Chapter 4

Functions of the Fed

Organization of the Fed (pp.74-77)

 The Federal Reserve System (the FED) is the Central Bank of the U.S.
 It has five major components:
• Federal Reserve district banks
• Member banks
• Board of Governors
• Federal Open Market Committee (FOMC)
• Advisory committees

 Federal Reserve District Banks

 There are 12 Federal Reserve district banks

− The New York district bank is considered the most important because
many large banks are located in this district.

 Commercial banks that become members of the Fed must purchase stock in their
Federal Reserve district banks
− This stock, which is not traded in a secondary market, pays a maximum
dividend of 6% annually

 Each Fed district bank has nine directors

− Six are elected by member banks in that district ( 3 are professional
bankers & 3 are businesspeople); the other 3 are appointed by the Board of
Governors
− The nine directors appoint the president of their Fed district bank

 Fed District banks facilitate operations within the banking system. They:
− clear checks,
− replace old currency,
− provide loans (through the discount window) to depository institutions in
need of funds, and
− conduct research on commercial banking and economic trends

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 Fed Member Banks
• Commercial banks can elect to become member banks if they meet specific
requirements of the Board of Governors

• 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

 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 nonrenewable 14-year terms

− This long term reduces political pressure on the governors
− Terms are staggered so that one term expires in every even-numbered year

• The Fed Board has two main roles:

− Regulate commercial banks
− Control monetary policy

 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
− The New York district bank plus four of the other 11 Fed district banks
on a rotating basis

• The main goals of the FOMC are:

− promote high employment,
− economic growth, and
− price stability

• The FOMC attempts to achieve its goals 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

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 Advisory Committees

• Federal Advisory Council: consists of one member from each Fed district
− This council makes recommendations to the Fed about economic and
banking issues

• Consumer Advisory Council: consists of up to 30 members

− This council represents the financial institutions industry and its
consumers

• Thrift Institutions Advisory Council: consists of 12 members, representing

savings banks, S&L associations, and credit unions
− This council offers views on issues specifically related to thrift institutions

Integration o
Components

Advisory 3
How the FED Controls Money Supply (pp.77-83)
The Fed can use three monetary policy tools to either increase or decrease the money supply:
1. Open Market Operations
2. Adjustments in the Discount Rate
3. Adjustments in the Reserve Requirement Ratio

 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

 Actions are taken to implement the monetary policy dictated by the FOMC

 Pre-Meeting Economic Report & Economic Presentations

• FOMC members receive the Beige Book two weeks prior to the meeting

• The Beige Book is a consolidated report of regional economic conditions

in each of the 12 districts

• Each Fed district bank is responsible for reporting its regional economic
conditions, all these reports are consolidated to compose the Beige Book

• Meeting is attended by the Board of Governors, the 12 presidents of the

Fed district banks, and staff members (typically economists of the Board
of Governors)

• 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

• The FOMC’s decision on target money supply levels is forwarded to the

Trading Desk at the New York district bank through a policy directive

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 • FOMC objectives are specified in the form of a target range (for example
an annualized growth rate of 3-5 % in the money supply over the next few
months, rather than one specific money supply level

• The FOMC also specifies a desired target for the federal funds rate (the
rate charged by banks on short-term loans to each other)

• Even though this rate (federal funds rate) is determined by the banks that
participate in the federal funds market, it is subject to the supply and
demand for funds in the banking system

• Thus, the Fed can influence the federal funds rate by revising the amount
of funds in the banking system

 Role of the Fed’s Trading Desk

• After receiving the policy directive from the FOMC, the manager of the
Trading Desk instructs traders who work at that desk on the amount of
government securities to buy or sell in the secondary market based on the
directive
− This is called open market operations

• The Trading Desk continuously conducts open market operations in

response to ongoing changes in bank deposit levels to maintain the money
supply within the specified target range

 Fed purchase of securities

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

securities
− Dealers provide a list of securities for sale
− Traders purchase those that are most attractive (lowest prices)

• When the Fed purchases securities through the government securities

dealers, the account balances of the dealers are credited with this amount

• Thus, the total amount of funds at the dealers’ banks increase

• The total funds of commercial banks increase by the dollar amount of

securities purchased by the Fed
− This activity is referred to as loosening of the money supply
growth

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 • To force a decline in the Fed funds rate, the Trading Desk can also
purchase Treasury securities until it reduces the federal funds to a new
targeted level
− As the supply of funds in the banking system increases, the Fed
funds rate declines along with other interest rates
• The Fed’s purchase of government securities has a different impact than a
purchase by another investor would have

− The Fed’s purchase results in additional bank funds and increases

the ability of banks to make loans and create new deposits in the
banking system

− An increase in funds can allow for a net increase in deposit

balances and therefore an increase in the money supply

− The purchase of government securities by someone other than the

Fed (such as an investor) results in offsetting account balance
positions t commercial banks

 Fed sale of securities

• To decrease the money supply, traders sell government securities

(obtained from previous purchases) to government securities dealers
− The securities are sold to the dealers that submit the highest bid

• As dealers pay, their account balances are reduced and the total amount of
funds at commercial banks is reduced
− This activity is referred to as a tightening of the money supply
growth

• To force an increase in the Fed funds rate, the Trading Desk can also sell
Treasury securities
− This creates a shortage of funds in the banking system
− Consequently, the federal funds rate increases along with other
interest rates

 Fed use of repurchase agreements

• Used to increase the aggregate level of bank funds for only a few days to
ensure adequate liquidity in the banking system
• The Trading Desk trades repurchase agreements rather than government
securities

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 − 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 in the level of

bank funds

 How Open Market Operations Affect Interest Rates

• Even though most interest rates are market determined, the Fed can have a
strong influence on these rates by controlling the supply of loanable funds

• When the Fed uses open market operations to increase bank funds, banks
have more funds that can be loaned out,

• This can influence various market-determined interest rates because:

− The fed funds rate may decline because some banks have a larger
supply of excess funds to lend out in the federal funds market

− Banks with excess funds may offer new loans at a lower interest
rate in order to make use of these funds

− Banks may lower interest rates offered on deposits because they

have more than adequate funds to conduct existing operations

− Since open market operations (OPO) involve the buying and

selling of Treasury bills, the yields on Treasury securities are
influenced along with the interest rates offered on bank deposits

− For example, when the Fed buys T-bills to increase the money
supply, it places upward pressure on their prices
− Since T-bills offer a fixed value to investors at maturity, a higher
price translates into a lower yield for investors who buy them and
hold until maturity

− Thus the yield on Treasury securities may decline

• As the yields on bank deposits and Treasury bills decline, investors look
for alternative investments such as other debt securities

• The yields on the alternative investments will decline as more money is

invested in them

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 • Thus, OPO used to increase bank funds influence not only bank deposit
and loan rates but also the yields on other debt securities

• The reduction in yields on debt securities lowers the cost of borrowing for
the issuers of debt securities
− This can encourage potential borrowers to borrow and make
expenditures

 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

 Open market operations in response to economic conditions

− During the 2001-2003 period, when economic conditions were weak, the
Fed frequently used open market operations to reduce interest rates.

− During the 2004-2007 period, when the economy improved, and the Fed’s
concern shifted from a weak economy to high inflation, the Fed frequently
used open market operations to raise interest rates over this period.

 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

• How reserve requirement adjustments affect money growth

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 − 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

 Adjusting the Fed’s Loan Rate (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

• 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

• 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