Financial Markets and Institutions

13th Edition
by Jeff Madura

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 4 Functions of the Fed
Chapter Objectives

• Describe the organizational structure of the Fed.

• Describe how the Fed influences monetary policy.
• Explain how the Fed revised its lending role in
response to the credit crisis.
• Explain how monetary policy is used in other
countries.

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2
 Overview

As the central bank of the United States, the Fed conducts

national monetary policy in an attempt to achieve full
employment and price stability (low or zero inflation) in the
United States.
• Since the Fed’s monetary policy affects interest rates, it
has a major influence on financial markets and
institutions.

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 Organizational Structure of the Fed (1 of 8)

The Fed as it exists today has five major components:

• Federal Reserve district banks
• Member banks
• Board of Governors
• Federal Open Market Committee (FOMC)
• Advisory committees

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 Organizational Structure of the Fed (2 of 8)

Federal Reserve District Banks (Exhibit 4.1)

• There are 12 Federal Reserve district banks. New York Fed
is considered the most important.
• Commercial banks purchase stock in their Federal Reserve
district bank to become members. The stock pays a
maximum dividend of 6% annually.
• Each Fed district bank has nine directors.
• Facilitate operations within the banking system by clearing
checks, replacing old currency, and providing loans
(through the discount window) to depository institutions in
need of funds.

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 Exhibit 4.1 Locations of Federal Reserve
District Banks

Source: Federal Reserve Bulletin.

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 Organizational Structure of the Fed (3 of 8)

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.

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 Organizational Structure of the Fed (4 of 8)

Board of Governors
• The Federal Reserve Board is made up of seven
members
• Each member is appointed by the President of the U.S.
and serves a nonrenewable 14-year term.
• One of the seven board members is selected by the
President to be the Federal Reserve Chairman for a
4-year renewable term.
• One of the seven board members is designated by the
President to be the Vice Chairman for Supervision
according to the Financial Reform Act of 2010.

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 Organizational Structure of the Fed (5 of 8)

Federal Open Market Committee (FOMC)

• Made up of the seven members of the Board of Governors
plus the presidents of five Fed district banks (the New York
district bank plus 4 of the other 11 Fed district banks as
determined on a rotating basis).

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 Organizational Structure of the Fed (6 of 8)

Advisory Committees
• Federal Advisory Council consists of one member from each
Federal Reserve district who represents the banking industry.
Meets with the Board of Governors in Washington, D.C., at least
four times a year and makes recommendations about economic
and banking issues.
• Community Depository Institution Advisory Council (CDIAC,
formerly called Thrift Institutions Advisory Council) consists of 12
members who represent savings banks, S&Ls, and credit unions.
Meets with the Board of Governors twice a year.
• Community Advisory Council consists of 15 members who offer
diverse views on economic circumstances and the financial
services needs of consumers and communities, with particular
emphasis on low- and moderate-income populations. Meets with
the Board of Governors twice a year.

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 Organizational Structure of the Fed (7 of 8)

Integration of Federal Reserve Components

• Exhibit 4.2 shows the relationship among the various
components of the Federal Reserve System.
• Advisory committees advise the board.
• The board oversees operation of the district banks.

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 Exhibit 4.2 Integration of Federal Reserve
Components

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 Organizational Structure of the Fed (8 of 8)

Consumer Financial Protection Bureau

• Established as a result of the Financial Reform Act of 2010.
• Responsible for regulating financial products and services,
including online banking, certificates of deposit, and
mortgages.

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 Fed Controls the Money Supply (1 of 7)

Fed implements monetary policy with the goals of achieving full

employment, low or zero inflation, and moderate long-term interest
rates. Through its monetary policy, the Fed can influence the U.S.
economy in multiple ways.
• First, the Fed’s monetary policy affects interest rates, it has a strong
influence on the cost of borrowing by households and thus affects
the amount of monthly payments on mortgages, car loans, and other
loans.
• Second, monetary policy affects the cost of borrowing by
businesses, thereby influencing how much money businesses are
willing to borrow to support or expand their operations.
• Third, because the Fed’s monetary policy affects interest rates and
therefore the return that is required by investors on investments, it
can influence the prices of debt and equity securities.
In these ways, the Fed’s monetary policy can have a major impact on
households, businesses, and investors.
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 Fed Controls the Money Supply (2 of 7)

Decision Process- The FOMC meets eight times a year, sets

targets for the money supply growth level and the interest rate
level, and implements monetary policy.
• Pre-meeting economic report (Beige book) — a consolidated
report of regional economic conditions in each district.
• Economic presentations — Presentations include data and
trends for wages, consumer prices, unemployment, GDP,
business inventories, foreign exchange rates, interest rates, and
financial market conditions.
• FOMC decisions — each member can offer recommendations
regarding the federal funds rate target. (Exhibit 4.3)
• FOMC Statement — a statement that summarizes their
conclusion.
• Minutes of FOMC Meeting — provided to the public and are also
accessible on Federal Reserve websites.
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 Exhibit 4.3 Federal Funds Rate over Time

Source: Board of Governors, Federal Reserve.

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 Fed Controls the Money Supply (3 of 7)

Role of the Fed’s Trading Desk — If a change in monetary

policy is appropriate, the FOMC decision is forwarded to the
Trading Desk (Open Market Desk) at the NY Fed through a
policy directive.
• Fed purchase of securities — To lower the federal funds rate,
traders purchase Treasury securities from securities dealers. The
dealers’ bank account balances increase, causing an increase in
the supply of funds.
• Fed sale of securities — To increase the federal funds rate,
traders sell government securities to government securities
dealers. As the dealers pay for the securities, their bank balances
decrease, leading to a decrease in the supply of funds.
• Dynamic versus Defensive Open Market Operations— The
Trading Desk’s open market operations to either reduce or
increase the federal funds rate are classified as dynamic, because
they are intended to have a lasting impact on economic conditions.
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 Fed Controls the Money Supply (4 of 7)

Control of M1 versus M2(Exhibit 4.4)

The optimal form of money should (1) be controllable by
the Fed and (2) have a predictable impact on economic
variables when adjusted by the Fed.
• M1 includes currency held by the public and checking
deposits (such as demand deposits, NOW accounts, and
automatic transfer balances) at depository institutions.
• M2 includes everything in M1 as well as savings accounts
and small time deposits, MMDAs, and some other items.
• M3 includes everything in M2 in addition to large time
deposits and other items.

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 Exhibit 4.4 Comparison of Money Supply
Measures

MONEY SUPPLY MEASURES

M1 = currency + checking deposits
M2 = M1 + savings deposits, MMDAs, overnight
repurchase agreements, Eurodollars, and small time
deposits
M3 = M2 + institutional money market mutual funds, large
time deposits, and repurchase agreements and Eurodollars
lasting more than one day

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 Fed Controls the Money Supply (5 of 7)

How Fed Operations Affect All Interest Rates

Even though the Fed focuses solely on controlling a targeted
federal funds rate, it has a major influence on all types of interest
rates, which means it also has a major influence on economic
conditions.
• When the Fed increases the supply of funds in the banking
system by purchasing Treasury bills, banks have more funds
available, and this should naturally place downward pressure on
the federal funds rate
• When the Fed buys Treasury bills as a means of increasing the
money supply, it places upward pressure on those securities’
market prices.
• Thus, the Fed’s open market operations reduce not only the
federal funds rate, but also the rates (or yields) on bank deposits,
bank loans, T-bills, and other short-term debt securities.
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 Fed Controls the Money Supply (6 of 7)

Adjusting the Reserve Requirement Ratio

• The Reserve Requirement is the proportion of bank deposit
accounts that must be held as required reserves or funds held
in reserve. This ratio is set by the Fed’s Board of Governors.
• Since the reserve requirement ratio affects the degree to
which the money supply in the banking system can change in
response to an injection of new deposits, it should be
considered as a monetary policy tool.
• However, an adjustment in the reserve requirement ratio could
cause erratic shifts in the money supply. Consequently, the
Fed normally relies on open market operations rather than
adjustments in the reserve requirement ratio when controlling
the money supply.

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 Fed Controls the Money Supply (7 of 7)

The Fed’s Loan Rate

• The Fed maintains a lending facility through which it
provides short-term loans to depository institutions.
• It charges a lower interest rate (called the primary credit
rate) to the most creditworthy depository institutions and
a higher interest rate (called the secondary credit rate) to
depository institutions that not as creditworthy.
• The Fed no longer considers its lending facility as a
potential monetary policy tool, since its open market
operations are more effective at controlling money
supply. Nevertheless, the lending facility can still be an
important source of liquidity for some depository
institutions.
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 The Fed’s Intervention During the Credit
Crisis (1 of 2)

Fed loans to facilitate rescue of Bear Stearns

• During the crisis, the Fed provided funding through the discount
window.
• Bear Stearns, a non-depository institution, was able to borrow at
the discount window through a loan to J.P. Morgan Chase.
The Fed’s Strategy of Quantitative Easing
• Fed purchases of mortgage-backed securities
• In 2008, the Fed created various facilities that provided loans to
financial institutions that purchased particular types of debt
securities. In 2010, the Fed closed most of these facilities.
• Fed purchase of bonds backed by loans
• Term Asset-Backed Security Loan Facility (TALF) — created to
provide financing to financial institutions purchasing high-quality
bonds backed by consumer loans, credit card loans, or
automobile loans.
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 The Fed’s Intervention During the Credit
Crisis (2 of 2)

The Fed’s Strategy of Quantitative Easing (continued)

• Fed’s purchase of commercial paper
• Normally did not purchase commercial paper.
• Implemented in 2008-2009 to offset the reduction in market
demand due to investors fears of defaults.
• Fed’s purchase of long-term Treasury securities
• Purchased large amounts in 2010 to reduce long-term
Treasury bond yields.
Perceptions of Fed intervention during the crisis
• Most agree that the Fed took much initiative.
• Many disagree on what steps the Fed should have taken.

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 Global Monetary Policy (1 of 3)

Each country has its own central bank that controls the
money supply and monetary policy.
• Central banks of other industrialized countries use open
market operations and reserve requirement adjustments as
monetary policy tools.
• The Fed must consider economic conditions in other
countries when assessing the U.S. economy.

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 Central Bank of Bangladesh

VISION

“To develop continually as a forward-looking central bank with competent and committed professionals
of high ethical standards, conducting monetary management and financial sector supervision to maintain
price stability and financial system robustness, supporting rapid broad based inclusive economic growth,
employment generation and poverty eradication in Bangladesh.”

MISSION

• Formulating Monetary And Credit Policies;

• Managing Currency Issue And Regulating Payment System;
• Managing Foreign Exchange Reserves And Regulating The Foreign Exchange Market;
• Regulating And Supervising Banks And Financial Institutions, And Advising The Government
On Interactions And Impacts Of Fiscal, Monetary And Other Economic Policies.

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 Core functions

BB formulates and implements monetary policy aiming at stabilising domestic

monetary value and maintaining competitive external per value of taka for fostering
growth and development of country's productive resources in the best national interest;

BB formulates and implements intervention policies in the domestic money market

and foreign exchange market. BB intervenes the money market with some policy
instruments such as

• open market operation (treasury bills/bonds, repo, reverse repo auctions),

• variations in reserve ratios such as cash reserve requirements (CRR) and statutory liquidity ratio (SLR)
• secondary trading,
• discounting rate/ bank rate, and
• moral suasion;

BB monitors and supervises scheduled banks and non-bank financial instructions

(NBFIs) that include off-site supervision and on-site supervision in order to enhance
the safety, soundness, and stability of the banking system to ensure banking discipline,
protect depositors' interest and retain confidence in the banking system;

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 Core functions of BB

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 Overview of BB

• Monetary Policy: The main objectives of monetary policy

of Bangladesh Bank are:
• Price stability both internal & external
• Sustainable growth & development
• High employment
• Economic and efficient use of resources
• Stability of financial & payment system

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 Reserve Management Strategy

• Bangladesh Bank maintains the foreign exchange

reserve of the country in different currencies to minimize
the risk emerging from widespread fluctuation in
exchange rate of major currencies and very irregular
movement in interest rates in the global money market.
BB has established Nostro account arrangements with
different Central Banks. Funds accumulated in these
accounts are invested in Treasury bills, repos and other
government papers in the respective currencies. It also
makes investment in the form of short term deposits with
different high rated and reputed commercial banks.

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30 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Interest Rate Policy

• Under the Financial sector reform program, a flexible

interest policy was formulated. According to that, banks
are free to charge/fix their deposit (Bank /Financial
Institutes) and Lending (Bank /Financial Institutes) rates
other than Export Credit. Yet, banks can differentiate
interest rate up to 3% considering comparative risk
elements involved among borrowers in same lending
category.

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 Exchange Rate Policy

• The exchange rate policy of Bangladesh Bank aims at

maintaining the competitiveness of Bangladeshi products
in the international markets, encouraging inflow of wage
earners' remittances, maintaining internal price stability,
and maintaining a viable external account position. Under
the existing floating exchange rate regime (that started
from 31/05/2003), the interbank foreign exchange market
sets the exchange rates for customer transactions and
interbank transactions based on demand-supply
interplay; However, along with intervention in the taka
money market, the US dollar purchase or sale
transactions take place by the Bangladesh Bank as
needed, to maintain orderly market conditions.

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34 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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35 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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36 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 https://www.adb.org/sites/default/files/publication/762161/sawp-
086-monetary-policy-transmission-mechanism-bangladesh.pdf

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37
 https://archive.dhakatribune.com/business/banks/2020/04/12/b
b-raises-adr-by-2-to-boost-investment

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38
 Additional Resources

https://wedocs.unep.org/bitstream/handle/20.500.11822/9769/
Monetary_Policy_and_Sustainability_The_Case_of_Banglades
h.pdf?sequence=3&isAllowed=y

https://cpd.org.bd/wp-content/uploads/2021/08/Presentation-
CPDs-Reaction-on-MPS-FY2021-22.pdf

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39
 Global Monetary Policy (2 of 3)

A Single Eurozone Monetary Policy

• The European Central Bank (ECB), based in Frankfurt, is
responsible for setting monetary policy for all European
countries that use the euro. The ECB’s monetary goals are
price and currency stability.
• Impact of the Euro on Monetary Policy
• Any changes in the money supply affect all European
countries that use the euro.
• Prevents participating countries from solving local economic
problems using their own unique economic policies.

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40 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Global Monetary Policy (3 of 3)

Limitations of Monetary Policy in the Eurozone

• Because all countries participating in the eurozone are
subject to the monetary policy imposed by the ECB, each
participating country no longer has full control over the
monetary policy implemented within its borders at any
given time. Thus, any participating country cannot solve
local economic problems with its own monetary policy.
• The monetary policy implemented by the ECB in a
particular period may enhance economic conditions in
some countries and adversely affect others

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41 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (1 of 3)

• The key components of the Federal Reserve System are

the Board of Governors and the Federal Open Market
Committee. The Board of Governors determines the
reserve requirements on account balances at depository
institutions. It is also an important subset of the Federal
Open Market Committee (FOMC), which determines U.S.
monetary policy. The FOMC’s monetary policy has a
major influence on interest rates and other economic
conditions.
• The Fed uses open market operations (the buying and
selling of securities) as a means of adjusting the money
supply. The Fed purchases securities to increase the
money supply and sells them to reduce the money
supply.
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42 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (2 of 3)

• In response to the credit crisis, the Fed provided indirect

funding to Bear Stearns (a large securities firm) so that it
did not have to file for bankruptcy. In an effort to
stimulate the economy and lower long-term interest
rates, the Fed engaged in quantitative easing, which
involved purchasing long-term Treasury securities and
risky debt securities such as mortgage-backed securities.
It also purchased commercial paper issued by
corporations. In addition, the Fed created various
facilities for providing funds to financial institutions and
other corporations.

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43 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (3 of 3)

• Each country has its own central bank, which is

responsible for conducting monetary policy to achieve
economic goals such as low inflation and low
unemployment. Sixteen countries in Europe have
adopted a single currency, which means that all of these
countries are subject to the same monetary policy.

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