Chapter 14:The Federal Reserve System

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Federal Reserve System• We examine how the government controls

money creation and thus aggregate demand (AD).

• The core issues are– Which government agency is responsible for

controlling the money supply?– What policy tools are used to control the amount of

money in the economy?– How are banks and bond markets affected by the

government’s policies?

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Learning Objectives

• 14-01. Describe how the Federal Reserve is organized.

• 14-02. Identify the Fed’s major policy tools.• 14-03. Explain how open market operations

work.

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The Structure of the Fed• The Fed was created in 1913.• It consists of 12 Federal Reserve banks, which

act as the central bank for private banks in their regions and perform the following services:– Clearing checks.– Holding bank reserves.– Providing currency.– Providing loans.

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The Structure of the Fed• The Fed Board of Governors is responsible for

setting monetary policy.– Monetary policy: the use of money and credit

controls to influence macroeconomic outcomes.

• Board members are appointed to a 14-year term, in a two-year stagger, to ensure a measure of political independence.

• One board member is appointed chairman for 4 years.

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The Structure of the Fed

• The current Fed chairman is Ben Bernanke, serving his second 4-year term.

• The Federal Open Market Committee (FOMC) is responsible for the Fed’s daily activity in financial markets.– The FOMC meets monthly to review economic

performance and to adjust monetary policy as needed.

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Monetary Tools

• The Fed controls the money supply by using three policy tools:– Reserve requirements.– Discount rates.– Open market operations.

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Reserve Requirements

• Private banks are required to keep a fraction of deposits “in reserve,” either as cash or on deposit at the regional Fed bank.

• By changing reserve requirements, the Fed can directly alter the lending capacity of the banking system.

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Reserve Requirements

• Increase the reserve requirement and …– The amount of excess reserves decreases.– The money multiplier decreases.– The available lending capacity shrinks.

• Decrease the reserve requirement and …– The amount of excess reserves increases.– The money multiplier increases.– The available lending capacity expands.

Available lending capacity = Excess reserves x Money multiplier

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The Discount Rate• Profit-seeking private banks earn income by

making loans.– They try to fully lend out their excess reserves.

• At times, a bank might fall short of satisfying the reserve requirement.– It can borrow excess reserves overnight from

another bank and pay interest: the federal funds rate.

– It can borrow reserves overnight from the Fed and pay interest: the discount rate.

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The Discount Rate• Discount rate: the rate of interest the Fed

charges for lending reserves to private banks.– If the discount rate is raised, borrowing

reserves from the Fed becomes more expensive, and fewer reserves are borrowed. Fewer loans are made, decreasing the money supply.

– If the discount rate is lowered, borrowing reserves from the Fed becomes less expensive, and more reserves are borrowed. More loans are made, increasing the money supply.

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Open Market Operations• This is the principal mechanism to directly alter the

reserves of the banking system.• Portfolio decision: the choice of how and where to

hold idle funds.– There are several choices: cash, savings accounts, stocks, and

bonds. The last three may generate additional income in the form of dividends or interest.

• Should you keep your idle funds in a savings account or purchase government bonds?– The Fed influences this decision by making bonds more or

less attractive.

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Open Market Operations

• If the public moves funds from savings to bonds, reserves fall, and vice versa.– When the Fed buys government bonds from the

public, reserves increase, more loans can be made, and the money supply grows.

– When the Fed sells government bonds to the public, reserves decrease, fewer loans can be made, and the money supply shrinks.

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The Bond Market• A bond is a certificate acknowledging a debt

and the amount of interest to be paid each year until repayment.– It is an IOU.

• People buy bonds because they pay interest and are a safe investment.– Yield: the rate of return on a bond.

Annual interest paymentYield = Price paid for the bond

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The Bond Market

• Pay $1,000 for a bond that pays out $80 a year, and its yield is 0.08 or 8%.

• If its price fell to $900 in the bond market, its yield would increase to 0.089 or 9%.

• The objective of open market operations is to alter the price of bonds, and also their yields, to make them more or less attractive as investments.

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Open Market Activity• The Fed can induce people to buy bonds by

offering to sell them at a lower price.– When the public pays for the bonds, bank reserves

fall. Fewer loans are made, and the money supply decreases (or its growth slows).

• The Fed can induce people to sell bonds by offering to buy them at a higher price.– When the Fed pays the public for the bonds, bank

reserves rise. More loans are made, and the money supply increases.

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The Fed Funds Rate• The Fed funds rate: the interest rate one bank

charges another for an overnight loan of excess reserves.– If the Fed increases reserves by buying bonds, the

Fed funds rate falls.– If the Fed decreases reserves by selling bonds, the

Fed funds rate rises.

• The Fed funds rate is a highly visible signal of Federal Reserve open market operations.

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Increasing the Money Supply

• To increase the money supply, the Fed can– Lower reserve requirements.– Reduce the discount rate.– Buy bonds in open market operations.

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Decreasing the Money Supply

• To decrease the money supply, the Fed can– Raise reserve requirements.– Increase the discount rate.– Sell bonds in open market operations.