CHAPTER 14 - The Federal Reserve System

This chapter examines the mechanics of government control of banks and money supply. It describes the structure of the Fed and the tools the Fed uses to control the money supply, focusing on the following questions:

I. Introduction
A. This chapter addresses the following issues:

1. How does government control the amount of money in the economy?

2. Which government agency is responsible for exercising this control?

3. How are banks and bond markets affected by the government’s policies?

B. The Fed’s control over the supply of money is the key mechanism of monetary policy.

II. Structure of the Fed (Figure 14.1, Page 283)
A. Monetary Policy – The use of money and credit controls to influence macroeconomic activity.
B. A series of bank failures resulted in a severe financial panic in 1907 and millions of depositors lost their savings. Consequently, the National Monetary Commission was established to examine ways of restructuring the banking system.
C. To address the problem of restructuring the banking system, Congress passed the Federal Reserve Act in 1913.
D. Federal Reserve Banks - Twelve (12) Federal Reserve banks act as a central banker for the banks in their region. They perform the following services:

1. Clearing checks between private banks.

2. Holding bank reserves.

3. Providing currency.

4. Providing loans.

E. The Board of Governors - The Fed is controlled by a seven person Board of Governors. Each governor is appointed to a 14-year term by the President (with confirmation by the U.S. Senate). The long term is intended to give the Fed a strong measure of political independence. The President selects one of the advisors to serve as chairman for 4 years at a time.
F. The Federal Open Market Committee (FOMC) - is a twelve member group (the seven governors along with five of the 12 regional Reserve bank presidents). The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes.

III. Monetary Tools
A. The Federal Reserve is able to alter the money supply and does so using the following three policy instruments:

1. Reserve requirements.

2. Discount rates.

3. Open-market operations.

B. Money Supply (M1) - Currency held by the public, plus balances in transactions accounts.
C. M2 Money Supply – M1 plus balances in most savings accounts and money market mutual funds.
D. Reserve Requirements. (Table 14.1, Page 283)

1. The Fed requires banks to keep a minimum amount of required reserves. By changing the reserve requirement, the Fed can directly alter the lending capacity of the banking system.

2. Required Reserves – The minimum amount of reserves a bank is required to hold; equal to required reserve ratio times transactions deposits.

3. Formula:
    

   Required Reserves = required reserve ratio X total deposits

4. Excess Reserves – Bank reserves in excess of required reserves.

5. Formula:
    

   Excess Reserves = Total Reserves - Required Reserves

6. The money multiplier determines how much in additional loans the banking system can make based on their excess reserves.

7. Money Multiplier – The number of deposit (loan) dollars that the banking system can create from $1 of excess reserves; equal to 1 / required reserve ratio.

8. Formula:
    

   Available Lending Capacity of banking System = Excess Reserves X Money Multiplier

9. The Fed can affect the money supply (bank loans) by adjusting the reserve ratio up or down as desired. A change in the reserve requirement causes:

   1. A change in excess reserves.

   2. A change in the money multiplier.

   3. A change in the lending capacity of the banking system.

10. In The News: “Fed Cuts Deposit-Reserve Requirements”
    This article discusses the Fed’s reduction of the Reserve Requirement to help encourage banks to make more loans. A reduction in the reserve requirement transforms some of the banking system’s required reserves into excess reserves. This increases potential lending activity, the size of the money multiplier, and the money supply if lending activity increases.

E. The Discount Rate. (Figure 14.2, Page 286)

1. Banks have a tremendous profit incentive to keep their reserves as close to their required reserve level as possible. Excess reserves earn no interest.

2. The Federal Funds Market - A bank that finds itself short of reserves can turn to other banks for help. Reserves borrowed in this manner are called “federal funds” and are lent for short periods - usually overnight.

3. Federal Funds Rate – The interest rate for inter-bank reserve loans.

4. Sale of Securities - A bank that is low on reserves can also sell securities. Banks use some of their excess reserves to purchase government bonds. These may be converted to reserves instantly if necessary - however, this usually forfeits any interest-earning potential it might have had.

5. Discounting – A third option for avoiding a reserve shortage is to go to the Fed’s “discount window” and borrow reserves directly from a Federal Reserve bank. This is called discounting.

6. Discounting – Federal Reserve lending of reserves to private banks.

7. Discount Rate – The rate of interest charged by the Federal Reserve banks for lending reserves to private banks.

8. By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

9. In the News: “Fed again Reduces Key Rate”
   In August 2001, the Federal Reserve lowered interest rates amid concerns about the outlook for the US economy and a global slowdown.

F. Open-Market Operations (Figure 14.3, Page 288)

1. Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

2. Portfolio Decisions

• People do not hold all their idle funds in transactions accounts or cash.

• Idle funds are also used to purchase stocks, build up savings account balances, and purchase bonds.

• These alternative uses of idle funds are attractive because they promise some additional income in the form of interest, dividends, or capital appreciation.

3. Portfolio Decision – The choice of how (where) to hold idle funds.

4. Hold Money or Bonds (Figure 14.3, Page 288)

• The open-market operation of the Fed focus on one of the portfolio choices people make – whether to deposit idle funds in bank accounts or to purchase government bonds.

• The Fed attempts to influence this choice by making bonds more or less attractive, as circumstances warrant.

• When the Fed buys bonds from the public, it increases the flow of deposits (reserves) to the banking system. Bond sales by the Fed reduce the flow.

5. The Bond Market

• Not all of us buy and sell bonds, but a lot of consumers and corporations do.

• Bond – A certificate acknowledging a debt and the amount of interest to be paid each year until repayment; an IOU.

• Like other markets, the bond market exists whenever and however bond buyers and sellers get together.

6. Bond Yields

• People buy bonds because bonds pay interest.

• Bond Yields – The rate of return on a bond; the annual interest payment divided by the bond’s price.

• Formula:
   

  Yield =	Annual Interest Payment
  	Price Paid for Bond

• A principle objective of Federal Reserve open-market activity is to alter the price of bonds, and therewith their yields.

• In The News: “Zero-Coupon Bonds”
  Zero-coupon bonds make no interest payments. The yield on a bond depends not only on annual interest payments but also on the difference between the price paid for the bond and its face value.

7. Open Market Activity

• Open Market Operations – Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves.

• Bonds do not have to be (and frequently are not) bought at the bond’s face value. It is possible, for example, to buy a $1000 bond for $900 -making the bond’s yield higher.

• A principal objective of the Federal Reserve open-market activity is to alter the price of bonds, and therewith their yields. By doing so, the Fed makes bonds a more or less attractive alternative to holding money.

8. Open-Market Purchases – By buying bonds, the Fed increases bank reserves. (Figure 14.4, Page 290)

9. Open-Market Sales – By selling bonds, the Fed reduces bank reserves

10. The Fed Funds Rate

• Fed funds rate act as a market signal of the changing reserve flows.

• If the Fed is pumping more reserves into the banking system, the federal funds rate will decline.

• If the Fed is reducing bank reserve by selling bonds, the federal funds rate will increase.

11. Volume of Activity

• The volume of trading in U.S. government securities exceeds $100 billion per day.

• Each dollar in reserves represents approximately $10 in potential lending due to the money multiplier.

IV. Increasing the Money Supply (Table 14.2, Page 286)
A. To increase the money supply, the Fed can:

1. Lower reserve requirements.

2. Reduce the discount rate.

3. Buy bonds.

B. Lowering Reserve Requirements - This will increase the banking system’s excess reserves with which they will increase the money supply through deposit creation (loans).
C. Lowering the Discount Rate - This makes the cost of borrowing reserves from the Federal Reserve cheaper for banks. The new borrowed (excess) reserves will be used to make more loans - thus increasing the money supply. The effectiveness of lowering the discount rate depends primarily on the difference in the new discount rate and the rate that banks charge their loan customers.
D. Buying Bonds - By purchasing bonds, the Fed places money in bank reserves (via bond sellers). The banks will then increase the money supply even more through additional loans.
E. World View: “Interest Rates are Boosted again in Europe”
In 2000, the European Central Bank raised interest rates citing inflation risks.

V. Decreasing the Money Supply
A. To reduce the money supply, the Fed can:

1. Raise reserve requirements.

2. Increase the discount rate.

3. Sell bonds.

B. The Fed rarely seeks an outright reduction of the size of the money supply. What it does do is to regulate the rate of growth of the money supply.

VI. The Economy Tomorrow: Is the Fed Losing Control?
A. Monetary Control Act

1. Before 1980, the Fed’s control of the money supply was not only incomplete - it was weakening. Only one-third of all commercial banks were members of the Federal Reserve System and subject to its regulations.

2. Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980. Its principal objectives were:

• To extend the Fed’s control of the money supply.

• To encourage greater competition in the banking industry.

3. The Monetary Control Act subjected all commercial banks, S&Ls, savings banks and most credit unions to Fed regulation.

B. Decline of Traditional Banks

1. As the Fed’s control of the banks was increasing, the banks themselves were declining in importance due to competition from “non-bank” financial institutions.

2. Thirty percent of all consumer loans are now made through credit cards.

3. Insurance companies and pension funds also make loans.

4. Foreign banks, corporations, and pension funds may also extend credit to American businesses.

5. World View: “Fighting Terror/Targeting Funds: Laws May Not Stop Flow Of Terror Funds”
   The article describes how the globalization of electronic money transfer systems has made it easier than ever to move cash without detection.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. Bank reserves are required for the safety of depositor’s money. Many people have the idea that bank reserves provide for the safety of depositors’ money. They don’t. the statistics in Chapter 12 indicate that the amount of demand deposits is several times larger than that of reserves. Reserves are for control of the money supply. The FDIC provides for safety of deposits by insuring them. Reserves are not principally for depositors’ safety.

2. Deposits of cash are necessary to start the process of lending and deposit creation. Many find it difficult to understand that for deposit creation to occur, the banking system needs only to acquire reserves from outside the system or be able to stretch existing reserves further. It may acquire reserves by selling a security to the Fed or by borrowing from the Fed. An individual bank, however, may acquire reserves from another bank. Therefore, to the extent that it has increased its reserves, reserves of another bank have shrunk. Thus, the system has no more reserves after the transaction than it had before and so the system’s lending capacity is unchanged.

3. Rising interest rates make existing bonds more valuable. The relationship between the price of a bond maturing in 1 year and the “yield” (which is usually close to current market interest rates) is given by
    

   Current Market Price of Bonds =	face value of the bond X (1/bond interest rate)
   	1+current market interest rate

   
   There are two interest rates involved here: the interest rate stated on the bond when it is issued and the current market interest rate that can change before the bond matures. The price of bonds moves in the opposite direction (i.e., inversely) to movements in market rates of interest.

4. When the Fed sells government bonds in open-market operations, it is increasing the money supply. The key here is to realize the payment of reserves to the Fed means that there are fewer reserves available to the entire banking system. By selling bonds the Fed is tightening monetary policy.