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

Chapter Four The Federal Reserve System, Monetary Policy, and Interest Rates ©McGraw-Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overvi...

Chapter Four The Federal Reserve System, Monetary Policy, and Interest Rates ©McGraw-Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview  Central  banks determine, Central banks determine, implement, implement, and and control control the the monetary monetary policy policy in in their their home home countries countries  The  The Federal Federal Reserve Reserve (the(the Fed) Fed) isis the the central central bank bank of of the the United United States States   Founded Foundedby byCongress Congressunder underFederal FederalReserve ReserveAct Actof of1913 1913   Independent Independentcentral centralbank bank  Duties  Dutiesincorporate incorporatefour fourmajor majorfunctions: functions: 1.1. Conducting Conductingmonetary monetarypolicy policy 2.2. Supervising Supervisingand andregulating regulatingdepository depositoryinstitutions institutions 3.3. Maintaining Maintainingthe thestability stabilityof ofthe thefinancial financialsystem system 4.4. Providing Providingpayment paymentandandother otherfinancial financialservices servicestotothe theU.S. U.S. government, government,the thepublic, public,financial financialinstitutions, institutions,and andforeign foreign official officialinstitutions institutions ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill. 4-2  Structure of the Federal Reserve System (FRS)  12  12 Federal Federal Reserve Reserve Banks Banks in in cities cities throughout throughout the the U.S. U.S.   Each Eachacts actsasasaadepository depositoryinstitution institutionfor forthe thebanks banksin inits itsdistrict district  Operate  Operateunder undergeneral generalsupervision supervisionof ofthe theBoard Boardof ofGovernors Governors  Each  Eachhas hasits itsown own9-member 9-memberboard boardof ofdirectors directors  Nationally  Nationallychartered charteredbanks banksare arerequired requiredtotobecome becomemembers members of ofthe theFRS FRS  7-member  7-member Board Board of of Governors Governors in in Washington, Washington, D.C. D.C.   Each Eachmember memberappointed appointedbybythe thepresident presidentof ofthe theU.S. U.S.and andmust must be beconfirmed confirmedby bythe theSenate Senate  Members  Membersserveserveaanonrenewable, nonrenewable,14-year 14-yearterm term  Primary  Primaryresponsibilities responsibilitiesare arethe theformulation formulationand andconduct conductofof monetary monetarypolicy policyand andthe thesupervision supervisionand andregulation regulationof ofbanks banks ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-3 Federal Reserve Districts ©McGraw Hill LLC. All rights reserved. No 4-4 reproduction or distribution without prior written consent of McGraw Hill 4-4 Federal Open Market Committee (FOMC) FOMC isis the  FOMC  the major major monetary monetary policy-making policy-making body body of of the the Federal Federal Reserve Reserve System System   Required Requiredto tomeet meetat atleast leastfour fourtimes timeseach eachyear yearinin Washington, Washington,D.C., D.C.,but buttypically typicallymeet meetmore moreoften often  Main  Mainresponsibilities responsibilitiesare areto toformulate formulatepolicies policiesto topromote promote full fullemployment, employment,economic economicgrowth, growth,price pricestability, stability,an anda da sustainable sustainablepattern patternofofinternational internationaltrade trade  Set  Setguidelines guidelinesregarding regardingopen openmarket operations,the marketoperations, the purchase purchaseandandsale saleof ofU.S. U.S.government governmentand andfederal federalagency agency securities, securities,as asthe themain mainpolicy policytool toolto toachieve achievemonetary monetary targets targets  Beige  BeigeBook Booksummarizes summarizesinformation informationon oncurrent currenteconomic economic conditions conditionsbybyFederal FederalReserve Reservedistrict district ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-5  Functions Performed by Federal Reserve Banks (FRBs) 1.1. Assistance Assistance in in the the conduct conduct of of monetary monetary policy policy   Set Setand andchange changethe thediscount discountrate rate   Loans Loanstransacted transactedthrough througheach eachFRBs FRBsdiscount discountwindow window 2.2. Supervision Supervision and and regulation regulation   Each EachFRBFRBhashassupervisory supervisoryandandregulatory regulatoryauthority authorityover overthe the activities activitiesof ofstate-chartered state-charteredmember memberbanks banksandandbank bankholding holding companies companieslocated locatedinintheir theirdistricts districts 3.3. Consumer Consumer protection protection and and community community affairs affairs   Possess Possessauthority authorityto toimplement implementfederal federallaws lawsintended intendedto toprotect protect consumers consumersinincredit creditand andother otherfinancial financialtransactions transactions 4.4. Government Government services services   Serves Servesas asthe thecommercial commercialbank bankfor forthe theU.S. U.S.Treasury Treasury ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-6  Functions Performed by Federal Reserve Banks (FRBs) (Continued) 5.5. New New currency currency issue issue   Responsible Responsiblefor forthe thecollection collectionand andreplacement replacementof ofcurrency currency (paper (paperand andcoin) coin)from fromcirculation circulation 6.6. Check Check clearing clearing   Operates Operatesaacentral centralcheck checkclearing clearingsystem systemfor forU.S. U.S.banks, banks,routing routing interbank interbankchecks checkstotoDIs DIson onwhich whichthey theyare arewritten writtenand and transferring transferringthe theappropriate appropriatefunds fundsfrom fromone onebank banktotoanother another 7.7. Wire Wire transfer transfer services services   FRBs FRBsand andmember memberbanks banksare arelinked linkedelectronically electronicallythrough throughthe the Federal FederalReserve ReserveCommunications CommunicationsSystem System 8.8. Research Research services services   Each EachFRB FRBuses usesprofessional professionaleconomics economicsto toconduct conductresearch research ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-7  Balance Sheet of the Federal Reserve  Liabilities  Liabilities   Major Majorliabilities liabilitieson onthe theFed’s Fed’sbalance balancesheet sheetare arecurrency currencyinin circulation circulationand reserves,the andreserves, thesum sumof ofwhich whichisisreferred referredto toas asthe the Fed’s Fed’smonetary monetarybase baseor ormoney moneybase base   Total Totalreserves reservescan canbebeclassified classifiedinto intotwo twocategories: categories: Required reservesare Requiredreserves arethose thosethe theFed Fedrequires requiresbanks bankstotohold holdby bylaw   law  Excess reservesare Excessreserves areadditional additionalover overand andabove aboverequired requiredreserves  reserves  Assets  Assets   Major Majorassets assetsare areTreasury Treasuryandandgovernment governmentagency agency(i.e., (i.e.,Fannie Fannie Mae, Mae,Freddie FreddieMac) Mac)securities, securities,Treasury Treasurycurrency, currency,and andgold goldand and foreign foreignexchange exchange   Interbank Interbankloans loansare areaasmall smallportion portionof oftotal totalassets, assets,but butthey theyplan plan an animportant importantrole roleininimplementing implementingmonetary monetarypolicy policy ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-8 Balance Sheet of the Federal Reserve (Continued) ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-9  Monetary Policy Tools  Federal  Federal Reserve Reserve uses uses the the following following to to implement implement monetary monetary policy: policy:   Open Openmarket marketoperations operations   Discount Discountrate rate   Reserve Reserverequirements requirements  Major  Major link link by by which which monetary monetary policy policy impacts impacts the the macroeconomy macroeconomy occurs occurs through through thethe Federal Federal Reserve Reserve influencing influencing thethe market market for for bank bank reserves reserves  Federal  Federal Reserve’s Reserve’s monetary monetary policy policy seeks seeks to to influence influence either either the the demand demand for,for, or or supply supply of,of, excess excess reserves reserves at at depository depository institutions institutions and and inin turn turn the the money money supply supply and and the the level level of of interest interest rates rates ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-10 Federal Reserve Monetary Policy Activities ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-11  Monetary Policy Tools (Continued)  Depository  Depository institutions institutions trade trade excess excess reserves reserves held held at at their their local local Federal Federal Reserve Reserve Banks Banks among among themselves themselves   Rate Rateof ofinterest interest(or (orprice) price)on onthese theseinterbank interbanktransactions transactionsisisaa benchmark benchmarkinterest interestrate, rate,called calledthe thefed fedfunds fundsrate rate  Financial  Financial Services Services Regulatory Regulatory Relief Relief Act Act of of 2006 2006 authorized authorized the the Federal Federal Reserve Reserve to to pay pay interest interest on on reserve reserve balances balances   Interest Intereston onexcess excessreserves reserves(IOER) (IOER)and andrequired requiredreserves reserves(IORR) (IORR)  Federal  Federal Reserve Reserve can can take take one one of of two two basic basic approaches approaches to to affect affect the the market market for for banks’ banks’ excess excess reserves reserves 1.1. Target Targetthe thequantity quantityofofreserves reservesininthe themarket market 2.2. Target Targetthe theinterest interestrate rateononthose thosereserves reserves(the (thefed fedfunds fundsrate) rate) ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-12  Monetary Policy Tools: Open Market Operations  Open  Open market market operations operations   When Whenaatargeted targetedmonetary monetaryaggregate aggregateor orinterest interestrate ratelevel levelisis determined determinedby bythe theFOMC, FOMC,ititisisforwarded forwardedto tothe theFederal FederalReserve Reserve Board BoardTrading Deskat TradingDesk atthe theFederal FederalReserve ReserveBank BankofofNew NewYorkYork (FRBNY) (FRBNY)through throughaastatement statementcalled calledthe thepolicy policydirective directive   Manager Managerof ofTrading TradingDesk Deskuses usespolicy policydirective directiveto toinstruct instructtraders traders on ondaily dailyamount amountof ofopen openmarket marketpurchases purchasesor orsales salestototransact transact  Open  Open market market operations operations are are the the primary primary determinant determinant of of changes changes in in bank bank excess excess reserves reserves in in the the banking banking system system   Directly Directlyimpact impactthe thesize sizeof ofthe themoney moneysupply supplyand/or and/orthe thelevel levelof of interest interestrates rates(e.g., (e.g.,the thefed fedfunds fundsrate) rate)  Open  Open market market operations operations are are primarily primarily conducted conducted using using Treasury Treasury securities, securities, but but others others can can be be used used as as well well ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-13 Federal Reserve’s Balance Sheet and Large-Scale Asset Purchases ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-14  Monetary Policy Tools: Discount Rate  Recall,  Recall, the the discount discount rate rate isis the the rate rate of of interest interest Federal Federal Reserve Reserve Banks Banks charge charge on on loans loans to to FIs FIs in in their their district district   Raising Raisingthe thediscount discountrate ratesignals signalsaadesire desiretotosee seeaatightening tighteningof of monetary monetaryconditions conditionsand andhigher higherinterest interestrates ratesiningeneral general   Lowering Loweringthe thediscount discountrate ratesignals signalsaadesire desiretotosee seemore more expansionary expansionarymonetary monetaryconditions conditionsand andlower lowerinterest interestrates ratesinin general general  Federal  Federal Reserve Reserve has has rarely rarely used used the the discount discount rate rate as as aa monetary monetary policy policy tool tool for for the the following following reasons: reasons: 1.1. ItItisisdifficult difficultfor forthe theFed Fedto topredict predictchanges changesininbank bankdiscount discount window windowborrowing borrowingwhenwhenthethediscount discountrate ratechanges changes 2.2. Because Becauseof ofits its“signaling” “signaling”importance, importance,aadiscount discountrate ratechange change often oftenhas hasgreat greateffects effectson onthe thefinancial financialmarkets markets ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-15 Various U.S. Interest Rates ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-16  Monetary Policy Tools: Discount Rate (Continued)  Historically,  Historically, discount discount window window lending lending was was limited limited to to depository depository institutions institutions (DIs) (DIs) with with severe severe liquidity liquidity needs needs   Fed Fedmade madechanges changesto todiscount discountwindow windowlending lendingthat thatincreased increasedthethe cost costofofborrowing borrowingbut buteased easedthe theterms termsininJanuary January2003 2003   Three Threelending lendingprograms programsare arenow nowoffered offeredthrough throughthe theFed’s Fed’s discount discountwindow: window:  Primary creditisisavailable Primarycredit availableto togenerally generallysound soundDIs DIson onaavery veryshort-  short- term termbasis, basis,typically typicallyovernight, overnight,at ataarate rateabove abovethe theFederal FederalOpen Open Market MarketCommittee’s Committee’stargettargetrate rateforforfederal federalfunds funds  Secondary Secondarycreditcreditisisavailable availableto tomeet meetbackup backupliquidity liquidityneeds needswhen  when its itsuse useisisconsistent consistentwith withaatimely timelyreturn returntotoaareliance relianceon onmarket market sources sourcesof offunding fundingor orthe theorderly orderlyresolution resolutionof ofaatroubled troubledinstitution institution  Seasonal creditisisavailable Seasonalcredit availableto toDIs DIsthat thatcan candemonstrate demonstrateaaclear  clear pattern patternof ofrecurring recurringintrayearly intrayearlyswings swingsininfunding fundingneeds needs ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-17  Reserve Requirements (Reserve Ratios)  Reserve  Reserve requirements requirements determine determine the the minimum minimum amount amount of of reserve reserve assets assets that that DIs DIs must must maintain maintain byby law law to to back back transaction transaction deposit deposit accounts accounts held held as as liabilities liabilities on on their their balance balance sheets sheets   Requirement Requirementisisusually usuallyset setas asaaratio ratioof oftransaction transactionaccounts accounts   Very Veryrarely rarelyused usedby bythe theFederal FederalReserve Reserveas asaamonetary monetarypolicy policytool tool  A(n)  A(n) decrease decrease (increase) (increase) in in the the reserve reserve requirement requirement ratio ratio means means that that DIs DIs may may hold hold fewer fewer (must (must hold hold more) more) reserves reserves against against their their transaction transaction accounts, accounts, allowing allowing them them to to lend lend out out aa greater greater (smaller) (smaller) percentage percentage ofof their their deposits deposits andand increasing increasing (decreasing) (decreasing) credit credit availability availability in in the the economy economy ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-18  Reserve Requirements (Reserve Ratios) (Continued)  Decrease  Decrease in in the the reserve reserve requirement requirement results results in in aa multiplier multiplier increase increase in in the the supply supply of of bank bank deposits deposits and and thus thus the the money money supply supply   Multiplier Multipliereffect: effect:  Increase  Increase in in the the reserve reserve requirement requirement results results in in aa multiple multiple contraction contraction in in deposits deposits and and aa decrease decrease in in the the money money supply supply   Multiplier Multipliereffect: effect: ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-19 The Process of Monetary Policy Implementation ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-21 Effects of Monetary Tools on Various Economic Variables Expansionary Activities Contractionary Activities  Open market purchases  Open market sales of of securities securities  All else constant, reserve  All else constant, reserve accounts of banks increase accounts of banks  Discount rate decreases decrease  All else constant, interest  Discount rate increases rates in the economy  All else constant, interest decrease rates in the open market  Reserve requirement ratio increase decreases  Reserve requirement ratio  All else constant, bank increases reserves increase  All else constant, bank reserves ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without decrease prior written consent of McGraw Hill 4-22 4-22 The Impact of Monetary Policy on Various Economic Variables 4-23 ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-23  Money Supply versus Interest Rate Targeting  Federal  Federal Reserve Reserve can can successfully successfully target target only only one one of of these these two variables (money two variables (money supply supply or or interest interest rates) rates) at at any any one one moment moment   IfIfthe themoney moneysupply supplyisisthe thetarget targetvariable variableusedusedto toimplement implement monetary monetarypolicy, policy,interest interestrates ratesmust mustbebeallowed allowedto tofluctuate fluctuate relatively relativelyfreely freely   IfIfan aninterest interestrate rate(e.g., (e.g.,fed fedfunds fundsrate) rate)isisthe thetarget, target,bank bankreserves reserves and andthethemoney moneysupply supplymust mustbe beallowed allowedto tofluctuate fluctuaterelatively relativelyfreely freely ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-24 Federal Reserve Monetary Policy Targets ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-25 4-25  Money Supply versus Interest Rate Targeting (Continued)  Fed  Fed announced announced that that itit would would use use interest interest rates—the rates—the federal federal funds funds rate—as rate—as thethe main main target target variable variable to to conduct conduct monetary monetary policy policy in in 1993 1993   Guiding Guidingprinciple principleused usedby bythe theFed Fedto toset setshort-term short-terminterest interestrates ratesisis the theTaylor Taylorrule, rule,which whichstates statesshort-term short-terminterest interestrates ratesshould shouldbe be determined determinedby bythree threeconditions: conditions: 1.1. Where Whereactual actualinflation inflationisisrelative relativeto tothe theFed’s Fed’stargeted targetedlevel level 2.2. The Theextent extenttotowhich whichthetheeconomy economyisisabove aboveororbelow belowits itsfull full employment employmentlevellevel 3.3. What Whatshort-term short-terminterest interestrates ratesshould shouldbe beto toachieve achievefull full employment employment  Under  Underthethecurrent currentregime, regime,the theFed Fedsimply simplyannounces announceswhether whetherthe the federal federalfunds fundsrate ratetarget targethashasbeen beenincreased, increased,decreased, decreased,or orleft left unchanged unchangedafterafterevery everymonthly monthlyFOMCFOMCmeeting meeting ©McGraw Hill LLC. All rights reserved. No reproduction or distribution without prior written consent of McGraw Hill 4-26 Practice problem 1 Practice problem 2