Chapter Four

The Federal
Reserve System,
Monetary Policy,
and Interest Rates
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consent of McGraw-Hill Education.
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 1

Conduct monetary policy.

Supervise and regulate depository institutions.
Provide payment and other financial services to the
U.S. government, the public, FIs, and foreign official
institutions.

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 Functions of the Federal Reserve 2

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 (and others) 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
Concluded
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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 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 (O CC)
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) 1

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 major monetary policy-making body of the FRS.

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 Federal Open Market Committee
(FOMC) 2

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) Concluded
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 1

2007.
• Term Auction Facility (TAF) created.

2008.
• March: Fed facilitates J.P. Morgan Chase purchase of Bear-Stearns.
• Term Securities Lending Facility (TSLF) created.
• Primary Dealer Credit Facility (PDCF): 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 2

2008.
• 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 Concluded

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 Q E2.
September 2012 began QE3, monthly purchases of Treasuries and
mortgage backed securities, tapering began in 2013.
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 Federal Reserve Banks 1

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 2

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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 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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 Figure 4-5: The Process of Monetary
Policy Implementation
Figure 4-5 The Process of Monetary Policy Implementation

Access the long description slide. 4-17

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 Balance Sheet of the Federal Reserve

Major liabilities.
• Reserve deposits.
• Currency in circulation.
• Note that currency in circulation + reserves =
monetary base.
Major assets.
• Treasury securities.
• U.S. government agency securities.
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 Monetary Policy Tools 1

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 employment,
output, and prices.

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 Monetary Policy Tools 2

Financial Services Regulatory Relief Act of 2006.

• Authorized Federal Reserve to pay interest on reserve
balances held by depository institutions.
Federal Reserve can take one of two basic
approaches to affect the market for banks’ excess
reserves.
• Target quantity of reserves.
• Target interest rate on those reserves.

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 Open Market Operations 1

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 (O TC) market, which
keeps the fed funds rate near its desired target.

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 Open Market Operations 2

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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 Discount Rate

The discount rate is the rate Federal Reserve Banks charge

on loans to financial 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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 Reserve Requirements

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.

 1 
Δ in money supply =   × Δ in reserves
 new reserve requirement ratio 

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 Reserve Requirements: Example 1

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?

 1 
  × $20 million = $200 million
 0.10 

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 Reserve Requirements: Example 2

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
 1 
  × $20 million = $222 million
 0.09 

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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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 Money Supply versus Interest Rate
Targeting

Access the long description slide. 4-28

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 Problems in Conducting Monetary
Policy 1

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 2

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 Concluded
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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 Figure 4-5: The Process of Monetary
Policy Implementation Long Description
The monetary policy tools are open market operations, discount rate
changes, reserve requirement ratio changes. These tools are used to
manage the following targets: Money supply (bank reserves) and
interest rates (fed funds rate). These tools and targets are used to
make changes in the financial markets such as change in bank reserves,
change in money supply, change in credit availability, change in interest
rates, change in borrowing, change in security prices, and change in
foreign exchange rates. The objectives are price stability, economic
growth, low inflation, full employment, sustainable pattern of
international trade. They receive analysis and feedback on these
objectives and then reevaluate.

Return to slide containing original image. 4-34

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 Money Supply versus Interest Rate
Targeting Long Description
Both graphs consist of 3 parallel lines with negative slopes
representing the demand lines. When setting a targeted
money supply, the interest rate could be 4%, 6%, or 8%.
When targeting specific interest rates (5% or 6%), the
money supply could be one of two options depending on
the demand line referenced.

Return to slide containing original image. 4-35

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