreases (or its growth slows). • The Fed can induce people to sell bonds by offering to buy them at a higher price. • When the Fed pays the public for the bonds, bank reserves rise. More loans are made, and the money supply increases.

17. The Fed Funds Rate • The Fed funds rate: the interest rate one bank charges another for an overnight loan of excess reserves. • If the Fed increases reserves by buying bonds, the Fed funds rate falls. • If the Fed decreases reserves by selling bonds, the Fed funds rate rises. • The Fed funds rate is a highly visible signal of Federal Reserve open market operations.

18. Increasing the Money Supply • To increase the money supply, the Fed can • Lower reserve requirements. • Reduce the discount rate. • Buy bonds in open market operations.

19. Decreasing the Money Supply • To decrease the money supply, the Fed can • Raise reserve requirements. • Increase the discount rate. • Sell bonds in open market operations.