Download PPT - Ch. 14 The Federal Reserve System

The Federal Reserve System
Ch. 14
How the Federal Reserve is organized
The Fed’s major policy tools
How open market operations work
The Federal Reserve System
*We examine how the government
controls money creation and thus
aggregate demand (AD).
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.
The Structure of the Fed
*The Fed Board of Governors sets monetary
policy: the use of money and credit controls to
influence macroeconomic outcomes.
*Board members have a 14-year term, in a twoyear stagger, to ensure a measure of political
independence. (7 members)
• One board member is appointed chairman for 4
years.
The current Fed chairman is Janet Yellen, serving
her first 4-year term.
*The Federal Open Market Committee (FOMC):
*Responsible for the Fed’s daily activity
in financial markets.
• Meets monthly to review economic
performance and to adjust monetary
policy as needed.
Monetary Tools
*The Fed controls the money supply by using three policy
tools:
• Reserve requirements.
• Discount rates.
• Open market operations.
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.
• Banks cannot loan out these required reserves.
*By changing reserve requirements, the Fed can directly alter
the lending capacity of the banking system.
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.
• Available lending capacity = Excess reserves x Money
multiplier
*The Discount Rate
• Private banks earn income by making loans, so
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.
• If the discount rate is raised, borrowing reserves
from the Fed becomes more expensive.
• 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.
• More reserves are borrowed.
• More loans are made, increasing the money supply.
Open Market Operations
*The Fed’s daily activity in financial
markets: they buy and sell securities
• This is the principal mechanism to
directly alter the reserves of the
banking system.
• When the Fed buys government
bonds (aka securities) from the public,
reserves increase, more loans can be
made, and the money supply grows.
• When the Fed sells government bonds
(aka securities) to the public, reserves
decrease, fewer loans can be made,
and the money supply shrinks.
The Bond Market (aka securities)
*A bond is a certificate acknowledging a debt and the amount of interest to
be paid each year until repayment, 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
*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.
Ex: *if the Federal Reserve buys government bonds from the public, banks
will be able to make additional loans.
Open Market Activity
*The Fed can induce people to sell bonds to them by offering
to buy them at a higher price.
• The Fed pays the public for the bonds and bank
reserves rise.
• More loans can be made.
*The money supply increases (or its growth slows).
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.
*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.
The Economy Tomorrow
• Is the Fed losing control?
• The Fed shifted from targeting
the money supply to targeting
interest rates, which are ….
• Easier and faster to track.
• Of more immediate
concern in investment and
consumption decisions.
• The Fed most likely will use
the federal funds rate as its
primary barometer of
monetary policy in the
economy tomorrow.