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Chapter 4

Functions of the Fed

Financial Markets and Institutions, 7e, Jeff Madura

Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline

Organization of the Fed

Monetary policy tools

Impact of technical factors on funds

Fed control of the money supply

Monetary Control Act of 1980 Global monetary policy

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Organization of the Fed

The Fed has five major components:

Federal Reserve district banks

Member banks

Board of Governors

Federal Open Market Committee (FOMC)

Advisory committees

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Organization of the Fed (contd)

Federal Reserve district banks There are 12 Federal Reserve district banks

The NY bank is the most important

Commercial banks that become members of the Fed mustpurchase stock in their district banks

Pays a maximum dividend of 6% annually

Each district bank has nine directors

Six elected by member banks; three appointed by the Board ofGovernors

The nine directors appoint the president of the district bank

District banks clear checks, replace old currency, provide loansto depository institutions, and conduct research

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Member banks

All national banks are required to be members

of the FedState-chartered banks are not required to be

members

About 35% of all banks are members

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Board of Governors The Board of Governorsconsists of seven members

Each member is appointed by the President of the

U.S. and confirmed by the SenateMembers serve 14-year terms

Reduces political pressure

Terms are staggered so that one term expires in every even-numbered year

Main roles: Regulate commercial banks

Control monetary policy

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Federal Open Market Committee (FOMC) The FOMCconsists of the seven members of the

Board of Governors plus the presidents of five Fed

district banks NY plus four others on a rotating basis

Goals: promote high employment, economic growth,and price stability Achieved through control of the money supply

Decisions on changes in monetary policy areforwarded to the Trading Desk(Open Market Desk)at the NY Fed district bank

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Advisory committees The Federal Advisory Council consists of one member from each

district

Makes recommendations to the Fed about economic and bankingissues

The Consumer Advisory Council consists of up to 30 members

Represents the financial institutions industry and its consumers

The Thrift Institutions Advisory Council consists ofrepresentatives of savings banks, S&Ls, and credit unions

Offers views on issues specifically related to thrift institutions

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Integration of Federal Reserve

Components

Advisory

Committee

Board of Governors

Regulates member

banks and BHCs

Sets reserve

requirements

Supervision

Federal Open

Market Committee

Conducts open

market operations

Federal Reserve

District Banks

Clear checks

Replace old currency

Provide loans to

depository institutions

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Monetary Policy Tools

Open market operations The FOMC meets 8 times a year

At each meeting, the target money supply growth level andinterest rate level are determined

FOMC meeting agenda Members receive the Beige Booktwo weeks prior to the meeting

Meeting is attended by the Board of Governors, the 12 presidents ofthe district banks, and staff members

Staff members begin with presentations about current economicconditions and recent economic trends

Next, each FOMC member can offer recommendations aboutwhether monetary growth and interest rate target levels should bechanged

Last, voting members vote on monetary policy and interest rates

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Monetary Policy Tools (contd)

Open market operations (contd)

Communication to the Trading Desk

The FOMCs decision on target money supply levels isforwarded to the Trading Desk at the NY district bank through

a policy directive

FOMC objectives are specified in a target range for the

money supply growth

The FOMC also specifies a desired target for the federalfunds rate

The federal funds rate is the rate charged by banks on short-

term loans to each other

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Role of the Trading Desk

The manager of the Trading Desk instructs traderson the amount of government securities to buy or

sell in the secondary market

This is called open market operations

The Trading Desk continuously conducts openmarket operations in response to ongoing changes

in bank deposit levels

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Open market operations (contd) Fed purchase of securities

Traders at the Trading Desk call government securities

dealers to purchase securities Dealers provide a list of securities for sale

Traders purchase those that are most attractive

The total funds of commercial banks increase by the dollaramount of securities purchased by the Fed A loosening of the money supply

To force a decline in the Fed funds rate, the Trading Deskcan also purchase Treasury securities The Fed funds rate will decline along with other interest rates

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Fed sale of securities

To decrease the money supply, traders sell governmentsecurities to government securities dealers

Sold to the dealer submitting the highest bid

As dealers pay, their account balances are reduced and the

total amount of funds at commercial banks is reduced

A tightening of the money supply To force an increase in the Fed funds rate, the Trading Desk

can also sell Treasury securities

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Fed use of repurchase agreements

Used to increase the aggregate level of bank fundsfor only a few days

The Trading Desk trades repurchase agreementsrather than government securities Purchases Treasury securities with an agreement to sell

back the securities at a specified date in the near future

Often used during holidays to correct temporaryimbalances

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How open market operations affect interest rates

When the Fed uses open market operations to increase bankfunds, interest rates are affected because:

The fed funds rate may decline

Banks with excess funds may offer new loans at a lower

interest rate

Banks may lower interest rates on deposits

The yield on Treasury securities may decline

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Dynamic vs. defensive open market

operations Dynamic operationsare implemented to increase

or decrease the level of funds

Defensive operationsoffset the impact of other

conditions that affect the level of funds

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Open market operations (contd)Open market operations in response to the Crash

Stock prices declined by 22 percent on October 19, 1987

The Fed loosened the money supply to provide liquidity The Fed monitored bank deposits to ensure there was no run

on deposits

The Fed monitored credit relationships between commercialbanks and securities firms

Open market operations in response to the weak

economy in 2001 The Fed increased money supply growth to stimulate the

economy

Businesses did not respond to lower interest rates

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Open market operations in response to the

September 11 attack on the United States The FOMC decided to add liquidity to the banking system to

prevent a banking crisis

The FOMC left the federal funds rate target unchanged

On September 17, the FOMC reduced the federal funds

target rate by 50 basis points just before markets reopened

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Adjusting the discount rate

To increase the money supply, the Fed can

authorize a reduction in the discount rate Encourages depository institutions to borrow from

the Fed

To decrease the money supply, the Fed can

increase the discount rate

Discouraged borrowing from the Fed

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Adjusting the discount rate (contd)

In January 2003 the Fed classified its loans

as primary or secondary credit Primary credit can be used for any purpose but it

available only to financially sound institutions

Secondary credit is provided to banks that do not

qualify for secondary credit Contains a risk premium above the discount rate

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Adjusting the discount rate (contd)

Recently, the Fed has often adjusted the discount

rate to keep it in line with changes in the targetedfederal funds rate

In January 2003, the Fed set the discount rate at a

level above the federal funds rate

Loans from the Fed serve as a backup source of funds

The discount rate no longer serves as a signal about the

Feds monetary policy

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Adjusting the reserve requirement ratio

The reserve requirement ratiois the proportion of

bank deposits that must be held as reserves Set by the Board of Governors

Historically set between 8 and 12 percent

Currently 10 percent of transaction accounts

Sometimes changed to adjust the money supply

A reduction increases the proportion of bank deposits that canbe lent out

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Adjusting the reserve requirement ratio

(contd)

How reserve requirement adjustments affectmoney growth

An initial increase in demand deposits as a result

of loosening the money supply multiplies into

(1/reserve requirement ratio)A higher ratio causes an initial injection to multiply by a

smaller amount

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Comparison of monetary policy tools

The most frequent monetary policy tool is open

market operations

Open market operations can be used without signaling the

Feds intentions and can be easily reversed

Adjustments in the discount rate only work if depository

institutions respond to the adjustment

Adjustments in the reserve requirement ratio can causeerratic shifts in the money supply

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Impact of Technical Factors on

Funds The volume of funds can change without the

Feds intervention because of:

Federal Reserve float The amount of checks credited to banks funds that have not

yet been collected

Currency in circulation

Staff at the NY Fed and the Board of Governorsprovide daily forecasts of how technical factors

will affect the level of funds

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Fed Control of the Money Supply

The Fed must decide what form of money

to manipulate

The optimal form of money should: Be controllable by the Fed

Have a predictable impact on economic variables

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(contd) M1includes currency held by the public and

checking depositsM1 is the most narrow form of money

M2includes everything in M1 plus savingsaccounts and small time deposits, moneymarket deposit accounts (MMDAs), and otheritems

M3includes everything in M2 plus large timedeposits and other items

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(contd) Limitations of controlling money supply

It may be difficult for the Fed to simultaneously control

money supply growth and the federal funds rate

In October 1979 it focused primarily on the money supply

In the last several years, the Fed focused on maintaining the

federal funds rate within a narrow target range

In 2000, the Fed reduced its focus on the use of specific

money supply target ranges M2 remains in the Index of Leading Economic Indicators

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Monetary Control Act of 1980

The Depository Institutions Deregulations

and Monetary Control Act (DIDMCA)of

1980 had two objectives: To deregulate some aspects of the depository

institutions industry

To enhance the Feds ability to control the money

supply

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Monetary Control Act of 1980

(contd) DIDMCA mandates that all depository institutions be

subject to the same reserve requirements imposed bythe Fed

Applies to member and nonmember banks All depository institutions must report their deposit

levels promptly to the Fed Improves the Feds knowledge of the current level of deposits

in the banking system

DIDMCA allowed all depository institutions that offertransaction accounts to have access to the discountwindow

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Global Monetary Policy

Central banks of other countries use openmarket operations, reserve requirementadjustment, and adjustments in the interest

rate they charge on loans

The Fed must consider economic conditions inother major countries when assessing the U.S.economy Coordinating monetary policy may be difficult

because of conflicts of interest

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Global Monetary Policy (contd)

A single Euro zone monetary policy On June 1, 2002, the euro replaced the currencies of 12

European countries

The European Central Bank (ECB) sets monetary policy for allparticipating countries

Objective is to control inflation and to stabilize the value of theeuro

Impact of the euro on monetary policy

The interest rate offered on government securities must be

similar across participating countries The euro prevents any single country from using a unique

monetary policy

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Global Monetary Policy (contd)

Global central bank coordination

Sometimes central banks of various countries coordinate

efforts for a common cause

After September 11, 2001, central banks of various countriesinjected money into the banking system to provide more liquidity

On September 17, 2001, several central banks reduced their

interest rates

Sometimes central banks have conflicting objectives

If two countries attempt to weaken their currenciessimultaneously, the exchange rate is subject to conflicting forces

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