Download The Federal Reserve, Money, and Interest Rates

The Federal Reserve, Money, and
Interest Rates
Structure of the Federal Reserve
Introduction
Much of the information in the lecture comes from The Federal
Reserve's web page. The page is an excellent source for learning
about how the Federal Reserve (Fed) affects our economy. The Fed
is the most important economic player in the world. The Fed controls
the money supply and credit conditions in the United States, which in
turn has a major impact on the global economy. The Fed is "quasi
governmental". The Federal Reserve is privately owned. It
develops policy positions independently of the federal government
after presidential appointments of certain key members. The
Chairman of the Board of Governors and of the main policy
determining committee is Alan Greenspan.
If you desire more information than
is contained in this lecture or than is available at the Federal
Reserve's web page, you may order The Federal Reserve System:
Purposes and Functions from the Federal Reserve or may access an
Adobe Acrobat file at the Fed's web page. This book is an excellent
introduction to the Fed.
The Federal Reserve, the central bank of the United States, was
founded by Congress in 1913 to provide the nation with a safer,
more flexible, and more stable monetary and financial system.
Notes:
Today the Federal Reserve's duties fall into four general areas:
1. conducting the nation's monetary policy;
2. supervising and regulating banking institutions and protecting
the credit rights of consumers;
3. maintaining the stability of the financial system; and
4. providing certain financial services to the U.S. government,
the public, financial institutions, and foreign official
institutions.
The Board of Governors of the Federal Reserve System
On December 23, 1913, the Federal Reserve System, which serves
as the nation's central bank, was created by an Act of Congress. The
System consists of
1. a seven member Board of Governors with headquarters in
Washington, D.C., and
2. twelve Reserve Banks located in major cities throughout the
United States.
Appointments to the Board
The seven members of the Board of Governors are appointed by the
President and confirmed by the Senate to serve 14 year terms of
office. Members may serve only one full term, but a member who
has been appointed to complete an unexpired term may be
reappointed to a full term. The President designates, and the Senate
confirms, two members of the Board to be Chairman and Vice
Chairman, for four-year terms.
Representation
Only one member of the Board may be selected from any one of the
twelve Federal Reserve Districts. In making appointments, the
President is directed by law to select a "fair representation of the
financial, agricultural, industrial, and commercial interests and
geographical divisions of the country." These aspects of selection
are intended to ensure representation of regional interests and the
interests of various sectors of the public.
Responsibilities
The primary responsibility of the Board members is the formulation of
monetary policy. The seven Board members constitute a majority of
the 12 member Federal Open Market Committee (FOMC), the group
that makes the key decisions affecting the cost and availability of
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money and credit in the economy. The other five members of the
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FOMC are Reserve Bank presidents, one of whom is the president of
the Federal Reserve Bank of New York. The other Bank presidents
serve one year terms on a rotating basis. By statute the FOMC
determines its own organization, and by tradition it elects the
Chairman of the Board of Governors as its Chairman and the
President of the New York Bank as its Vice Chairman.
The monetary policy tools of the Federal Reserve System
1. The Board sets reserve requirements
2. The Board shares the responsibility with the Reserve Banks
for discount rate policy
3. open market operations
In addition to monetary policy responsibilities, the Federal Reserve
Board has regulatory and supervisory responsibilities over banks that
are members of the System, bank holding companies, international
banking facilities in the United States, Edge Act and agreement
corporations, foreign activities of member banks, and the U.S.
activities of foreign owned banks. The Board also sets margin
requirements, which limit the use of credit for purchasing or carrying
securities.
In addition, the Board plays a key role in assuring the smooth
functioning and continued development of the nation's vast
payments system .
Another area of Board responsibility is the development and
administration of regulations that implement major federal laws
governing consumer credit such as the Truth in Lending Act, the
Equal Credit Opportunity Act, the Home Mortgage Disclosure Act
and the Truth in Savings Act .
Meetings
The Board usually meets several times a week. Meetings are
conducted in compliance with the Government in the Sunshine Act,
and many meetings are open to the public. If the Board has
convened to consider confidential financial information, however, the
sessions are closed to public observation.
Contacts within Government
As they carry out their duties, members of the Board routinely confer
with officials of other government agencies, representatives of
banking industry groups, officials of the central banks of other
countries, members of Congress and academicians. For example,
they meet frequently with Treasury officials and the Council of
Economic Advisers to help evaluate the economic climate and to
discuss objectives for the nation's economy. Governors also discuss
the international monetary system with central bankers of other
countries and are in close contact with the heads of the U.S.
agencies that make foreign loans and conduct foreign financial
transactions.
Regional Federal Reserve Banks
The map below gives the location of the twelve district Federal
Reserve banks
The Federal Open Market Committee
The Federal Open Market Committee (FOMC) is the most important
monetary policy making body of the Federal Reserve System. It is
responsible for formulation of a policy designed to promote:
1.
2.
3.
4.
economic growth
full employment
stable prices
and a sustainable pattern of international trade and payments.
The FOMC makes key decisions regarding the conduct of open
market operations—purchases and sales of U.S. government and
federal agency securities—which affect the provision of reserves to
depository institutions and, in turn, the cost and availability of money
and credit in the U.S. economy. The FOMC also directs System
operations in foreign currencies.
Notes:
Membership
Notes:
The FOMC is composed of the seven members of the Board of
Governors and five Reserve Bank presidents. The president of the
Federal Reserve Bank of New York serves on a continuous basis;
the presidents of the other Reserve Banks serve one year terms on a
rotating basis beginning January 1 of each year. Rotation is such
that each year one member is elected to the Committee by the
boards of directors of Reserve Banks in each of the following groups:
(1) Boston, Philadelphia, and Richmond; (2) Cleveland and Chicago;
(3) Atlanta, St. Louis, and Dallas; and (4) Minneapolis, Kansas City,
and San Francisco.
Organization
By statute, the FOMC determines its own organization. Each year at
its first meeting, the Committee elects its Chairman and Vice
Chairman and selects staff officers to serve the Committee for the
coming year. Traditionally, the Chairman of the Board of Governors
is elected Chairman and the president of the Federal Reserve Bank
of New York is elected Vice Chairman. Staff officers are selected
from a mong the officers and employees of the Board of Governors
and the Federal Reserve Banks.
Meetings
By law, the FOMC must meet at least four times each year in
Washington, D.C. Since 1980, eight regularly scheduled meetings
have been held each year at inte rvals of five to eight weeks. If
circumstances require consultation or consideration of an action
between these regular meetings, members may be called on to
participate in a special meeting or a telephone conference, or to vote
on a proposed action by telegram or telephone. At each regularly
scheduled meeting, the Committee votes on the policy to be carried
out during the interval between meetings. At least twice a year, the
Committee also votes on its long -run policy objectives for growth in
key money and debt aggregates.
Attendance at meetings is restricted because of the confidential
nature of the information discussed, and is limited to Committee
members, nonmember Reserve Bank presidents, staff officers, the
Manager of the System Open Market Account, and a small number
of Board and Reserve Bank staff.
The Decision Making Process
Before each regularly scheduled meeting of the FOMC, System staff
prepare written reports on past and prospective economic and
financial developments which are sent to Committee members and
to nonmember Reserve Bank presidents. Reports prepared by the
Manager of the System Open Market Account on operations in the
domestic open market and in foreign currencies since the last regular Notes:
meeting are also distributed. At the meeting itself, staff officers
present oral reports on the current and prospective business
situation, on conditions in financial markets, and on international
financial developments. In its discussions, the Committee considers
such factors as trends in prices a nd wages, employment and
production, consumer income and spending, residential and
commercial construction, business investment and inventories,
foreign exchange markets, interest rates, money and credit
aggregates, and fiscal policy. The Manager of the System Open
Market Account also reports on account transactions since the
previous meeting.
After these reports, the Committee members and other Reserve
Bank presidents turn to policy. Typically, each participant expresses
his or her own views on the state of the economy and prospects for
the future, and on the appropriate direction for monetary policy. Then
each makes a more explicit recommendation on policy for the
coming inter meeting period (and for the longer run, if under
consideration). Finally, the Committee must reach a consensus
regarding the appropriate course for policy, which is incorporated in
a directive to the Federal Reserve Bank of New York—the Bank
which executes transactions for the System Open Market Account.
The directive is cast in terms designed to provide guidance to the
Manager in the conduct of day today open market operations. The
directive sets forth the Committee's objectives for long-run growth of
certain key monetary and credit aggregates. It also sets forth
operating guidelines for the degree of ease or restraint to be sought
in reserve conditions and expectations with regard to short-term
rates of growth in the monetary aggregates. Policy is implemented
with emphasis on supplying reserves in a manner consistent with
these objectives and with the nation's broader economic objectives.
Effects of Policy
Depository institutions are required to maintain reserves in certain
proportions against various types of their checkable deposits. Open
market operations directly affect the leve l of reserves in the banking
system. Federal Reserve purchases of securities add to reserves;
sales withdraw reserves from the System. If reserves increase,
depository institutions will generally acquire new loans and
investments, which will tend to exert downward pressure on interest
rates.
Open market operations as directed by the FOMC are the major tool
used to influence the total amount of money and credit available in
the economy. The Federal Reserve attempts to provide enough
reserves to encourage expansion of money and credit in keeping
with the goals of price stability and sustainable growth in economic
activity.
Reports
By law, the Board of Governors must keep a record of the actions
taken by the FOMC on all questions of policy and to include in its
annual report to Congress the vote on and reasons for each action.
To provide this information on a timely basis, minutes are prepared
after each meeting and are released to the public a few days after
the next regularly scheduled FOMC meeting.
Twice a year, as required in the Full Employment and Balanced
Growth (Humphrey-Hawkins) Act of 1978, the Board submits a
written report to Congress on the state of the economy and the
course of monetary policy, and the Chairman is called on to testify on
this report.
[Some of the remainder of the lecture is redundant with the above
information which was gleaned from the Federal Reserve's web site.
The material below comes from my lecture notes which have been
developed over the years]
The Federal Reserve's Policy Tools
used by the Fed to adjust the reserves of the banking system to
influence money and credit
Legal Required Reserves
rules that state the amount of reserves depository institutions must
keep on hand to back bank deposits
•
•
expansionary monetary policy: cut the reserve requirements
contractionary monetary policy: raise reserve requirements
Changing reserve requirements is rarely used as policy tool because
of the effect changes the requirement can have on bank profitability.
Discount Window
Banks which keep reserves with the Fed may borrow from the Fed if
the individual bank does not have enough reserves to meet
requirements at the end of the business day. The bank is said to go
to the "discount window".
Notes:
the discount rate is the rate of interest the Fed charges for these
loans
•
•
expansionary monetary policy: cut the discount rate
contractionary monetary policy: raise the discount rate
The discount rate is indicative of the direction of Federal Reserve
policy.
Open Market Operations
purchases and sales of federal government securities by the Fed as
directed by the FOMC to control the money supply
Policy decisions are made by the FOMC and are carried out by the
New York branch.
•
•
expansionary monetary policy: open market purchases
contractionary monetary policy: open market sales
Open market operations are used on a daily basis to influence credit
and the money supply, They are how most monetary policy is
operationalized.
Notes:
Interest Rate Determination
If the Federal Reserve offers to purchase securities, it will offer a
higher price than market price to entice the holders of those bonds to
sell the bonds. The Fed's primary goal is not to make a profit. The
Fed's goal is to increase the money supply to stimulate economic
growth -- if the Fed is buying bonds. Hence, in the very act of
purchasing the bonds the Fed is carrying out policy consistent with
its overall goal of easing monetary and credit conditions in the
economy.
If the Federal Reserve attempts to sell securities, it will lower the
price of the bond below the market price to entice people to
purchase the bonds. The Fed's primary goal is not to make a profit.
The Fed's goal is to decrease the money supply to curb economic
growth -- if the Fed is selling bonds. Hence, in the very act of selling
the bonds the Fed is carrying out policy consistent with its overall
goal of tightening monetary and credit conditions in the economy.
Notes:
This may also be shown through graphical analysis.
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