Chapter 4: The Federal Reserve System, Monetary Policy and Interest Rates

Federal Reserve
also called “Fed”
is the CENTRAL BANK of the United STATES.
Founded by the Congress under the Federal Reserved Act of 1913.
It’s original duties were to provide the nation with a safer, more flexible, and more stable
monetary and financial system.

Major Functions of the Federal Reserve System

1. Conducting Monetary Policy
2. Supervising and Regulating Depository Institutions
3. Maintaining the stability of the financial system
4. Providing payment and other financial services to the U.S. Government, the public,
financial and foreign official institutions

The Federal Reserve System

Is divided into 12 Federal Reserve districts that are the “operating arms” of the central
banking system
In terms of total assets, the three largest Federal Reserve Banks are the NEW YORK,
CHICAGO and SAN FRANCISCO banks. It holds the 50% of TOTAL ASSETS of the
FEDERAL RESERVE SYSTEM.
New York is basically most important among the three because so many of the largest U.S.
and international banks are located in New York.
Federal Reserve banks operates as non-profit organizations. They generate income
primarily from three sources:
1. Interest earned on government securities acquired in the course of Federal Reserve.
2. Interest earned on reserves that banks are required to deposit at the Fed
3. Fees from the provision of payment and other services to member depository
institutions.

Federal Open Market Committee (FOMC)

The major monetary policy-making body of the Federal Reserve System.

Open Market Operations

 Purchases and sales of U.S. government and federal agency securities by the Federal
Reserve.

Functions performed by the Federal Reserve Banks

1. Assistance in conduct of monetary policy-Federal Reserve Bank presidents serve on the
Federal Open Market Committee (FOMC). FRBs set and change discount rates.
 Discount Rate- the interest on loans made by Federal Reserve Banks to depository
institutions.
Chapter 4: The Federal Reserve System, Monetary Policy and Interest Rates

 Discount Window- the facility through which Federal Reserve Banks issues loans to
depository institutions.
2. Supervision and Regulation- Federal Reserve Banks have supervisory and regulatory
authority over the activities of banks located in their district.
3. Consumer protection and community affairs-Federal Reserve Banks write regulations
to implement many of the major consumer protection laws and establish programs to
promote community development and fair and impartial access to credit.
4. Government Services-Federal Reserve Banks serves as the COMMERCIAL BANK for
the U.S. Treasury
5. New Currency Issue-Federal Reserve Banks are responsible for the collection and
replacement of damaged currency from circulation.
6. Check Clearing-Federal Reserve Banks process, route, and transfer funds from one bank
to another as checks clear through the Federal Reserve System.
7. Wire transfer services-Federal Reserve Banks and their member banks are linked
electronically through the Federal Reserve Communications System.
8. Research services-Each Federal Reserve Banks has a staff of professional economists who
gather, analyze and interpret economic data and developments in the banking sector in their
district and economywide.
Chapter 4: The Federal Reserve System, Monetary Policy and Interest Rates

Reserves
 Depository institutions’ vault cash plus reserves deposited at the Federal Banks
Monetary Base
 Currency in circulation and reserves (depository institution reserves and vault cash
of commercial banks) held by the Federal Reserve.
Reserve Deposits
 The largest liability on the Federal Reserve’s Balance Sheet.
 Reserve accounts also influence the size of money supply.
Two (2) Categories of TOTAL RESERVES
1. Required Reserves- Reserves the Federal Reserve requires banks to hold.
2. Excess Reserves- Additional reserves banks chose to hold.
Fed Fund’s Interest Rate
 The interest rate on short-term funds transferred between financial institutions,
usually for a period of one day.
Federal Reserve Board Training Desk
 Unit of the Federal Reserve Bank of New York through which open market
operations are conducted.
Policy Directive
 Statement sent to the Federal Reserve Board Training Desk from the FOMC that
specifies the money supply target.

Monetary Policy Tools

1. Open Market Operations- Particularly important because they are the primary
determinant of changes in bank excess reserves in the banking system and thus directly
impact the size of the money Supply
 Repurchase Agreements- Open market transactions in which the Trading
Desk purchases government securities with an agreement that the seller will
repurchase them within a stated period of time.

2. Discount Rate- is the second monetary policy tool or instrument used by the Federal
Reserve to control the level of bank reserves (and thus the money supply or interest
rates)
Chapter 4: The Federal Reserve System, Monetary Policy and Interest Rates

 It is also the rate of interest Federal Reserve Banks charge on loans and to
financial institution in their district.
 Is like a signal of the FOMC’s intentions regarding the tenor of monetary
Policy.
 Lowering the discount rates signals a desire to see more expansionary
monetary conditions and lower interest rates in general.
 Federal Reserve has rarely used the discount rate as a monetary policy
tool. It has two main reasons:
1. It is difficult to predict changes in bank discount window borrowing when
the discount rate changes.
2. Signaling importance.
3. Reserve Requirements- a portions of deposits that banks must hold in cash, either
in their vaults or on deposit at a Reserve Bank.
 A decrease in the reserve requirement ratio means that depository institutions
may hold fewer reserves against their transaction accounts.
 An increase in reserve requirements is contradictory because it reduces the
funds available in the banking system to lend to consumers and businesses.
 The Board of Governors has sole authority over changes to reserve
requirements.
 The Fed rarely Changes reserve Requirements.
 A decrease in the reserve requirement results in a multiplier increase in the
supply of bank deposits and thus the money supply. The multiplier effect can
be written as follows:
Change in bank deposits= (1/new reserve requirement) x Increase in
reserves created by reserve requirement change.

4. Interest on Reserves- is the newest and most frequently used tool given to the Fed
by Congress after the Financial Crisis of 2007-2009.
 Is paid on excess reserves held at Reserve Banks.

Effect of Monetary Tools on Various Economic Variables

Chapter 4: The Federal Reserve System, Monetary Policy and Interest Rates

1. Expansionary Activities
2. Contractionary Activities
Money Supply versus Interest Rate Tagging
 The relationship between interest rate and money supply is all else being
equal, a larger money supply lowers market interest rate.
 Conversely, smaller money supplies tend to raise market interest rates.
Systemwide Rescue Programs Employed During the Financial Crisis
1. Expansion of retail deposit insurance
 Increased retail bank deposit insurance coverage was widely used during the
crisis to ensure continued access to deposit funding.
2. Capital Injection
 Direct injections of capital by central governments were the main mechanism
used to directly support bank balance sheets. Governments increased banks’
capital by injecting combinations of common shares, preference shares,
warrants, subordinated debt, mandatory convertible notes, or silent
participations. These capital injections improved bank’s abilities to absorb
additional losses and strengthened protection for banks’ uninsured creditors.
 It allows the bank to increase their lending.
3. Debt Guarantees
 As financial market froze, so did the wholesale funding market used by banks
to support lending activities. In response to these events, government
announced state guarantees on bank wholesale debt.
 Governments provided explicit guarantees against default on uninsured bank
liabilities.
 It allowed the banks to maintain access to reasonably priced, medium term
funding.
 They also reduced liquidity risk and lowered overall borrowing costs for
banks.
4. Asset purchases or guarantees
 Asset purchase programs removed distressed assets from balance sheets.
 Asset purchase and guarantee programs were not used extensively. A main
reason for this is that it was difficult to determine the price at which the
central bank would purchase the distressed assets.
 A purchase price set too close to par effectively amounted to a covert
recapitalization of the bank.