13e

Chapter 14:
The Federal Reserve
System

McGraw-Hill/Irwin

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

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 governments policies?
14-2

Learning Objectives
14-01. Describe how the Federal
Reserve is organized.
14-02. Identify the Feds major policy
tools.
14-03. Explain how open market
operations work.

14-3

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.
14-4

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.
14-5

The Structure of the Fed

The current Fed chairman is Janet
Yellen.
The Federal Open Market Committee
(FOMC) is responsible for the Feds
daily activity in financial markets.
The FOMC meets monthly to review
economic performance and to adjust
monetary policy as needed.
14-6

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

14-7

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.

14-8

Reserve Requirements
Available lending capacity = Excess reserves x Money multiplier

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.
14-9

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.
14-10

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.
14-11

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.

14-12

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.

14-13

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.
Yield =

Annual interest payment

Price paid for the bond
14-14

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.
14-15

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.

14-16

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.

14-18

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.

14-19

The Economy Tomorrow

Is the Fed losing control?
Since 1980, all depository institutions have
had to satisfy Fed reserve requirements.
Traditional banks have declined in number and
are replaced by multifunction financial services
firms. Controlling these large units is more
complicated than controlling single-purpose
banks.
Finance is global. Foreign banks hold dollars.
This makes it more difficult to control the size
of the money supply.
14-20

The Economy Tomorrow

Is the Fed losing control?
Because of these changes, the Fed shifted
away from targeting the money supply to
targeting interest rates.
This is easier and faster to track.
Interest rates are of more immediate concern in
investment and consumption decisions.

Thus the Fed most likely will use the federal

funds rate as its primary barometer of
monetary policy in the economy tomorrow.
14-21

Revisiting the Learning

Objectives
14-01. Describe how the Federal
Reserve is organized.
There are 12 regional Federal Reserve
banks.
The Board of Governors sets general policy.
The chairman is the spokesperson for
monetary policy.
The Federal Open Market Committee (FOMC)
implements policy strategy.
14-22

Revisiting the Learning

Objectives
14-02. Identify the Feds major policy
tools.
The Fed controls the size and growth of the
money supply by regulating loan activity of
private banks.
The three tools are
Altering the reserve requirement.
Altering discount rates.
Buying or selling government bonds in open
market operations.
14-23

Revisiting the Learning

Objectives
14-03. Explain how open market
operations work.
When the Fed buys bonds, it pays the
seller, and bank reserves increase. More
loans can be made, and the money supply
grows.
When the Fed sells bonds, the buyer pays
the Fed, and bank reserves decrease.
Fewer loans can be made, and the money
supply shrinks (or grows slower).
14-24