The Federal Reserve System, Monetary Policy, and Interest Rates

Chapter FourThe Federal Reserve System, Monetary Policy, and Interest Rates1McGraw-Hill/IrwinThe Federal ReserveFounded by Congress under the Federal Reserve Act in 1913Subject to oversight by Congress under its authority to coin moneyAn independent central bank–its decisions do not have to be ratified by the President2McGraw-Hill/IrwinFunctions of the Federal ReserveConduct monetary policySupervise and regulate depository institutionsMaintain financial system stabilityProvide payment and other financial services to the U.S. government, the public, FIs, and foreign official institutions3McGraw-Hill/IrwinStructure of the Federal ReserveDivided into 12 Federal Reserve districts, each with a main Federal Reserve BankFederal Reserve Banks operate under the general supervision of the Board of Governors of the Federal ReserveThe Office of the Comptroller of the Currency (OCC) charters national banks, which are members of the Federal Reserve System (FRS)FRS member banks “own” the 12 Federal Reserve Banks4McGraw-Hill/IrwinBoard of Governors of the FRSSeven member board headquartered in Washington, DCPresident appoints and Senate confirms members to nonrenewable 14-year termsPresident appoints and Senate confirms Chairman and vice-chairman to renewable 4-year termsFormulates and conducts monetary policy and supervises and regulates banks5McGraw-Hill/IrwinFederal Open Market Committee (FOMC)FOMC consists of 12 membersseven members of the Board of Governorsthe president of the Federal Reserve Bank of NYthe presidents of four other Federal Reserve Banks (on a rotating basis)The monetary policy-making body of the FRSPolicies seek to promote full employment, economic growth, price stability, and a sustainable pattern of international trade6McGraw-Hill/IrwinFederal Open Market Committee (FOMC)The FOMC sets ranges for growth of monetary aggregates and the fed funds rate, and also directs FR operations in FX marketsOpen market operations are the main policy tool used to achieve monetary targetsinvolve the purchase and sale of U.S. government and federal agency securitiesare implemented by the Federal Reserve Board Trading Desk of the New York Federal Reserve Bank7McGraw-Hill/IrwinFederal Reserve BanksAssist in the conduct of monetary policyset and change the discount rate (must be approved by the Board of Governors)make discount window loans to depository institutionsSupervise and regulate FRS member banksconduct examinations and inspections of member banksissue warnings when banking activity is unsafe or unsoundapprove bank mergers and acquisitionsProvide government servicesact as the commercial banks of the U.S. Treasury8McGraw-Hill/IrwinFederal Reserve BanksIssue new currencycollect and replace currency in circulation as necessaryClear checksact as a central clearing system for U.S. banksclear ~25% of all checks written in the U.S.Provide wire transfer servicesFedwireAutomated Clearinghouse (ACH)Perform banking sector and economic researchused in the formulation of monetary policy9McGraw-Hill/IrwinBalance Sheet of the Federal ReserveMajor assetsTreasury securitiesTreasury currencygold and foreign exchangeloans to domestic banksMajor liabilitiesreservescurrency in circulationcurrency in circulation + reserves = money base10McGraw-Hill/IrwinPlease insert Table 4-5 here. 11McGraw-Hill/IrwinMonetary PolicyMonetary policy affects the macroeconomy by influencing the supply and demand for excess bank reservesinfluences the money supply and the level of short-term and long-term interest ratesaffects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices12McGraw-Hill/IrwinMonetary PolicyOpen market operationspolicy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New YorkTrading Desk manager buys or sells U.S. Treasury securities in the over-the-counter (OTC) market, which keeps the fed funds rate near its desired target13McGraw-Hill/IrwinMonetary PolicyOpen market operations (cont’d)FRBNY acts through the Trading Desk to implement policy directives each business dayoperations may be permanent or temporarymay use repurchase agreements for temporary increases or decreases in excess reserves14McGraw-Hill/IrwinMonetary PolicyThe discount rate is the rate Federal Reserve Banks charge on loans to depository institutions in their districtThe Federal Reserve rarely uses the discount rate as a policy tooldiscount rate changes are strong signals of the Federal Reserves intentionsthere is no guarantee that banks will borrow15McGraw-Hill/IrwinMonetary PolicyReserve requirements are the reserve assets depository institutions must keep to “back” transaction depositsreserve assets include vault cash and deposits at Federal Reserve BanksThe multiplier effect16McGraw-Hill/IrwinMonetary PolicyExpansionary monetary policyopen market purchases of securities by the Feddiscount rate decreasesreserve requirement ratio decreasesContractionary monetary policyopen market sales of securities by the Feddiscount rate increasesreserve requirement ratio increases17McGraw-Hill/IrwinMoney Supply versus Interest Rate TargetingInterest RateQuantity of Moneyi’=8%i*=6%i’’=4%MS MD’MD’’MDInterestRateQuantity of MoneyiT = 6%i’’= 5%MS’MSMD’MDMD’’MS 18McGraw-Hill/IrwinInternational Monetary PolicyThe Federal Reserve generally allows foreign exchange rates to fluctuate freelyForeign exchange interventioncommitments between countries about the institutional aspects of their intervention in the foreign exchange marketssimilar to open market purchases and sales of Treasury securities19McGraw-Hill/IrwinMajor Foreign Central BanksThe Bank of Japanloose monetary policy is fueling an economic recoveryThe European Central Bankrecently switched from targeting the money supply to targeting inflationThe People’s Bank of Chinainterest rates are becoming a more important policy tool as China moves to a market oriented financial system20McGraw-Hill/Irwin