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13
Chapter
The Roles and Services of
The Federal Reserve & Other
Central Banks Around The World
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
13 - 2
 Learning Objectives 
 To explore the many roles and functions of the
central banks around the world.
 To see how and why the Federal Reserve
System came to be established as the U.S.
central bank.
 To examine how the Federal Reserve System
is organized to carry out the many tasks it must
perform.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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 Learning Objectives 
 To discover how important central bank
independence from the dictates of
governments is in designing and carrying out
an effective central banking (monetary) policy.
 To understand the concept of legal reserves
and how the Federal Reserve System
influences the level and growth of legal
reserves.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Introduction
 A central bank is a government agency that
monitors the operation of its financial system
and controls the growth of its money supply.
 Central banks are “bankers’ banks.” They
communicate with commercial banks and
securities dealers in carrying out their essential
public policy functions.
 The U.S. central bank is the Federal Reserve
System.
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The Roles of Central Banks
 Control
of the money supply, which is closely
linked to economic activity and price inflation
 Stabilizing the money and capital markets, by
fostering their development and ensuring a
stable flow of funds through them
 Lender of last resort for financial institutions
squeezed by severe liquidity pressures
 Supervisor of the banking system
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The Roles of Central Banks
 Maintaining and
improving the payments
mechanism - a smoothly functioning and
efficient payments mechanism is vital for
business and commerce
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The Goals of Central Banking
 Central banking in the U.S. and in most other
nations is directed toward four major goals:
 Full employment of resources
 Reasonable stability in the general price
level of all goods and services
 Sustained economic growth
 A stable balance-of-payments position for
the nation vis-à-vis the rest of the world
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The Goals of Central Banking
 Through its influence over interest rates and
the growth of the money supply, the central
bank is able to influence the economy’s
progress toward each of the goals.
 However, the goals often conflict and tradeoffs have to be accepted.
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The Channels Through Which Central Banks Work
Cost & availability of
credit
Policy
tools
of the
central
bank
McGraw Hill / Irwin
Market
interest
rates
Size & growth
of the money supply
Market value
of the public’s
security holdings
Level &
growth
of
reserves
in the
banking
system
Currency exchange
rates
Public expectations
regarding security
prices, interest rates,
currency prices,
money supply &
credit availability
Volume & growth
of borrowing &
spending
by the public on
domestic & foreign
consumer & capital
goods & services
Economic goals:
•Full employment
•A stable price level
•Sustainable
economic growth
•A stable balance-ofpayments position
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The History of the Federal Reserve System
 The U.S. was one of the last major nations in
the Western hemisphere to permanently charter
a central bank.
 U.S. public officials were hesitant to do so for
fear that a central bank with great financial
power will restrict the availability of credit.
 However, a series of crises plagued the U.S.
financial system in the late 19th and early 20th
centuries.
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Problems in the Early U.S. Banking System
 Prior to the Civil War, the states controlled the
banking system and many did a poor job.
 The high failure rate among poorly capitalized
and ill-managed banks resulted in substantial
losses for unlucky depositors.
 The 1863 National Banking Act created a dual
banking system, but competition between
federal and state bank regulatory agencies
sometimes led to actions detrimental to public
interest.
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Problems in the Early U.S. Banking System
 The new national bank notes proved to be
unresponsive to the nation’s growing need for
a money or cash medium.
 The process of clearing and collecting checks
was also too slow and expensive, and many
banks charged a check redemption fee.
 There were recurring liquidity crises too, when
the massive sell-offs of bank-held securities
led to panic selling by other investors.
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Creation of the Federal Reserve System
 The Federal Reserve Act was signed in 1913.
Twelve Federal Reserve banks were chartered
and they opened for business as World War I
began in Europe.
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The Early Structure of the Fed
 The first Federal Reserve System was quite
different from the Fed of today.
 The chief policy tool was the discount rate
charged on loans of reserves to eligible banks,
and each Reserve bank had the authority to set
its own discount rate.
 The Federal Reserve banks were also given
authority to issue their own paper notes to
serve as a circulating currency.
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The Early Structure of the Fed
 Hence, although a supervisory board of seven
members had been set up in Washington, D.C.,
the regional Reserve banks possessed the
essential monetary tools and made the key
policy decisions during the Fed’s early years.
 Then slowly, economic, financial, and political
forces combined to amend the original Federal
Reserve Act and remake the character and
methods of the central bank.
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Goals and Policy Tools of the Fed
 The Great Depression brought about a
concentration of power within the Fed.
 The seven-member Board of Governors in
Washington, D.C., became the central
administrative and policymaking group.
 In addition, the Federal Open Market
Committee was created to oversee the conduct
of open market operations, which rapidly
became the Fed’s main policy tool.
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How the Fed is Organized
Supervise
Board of Governors
(7 members appointed
by the president)
12 Federal Reserve banks
& 25 branch banks
(reserve bank presidents
appointed by Board of
Governors)
Supervise
3,200 member banks
of the system
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Serve
Serve
Federal Open Market
Committee
(12 voting members)
Supervise
Manager of the System
Open Market Account
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How the Fed is Organized
 In principle, the Board of Governors is
independent of both legislative and executive
branches of the federal government.
 This independence is supported by terms of
office much longer than the president’s (up to
14 years), and by the fact that the Fed is selfsupporting (it reported operating income of
$34 billion in 2000).
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How the Fed is Organized
 When the Federal Open Market Committee
(FOMC) has reached a consensus on the
appropriate future course for monetary policy,
a directive is given to the manager of the
System Open Market Account (SOMA)
 The SOMA manager is a vice president of the
Federal Reserve Bank of New York.
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How the Fed is Organized
There is a Federal Reserve bank in each of the twelve districts.
McGraw
Source:
Board
Hill /of
Irwin
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How the Fed is Organized
 Each Reserve bank houses a research division
that studies regional economic and financial
developments, and reports its findings to the
Board of Governors and to the FOMC.
 The Reserve banks also provide the securities
needed for open market sales, and take their
pro rata share of security purchases made by
the Federal Reserve System.
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How the Fed is Organized
 The member banks of the Federal Reserve
System consist of national banks, which are
required to join the system, and state-chartered
banks that agree to conform to the Fed’s rules.
 At year-end 2000, there are 2,230 national
banks and just under 1,000 state-chartered
banks registered as members of the Federal
Reserve System, compared to more than 5,000
nonmember banks.
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Roles of the Federal Reserve System Today
 Collecting and clearing checks and other
means of payment (through an electronic
network known as the FEDWIRE)
 Issuing currency and coin
 Maintaining a sound banking and financial
system, by serving as a lender of last resort
(through the discount window of each Reserve
bank) and by supervising member banks
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Roles of the Federal Reserve System Today
 Serving as the Federal government’s fiscal
agent, by holding the Treasury’s checking
account and by maintaining reasonable
stability in the government securities market
 Providing information to the public, through
statistical releases and research reports
 Carrying out monetary policy, through the use
of various tools
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The Key Focus of
Central Bank Monetary Policy
 In regulating money and credit conditions to
strengthen the economy, most central banks
target market interest rates.
 To impact market rates, central banks usually
make use of their control over the volume of
reserves available to the banking system.
 These reserves are the raw material out of
which depository institutions create credit and
cause the money supply to grow.
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The Key Focus of
Central Bank Monetary Policy
 The total supply of reserves can be changed
 through open market operations,
 by making loans to depository institutions
through the central bank’s discount window,
and
 by changing the legal reserve requirements
applicable to deposits held by depository
institutions.
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The Composition of Reserves
for Depository Institutions
 Legal reserves in the U.S. consist of the
amount of deposits each institution keeps with
the Federal Reserve bank in its district plus the
amount of currency and coin held in its vault.
 Total legal reserves
= Required reserves + Excess reserves
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The Deposit Multiplier
 As a whole, the banking system can create
more deposit money by using its excess
reserves to make loans and purchase securities.
 The deposit multiplier indicates how many
dollars of deposits can result from an injection
of new excess reserves into the system.
 Transaction deposit multiplier
=
1
Reserve requirement on transaction deposits
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The Deposit Multiplier
 Maximum volume of new deposits and loans
= Deposit multiplier  Excess reserves
 Central bankers are usually more interested in
a related concept known as the money
multiplier, which defines the relationship
between the size of the money supply and the
size of the total reserve base available to
depository institutions.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Money and Capital Markets in Cyberspace
 Most central banks maintain comprehensive
websites. Visit, for example,

http://www.federalreserve.gov/

http://www.ecb.int/

http://www.bankofengland.co.uk/

http://www.boj.or.jp/en/

http://www.bis.org/cbanks.htm
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 Introduction
 The Roles of Central Banks in the Economy
and Financial System
Control of the Money Supply
 Stabilizing the Money and Capital Markets
 Lender of Last Resort
 Supervisor of the Banking System
 Maintaining and Improving the Payments
Mechanism

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 The Goals and Channels of Central Banking
 The History of the Federal Reserve System
Problems in the Early U.S. Banking System
 Creation of the Federal Reserve System
 The Early Structure of the Fed
 Goals and Policy Tools of the Fed
 How the Fed is Organized

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 Roles of the Federal Reserve System Today
The Clearing and Collection of Checks and Other
Means of Payment
 Issuing Currency and Coin
 Maintaining a Sound Banking and Financial
System
 Serving as the Federal Government’s Fiscal Agent
 Providing Information to the Public
 Carrying Out Monetary Policy

McGraw Hill / Irwin
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Chapter Review
 The Key Focus of Central Bank Monetary
Policy: Interest Rates, Reserves and Money
 The Composition of Reserves for Depository
Institutions
 The Deposit Multiplier

The Money Multiplier
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.