Download What is the Federal Reserve?

Monetary Policy
Chapter 16
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The Federal Reserve System
• What is the Federal Reserve?
– The “Fed” is the central bank of the United
States…It oversees many financial
institutions and ensures the continued
efficient functioning of the payments
system
– Comprised of three main parts
• The Federal Reserve banks
• The Board of Governors
• The Federal Open Market Committee (FOMC)
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The Federal Reserve System (cont’d)
• System is headed
by the Board of
Governors
Figure 15.1 The Structure of the
Federal Reserve System
• The twelve Federal
Reserve banks are
located throughout
the nation
• U.S. monetary
policy is determined
by the FOMC
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Structure of a Federal Reserve Bank
•
•
•
•
The Board of Governors
– The Federal Reserve System is overseen by the seven-member Board of
Governors of the Federal Reserve. Actions taken by the Federal Reserve are
called monetary policy.
Federal Reserve Districts
– The Federal Reserve System consists of 12 Federal Reserve Districts, with one
Federal Reserve Bank per district. The Federal Reserve Banks monitor and
report on economic activity in their districts.
Member Banks
– All nationally chartered banks are required to join the Fed. Member banks
contribute funds to join the system, and receive stock in and dividends from the
system in return. This ownership of the system by banks, not government, gives
the Fed a high degree of political independence.
The Federal Open Market Committee (FOMC)
– The FOMC, which consists of The Board of Governors and 5 of the 12 district
bank presidents, makes key decisions about interest rates and the growth of the
United States money supply.
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Federal Reserve Banks
Banks provide many services
• Check clearing services
• Supervision and examination of member
banks
• Track banking statistics and monetary
aggregates
• Supply currency and coin to member
banks
• Serve as fiscal agent of the U.S. Treasury
• Act as a lender of last resort
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The Federal Reserve System
The locations of the 12 banks are a reflection of the political power
structure of 1913 and are spread out to diffuse power
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The Federal Reserve System
Figure 15.3 Board of Directors of a Federal Reserve Bank
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The Board of Governors
• The Board is more like a government agency
than the banks, and subject to more scrutiny
• Each member is appointed by the President
to a 14 year term which is not renewable
– 7 governors serve
– One member’s term expires every 2 years
– Can stay more than 14 years if appointed to lessthan-full term initially
• Chairman of the Board of Governors is
second most-powerful position in U.S. after
President
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The Board of Governors (cont’d)
• Chairman & Vice-Chairman are
appointed by the President to
renewable 4-year terms
• Chairman wields tremendous power
– Measure Chairman’s success by the
inflation rate, the only economic variable
the Fed can control in the long run
– Effects of monetary policy are short-lived
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The Federal Open Market Committee
• When the press discusses the Fed, their focus is
generally on the Federal Open Market Committee
(FOMC).
– This group sets the interest rates to control the
availability of money and credit to the economy.
– It has existed since 1936 and has 12 voting
members:
• The seven governors,
• The president of the Federal Reserve Bank of
New York, and
• Four Reserve Bank presidents.
16-10
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The Federal Open Market Committee
• The chair of the Board of Governors chairs
the FOMC.
• The committee’s vice chair is the president
of the Federal Reserve Bank of New York.
• While only 5 of the 12 Reserve Bank
presidents vote at any one time, all of them
participate in the meeting.
16-11
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The Federal Open Market Committee
• The FOMC could control any interest rate, but it
chooses to control the federal funds rate.
– This is the rate banks charge each other for
overnight loans on their excess deposits at the
Fed.
• By controlling the federal funds rate, the FOMC
influences real growth.
• The FOMC currently meets 8 times a year.
• The primary purpose of a meeting is to decide on
the target interest rate.
16-12
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Responsibilities of the Fed
• Maintaining the
currency (currency & coins)
• Maintaining the
payments system (online
banking & check writing)
• Regulating and
supervising banks (FDIC
& bank holding companies)
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Responsibilities of The Fed
• Financial literacy and
consumer protection
(Consumer Financial
Protection Bureau)
• Acting as the
government’s bank
(financial services)
• Conducting monetary
policy
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The Journey of a Check
• After you write a check,
the recipient presents it
at his or her bank.
The Path of a Check
Check writer
Recipient
The check is then sent to a
Federal Reserve Bank.
The reserve bank collects
the necessary funds
from your bank and
transfers them to the
recipient’s bank.
Your processed check is
returned to you by your
bank.
Check
writer’s bank
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Federal
Reserve Bank
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Bank Reserves
• So far we have been assuming that banks hold the entire
amount of their deposits in reserve.
• Clearly this is a false assumption as banks rarely ever
have enough currency in their vaults (or on reserve at the
Fed) to cover all deposits made with them.
• The banking system operates as a fractional reserve
system in which only a portion of the banks deposits are
held in reserve.
• The Fed sets a lower limit for the fraction of deposits that
must be held in reserve: the reserve requirement ratio
• Since banks earn profit by lending at higher interest
rates than they give on deposits, the reserve
requirement is generally a binding limit.
THE
MONETARY
SYSTEM
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Reserve Requirements
• The Fed requires banks to keep a minimum
amount of required reserves.
– Required reserves – The minimum amount of
reserves a bank is required to hold; equal to
required reserve ratio times transactions
deposits.
– The fed directly alters the lending capacity of
the banking system by changing the reserve
requirement.
Required reserves = required reserve ratio X total
deposits
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Reserve Requirements
* By changing the reserve requirement, the
Fed changes the level of excess reserves in
the banking system.
* Excess reserves are bank reserves in excess of
required reserves.
* By raising the required reserve ratio, the Fed
can immediately reduce the lending capacity of
the banking system.
Excess reserves = Total reserves – Required
reserves
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Open Market Operations
• The main “thing” the Fed
buys and sells is U.S.
government securities,
which are bonds the
government originally
sold to investors when it
needed to borrow funds.
• The Fed buys and sells
such securities in the
financial market, it is said
to be engaged in open
market operations.
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Open Market Purchases
• Consider an open market purchase of
government securities by the Fed.
• The Fed receives the securities from a bank,
and the bank’s reserves increase by the
amount the purchase (remember Reserves =
Bank deposits at the Fed + Vault Cash).
• When the banks have a reserve increase and
no other bank has a similar decline, the
money supply expands through a process of
increased loans and checkable deposits.
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Open Market Sales
• Open market sales refer to Fed sales of
government securities to banks and others.
• In one of these sales, a bank buys securities
from the Fed and the money is taken from the
reserves of the bank.
• This decreases the money supply by having
the bank reduce total loans outstanding,
which reduces the total volume of checkable
deposits and money in the economy.
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Open Market Operations
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How Monetary Policy Works
Monetarism is the belief that the money supply is the
most important factor in macroeconomic performance.
The Money Supply and Interest
Rates
• The market for money is like
any other, and therefore the
price for money — the interest
rate – is high when the money
supply is low and is low when
the money supply is large.
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Interest Rates and Spending
• If the Fed adopts an easy
money policy, it will increase
the money supply. This will
lower interest rates and
increase spending. This
causes the economy to
expand.
• If the Fed adopts a tight
money policy, it will decrease
the money supply. This will
push interest rates up and will
decrease spending.
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Discount Rate
The discount rate is the interest rate that banks pay to borrow money
from the Fed.
Reducing the Discount Rate
Increasing the Discount Rate
• If the Fed wants to encourage • If the Fed wants to discourage
banks to loan out more of
banks from loaning out more of
their money, it may reduce the
their money, it may make it
discount rate, making it easier
more expensive to borrow
or cheaper for banks to
money if their reserves fall too
borrow money if their
low.
reserves fall too low.
• Increasing the discount rate
• Reducing the discount rate
causes banks to lend out less
causes banks to lend out
money, which leads to a
decrease in the money supply.
more money, which leads to
an increase in the money
supply.
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Policy Lags
Policy lags are problems experienced in the timing of
macroeconomic policy. There are two types:
Inside Lags
Outside Lags
• An inside lag is a delay
• Outside lags are the time
in implementing
it takes for monetary
monetary policy.
policy to take affect once
enacted.
• Inside lags are caused by
the time it actually takes
to identify a shift in the
business cycle.
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Monetary Policy Dilemmas
The Federal Reserve must not only react to current trends, but
also must anticipate changes in the economy.
Monetary Policy and Inflation
• Expansionary policies
enacted at the wrong time can
push inflation even higher.
• If the current phase of the
business cycle is anticipated
to be short, policymakers may
choose to let the cycle fix
itself. If a recession is
expected to last for years,
most economists will favor a
more active monetary policy.
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How Quickly Does the Economy
Self-Correct?
• Economists disagree about
how quickly an economy can
self-correct. Estimates range
from two to six years.
• Since the economy may take
quite a long time to recover on
its own, there is time for
policymakers to guide the
economy back to stable levels
of output and prices.
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Changing Nature of Economics
• Discretionary fiscal policies were popular in the postWorld-War II period, but their popularity declined after
President Reagan took office.
• The Federal Reserve System has filled the void left by
the decline of discretionary fiscal policy.
• The Fed is much more responsive to economic issues
than the federal government.
• Supply-side policies have been popular, but they did
little to help when the economy slumped in 2008.
• Policies used to stabilize the economy during the Great
Recession included monetary policy, qualitative easing,
and passive fiscal policies.
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Economics and Politics
• In recent years, the fields of economics and politics have
merged.
• The main reason for differences of opinions among
economists is that they place different importance on
various problems.
• Most economic theories are a product of their times; as
times and issues change, so does economic theory.
• The president’s Council of Economic Advisers is a threemember group that reports on economic developments
and proposes strategies.
• Economists have helped the American people become
more aware of the workings of the economy, which
benefits everyone.
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