CHAPTER 2

1. CHAPTER 2 THE FEDERAL RESERVE AND ITS POWERS

2. Early Banking • Served the safekeeping function • Receipts were used as money • With 100% reserves early banks were only custodians • The lending function and money creation function developed with use of fractional reserves • Increased risk and bank panics • Modern banking is fractional reserve system

3. Early U.S. Banking • Bank of North America, 1782, was the first American bank • Early banks issued bank notes, convertible to specie • Industrial interest promoted banking; agrarian and frontier interests disliked banks • Bank note issue has poor reputation

4. Early U.S. Central Banking • The Bank of the United States (1791-1811) was the first U.S. central bank • Federal charter • Performed both public and private functions • Privately owned • Publicly—controlled bank note issue and intercountry transactions

5. Early U.S. Central Banking • Second Bank of the United States (1816-1832) • Central banking functions very unpopular • President Jackson vetoed renewal of charter in 1832

6. Early State Banking • States chartered banks • Prosperity varied with business cycle • No central bank control over loan/note issue • Wild expansion/contraction cycles hurt economic development • State political influences, under capitalization, and abuses prevailed • Many bank failures in economic downturns

7. Federal Banking Legislation • National Banking Acts of 1863 and 1864 • Promoted a safe and uniform currency • Aided in financing Civil War • Provisions included: • Federal Charters for national banks • Increased capital requirements • Established minimum reserve requirements • Maximum loan size to single borrower • Began issuance of uniform bank notes printed by U.S. Treasury, backed by Federal Government

8. Federal Banking Legislation • Deposit banking evolved from the National Bank Acts • State bank notes taxed • State banks issued demand deposits instead of bank notes

9. Federal Banking Legislation • Problems with “national” banking system • Inelastic money supply—no lender of last resort • Pyramiding of reserves from small to large banks produced financial panics at times • Payment and check clearing system inefficient

10. Origins of the Federal Reserve System • Prior to 1863, banks issued bank notes that functioned like our present day currency but were the obligations of individual banks. • Because of the risk of failure, some banks’ notes traded at a discount. • The quantity of money in circulation fluctuated with the business cycle, possibly exaggerating those cycles.

11. Origins of the Federal Reserve System (concluded) • Demand deposits were not insured, so they were often discounted when the bank was distant, suspect, or unknown. • Further, banks were subject to liquidity problems and the economy suffered several recessions and crises, culminating in the crash of 1907. • These problems lead to the passage of the Federal Reserve Act in 1913.

12. The Initial Purposes of the Fed Were to: • Provide an elastic currency supply (money supply control). • Serve as a lender of last resort (discount window). • Provide for a sounder banking system (bank regulatory powers). • Improve the payments system (check clearing and promoting payments system technology).

13. Nonmonetary Powers of the Fed • Regulation Q -- established the maximum rate that depository institutions could pay on deposit accounts until it was phased out over the 1980-1986 period. • Securities Credit Regulation -- establishes borrowing (margin) limits for buyers of securities on margin. • Supervision and Examination of State Member Banks by Fed.

14. Nonmonetary Powers of the Fed (concluded) • Regulation of Bank and Financial Holding Companies. • Regulation of Payment System. • Control of International Banking Activities. • Consumer Credit Regulation.

15. Organization of the Fed

16. The Fed's Balance Sheet (2000) Source: Board of Governors, Federal Reserve System.

17. Payments Clearing System • Banks hold deposits in other banks and the Federal Reserve Banks in order to clear checks. • While the physical paper check moves from bank to bank, the deposit accounts of banks are merely debited or credited. • Many checks are cleared locally through clearing house associations. • Checks drawn on association member banks are netted out.

18. Payment System Processes • The Federal Reserve Banks are heavily involved in the check clearing of out of town checks • Most depository institutions either directly or indirectly (through other banks) hold reserve deposits in the Fed. • Checks written on other banks are sent to the Fed and, depending on the distance and time needed to present the check to the paying bank • The reserve account of the check depositing bank may receive immediate or delayed (DACI) credit.

19. Payment System Processes • Federal Reserve float is created by the double counting of clearing-delayed checks. • One bank is given credit in its reserve account after two days (from DACI) • while the check has not yet (CIPC) been presented to the paying bank. • Float, at any time, is the difference between CIPC and DACI, and represents a net credit to the reserve account of all depository institutions.

20. Payment System Processes • When a check is cleared and a deposit transfer is made at the Fed, the total bank reserves remain the same • Only the ownership (one bank to another) changes. • Payments do not impact money supply • Only Fed’s impact upon bank reserve account impacts money supply

21. Three Tools of Federal Reserve Monetary Policy 1. Establishing reserve requirements, the minimum proportion (percentage) of bank deposits they must keep on deposit at the Fed. • Increasing reserve requirements (%) increases the percentage of bank deposits kept in noninterest bearing deposits at the Fed and limits bank lending. • Decreasing reserve requirements (%) reduces the percentage of bank deposits kept in the Fed and provides the banking system with excess reserves.

22. Three Tools of Federal Reserve Monetary Policy (continued) • Bank deposits (reserves) in the Fed are needed to clear checks and to satisfy reserve requirements. • Actual reserves (AR) are balances needed to meet check clearing and legal reserve requirements including • vault cash. • noninterest bearing bank deposits in Federal Reserve banks.

23. Three Tools of Federal Reserve Monetary Policy (continued) • Required reserves (RR) is the dollar level of reserves needed to meet legal reserve requirements. • Reserve requirements (%) and the level and type of deposits determine the level of required reserves in a period. • Actual reserves (have) needed for check clearing may exceed required reserves (have to have) and vice versa.

24. Three Tools of Federal Reserve Monetary Policy (continued) • Excess reserves (ER) equals actual minus required reserves. • Excess reserves may be loaned to customers or sold to other banks (federal funds market) by an individual bank. • If the level of the banking system's Federal Reserve borrowed reserves (BR) (Fed loan credited to reserve accounts) exceeds the level of excess reserves in a period, the banking system is in a net borrowed reserve position, is less likely to promote lending activities, and interest rates are most likely to be increasing.

25. Three Tools of Federal Reserve Monetary Policy (continued) • If the level of level of excess reserves exceeds Fed borrowing, the banking system is in a net-free reserve position, credit is easier and interest rates are generally lower.

26. Three Tools of Federal Reserve Monetary Policy (continued) 2. Open market operations affect the level of member bank reserves and the monetary base. • Buying government securities from the private sector, the Fed eventually credits member bank deposits, thus increasing the level of bank reserves and the banks' ability to make loans and expand the money supply. • Selling securities (could be any asset) to private security dealers or banks, the Fed is paid with a bank check which reduces the level of member bank actual reserves.

27. Three Tools of Federal Reserve Monetary Policy (concluded) 3. Discount Rate Policy -- The rate of interest depository institutions pay for borrowing from the Fed. • Raising the discount rate increases the cost of borrowing for needed reserve balances. • Lowering the discount rate lowers the cost of bank liquidity and encourages lending and money supply expansion.