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Federal Reserve System (ch7 & 8) -- Fin331 1 Federal Reserve System Overview of Federal Reserve System (central banking) Structure of Federal Reserve Fed Practice Monetary Policies Targets and Goals Use of Target to achieve goals

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T1-1 Why Study Financial Markets*
Structure of Federal Reserve
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Overview of Fed
Tradeoff between benefits and costs of having a regulated banking system
particularly, preventing bank run
Started in 1913, 12 regional Federal Reserve banks (the system consists of 12 districts)
quasi-public
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Terminology
Reserve requirement -- all banks are required to hold an account at the Fed
discount lending -- the Fed provides reserves to the banking system by making discount loans to banks
open market operation -- the central bank’s purchase or sale of bonds in the open market
Federal Reserve System (ch7 & 8) -- Fin331
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Governors serve one nonrenewable 14-year term
Chairman’s term is 4-year
Actively involved in conduct of monetary policy

Has substantial regulatory functions: approves bank mergers and the activities of foreign banks in the US
Federal Reserve System (ch7 & 8) -- Fin331
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Withdraw damaged currency from circulation
Evaluate proposed mergers and applications for banks to expand their activities
Administer and make discount loans to banks in their district
Act as liaisons
Conduct research related to monetary policy
Federal Reserve System (ch7 & 8) -- Fin331
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Member banks
All national banks (commercial banks charted by the Office of Comptroller of the Currency) are required
Currently, 1/3 commercial banks are members
Before 1980, only member banks were required to keep reserve
After 1980, all depository institutions became subject to the same requirement
Federal Reserve System (ch7 & 8) -- Fin331
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Makes decisions regarding the conduct of open market operations
-- purchase or sale of bonds in the open market to determine changes in reserves and interest rate
Federal Reserve System (ch7 & 8) -- Fin331
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2. Fed is financially independent
Factors making Fed dependent
1. Congress can amend Fed legislation
2. President appoints Chairmen and Board members and can influence legislation
Overall: Fed is quite independent
Federal Reserve System (ch7 & 8) -- Fin331
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Assets
Liabilities
Federal Reserve System (ch7 & 8) -- Fin331
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Open Market Purchase from Bank
The Banking System The Fed
Assets Liabilities Assets Liabilities
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Public The Fed
Federal Reserve System (ch7 & 8) -- Fin331
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Federal Reserve System (ch7 & 8) -- Fin331
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Reserves and Federal Funds Rate
Federal Funds Rate: the interest rate on overnight loans of reserves from one bank to another.
Federal Reserve System (ch7 & 8) -- Fin331
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Market for Reserves and the Fed Funds Rate
1. Demand curve slopes down because iff , ER and Rd up
2. Supply curve slopes down because iff , DL , Rs
3. Equilibrium iff where Rd = Rs
Federal Reserve System (ch7 & 8) -- Fin331
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1. Open market purchase, Rs shifts to right and iff
2. id , DL , Rs shifts to right and iff
Federal Reserve System (ch7 & 8) -- Fin331
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1. RR , Rd shifts to right, iff
Federal Reserve System (ch7 & 8) -- Fin331
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A. Open Market Operations
Meant to offset other factors affecting Reserves, typically uses repos
Federal Reserve System (ch7 & 8) -- Fin331
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2. Seasonal Credit
Lender of Last Resort
To prevent nonbank financial panics
Example: 1987 stock market crash
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C. Reserve Requirement
Those deposits in an account at the Fed plus currency that is physically held by banks
All depository institutions, including commercial banks, savings and loan associations, mutual saving banks and credit unions are subject to the same requirement
All checkable deposits
In 1999, required reserve is 3% of bank’s first $49.3 million of checkable deposits and 10% if checkable deposits over $49.3m
Federal Reserve System (ch7 & 8) -- Fin331
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Advantages
2. Raising causes liquidity problems for banks
3. Frequent changes cause uncertainty for banks
4. Tax on banks
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Goals often in conflict
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1. Md fluctuates between Md' and Md''
2. With M-target at M*, i fluctuates between i ' and i ''
Federal Reserve System (ch7 & 8) -- Fin331
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1. Md fluctuates between Md' and Md''