Learning Unit #20

Federal Reserve System

Objectives of Learning Unit

Structure of Federal Reserve System Functions of Federal Reserve System Independence of Federal Reserve System Balance sheet of Federal Reserve System Two Monetary Operations

Functions of Central Bank Each country has one central bank which is

responsible for– Conducting monetary policy.– Regulating an amount of money supply in economy.– Supervising banks.

In addition, a central bank may – Regulate financial markets and financial institutions

other than banks.– Control foreign exchanges and foreign reserves.– Act as the government’s bank.– Advising the government on the economic policy.

Federal Reserve System

In the United States, the federal reserve system (the Fed) acts as the central bank.

In most developed countries there is only one central bank. However, in the U.S. the Fed is divided into various organizational components for check and balance.– The federal government have attempted to establish a

single central bank twice, but due to fear of concentration of economic and monetary power, the Congress abolished such institutions.

– In 1931 the Congress established the twelve regional Federal Reserve banks.

Mission of Federal Reserve SystemThe Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. Today, the Federal Reserve's duties fall into four general areas:– conducting the nation's monetary policy by influencing the

monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

– supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers

– maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

– providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system

From http://www.federalreserve.gov/aboutthefed/mission.htm

Functions of Federal Reserve System

Like any other central banks, the Federal Reserve System performs various important functions through its organizational components. Provide financial services to banks

– Clear checks Act as government’s bank

– Print new currencies and withdraw old ones– Maintain government accounts

Regulate banking and financial industries Conduct monetary policy

Organizational Components of the Federal Reserve System

Three main organizational components of the Federal Reserve System: Regional Federal Reserve banks Board of Governors Federal Open Market Committee

Regional Federal Reserve Banks

The U.S. is divided into twelve Federal Reserve districts.– Each district has one Federal Reserve bank.

• Ex. Federal Reserve Bank of Richmond covers states of Maryland, Virginia, North Carolina, and South Carolina.

– By dividing into twelve districts, no one Federal Reserve bank can dominate in the U.S. economy.• Federal Reserve Bank of New York covers only

the state of New York, but holds one-quarter of the assets of the Federal Reserve System.

Twelve Federal Reserve BanksFederal Reserve districts vary in geographical economic size and sometime cut through states.

Organization of Federal Reserve Banks

Each Federal Reserve Bank has the same organizational structure.– A quasi-public institution, which issued stocks

and were owned by the member commercial banks in the district.

– Nine directors: six elected by the member banks and three appointed by the Board of Governors.

– One president of the bank is appointed by the nine directors.

Functions of Federal Reserve Banks Federal Reserve banks perform

– Clearing checks– Issuing new currency and withdrawing damaged

currency– Setting a discount rate and making discount loans to

banks in their districts– Examining bank holding companies and state-chartered

member banks– Acting as liaisons between the business community

and the Federal Reserve System– Collecting data on local business conditions– Researching for the conduct of monetary policy

U.S. Dollar Bills U.S. dollar bills are issued by the Federal

Reserve banks.

Emblem of the Federal Reserve System

“Federal Reserve Note” means IOU (note payable) issued by the Federal Reserve System.

Federal Reserve Bank of San Francisco issued this note.

Member banks

All national banks are required to be members of the Federal Reserve System.– Currently, about 37% of the commercial banks are

members of the Federal Reserve System. Depository Institutions Deregulation and

Monetary Control Act of 1980 – Requires all depository institutions (member and

nonmember banks) to hold required reserves.– Makes check-clearing services and the discount

window available for all depository institutions.

Board of Governors The Board of Governors acts like the

headquarter of the Federal Reserve System.– Located in Washington, D.C.– Seven members of the Board of Governors are

appointed by the president of the United States and confirmed by the Senate.

– Each member serves for nonrenewable 14-year term and comes from different districts.• Why 14-year term? To avoid political pressure from

the President and the Congress.• Why from different districts? To prevent one district

over-representing its interest over other districts.

Chairman of Board of Governors

The chairman of the Board of Governors is chosen from the seven governors.

– Serves for renewable four-year term.

– Acts like the CEO of the Federal Reserve System.

– Janet Yellen is the current chairman.

Functions of Board of Governors The Board of Governors

– Sets the reserve requirement– Approves the discount rate requested by the Federal

Reserve banks– Advise the president of the United States, testifies in

Congress, and speaks for the Federal Reserve System for the media.

– Represents the United States in negotiations with foreign governments on economic matters

– Provides economic analysis for the conduct of monetary policy

– Sets margin requirements– Approves bank mergers and applications for new activities

and specifies the permissible activities of bank holding companies

– Supervise the activities of foreign banks in the U.S.

Federal Open Market Committee

The Federal Open Market Committee– Meets eight times a year– Makes decisions regarding the conduct of open

market operations, including setting a target rate on federal funds

– Consists of twelve members: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve banks.

– Directed by the chairman of the Board of Governors

Monetary Policy and FOMC The Federal Open Market Committee (FOMC) is

the major body of monetary policy decision-making at the Federal Reserve.– Twelve members of FOMC vote for or against the

proposed monetary policy.– The chairman of the Fed, acting as the chairman of the

FOMC, announces in public about the decision.– “Tightening of monetary policy” (lowering money supply

growth – “hawkish policy”) is accompanied by a rise in the federal funds rate, while “easing of monetary policy” (increasing money supply growth – “dovish policy”) is done by lowering the federal funds rate.

Organizational Structure of the FedThree main organizational components of the Federal Reserve System and their responsibilities for monetary policy tools.

Relations among Organizational Components of the Fed

Although the Federal Reserve System was set up to diffuse its power among its organizational components, over time it evolved to be more centralized around the chairman of the Board of Governors.

Independence of the FedThe Federal Reserve System must be free from any government direction or pressure when it conducts monetary policy.– Instrumental independence: the ability to set

monetary instruments• Can the Fed change freely its instruments of

monetary policy?– Goal independence: the ability to set the goals

of monetary policy• Can the Fed set own goals of monetary policy? Can

the federal government set or influence the goals?

Why Independence of the Fed Important?

The Federal Reserve System needs to be independent from the federal government.– The government should not influence the Fed’s decision

to maintaining stable financial system.• Should the federal government make the Federal Reserve to

rescue a particular financial institution (e.g. Bear Stern, Fannie Mae)?

– The government should not use the Fed as source of free spending.• Politicians do not like to raise taxes or cut expenditures to

balance the government budget, because such unpopular policy may affect their election. Should they ask the Fed to print more money or borrow free loans from the Fed, so the government can spend more without raising taxes?

Consequence of Not-Independent Central Bank

Each country maintains different degree of independence of its central bank from the government.

– When a central bank has very limited independence from its government, the government tends to make the central bank issue more money and the economy tends to experience high inflation.

Why not Independence of the Fed?

The Federal Reserve System should not be completely independent from the federal government.– Because the officials at the Federal Reserve

System are not elected by the people of the U.S., the federal government must make sure that they do not act for their own gain or against the welfare of the economy.

– The economic policy needs to be coordinated between the federal government (fiscal policy) and the Fed (monetary policy) to be effective.

Independence of the Fed: Reality The Federal Reserve System maintains its

independence from the federal government.– The Board of Governors serves for 14 years, making

it free from influence of current president and Congress.

– Its budget is not subject to the appropriation process. But, its independence is not complete.

– The chairman of the Board of Governors must testify at the Congress twice a year, so the Congress can keep eyes on the Fed.

– The Congress has power to change the structure of the Fed if necessary.

– The president of the U.S. can appoint new chairman every four years.

Instrumental and Goal Independence of the Federal Reserve System

The Federal Reserve System is not completely independent from the federal government.– Instrumental independence: The Federal Reserve

System can set freely its monetary instruments (e.g. target rate of federal funds, discount rate). However, the Congress sets what instruments available for the Fed (e.g. the Fed’s ability on interest rate ceiling and margin requirement is authorized by the legislation).

– Goal independence: The Congress established the Federal Reserve System with mandate goals (e.g. employment and price stability). However, there is great degree of freedom on how and what the Fed is going to achieve (e.g. the Fed can set own goal such as target unemployment rate or inflation rate).

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University