Download Chapter 3: Federal Reserve System

Chapter 3
The Federal Reserve System (FED)
The Beginning


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Severe nationwide financial panics led
Congress to pass the Federal Reserve
Act in 1913, setting up the Federal
Reserve System.
The Federal Reserve Act divided the
United States into 12 Federal Reserve
districts, each of which has a Federal
Reserve Bank in one city to conduct
discount lending.
Formal Structure


The Federal Reserve System (Fed) is the
central bank of the United States (created by
Congress in 1913) that regulates the banking
system and determines monetary policy. The
original purpose of the Fed was to provide an
elastic currency and to act as lender of last
resort. The Banking Reform Acts of 1933
and 1935 broadened the powers of the Fed to
promote the overall health and stability of the
economy.
Functions of the FED
 Bank’s Bank
 Lender of the last resort
 Conducts monetary policy
 Supervises, examines and regulates the
financial system
 Provides financial services
 Issues new currency and clears checks
 U.S. Governments bank
Organization

Federal Reserve Banks
 Facts
Each district bank has a board of directors
consisting of three bankers (Class A directors),
three leaders in industry, commerce, and
agriculture (Class B directors), and three public
interest directors (Class C directors).

Class A and B directors are elected by member
banks and Class C directors are appointed by
the Fed’s Board of Governors.

Subject to the Board’s approval, the nine
directors of a Federal Reserve Bank elect the
president of that bank.
 The 12 Federal Reserve banks carry out duties
related to the Fed’s roles in the payments system,
monetary control, and financial regulation.

 12 Districts

each has branches
 Each has 9 directors who appoint a
President
 Each has an advisory Board of 9 members
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3 from the local banking community
3 from local community
3 from the local community chosen by the
Board of Governors in Washington
 New York is the most important
 5 Serve on the FOMC

New York and 4 others
 Functions: Day to day operations
Issues new currency
Evaluates mergers and applications
Collects data within their districts
Conducts research
Conducts monetary policy
Appoints commercial bankers to sit on the Federal
Advisory Council
 Bank’s Bank

Collects and Clears checks

Automated Clearing house

Fedwire

Makes loans to banks in their districts

Examines banks
 U.S. Governments bank

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 Member banks (3000 of 8178
commercial banks)
 All national banks must be members
 State banks may join
 All banks and depository institutions
(20000) (as of 1987) must hold reserves
in the FED and follow the rules

Board of Governors

Seven members appointed by the President and
confirmed by the Senate to 14 year terms


Establish monetary policy
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Chairman – second most important person in the world

Term is for 4 years (as is the vice chairman)
Sets Reserve Requirement – percentage of deposits that
must be held in the FED
Set Discount Rate

Determines and reviews discount rates and policy
Sits on FOMC

Determines Open Market Operations – buying and
selling securities to the banks

Determines Federal Funds Rate
Appoints 3 directors to the district banks

Federal Open Market Committee

Meets 8 times a year- about every 6 weeks

Directs open market operations
 The meeting

Boardroom on the second floor of the BOG in
Washington

9:00 am on Tuesday

Attendance

Agenda

Go through “the books”

Discuss the target (FFR) and goals (full
employment, price stability and economic
growth

Discuss the state of the economy

Votes on policy

Announcement 2:15 ET (Tuesday or
Wednesday)
 Issues FOMC Directive – written instructions to the
Head of the Trading Desk of the New York District
 The Books
 Green – 2 year forecast
 Blue – Monetary aggregates
 Beige – Produced by the districts
 Covers conditions in each district and
overall economic conditions
Policy Tools

Open Market Operations (the buy and selling of government
securities to change reserves): are the most important monetary
policy tool. They are executed by the New York Fed.
Discount Rate: Changes in the primary credit rate and the
secondary credit rate (the rates depository institutions are
charged to borrow reserves from the Fed) are a highly publicized but
less important monetary policy tool. Increases (decreases) in the
discount rate raise (lower) the cost of borrowing reserves from the
Fed. In recent years, the primary credit rate has been set one
percent above another key short-term rate on which the Fed exerts a
great deal of influence and the secondary credit rate one and a half
percent higher.
Reserve Requirement: The Fed may also change the required
reserve ratio (the fraction of deposit liabilities which must be held
as required reserves). The ratio is increased to limit depository
institution’s ability to make more loans. The ratio is decreased to
allow depository institutions to make more loans.
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The Fed does not use this tool often but rather relies more heavily on
open market operations to change reserves.
Informal Structure
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Independent of the government
Still under political pressure because
Congress, which writes the laws, can
change its mind at any time
Members are driven by their power and
prestige

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Chairman has a lot of power
Says it acts in the public interest
Independence of the FED
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For
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Must remain unbiased
Must look to the long run not short run of
politics
Against

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Undemocratic to allow and unsupervised
and unaccountable organization
Makes it difficult to coordinate fiscal and
monetary policy
The political issue of the Fed’s
independence arises because of the
public’s negative reaction to Fed policy.

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The main argument for Fed independence is
that monetary policy is too important and
technical to be determined by politicians.
Opponents of Fed independence claim that in a
democracy elected officials should make public
policy.