• The Federal Reserve Act of 1913 created the Federal Reserve System– To provide for the establishment of Federal reserve

banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes

– First United States Bank [ 1791 - 1811]– Second United States Bank [ 1816 - 1836]

• The charters of both were allowed to lapse

– The 1907 bank crises caused the public to demand the government do something to keep this from happening again

Chapter 14 The Federal Reserve System

• The Federal Reserve has five main jobs– Conduct monetary policy which is, by far, the most

important job• Monetary policy is the control of the rate of growth of the

money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth

– Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions

– Issue currency

– Provide banking services to the U.S. government

– Supervise and regulate our financial institutions

The Federal Reserve District Banks

• Each Federal Reserve District Bank is owned by the several hundred member banks in that district– A commercial bank becomes a member by buying

stock in the Federal Reserve District Bank

– So, the Fed is a quasi public-private enterprise, not controlled by the President or Congress

• Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.

The Federal Reserve System• Board of Governors

– Seven members

– Appointed by President

– Confirmed by Senate

• Sets reserve requirements

• Supervises and regulates member banks

• Establishes and administers regulations

• Oversees Federal Reserve Banks

• 12 District Banks

• Propose discount rates

• Hold reserve balances for member institutions

• Lends reserves

• Furnish currency

• Collects & clears checks

• Handle U.S. government debt & cash balances

Federal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy

Legal Reserve Requirements

• The focal point of the Federal Reserve’s control of our money supply is legal reserve requirements– Every financial institution in the country is

legally required to hold a certain percentage of its deposits on reserve, either in the form of deposits at its Federal Reserve District Bank or in its own vaults

Legal Reserve Requirements• Technical Term Meanings

– Required Reserves (RR) is the minimum amount of vault cash and deposits (RD) at the Federal Reserve District Bank that must be held (kept on the books) by the financial institution

– Actual Reserves (RD) is what the bank is holding (on the books)

– Excess Reserves = Actual Reserves - Required Reserves

• ER = RD - RR

What About Negative Excess Reserves?

• If actual reserves (RD) are less than Required Reserves (RR), the excess Reserves (ER) are negative– If a bank does find itself short, it will usually

borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charge is called the federal funds rate

– A bank may also borrow reserves (RD) from its Federal Reserve District Bank at its discount window

• A bank’s primary reserves are its vault cash and its deposits at the the Federal District Bank– These reserves pay no interest, therefore the

banks try to hold no more than the Federal Reserve requires

Primary and Secondary Reserves

• Every bank holds secondary reserves, mainly in the form of very short-term U.S. government securities– Treasury bills, notes, certificates, and bonds

(that will mature in less than a year) are generally considered a bank’s secondary reserves

– These can be quickly converted to cash without loss if a bank suddenly needs money

Primary and Secondary Reserves

Deposition ExpansionHypothetical Deposit Expansion with 10 Percent Reserve Requirement

Deposits (thousands) Reserves $100.0 $10.0 $ 90.0 9.0 $ 81.0 8.1 $ 72.9 7.29 $ 65.61 6.661 $ 59.05 5.904 $ 53.541 5.354 $ 48.186 4.819 $ 43.368 4.337 $ 39.031 3.903 * To save space the rest of the calculations are omitted $1,000.00 100.00

Deposit Expansion Multiplier(DEM)

DEM = 1

Reserve Ratio

Assume a RR of 10%

DEM =1

.10= 10

Assume a RR of 25%

DEM = 1

.25= 4

When RR increases

DEM decreases

When RR decreases

DEM increases

Three Modifications of the Deposit Expansion Multiplier

• Not every dollar of deposit expansion will actually be redeposited again and lent out repeatedly– Some people may choose to hold or spend

some money as currency

• It is also possible that some banks will carry excess reserves– This is not likely in times of high inflation

Three Modifications of the Deposit Expansion Multiplier

• There are leakages of dollars to foreign countries– This is caused mainly by our foreign trade

imbalance

• The Deposit Expansion Multiplier is, in reality, quite a bit lower than if we based it solely on the reserve ratio– If the reserve ration tells us it is 10, perhaps

it’s only 6

• Increasingly, money is changing hands electronically– Today, more than $1.7 trillion a day is

transferred electronically– About $600 billion of these transfers are carried

out by the Federal Reserve’s electronic network– About $1.1 trillion are done by the Clearing

House Interbank Payment System (CHIPS) which is owned by 11 big New York Banks

Cash, Checks, and Electronic Money

• Does all this mean that we are well on our way to a checkless, cashless society?– Yes and no

– We still carry out nearly 85 percent of our monetary transactions in cash

– When the total dollars actually spent is considered, cash covers less than 1 percent of the total value

– Electronic transfers account for five out of every six dollars that move in the economy

Cash, Checks, and Electronic Money

The Tools of Monetary Policy

• The most important job of the Fed is to control the rate of growth of the money supply

• This effort focuses on the reserves held by financial institutions– The most important policy tool to do this is

open-market operations

How Open-Market Operations Work

• Open-Market operations are the buying and selling of U.S. government securities– U.S. government securities are treasury bills, notes,

certificates, and bonds

– The Fed buys and sells securities that have already been marketed by the treasury

• The total value of all outstanding U.S. government securities is more than $4.0 trillion. This is our national debt

– What open market operations consist of, then, is the buying and selling of chunks of the national debt

The Federal Open-Market Committee (FOMC)

• Open-market operations are conducted by the Federal Open-Market Committee (FOMC)– This committee consist of 12 people

• Eight permanent members – the board of Governors and the president of the New York Federal Reserve District Bank

• The other four are presidents of the other 11 Federal Reserve District Banks

– They serve on a rotating basis

The Federal Open-Market Committee (FOMC)

• The FOMC meets about once every six weeks to decide what policy to follow– To fight recessions, the FOMC buys

securities• This increases the rate of growth of the money

supply

– To fight inflation, the FOMC sells securities• This decreases the rate of growth of the money

supply

• The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District Bank

• The federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other– This is higher than the discount rate

• Banks borrow to maintain their required reserves (RR)– Banks tend to borrow reserve deposits from each

other because they may not like to call attention to the fact they are having to borrow reserve deposits

Borrowing Reserve Deposits

Changing Reserve Requirements

• The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14 percent for checkable deposits– Changing reserve requirements is the

ultimate weapon and is rarely used

Changing Reserve Requirements

• To fight inflation, before the Board would take the drastic step of raising reserve requirements– The District Banks would raise the discount

rate– The FOMC will be actively selling securities– Credit will be getting tighter– The chairman will be publicly warning that

the banks are advancing too many loans

Changing Reserve Requirements

• If the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises

reserve requirements– This weapon is so rarely used because it is simply

too powerful– If the reserve requirement on demand deposits were

raised by just one half of 1 percent, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reserves

• This would drastically reduce the nation’s money supply

Summary: The Tools of Monetary Policy

• To fight recession, the Fed will– Lower the discount rate– Buy securities on the open market– Lower reserve requirements

• This would be done only as a last resort

• To fight inflation, the Fed will– Raise the discount rate– Sell securities on the open market– Raise reserve requirements

• This would be done only as a last resort