Chapter Four

The Federal Reserve System,

Monetary Policy, and
Interest Rates
The Federal Reserve
• Founded by Congress under the Federal Reserve
Act in 1913
• Subject to oversight by Congress under its
authority to create money
• An independent central bank–its decisions do
not have to be ratified by the President or
Congress
• Congressional oversight

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Functions of the Federal Reserve

• Conduct monetary policy

• Supervise and regulate depository

institutions

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Functions of the Federal Reserve
• Maintain financial system stability
• The Wall Street Reform and Consumer Protection Act
of July 2010 requires the Fed to supervise complex
financial institutions that could generate systemic risk
to the economy.
• The Fed has now been given broader powers to seize
or break up institutions whose actions could harm the
economy.

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Functions of the Federal Reserve

• Maintain financial system stability

• Implementing federal laws designed to protect
consumers in credit and other financial transactions
• Implementing regulations to ensure compliance,
investigating complaints, and ensuring availability
of services to low and moderate income groups
and certain geographic regions

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Functions of the Federal Reserve

• Provide payment and other financial services to

the U.S. government, the public, FIs, and
foreign official institutions

• Payments are increasingly electronic in nature.

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Structure of the Federal Reserve
• Divided into 12 Federal Reserve districts, each with
a main Federal Reserve Bank
• Federal Reserve Banks operate under the general
supervision of the Board of Governors of the
Federal Reserve
• The Office of the Comptroller of the Currency
(OCC) charters national banks, which are members
of the Federal Reserve System (FRS).
• FRS member banks “own” the 12 Federal
Reserve Banks.

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Board of Governors of the FRS
• Seven member board headquartered in
Washington, DC.
• President appoints and Senate confirms members
to nonrenewable 14-year terms.
• President appoints and Senate confirms Chairman
and vice-chairman to renewable 4-year terms.
• Formulates and conducts monetary policy and
supervises and regulates banks.

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Federal Open Market Committee (FOMC)

• FOMC consists of 12 members

• seven members of the Board of Governors
• the president of the Federal Reserve Bank of NY
• the presidents of four other Federal Reserve Banks
(on a rotating basis)

• The monetary policy-making body of the FRS

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Federal Open Market Committee (FOMC)
• Policies seek to promote full employment,
economic growth, price stability, and a sustainable
pattern of international trade
• Are there tradeoffs between these goals?

• Why is international monetary cooperation

necessary?

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Federal Open Market Committee (FOMC)
• The FOMC sets ranges for growth of monetary
aggregates and the fed funds rate, and also directs
operations in FX markets
• Open market operations are the main policy tool used
to achieve monetary targets:
• involve the purchase and sale of U.S. government and
federal agency securities
• are implemented by the Federal Reserve Board Trading
Desk of the New York Federal Reserve Bank

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The Fed and the Crisis

• 2007
• Term Auction Facility
• 2008
• March: Fed facilitates J.P. Morgan Chase purchase of Bear-Stearns
• Term Securities Lending Facility
• Primary Dealer Credit Facility: Expands discount window borrowing to
investment banks
• September: Lehman Brothers collapses, Goldman-Sachs and Morgan
Stanley become commercial banks, Merrill-Lynch is bought by Bank of
America.

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The Fed and the Crisis

• 2008 (continued)
• Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility, the Commercial Paper Funding Facility, the Money
Market Investor Funding Facility and the Term Asset-Backed
Securities Loan Facility (TALF) are created.
• Average weekly lending from the Fed grew from about $59 million
in 2006 to almost $850 billion per week in late 2008.

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The Fed and the Crisis
• August 2006 fed funds rate = 5.25%
• April 2008 fed funds rate = 2.00%
• By year end 2008 target fed funds rate between 0 and 0.25% and the
discount rate was lowered to 0.5%.
• November 2008 -- The Fed announces it would engage in purchasing up to
$600 billion in Treasuries and mortgage-backed securities (quantitative
easing).
• This amount was increased to $1.7 trillion in March 2009.
• November 2010 the Fed announced a new series of bond buying of up to
$600 billion in what has been termed QE2.
• September 2012 began QE3, monthly purchases of Treasuries and mortgage
backed securities, tapering began in 2013.

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Federal Reserve Banks
• Assist in the conduct of monetary policy
• set and change the discount rate (must be approved by the
Board of Governors)
• make discount window loans to depository institutions
• Supervise and regulate FRS member banks
• conduct examinations and inspections of member banks
• issue warnings when banking activity is unsafe or unsound
• approve bank mergers and acquisitions
• Provide government services
• act as the commercial banks of the U.S. Treasury

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Federal Reserve Banks
• Issue new currency
• collect and replace currency in circulation as necessary
• Clear checks
• act as a central clearing system for U.S. banks
• Provide wire transfer services
• Fedwire
• Automated Clearinghouse (ACH)
• Perform banking sector and economic research
• used in the formulation of monetary policy

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Balance Sheet of the Federal Reserve
Balance Sheet of the Federal Reserve
Change over Period
2007 2008 2013 2007-2013
Assets (bill $) % (bill $) % (bill $) % $ %
Gold and Foreign Exchange $34.2 3.6% $35.7 3.8% $34.5 1.1% $0.3 0.9%
SDR Certificates 2.2 0.2% 2.2 0.2% 5.2 0.2% $3.0 136.4%
Treasury Currency 38.7 4.1% 38.7 4.1% 45.0 1.4% $6.3 16.3%
Federal Reserve Float 0 0.0% -1.5 -0.2% -0.6 0.0% ($0.6) na
Loans to Domestic Banks 48.6 5.1% 559.7 58.8% 0.0 0.0% ($48.6) -100.0%
Security Repurchase Agreements 46.5 4.9% 80.0 8.4% 0.0 0.0% ($46.5) -100.0%
U.S. Treasury Securities 740.6 77.9% 475.9 50.0% 1796 55.4% $1,055.4 142.5%
U.S. Government Agency Securities 0.0 0.0% 19.7 2.1% 1143.4 35.2% $1,143.4 na
Miscellaneous Assets 40.5 4.3% 1060.2 111.4% 220.3 6.8% $179.8 444.0%
Total Assets $ 951.3 100% $2,270.6 239% $3,243.8 100% $2,292.5 241.0%

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Balance Sheet of the Federal Reserve
Balance Sheet of the Federal Reserve
Change over Period
2007 2008 2013 2007-2013
Liabilities and Equity (bill $) % (bill $) % (bill $) % $ %
Depository Institution Reserves $20.8 2.2% $860.0 90.4% $1,790.4 55.2% $ 1,035.60 4978.8%
Vault cash of Commercial Banks 55.0 5.8% 57.7 6.1% 59.7 1.8% $ 10.70 19.5%
Deposits due to Fed. Government 16.4 1.7% 365.7 38.4% 79.4 2.4% $ 212.20 1293.9%
Deposits due to government agencies 1.7 0.2% 21.1 2.2% 20.2 0.6% $ 19.20 1129.4%
Currency Outside Banks 773.9 81.4% 832.2 87.5% 1,117.30 34.4% $ 118.20 15.3%
Security Repurchase Agreements 44.0 4.6% 88.4 9.3% 105.5 3.3% $ 57.80 131.4%
Miscellaneous Liabilities 2.5 0.3% 3.4 0.4% 16.2 0.5% $ (36.80) -1472.0%
Federal Reserve Bank Stock 18.5 1.9% 21.1 2.2% 27.6 0.9% $ 10.50 56.8%
Equity 18.5 1.9% 21.0 2.2% 27.5 0.8% $ 8.90 48.1%
Total Liabilities and Equity $951.3 100% $2,270.6 239% $3,243.8 100% $ 1,436.30 151.0%

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Discussion of the Federal Reserve
• What are the implications of the bailouts of the
financial crisis? Is the system safer now or can we
expect another crisis in the future?

• What does it mean to be too big to fail or systemically

risky? Does designating an institution as systemically
risky make the system safer?

• What are the pros and cons of deposit insurance?

Should the U.S. employ unlimited deposit insurance as
some other countries do?

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The Process of Monetary Policy Implementation

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Balance Sheet of the Federal Reserve

currency in circulation + reserves =

monetary base

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Monetary Policy
• Monetary policy affects the macroeconomy by
influencing the supply and demand for excess
bank reserves
• influences the money supply and the level of
short-term and long-term interest rates
• affects foreign exchange rates, the amount of
money and credit in the economy, and the levels
of unemployment, output, and prices

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Monetary Policy
• Open market operations
• policy directive of the FOMC is forwarded to the
Federal Reserve Board Trading Desk at the Federal
Reserve Bank of New York.
• Trading Desk manager buys or sells U.S. Treasury
securities in the over-the-counter (OTC) market,
which keeps the fed funds rate near its desired target.

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Monetary Policy

• Open market operations

• FRBNY acts through the Trading Desk to
implement policy directives each business day.
• operations may be permanent or temporary.
• may use repurchase agreements for temporary
increases or decreases in excess reserves.

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Monetary Policy
• The discount rate is the rate Federal Reserve Banks
charge on loans to depository institutions in their
district.
• The Federal Reserve rarely uses the discount rate as
a policy tool
• discount rate changes are strong signals of the
Federal Reserves intentions.
• there is no guarantee that banks will borrow, nor
that they will lend.

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Monetary Policy
• Reserve requirements are the reserve assets depository
institutions must keep to “back” transaction
deposits
• reserve assets include vault cash and deposits at
Federal Reserve Banks
• The multiplier effect
æ 1 ö
ç
D in money supply = ç ÷÷ ´ D in reserves
è new reserve requirement ratio ø

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Monetary Policy
• Suppose reserves are $2 billion and the Fed
increases reserves by 1% or $20 million when bank
reserve requirements are 10%.
• What is the predicted increase in bank deposits?

æ 1 ö
ç ÷ ´ $20 million = $200 million
è 0.10 ø

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Monetary Policy
• Suppose that instead of changing the $2 billion in
reserves the Fed reduces the reserve requirement
from 10% to 9%.
What is the predicted increase in bank deposits?

New level of excess reserves = 1% of $2 billion = $20 million

æ 1 ö
ç ÷ ´ $20 million = $222 million
è 0.09 ø

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Monetary Policy
• Expansionary monetary policy
• open market purchases of securities by the Fed
• discount rate decreases
• reserve requirement ratio decreases
• Contractionary monetary policy
• open market sales of securities by the Fed
• discount rate increases
• reserve requirement ratio increases

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Targeting Money Supply versus Interest Rate

Interest Interest MS’ MS

Rate Rate

MS
i’=8% iT = 6%
MD’
i*=6%
i’’= 5% MD
i’’=4% MD’
MD MD’’
MD’’
MS Quantity of Money Quantity of Money

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Problems in Conducting Monetary Policy

• Significant time lags involved between policy

implementation and effect

• Supplying money to lenders does not guarantee they will

lend.

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Problems in Conducting Monetary Policy

• Lowering interest rates or supplying money are attempts

to stimulate demand, but they may not work.
• Problems in consumer confidence
• High unemployment
• High debt levels

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Problems in Conducting Monetary Policy

• Excessive money creation may reduce the value of the dollar

and generate inflation.
• Inflation can cause interest rates to increase, hurting growth.
• Loss in confidence of foreign investors could cause higher
interest rates, hurting growth.

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International Monetary Policy
• The Federal Reserve generally allows foreign exchange
rates to fluctuate freely.
• Foreign exchange intervention
• commitments between countries about the institutional
aspects of their intervention in the foreign exchange
markets
• similar to open market purchases and sales of Treasury
securities

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Global Rescue Programs
• Responses by major central banks to the financial crisis:
• Expansion of retail deposit insurance
• Direct injections of capital to improve lender’s balance
sheets
• Debt guarantees
• Asset purchases or asset guarantees
• Stress tests of banks

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