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Chapter 14:

The Federal ReserveSystem

  Copyright © 2013 by The McGraw-Hill Companies, Inc !ll rights reser"e# McGraw-Hill$Irwin

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 The Federal Reserve System

• We examine how the governmentcontrols money creation and thus

aggregate demand (AD).•  The core issues are

 – Which government agency is responsile!or controlling the money supply"

 –What policy tools are used to control theamount o! money in the economy"

 – #ow are an$s and ond mar$ets a%ectedy the government&s policies"

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'earning ectives

• *+,-*. Descrie how the FederalReserve is organied.

• *+,-/. 0denti!y the Fed&s maor policytools.

• *+,-1. 2xplain how open mar$et

operations wor$.

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 The Structure o! the Fed

•  The Fed was created in *3*1.

• 0t consists o! */ Federal Reserve an$s4

which act as the central an$ !orprivate an$s in their regions andper!orm the !ollowing services5 – 6learing chec$s.

 – #olding an$ reserves. – 7roviding currency.

 – 7roviding loans.

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 The Structure o! the Fed

•  The Fed 8oard o! 9overnors is responsile!or setting monetary policy. – :onetary policy5 the use o! money and credit

controls to in;uence macroeconomicoutcomes.

• 8oard memers are appointed to a *+,yearterm4 in a two,year stagger4 to ensure a

measure o! political independence.• ne oard memer is appointed chairman

!or + years.

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 The Structure o! the Fed

•  The current Fed chairman is nancial mar$ets.

 – The F:6 meets monthly to revieweconomic per!ormance and to adustmonetary policy as needed.

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:onetary Tools

•  The Fed controls the money supplyy using three policy tools5

 – Reserve re?uirements. – Discount rates.

 – pen mar$et operations.

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Reserve Re?uirements

• 7rivate an$s are re?uired to $eep a!raction o! deposits @in reserve4

either as cash or on deposit at theregional Fed an$.

• 8y changing reserve re?uirements4

the Fed can directly alter the lendingcapacity o! the an$ing system.

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Reserve Re?uirements

• 0ncrease the reserve re?uirement and B – The amount o! excess reserves decreases. – The money multiplier decreases. – The availale lending capacity shrin$s.

• Decrease the reserve re?uirement and B – The amount o! excess reserves increases. – The money multiplier increases. – The availale lending capacity expands.

Available lending capacity = Excess reserves x Money multiplier

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 The Discount Rate

• 7ro>t,see$ing private an$s earn incomey ma$ing loans. – They try to !ully lend out their excess reserves.

• At times4 a an$ might !all short o!satis!ying the reserve re?uirement. – 0t can orrow excess reserves overnight !rom

another an$ and pay interest5 the !ederal!unds rate.

 – 0t can orrow reserves overnight !rom the Fedand pay interest5 the discount rate.

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 The Discount Rate

• Discount rate5 the rate o! interest the Fedcharges !or lending reserves to privatean$s. – 0! the discount rate is raised4 orrowing

reserves !rom the Fed ecomes moreexpensive4 and !ewer reserves are orrowed.Fewer loans are made4 decreasing the moneysupply.

 –0! the discount rate is lowered4 orrowingreserves !rom the Fed ecomes less expensive4and more reserves are orrowed. :ore loansare made4 increasing the money supply.

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pen :ar$et perations

•  This is the principal mechanism to directly alterthe reserves o! the an$ing system.

• 7ort!olio decision5 the choice o! how and where

to hold idle !unds. –  There are several choices5 cash4 savings accounts4

stoc$s4 and onds. The last three may generateadditional income in the !orm o! dividends or interest.

• Should you $eep your idle !unds in a savingsaccount or purchase government onds" –  The Fed in;uences this decision y ma$ing onds

more or less attractive.

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pen :ar$et perations

• 0! the pulic moves !unds !rom savings toonds4 reserves !all4 and vice versa.

 –

When the Fed uys government onds !romthe pulic4 reserves increase4 more loanscan e made4 and the money supply grows.

 – When the Fed sells government onds to the

pulic4 reserves decrease4 !ewer loans cane made4 and the money supply shrin$s.

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 The 8ond :ar$et

• A ond is a certi>cate ac$nowledginga det and the amount o! interest toe paid each year until repayment. – 0t is an 0C.

• 7eople uy onds ecause they payinterest and are a sa!e investment. – =ield5 the rate o! return on a ond.

  Annual interest paymentYield =

Price paid for the bond

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 The 8ond :ar$et

• 7ay *4--- !or a ond that pays out E-a year4 and its yield is -.-E or E.

•

0! its price !ell to 3-- in the ondmar$et4 its yield would increase to -.-E3or 3.

•  The oective o! open mar$et operations

is to alter the price o! onds4 and alsotheir yields4 to ma$e them more or lessattractive as investments.

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pen :ar$et Activity

•  The Fed can induce people to uy ondsy o%ering to sell them at a lower price. – When the pulic pays !or the onds4 an$

reserves !all. Fewer loans are made4 and themoney supply decreases (or its growth slows).

•  The Fed can induce people to sell ondsy o%ering to uy them at a higher price. – When the Fed pays the pulic !or the onds4

an$ reserves rise. :ore loans are made4 andthe money supply increases.

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 The Fed Funds Rate

•  The Fed !unds rate5 the interest rate onean$ charges another !or an overnightloan o! excess reserves. – 0! the Fed increases reserves y uying onds4

the Fed !unds rate !alls.

 – 0! the Fed decreases reserves y selling onds4the Fed !unds rate rises.

•  The Fed !unds rate is a highly visile signalo! Federal Reserve open mar$etoperations.

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0ncreasing the :oney

Supply•  To increase the money supply4 the

Fed can

 – 'ower reserve re?uirements. – Reduce the discount rate.

 – 8uy onds in open mar$et operations.

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Decreasing the :oney

Supply•  To decrease the money supply4 the

Fed can

 – Raise reserve re?uirements. – 0ncrease the discount rate.

 – Sell onds in open mar$et operations.

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 The 2conomy Tomorrow

• 0s the Fed losing control" – Since *3E-4 all depository institutions have

had to satis!y Fed reserve re?uirements.

 – Traditional an$s have declined in numer andare replaced y multi!unction >nancial services>rms. 6ontrolling these large units is morecomplicated than controlling single,purpose

an$s. – Finance is gloal. Foreign an$s hold dollars. This ma$es it more diGcult to control the sieo! the money supply.

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 The 2conomy Tomorrow

• 0s the Fed losing control" – 8ecause o! these changes4 the Fed shi!ted

away !rom targeting the money supply totargeting interest rates.•  This is easier and !aster to trac$.

• 0nterest rates are o! more immediate concern ininvestment and consumption decisions.

 – Thus the Fed most li$ely will use the !ederal!unds rate as its primary arometer o!monetary policy in the economy tomorrow.

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Revisiting the 'earning

ectives• *+,-*. Descrie how the Federal

Reserve is organied.

 –

 There are */ regional Federal Reservean$s.

 – The 8oard o! 9overnors sets general policy.

 – The chairman is the spo$esperson !or

monetary policy. – The Federal pen :ar$et 6ommittee (F:6)

implements policy strategy.

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Revisiting the 'earning

ectives• *+,-/. 0denti!y the Fed&s maor policy

tools. –

 The Fed controls the sie and growth o! themoney supply y regulating loan activity o!private an$s.

 – The three tools are• Altering the reserve re?uirement.

• Altering discount rates.

• 8uying or selling government onds in openmar$et operations.

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Revisiting the 'earning

ectives• *+,-1. 2xplain how open mar$et

operations wor$. –

When the Fed uys onds4 it pays theseller4 and an$ reserves increase. :oreloans can e made4 and the money supplygrows.

 – When the Fed sells onds4 the uyer paysthe Fed4 and an$ reserves decrease.Fewer loans can e made4 and the moneysupply shrin$s (or grows slower).