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.

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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

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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

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Organization of the Fed (cont’d)
 Federal Reserve district banks
 There are 12 Federal Reserve district banks
 The NY bank is the most important
 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
 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

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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

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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 even-
numbered year
 Main roles:
 Regulate commercial banks
 Control monetary policy

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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

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Organization of the Fed (cont’d)
 Advisory committees
 The Federal Advisory Council consists of one member from
each district
 Makes recommendations to the Fed about economic and banking
issues
 The Consumer Advisory Council consists of up to 30 members
 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

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Integration of Federal Reserve
Components
Board of Governors
•Regulates member
Advisory banks and BHCs
Committee •Sets reserve
requirements
Federal Open
Market Committee
•Conducts open
Supervision
market operations

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

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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 short-
term loans to each other

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Monetary Policy Tools (cont’d)
 Open market operations (cont’d)
 Role of the Trading Desk
 The manager of the Trading Desk instructs traders
on the amount of government securities to buy or
sell in the secondary market
 This is called open market operations
 The Trading Desk continuously conducts open
market operations in response to ongoing changes
in bank deposit levels

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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
 Dealers provide a list of securities for sale
 Traders purchase those that are most attractive
 The total funds of commercial banks increase by the dollar
amount of securities purchased by the Fed
 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

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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
 Sold to the dealer submitting the highest bid
 As dealers pay, their account balances are reduced and the
total amount of funds at commercial banks is reduced
 A tightening of the money supply
 To force an increase in the Fed funds rate, the Trading Desk
can also sell Treasury securities

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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

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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

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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

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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

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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

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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

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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

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Monetary Policy Tools (cont’d)
 Adjusting the discount rate (cont’d)
 InJanuary 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

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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

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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

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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

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Monetary Policy Tools (cont’d)
 Comparison of monetary policy tools
 The most frequent monetary policy tool is open
market operations
 Open market operations can be used without signaling the
Fed’s intentions and can be easily reversed
 Adjustments in the discount rate only work if depository
institutions respond to the adjustment
 Adjustments in the reserve requirement ratio can cause
erratic shifts in the money supply

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Impact of Technical Factors on
Funds
 The volume of funds can change without the
Fed’s intervention because of:
 Federal Reserve float
 The amount of checks credited to banks’ funds that have not
yet been collected
 Currency in circulation
 Staff at the NY Fed and the Board of Governors
provide daily forecasts of how technical factors
will affect the level of funds

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Fed Control of the Money Supply

 The Fed must decide what form of money

to manipulate
 The optimal form of money should:
 Be controllable by the Fed
 Have a predictable impact on economic variables

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Fed Control of the Money Supply
(cont’d)
 M1 includes currency held by the public and
checking deposits
 M1 is the most narrow form of money
 M2 includes everything in M1 plus savings
accounts and small time deposits, money
market deposit accounts (MMDAs), and other
items
 M3 includes everything in M2 plus large time
deposits and other items

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Fed Control of the Money Supply
(cont’d)
 Limitations of controlling money supply
 It
may be difficult for the Fed to simultaneously control
money supply growth and the federal funds rate
 In October 1979 it focused primarily on the money supply
 In the last several years, the Fed focused on maintaining the
federal funds rate within a narrow target range
 In 2000, the Fed reduced its focus on the use of specific
money supply target ranges
 M2 remains in the Index of Leading Economic Indicators

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Monetary Control Act of 1980
 The Depository Institutions Deregulations
and Monetary Control Act (DIDMCA) of 1980
had two objectives:
 To deregulate some aspects of the depository
institutions industry
 To enhance the Fed’s ability to control the money
supply

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Monetary Control Act of 1980
(cont’d)
 DIDMCA mandates that all depository institutions be
subject to the same reserve requirements imposed by
the Fed
 Applies to member and nonmember banks
 All depository institutions must report their deposit
levels promptly to the Fed
 Improves the Fed’s knowledge of the current level of deposits
in the banking system
 DIDMCA allowed all depository institutions that offer
transaction accounts to have access to the discount
window

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Global Monetary Policy
 Central banks of other countries use open
market operations, reserve requirement
adjustment, and adjustments in the interest
rate they charge on loans
 The Fed must consider economic conditions in
other major countries when assessing the U.S.
economy
 Coordinatingmonetary policy may be difficult
because of conflicts of interest

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Global Monetary Policy (cont’d)
 A single Euro zone monetary policy
 On June 1, 2002, the euro replaced the currencies of 12
European countries
 The European Central Bank (ECB) sets monetary policy for
all participating countries
 Objective is to control inflation and to stabilize the value of the
euro
 Impact of the euro on monetary policy
 The interest rate offered on government securities must be
similar across participating countries
 The euro prevents any single country from using a unique
monetary policy

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Global Monetary Policy (cont’d)
 Global central bank coordination
 Sometimes central banks of various countries coordinate
efforts for a common cause
 After September 11, 2001, central banks of various countries
injected money into the banking system to provide more liquidity
 On September 17, 2001, several central banks reduced their
interest rates
 Sometimes central banks have conflicting objectives
 If two countries attempt to weaken their currencies
simultaneously, the exchange rate is subject to conflicting forces

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