Download The Federal Reserve System

13e
Chapter 14:
The Federal Reserve System
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
• We examine how the government controls
money creation and thus aggregate demand
(AD).
• The core issues are
– Which government agency is responsible for
controlling the money supply?
– What policy tools are used to control the amount of
money in the economy?
– How are banks and bond markets affected by the
government’s policies?
14-2
Learning Objectives
• 14-01. Describe how the Federal Reserve is
organized.
• 14-02. Identify the Fed’s major policy tools.
• 14-03. Explain how open market operations
work.
14-3
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.
14-4
The Structure of the Fed
• The Fed Board of Governors is responsible for
setting monetary policy.
– Monetary policy: the use of money and credit
controls to influence macroeconomic outcomes.
• Board members are appointed to a 14-year
term, in a two-year stagger, to ensure a
measure of political independence.
• One board member is appointed chairman for
4 years.
14-5
The Structure of the Fed
• The current Fed chairman is Ben Bernanke,
serving his second 4-year term.
• The Federal Open Market Committee
(FOMC) is responsible for the Fed’s daily
activity in financial markets.
– The FOMC meets monthly to review economic
performance and to adjust monetary policy as
needed.
14-6
Monetary Tools
• The Fed controls the money supply by using
three policy tools:
– Reserve requirements.
– Discount rates.
– Open market operations.
14-7
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.
• By changing reserve requirements, the Fed
can directly alter the lending capacity of the
banking system.
14-8
Reserve Requirements
Available lending capacity = Excess reserves x Money multiplier
• 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.
14-9
The Discount Rate
• Profit-seeking private banks earn income by
making loans.
– 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.
14-10
The Discount Rate
• Discount rate: the rate of interest the Fed
charges for lending reserves to private
banks.
– If the discount rate is raised, borrowing
reserves from the Fed becomes more expensive,
and 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,
and more reserves are borrowed. More loans
are made, increasing the money supply.
14-11
Open Market Operations
• This is the principal mechanism to directly alter the
reserves of the banking system.
• Portfolio decision: the choice of how and where to
hold idle funds.
– There are several choices: cash, savings accounts, stocks, and
bonds. The last three may generate additional income in the
form of dividends or interest.
• Should you keep your idle funds in a savings account
or purchase government bonds?
– The Fed influences this decision by making bonds more or
less attractive.
14-12
Open Market Operations
• If the public moves funds from savings to
bonds, reserves fall, and vice versa.
– When the Fed buys government bonds from the
public, reserves increase, more loans can be
made, and the money supply grows.
– When the Fed sells government bonds to the
public, reserves decrease, fewer loans can be
made, and the money supply shrinks.
14-13
The Bond Market
• A bond is a certificate acknowledging a debt
and the amount of interest to be paid each
year until repayment.
– It is an IOU.
• People buy bonds because they pay interest
and are a safe investment.
– Yield: the rate of return on a bond.
Yield =
Annual interest payment
Price paid for the bond
14-14
The Bond Market
• Pay $1,000 for a bond that pays out $80 a
year, and its yield is 0.08 or 8%.
• If its price fell to $900 in the bond market,
its yield would increase to 0.089 or 9%.
• 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.
14-15
Open Market Activity
• The Fed can induce people to buy bonds by
offering to sell them at a lower price.
– When the public pays for the bonds, bank reserves
fall. Fewer loans are made, and the money supply
decreases (or its growth slows).
• The Fed can induce people to sell bonds by
offering to buy them at a higher price.
– When the Fed pays the public for the bonds, bank
reserves rise. More loans are made, and the money
supply increases.
14-16
The Fed Funds Rate
• The Fed funds rate: the interest rate one bank
charges another for an overnight loan of excess
reserves.
– If the Fed increases reserves by buying bonds, the
Fed funds rate falls.
– If the Fed decreases reserves by selling bonds, the
Fed funds rate rises.
• The Fed funds rate is a highly visible signal of
Federal Reserve open market operations.
14-17
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.
14-18
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.
14-19
The Economy Tomorrow
• Is the Fed losing control?
– Since 1980, all depository institutions have had to
satisfy Fed reserve requirements.
– Traditional banks have declined in number and are
replaced by multifunction financial services firms.
Controlling these large units is more complicated
than controlling single-purpose banks.
– Finance is global. Foreign banks hold dollars. This
makes it more difficult to control the size of the
money supply.
14-20
The Economy Tomorrow
• Is the Fed losing control?
– Because of these changes, the Fed shifted away
from targeting the money supply to targeting
interest rates.
• This is easier and faster to track.
• Interest rates are of more immediate concern in
investment and consumption decisions.
– Thus the Fed most likely will use the federal funds
rate as its primary barometer of monetary policy in
the economy tomorrow.
14-21
Revisiting the Learning Objectives
• 14-01. Describe how the Federal Reserve is
organized.
– There are 12 regional Federal Reserve banks.
– The Board of Governors sets general policy.
– The chairman is the spokesperson for monetary
policy.
– The Federal Open Market Committee (FOMC)
implements policy strategy.
14-22
Revisiting the Learning Objectives
• 14-02. Identify the Fed’s major policy tools.
– The Fed controls the size and growth of the
money supply by regulating loan activity of
private banks.
– The three tools are
• Altering the reserve requirement.
• Altering discount rates.
• Buying or selling government bonds in open market
operations.
14-23
Revisiting the Learning Objectives
• 14-03. Explain how open market operations
work.
– When the Fed buys bonds, it pays the seller, and
bank reserves increase. More loans can be
made, and the money supply grows.
– When the Fed sells bonds, the buyer pays the
Fed, and bank reserves decrease. Fewer loans
can be made, and the money supply shrinks (or
grows slower).
14-24