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Financial markets and institutions, 7e, jeff madura ch04

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.

1


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


2



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

3


Organization of the Fed (cont’d)


Federal Reserve district banks


There are 12 Federal Reserve district banks




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




Pays a maximum dividend of 6% annually

Each district bank has nine directors






The NY bank is the most important

Six elected by member banks; three appointed by the Board of
Governors
The nine directors appoint the president of the district bank

District banks clear checks, replace old currency, provide loans
to depository institutions, and conduct research
4


Organization of the Fed (cont’d)


Member banks
 All

national banks are required to be members
of the Fed
 State-chartered banks are not required to be
members
 About 35% of all banks are members

5


Organization of the Fed (cont’d)


Board of Governors
 The

Board of Governors consists of seven members
 Each member is appointed by the President of the
U.S. and confirmed by the Senate
 Members serve 14-year terms



Reduces political pressure
Terms are staggered so that one term expires in every evennumbered year

 Main



roles:

Regulate commercial banks
Control monetary policy

6


Organization of the Fed (cont’d)


Federal Open Market Committee (FOMC)
 The

FOMC consists 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 are
forwarded to the Trading Desk (Open Market Desk)
at the NY Fed district bank
7


Organization of the Fed (cont’d)


Advisory committees


The Federal Advisory Council consists of one member from each
district




The Consumer Advisory Council consists of up to 30 members




Makes recommendations to the Fed about economic and banking
issues
Represents the financial institutions industry and its consumers

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


Offers views on issues specifically related to thrift institutions

8


Integration of Federal Reserve
Components
Advisory
Committee

Board of Governors
•Regulates member
banks and BHCs
•Sets reserve
requirements

Supervision
Federal Reserve
District Banks
•Clear checks
•Replace old currency
•Provide loans to
depository institutions

Federal Open
Market Committee
•Conducts open
market operations

9


Monetary Policy Tools


Open market operations




The FOMC meets 8 times a year
At each meeting, the target money supply growth level and
interest rate level are determined
FOMC meeting agenda







Members receive the Beige Book two weeks prior to the meeting
Meeting is attended by the Board of Governors, the 12 presidents of
the district banks, and staff members
Staff members begin with presentations about current economic
conditions and recent economic trends
Next, each FOMC member can offer recommendations about
whether monetary growth and interest rate target levels should be
changed
Last, voting members vote on monetary policy and interest rates

10


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Communication






to the Trading Desk

The FOMC’s decision on target money supply levels is
forwarded 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 federal
funds rate


The federal funds rate is the rate charged by banks on shortterm loans to each other

11


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Role


The manager of the Trading Desk instructs traders
on the amount of government securities to buy or
sell in the secondary market




of the Trading Desk

This is called open market operations

The Trading Desk continuously conducts open
market operations in response to ongoing changes
in bank deposit levels
12


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Fed


purchase of securities

Traders at the Trading Desk call government securities
dealers to purchase securities





The total funds of commercial banks increase by the dollar
amount of securities purchased by the Fed




Dealers provide a list of securities for sale
Traders purchase those that are most attractive

A loosening of the money supply

To force a decline in the Fed funds rate, the Trading Desk
can also purchase Treasury securities


The Fed funds rate will decline along with other interest rates

13


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Fed


sale of securities

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




As dealers pay, their account balances are reduced and the
total amount of funds at commercial banks is reduced




Sold to the dealer submitting the highest bid

A tightening of the money supply

To force an increase in the Fed funds rate, the Trading Desk
can also sell Treasury securities

14


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Fed

use of repurchase agreements

Used to increase the aggregate level of bank funds
for only a few days
 The Trading Desk trades repurchase agreements
rather 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 temporary
imbalances
15


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 How


open market operations affect interest rates

When the Fed uses open market operations to increase bank
funds, 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

16


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 How

open market operations affect interest rates
(cont’d)






As yields on bank deposits and Treasuries decline, investors
look for alternative securities
The yields on the alternative investments will decline as
more money is invested in them
The reduction in yields on debt securities lowers the cost of
borrowing for the issuers of debt securities


Can encourage potential expenditures

17


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 Dynamic

vs. defensive open market
operations
Dynamic operations are implemented to increase
or decrease the level of funds
 Defensive operations offset the impact of other
conditions that affect the level of funds


18


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 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 commercial
banks 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
19


Monetary Policy Tools (cont’d)


Open market operations (cont’d)
 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

20


Monetary Policy Tools (cont’d)


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
21


Monetary Policy Tools (cont’d)


Adjusting the discount rate (cont’d)
 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

22


Monetary Policy Tools (cont’d)


Adjusting the discount rate (cont’d)
 Recently,

the Fed has often adjusted the discount rate
to keep it in line with changes in the targeted federal
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
Fed’s monetary policy

23


Monetary Policy Tools (cont’d)


Adjusting the reserve requirement ratio
 The

reserve requirement ratio is 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 can
be lent out

24


Monetary Policy Tools (cont’d)


Adjusting the reserve requirement ratio
(cont’d)
 How

reserve requirement adjustments affect
money 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
25


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