The Fed and Monetary Policy

1. The Fed and Monetary Policy 4 © 2003 South-Western/Thomson Learning

2. Chapter Objectives • Identify the Fed’s role in monetary policy • Describe the tools the Fed uses to influence monetary policy • Explain how changes in regulation in the 1980s affected the Fed and monetary policy

3. Federal Reserve System: Third U. S. Central Bank • First Bank of the United States (1791–1811) • Second Bank of the United States (1816–1836) • Federal Reserve System (1913–)

4. Structure of the Federal Reserve System • 12 Fed District Banks • Member Commercial Banks • 7 Members of Board of Governors • 14 year terms for Governors • 12 Open Market Committee (FOMC) Members • Advisory Committees to Fed from private sector

5. Functions of the Federal Reserve System • Effect Monetary Policy • U.S. Central Bank In International Area • Fiscal Agent of U.S. Treasury • Facilitate Efficient Payments System • Regulate Banks and Bank Holding Co. • Enforce Consumer Credit Laws

6. Organization of the Federal Reserve • Federal Reserve District Banks • 12 districts • Districts divided by population at 1912–13 • District bank size related to economic wealth of district • District banks owned by private member banks • Board of Directors of district banks • Three appointed by Board of Governors • Three professional bankers • Three business persons in district

7. Organization of the Federal Reserve • Member Banks • Must meet requirements of the Federal Reserve Board of Governors to be a member bank • Nationally chartered banks must be member banks • State chartered banks may be member banks • 35% of banks controlling 70% of all deposits are members

8. Organization of the Federal Reserve • Board of Governors • 7 individuals appointed by the U.S. president and confirmed by the Senate • U.S. president appoints one of the 7 chair whose 4-year term is renewable • Offices in Washington, D.C. • Serve nonrenewable 14-year terms • Independence of Federal Reserve • Staggered terms of Governors • Budget separate from Congress

9. Organization of the Federal Reserve • Board of Governors has two main functions: • Regulate commercial banks • Supervise and regulate member banks and bank holding companies • Oversight of 12 Fed district banks • Establish consumer finance regulations after Congressional legislation

10. Organization of the Federal Reserve • Establish and effect monetary policy • Direct control over two tools of monetary policy • Set reserve requirements • Approve discount rate set by district banks • Indirect control in a third area • Governors are members of the Federal Open Market Committee

11. Organization of the Federal Reserve • Federal Open Market Committee (FOMC) meets every 6 weeks • 12 members • 7 from the Board of Governors • President of the New York Fed • 4 other district bank presidents appointed on a rotating basis • Other presidents participate but do not vote on monetary policy matters

12. Organization of the Federal Reserve • Federal Open Market Committee (FOMC) • Monetary policy goals of: • high employment • price stability • economic growth • Make monetary policy decisions to achieve goals • Forward decisions to N.Y. Fed open market desk • Advisory committees from private sector also are a part of overall structure of the Fed

13. Business and Consumer Borrowing/Spending Fed’s Influence on Economy • Fed influences liquidity (supply of loanable funds) in money market to influence: Liquidity, Money Supply and Interest Rates Goals of Growth Price Stability Job Growth

14. Tools of Monetary Policy Open Market Op. Tools of Monetary Policy Discount Rate Reserve Req.

15. How Fed Controls Money Supply • Banks must maintain reserves as percent of deposits • Reserves kept as deposits in Fed (plus vault cash) • Fed controls level of member bank reserve deposits in Fed • Fed influences bank deposit portion of money supply

16. Monetary Policy Tools • Open market operations involve the purchase or sale of government securities based on FOMC directives sent to N.Y. Fed Trading Desk • Open market purchase of government securities: • Purchase securities from government securities dealers • Increase bank deposits and bank reserves, money market liquidity and, in time… • Increases the money supply

17. Exhibit 4.4 Increase in Required reserves Funds received from deposits held on new deposits that at banks new deposits can be lent out $100 million $10 million $90 million $90 million $9.0 million $81 million $81 million $8.1 million $72.9 million a a a

18. Monetary Policy Tools • Open market operations and interest rates • Most rates are market determined but Fed influences federal funds interest rate • Fed purchase of securities results in an injection of additional funds into the bank system • Shifts supply of federal funds to the right • Lowers federal funds rate • Lower rates spread to other money market securities • More funds available for money market and bank lending

19. Monetary Policy Tools • Adjusting the discount rate • Depository institutions borrow from Fed for three reasons: • Adjustment credit for short-term reserve deficiencies • Seasonal credit to agricultural banks • Extended credit for longer-term liquidity problems of problem banks • Lower discount rate • More bank borrowing from Fed, bank reserves expand, money supply increases

20. Monetary Policy Tools • Adjusting the reserve requirement ratio • Proportion of deposits at depository institutions set aside to meet their reserve requirements • Increase in lending or expansion limited by ($) reserves bank must hold the meet reserve requirements (%) • Total dollar expansion effect as follows: Dollar amount of open market Fed purchase or discount loan 1 × RR

21. Comparison of Policy Tools • Increasing the money supply • Open market operation purchase of securities via the Trading Desk in the secondary market • Discount rate lowered to encourage borrowing at the discount window • Reserve requirements lowered

22. Comparison of Policy Tools • Decreasing the money supply • Open market operation sale of securities via the Trading Desk in the secondary market • Discount rate raised to encourage borrowing at the discount window • Reserve requirements raised

23. Monetary Policy Deposit Expansion Provides • Excess Reserves to Lend • Loan/Deposit Expansion • Loans Finance Spending • Potential Expansion = Added $ Reserves  1/Required Reserve Ratio

24. Limiting Factors to Deposit Expansion • Banks may not lend excess reserves • Public may not re-deposit payments In expansion process (cash drains) • Lowers deposit expansion multiplier • Other fed functions impact member bank reserve level

25. Federal Reserve Policy Emphasis • Money Supply Growth • Interest Rate Levels • Price Level Changes • Real Economic Activity

26. Monetary Control Act of 1980 • To regain more control over the money supply the MCA required all depository institutions to • Meet the same reserve requirements • Hold noninterest-bearing reserves • Promptly report deposit levels to the Fed • Other provision of the MCA allowed all depository institutions • To offer transaction accounts • Access to the discount window

27. Global Monetary Policy • Each country has its own central bank and often industrialized countries have banks with similar goals • Integration in the global economy means the Fed must consider conditions in other countries when looking at the U.S. economy • Central banks try to work together but conflicts of interest can make cooperation difficult at times

28. Global Monetary Policy • A single European monetary policy • Euro replaced national currencies of 11 countries in January 1999 • National currencies withdrawn and replaced by euro by June 1, 2002 • Countries of the 15 in the European Union needed to meet economic criteria and chose to join • Created a European Central Bank