Chapter Four

The Federal Reserve

System, Monetary Policy,
and Interest Rates
4-1

2009, The McGraw-Hill Companies, All Rights

The Federal Reserve

Founded
Founded by
by Congress
Congress under
under the
the Federal
Federal
Reserve
Reserve Act
Act in
in 1913
1913
Subject
Subject to
to oversight
oversight by
by Congress
Congress under
under
its
its authority
authority to
to coin
coin money
money
An
An independent
independent central
central bankits
bankits
decisions
decisions do
do not
not have
have to
to be
be ratified
ratified by
by
the
the President
President

4-2

2009, The McGraw-Hill Companies, All Rights

Functions of the Federal Reserve

Conduct
Conduct monetary
monetary policy
policy
Supervise
Supervise and
and regulate
regulate depository
depository
institutions
institutions
Maintain
Maintain financial
financial system
system stability
stability
Provide
Provide payment
payment and
and other
other financial
financial
services
services to
to the
the U.S.
U.S. government,
government, the
the
public,
public, FIs,
FIs, and
and foreign
foreign official
official
institutions
institutions
4-3

2009, The McGraw-Hill Companies, All Rights

Structure of the Federal Reserve

Divided
Divided into
into 12
12 Federal
Federal Reserve
Reserve districts,
districts,each
each
with
with aa main
main Federal
Federal Reserve
Reserve Bank
Bank
Federal
Federal Reserve
Reserve Banks
Banks operate
operateunder
underthe
the
general
general supervision
supervision of
of the
the Board
Board of
of Governors
Governors
of
of the
the Federal
Federal Reserve
Reserve
The
The Office
Office of
of the
the Comptroller
Comptrollerof
of the
the Currency
Currency
(OCC)
(OCC) charters
chartersnational
national banks,
banks, which
which are
are
members
members of
of the
the Federal
Federal Reserve
Reserve System
System (FRS)
(FRS)
FRS
FRS member
memberbanks
banks own
own the
the 12
12 Federal
Federal
Reserve
Reserve Banks
Banks
4-4

2009, The McGraw-Hill Companies, All Rights

Board of Governors of the FRS

Seven
Seven member
memberboard
boardheadquartered
headquartered in
in
Washington,
Washington, DC
DC
President
President appoints
appoints and
and Senate
Senateconfirms
confirms
members
members to
to nonrenewable
nonrenewable 14-year
14-yearterms
terms
President
President appoints
appoints and
and Senate
Senateconfirms
confirms
Chairman
Chairman and
andvice-chairman
vice-chairmanto
to renewable
renewable44year
yearterms
terms
Formulates
Formulates and
and conducts
conducts monetary
monetary policy
policy and
and
supervises
supervises and
and regulates
regulates banks
banks
4-5

2009, The McGraw-Hill Companies, All Rights

Federal Open Market Committee (FOMC)

FOMC
FOMCconsists
consists of
of 12
12 members
members
seven
sevenmembers
membersof
ofthe
theBoard
Boardof
ofGovernors
Governors
the
thepresident
presidentof
ofthe
theFederal
FederalReserve
ReserveBank
Bankof
ofNY
NY
the
thepresidents
presidentsof
offour
fourother
otherFederal
FederalReserve
ReserveBanks
Banks(on
(on
aarotating
rotatingbasis)
basis)

The
The monetary
monetarypolicy-making
policy-making body
bodyof
of the
the FRS
FRS
Policies
Policies seek
seekto
to promote
promote full
full employment,
employment,
economic
economic growth,
growth, price
price stability,
stability,and
and aa
sustainable
sustainable pattern
pattern of
of international
international trade
trade
4-6

2009, The McGraw-Hill Companies, All Rights

Federal Open Market Committee (FOMC)

The
The FOMC
FOMC sets
sets ranges
ranges for
forgrowth
growth of
of monetary
monetary
aggregates
aggregates and
and the
the fed
fed funds
funds rate,
rate, and
and also
also
directs
directs FR
FR operations
operations in
in FX
FX markets
markets
Open
Open market
market operations
operations are
arethe
the main
main policy
policy
tool
tool used
used to
to achieve
achievemonetary
monetarytargets
targets
involve
involvethe
thepurchase
purchaseand
andsale
saleof
ofU.S.
U.S.government
governmentand
and
federal
federalagency
agencysecurities
securities
are
areimplemented
implementedby
bythe
theFederal
FederalReserve
ReserveBoard
BoardTrading
Trading
Desk
Deskof
ofthe
theNew
NewYork
YorkFederal
FederalReserve
ReserveBank
Bank
4-7

2009, The McGraw-Hill Companies, All Rights

Federal Reserve Banks

Assist
Assistin
inthe
theconduct
conductof
ofmonetary
monetarypolicy
policy

set
setand
andchange
changethe
thediscount
discountrate
rate(must
(mustbe
beapproved
approvedby
bythe
theBoard
Board
of
ofGovernors)
Governors)
make
makediscount
discountwindow
windowloans
loanstotodepository
depositoryinstitutions
institutions

Supervise
Superviseand
andregulate
regulateFRS
FRSmember
memberbanks
banks

conduct
conductexaminations
examinationsand
andinspections
inspectionsof
ofmember
memberbanks
banks
issue
issuewarnings
warningswhen
whenbanking
bankingactivity
activityisisunsafe
unsafeor
orunsound
unsound
approve
approvebank
bankmergers
mergersand
andacquisitions
acquisitions

Provide
Providegovernment
governmentservices
services

act
actas
asthe
thecommercial
commercialbanks
banksof
ofthe
theU.S.
U.S.Treasury
Treasury

4-8

2009, The McGraw-Hill Companies, All Rights

Federal Reserve Banks

Issue
Issuenew
newcurrency
currency

collect
collectand
andreplace
replacecurrency
currencyinincirculation
circulationas
asnecessary
necessary

Clear
Clearchecks
checks

act
actas
asaacentral
centralclearing
clearingsystem
systemfor
forU.S.
U.S.banks
banks
clear
clear~25%
~25%of
ofall
allchecks
checkswritten
writtenininthe
theU.S.
U.S.

Provide
Providewire
wiretransfer
transferservices
services

Fedwire
Fedwire
Automated
AutomatedClearinghouse
Clearinghouse(ACH)
(ACH)

Perform
Performbanking
bankingsector
sectorand
andeconomic
economicresearch
research
used
usedininthe
theformulation
formulationof
ofmonetary
monetarypolicy
policy

4-9

2009, The McGraw-Hill Companies, All Rights

Balance Sheet of the Federal Reserve

Major
Majorassets
assets
Treasury
Treasurysecurities
securities
Treasury
Treasurycurrency
currency
gold
goldand
andforeign
foreignexchange
exchange
loans
loansto
todomestic
domesticbanks
banks

Major
Majorliabilities
liabilities
reserves
reserves
currency
currencyin
incirculation
circulation
currency
currencyin
incirculation
circulation++reserves
reserves==money
moneybase
base

4-10

2009, The McGraw-Hill Companies, All Rights

Please insert Table 4-5 here.

4-11

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
Monetary
Monetary policy
policy affects
affects the
the
macroeconomy
macroeconomy by
by influencing
influencing the
the supply
supply
and
and demand
demand for
for excess
excess bank
bank reserves
reserves
influences
influences the
the money
money supply
supply and
and the
thelevel
level of
of
short-term
short-termand
and long-term
long-terminterest
interest rates
rates
affects
affects foreign
foreign exchange
exchange rates,
rates, the
the amount
amount of
of
money
money and
and credit
credit in
in the
the economy,
economy,and
and the
the
levels
levels of
ofunemployment,
unemployment, output,
output, and
and prices
prices
4-12

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
Open
Open market
market operations
operations
policy
policy directive
directive of
of the
the FOMC
FOMC isis forwarded
forwarded to
to
the
the Federal
Federal Reserve
Reserve Board
BoardTrading
Trading Desk
Desk at
at the
the
Federal
Federal Reserve
Reserve Bank
Bank of
ofNew
NewYork
York
Trading
Trading Desk
Desk manager
manager buys
buys or
or sells
sells U.S.
U.S.
Treasury
Treasury securities
securities in
in the
the over-the-counter
over-the-counter
(OTC)
(OTC) market,
market, which
which keeps
keeps the
the fed
fed funds
funds rate
rate
near
near its
its desired
desired target
target
4-13

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
Open
Open market
market operations
operations (contd)
(contd)
FRBNY
FRBNYacts
acts through
through the
theTrading
Trading Desk
Desk to
to
implement
implement policy
policy directives
directives each
each business
business day
day
operations
operations may
may be
be permanent
permanent or
or temporary
temporary
may
may use
use repurchase
repurchase agreements
agreements for
for temporary
temporary
increases
increases or
or decreases
decreases in
in excess
excess reserves
reserves

4-14

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
The
The discount
discount rate
rate isis the
the rate
rate Federal
Federal Reserve
Reserve
Banks
Banks charge
charge on
on loans
loans to
to depository
depository
institutions
institutions in
in their
theirdistrict
district
The
The Federal
Federal Reserve
Reserve rarely
rarelyuses
uses the
the discount
discount
rate
rateas
as aa policy
policy tool
tool
discount
discountrate
ratechanges
changesare
arestrong
strongsignals
signalsof
ofthe
theFederal
Federal
Reserves
Reservesintentions
intentions
there
thereisisno
noguarantee
guaranteethat
thatbanks
bankswill
willborrow
borrow

4-15

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
Reserve
Reserve requirements
requirements are
arethe
thereserve
reserveassets
assets
depository
depositoryinstitutions
institutions must
must keep
keepto
to back
back
transaction
transaction deposits
deposits
reserve
reserveassets
assetsinclude
includevault
vaultcash
cashand
anddeposits
depositsatat
Federal
FederalReserve
ReserveBanks
Banks

The
The multiplier
multipliereffect
effect

1
in reserves
new reserve requirement ratio

in money supply

4-16

2009, The McGraw-Hill Companies, All Rights

Monetary Policy
Expansionary
Expansionary monetary
monetarypolicy
policy
open
openmarket
marketpurchases
purchasesof
ofsecurities
securitiesby
bythe
theFed
Fed
discount
discountrate
ratedecreases
decreases
reserve
reserverequirement
requirementratio
ratiodecreases
decreases

Contractionary
Contractionary monetary
monetary policy
policy
open
openmarket
marketsales
salesof
ofsecurities
securitiesby
bythe
theFed
Fed
discount
discountrate
rateincreases
increases
reserve
reserverequirement
requirementratio
ratioincreases
increases

4-17

2009, The McGraw-Hill Companies, All Rights

Money Supply versus

Interest Rate Targeting
Interest
Rate

i=8%

Interest
Rate

MS

MS

MS
iT = 6%

i*=6%

MD
MD
MD

i=4%

MS

Quantity of Money

4-18

i= 5%

MD
MD
MD
Quantity of Money

2009, The McGraw-Hill Companies, All Rights

International Monetary Policy

The
The Federal
Federal Reserve
Reserve generally
generally allows
allows
foreign
foreign exchange
exchange rates
rates to
to fluctuate
fluctuate freely
freely
Foreign
Foreign exchange
exchange intervention
intervention
commitments
commitments between
between countries
countries about
about the
the
institutional
institutional aspects
aspects of
of their
their intervention
intervention in
in the
the
foreign
foreign exchange
exchange markets
markets
similar
similar to
to open
open market
market purchases
purchases and
and sales
sales of
of
Treasury
Treasury securities
securities
4-19

2009, The McGraw-Hill Companies, All Rights

Major Foreign Central Banks

The
The Bank
Bankof
of Japan
Japan
loose
loosemonetary
monetarypolicy
policyisisfueling
fuelingan
aneconomic
economicrecovery
recovery

The
The European
European Central
Central Bank
Bank
recently
recentlyswitched
switchedfrom
fromtargeting
targetingthe
themoney
moneysupply
supplyto
to
targeting
targetinginflation
inflation

The
The Peoples
PeoplesBank
Bankof
of China
China
interest
interestrates
ratesare
arebecoming
becomingaamore
moreimportant
importantpolicy
policy
tool
toolas
asChina
Chinamoves
movesto
toaamarket
marketoriented
orientedfinancial
financial
system
system
4-20

2009, The McGraw-Hill Companies, All Rights