Download Understanding the US Federal Reserve System

April 30, 2007 [Art Lightstone, HTS School of Economics] Understanding the American Federal Reserve
The Federal Reserve headquarters is in Washington, DC. The basic structure of the
Federal Reserve System includes:
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The Federal Reserve Board of Governors
The Federal Open Market Committee
The Federal Reserve Banks
The member banks
The Federal Reserve Board of Governors:
The seven members of the board are appointed by the President and confirmed by the
Senate. Members are selected to terms of 14 years (unless removed by the President),
with the ability to serve for no more than one term.
Each privately owned Federal Reserve Bank and each member bank of the Federal
Reserve System is subject to oversight by a Board of Governors.
Tools of Monetary Policy: The Federal Reserve essentially has three tools of monetary
policy at its disposal:
i)
ii)
iii)
Open Market Operations,
Interest Rates (The Discount Rate and the Federal Funds Rate), and
The Reserve Ratio
Of the three tools, the method most popularly used by the Fed is open market
operations.
Sidebar: Treasury Securities
Often referred to as “Treasuries,” treasury securities are government bonds issued by the United States
Department of the Treasury through the Bureau of the Public Debt. They are the debt financing
instruments of the U.S. Federal government. All treasury securities except savings bonds are very liquid
and are heavily traded on the secondary market. There are four types of treasury securities:
Treasury Bills: mature in one year or less; they do not pay interest prior to maturity (ie. no coupons);
instead, they are sold at a discount of the par value to create a positive yield to maturity.
Treasury Notes: mature in two to ten years; coupon payment every six months; denominations from
$1,000 to $1,000,000.
Treasury Bonds: mature between ten to thirty years; coupon payment every six months.
Savings Bonds: treasury securities for individual investors; they do not have coupons; rather, interest
payments are compounded or accrued, which means they are added to the value of the bond and paid
out only upon the bond's redemption; after a one-year holding period they can be redeemed with the
Treasury at any time, making them very liquid; since they are registered securities, physical possession of
a savings bond is of no legal consequence.
April 30, 2007 [Art Lightstone, HTS School of Economics] Open Market Operations
The Federal Open Market Committee (FOMC)
The FOMC is comprised of the 7 members of the Board of Governors and 5
representatives selected from the Federal Reserve Banks.
Control of the Money Supply:
The Federal Reserve System controls the size of the money supply by conducting open
market operations, in which the Federal Reserve lends or purchases specific types
of securities with authorized participants, known as primary dealers.
All open market operations in the United States are conducted by the Open Market
Desk at the Federal Reserve Bank of New York, with an aim to making the federal
funds rate as close to the target rate as possible.
The Open Market Desk has two main tools to adjust the monetary supply:
i)
ii)
repurchase agreements, and
outright transactions.
Repurchase Agreements (aka Repos):
The Fed can smooth temporary or cyclical changes in the monetary supply by engaging
in repurchase agreements (repos) with its primary dealers. Repos are essentially
secured, short-term lending by the Fed.
How a Repo Works:
On the day of the transaction, the Fed deposits money in a primary dealer’s reserve
account, and receives securities as collateral. When the transaction matures, the
process unwinds: the Fed returns the collateral and charges the primary dealer’s
reserve account for the principal and accrued interest.
The term of the repo (the time period between settlement and maturity) can vary from 1
day (called an overnight repo) to 65 days. The Fed most commonly conducts overnight
and 14-day repos.
Since there is an increase of bank reserves during the term of the repo, repos
temporarily increase the money supply. The effect is temporary since all repo
transactions unwind. The only lasting net effect will be a slight depletion of reserves
caused by the accrued interest (not a lot, given that one day of interest at, for example,
4.5% is only 0.0121% per day).
April 30, 2007 [Art Lightstone, HTS School of Economics] Reverse Repos:
The Fed can also temporarily shrink the money supply through reverse repos.
In a reverse repo, the Fed will borrow money from the reserve accounts of
primary dealers in exchange for Treasury securities as collateral.
At maturity, the Fed will return the money to the reserve accounts with the accrued
interest, and collect the collateral.
Outright Transactions:
The other main tool available to the Open Market Desk is the outright transaction.
Outright Purchase: In an outright purchase, the Fed buys Treasury securities from
primary dealers. The Fed finances the purchases by depositing newly created money
in the dealer’s reserve account at the Fed.
Since this operation does not unwind at the end of a set period, the resulting growth
in the monetary supply is permanent. That is to say that the principal growth is
permanent, but a yield on maturity of the security is still charged.
Outright Sale: The sale of Treasury securities results in a permanent decrease in
the money supply, as the money used as payment for the securities from the primary
dealers is removed from their reserve accounts, thus working the money multiplier
process in reverse. The sale of treasuries outright has been exceedingly rare since the
1980s.
On Outright Transactions, the Desk selects offers with the lowest prices (highest yields)
for its purchases, and bids with the highest prices (lowest yields) for its sales.
April 30, 2007 [Art Lightstone, HTS School of Economics] Interest Rates
The other main tools available to the Fed are related to interest rates.
The Federal Funds Rate: Similar to Canada’s “overnight rate,” the US has their
Federal Funds Rate. This is the rate that banks charge each other on short term
loans. This rate is really a “target” interest rate. While the Fed can declare such a
target, such a declaration serves only as a signal to the market. In order to actually
reach the target, the Fed engages in the open market operations (buying and
selling of securities) that we explored earlier.
Increasing the Federal Funds Rate will reduce borrowing, which will reduce the money
supply, and vice versa.
Discount Rate: Similar to Canada’s “Bank Rate,” the US has their Discount Rate.
When banks want to borrow money from the Fed, they are charged the Discount Rate.
Increasing the Discount Rate will reduce borrowing, which will reduce the money
supply, and vice versa.
Reserve Ratio
The final tool available to the Fed is the reserve ratio.
The “required reserve ratio” is the fraction of deposits that banks must keep in
reserve (i.e. not loan out).
As we have studied before, the more money that banks are required to keep on reserve,
the less money they are able to loan out, and vice versa.
Given that bank loans will increase the money supply through the bank money
multiplier, the more that banks are able to loan out, the more the money supply will
grow.
Thus, increasing the reserve ratio (increasing the amount of deposits that banks
must keep in reserve) will lower the money supply, while decreasing the reserve
ratio will increase the money supply.
April 30, 2007 [Art Lightstone, HTS School of Economics] Test Your Knowledge!
Exercise 1: Fed Actions and Their Effects
For each of the following Federal Reserve actions, circle the correct arrow ( for
increase, for decrease) to indicate the effect on the bank reserves, money supply,
and the Fed Funds Rate.
Federal Reserve
Action
A
Sell Treasury securities
on the open market:
B
Buy Treasury securities
on the open market:
C
Raise the discount rate:
D
Lower the discount
rate:
E
Raise the reserve
requirement:
F
Lower the reserve
requirement:
Bank
Reserves
Money
Supply
Fed Funds
Rate
April 30, 2007 [Art Lightstone, HTS School of Economics] Exercise 2: Understanding the Tools of Monetary Policy
Complete the following table by indicating how the Federal Reserve could use each of
the three monetary policy tools to pursue an expansionary (easy money) policy and a
contractionary (tight money) policy.
Monetary Policy
Tool
A
Open Market
Operations
B
Discount Rate
C
Reserve
Requirements
Expansionary Policy
Contractionary Policy
April 30, 2007 [Art Lightstone, HTS School of Economics] Exercise 3: Working with the Bank Money Multiplier
Complete the following table by calculating the bank money multiplier, and then
calculating the total money supply that would be generated from the bank reserves
indicated.
Reserve
Ratio
Bank Reserves
A
4%
$20 million
B
10%
$30 million
C
25%
$10 million
Bank Money
Multiplier
Total Money
Supply
Exercise 4: Explaining the Effects of Expansionary Monetary Policy
Suppose that the economy is operating at full capacity, but then assume that the Fed
implements an expansionary monetary policy in order to reduce interest rates.
Complete the table below by circling the arrows that would illustrate the short-run
(immediate) and the long-run (secondary) effects that an expansionary policy would
have on nominal interest rates, real interest rates, output, price level, and employment.
Nominal
Interest
Rates
Short-Run
(Immediate)
Long-Run
(Secondary
Reactions)
Consumption
Output
Employment
Price Level
Real Interest
Rates
April 30, 2007 [Art Lightstone, HTS School of Economics] Exercise 5: Graphing Changes in the Money Supply
Using money supply (MS) and money demand (MD) curves, illustrate the effect that an
increase in the money supply will have on interest rates under both the “Monetarist” and
the “Keynesian” schools of thought. Be sure to title your graphs as “Monetarist
Perspective” and “Keynesian Perspective,” and don’t forget to properly label both the Y
and the X axis of each graph.
Exercise 6: Graphing Monetary Policy Effects on the Economy
Using short-run aggregate supply (SRAS), long-run aggregate supply (LRAS), and
aggregate demand (AD) curves, illustrate the effect that an expansionary monetary
policy will have on the economy under two conditions: i) the economy is already at full
capacity, and ii) the economy is operating below capacity. Be sure to title your graphs
as “Starting at Full Capacity” and “Starting Below Full Capacity,” and don’t forget to
properly label both the Y and the X axis of each graph.