The Federal Reserve Act of 1913 created the Federal Reserve System

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The Federal Reserve Act of 1913 created the Federal Reserve System

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Title: The Federal Reserve Act of 1913 created the Federal Reserve System


1
Chapter 14 The Federal Reserve System
  • The Federal Reserve Act of 1913 created the
    Federal Reserve System
  • To provide for the establishment of Federal
    reserve banks, to furnish an elastic currency, to
    afford means of rediscounting commercial paper,
    to establish a more effective supervision of
    banking in the United States, and for other
    purposes
  • First United States Bank 1791 - 1811
  • Second United States Bank 1816 - 1836
  • The charters of both were allowed to lapse
  • The 1907 bank crises caused the public to demand
    the government do something to keep this from
    happening again

2
  • The Federal Reserve has five main jobs
  • Conduct monetary policy which is, by far, the
    most important job
  • Monetary policy is the control of the rate of
    growth of the money supply to foster relatively
    full employment, price stability, and a
    satisfactory rate of economic growth
  • Serve as lender of last resort to commercial
    banks, savings banks, savings and loan
    associations, and credit unions
  • Issue currency
  • Provide banking services to the U.S. government
  • Supervise and regulate our financial institutions

3
The Federal Reserve District Banks
  • Each Federal Reserve District Bank is owned by
    the several hundred member banks in that district
  • A commercial bank becomes a member by buying
    stock in the Federal Reserve District Bank
  • So, the Fed is a quasi public-private enterprise,
    not controlled by the President or Congress
  • Effective control is really exercised by the
    Federal Reserve Board of Governors in Washington,
    D.C.

4
The Federal Reserve System
  • Board of Governors
  • Seven members
  • Appointed by President
  • Confirmed by Senate
  • Sets reserve requirements
  • Supervises and regulates member banks
  • Establishes and administers regulations
  • Oversees Federal Reserve Banks
  • 12 District Banks
  • Propose discount rates
  • Hold reserve balances for member institutions
  • Lends reserves
  • Furnish currency
  • Collects clears checks
  • Handle U.S. government debt cash balances

Federal Open Market Committee (Board of Governors
plus 5 Reserve Bank Presidents. This committee
directs open market operations which is the
primary instrument of monetary policy
5
Legal Reserve Requirements
  • The focal point of the Federal Reserves control
    of our money supply is legal reserve requirements
  • Every financial institution in the country is
    legally required to hold a certain percentage of
    its deposits on reserve, either in the form of
    deposits at its Federal Reserve District Bank or
    in its own vaults

6
Legal Reserve Requirements
  • Technical Term Meanings
  • Required Reserves (RR) is the minimum amount of
    vault cash and deposits (RD) at the Federal
    Reserve District Bank that must be held (kept on
    the books) by the financial institution
  • Actual Reserves (RD) is what the bank is holding
    (on the books)
  • Excess Reserves Actual Reserves - Required
    Reserves
  • ER RD - RR

7
What About Negative Excess Reserves?
  • If actual reserves (RD) are less than Required
    Reserves (RR), the excess Reserves (ER) are
    negative
  • If a bank does find itself short, it will usually
    borrow reserves from another bank that does have
    excess reserves. These are called federal funds
    and the interest rate charge is called the
    federal funds rate
  • A bank may also borrow reserves (RD) from its
    Federal Reserve District Bank at its discount
    window

8
Primary and Secondary Reserves
  • A banks primary reserves are its vault cash and
    its deposits at the the Federal District Bank
  • These reserves pay no interest, therefore the
    banks try to hold no more than the Federal
    Reserve requires

9
Primary and Secondary Reserves
  • Every bank holds secondary reserves, mainly in
    the form of very short-term U.S. government
    securities
  • Treasury bills, notes, certificates, and bonds
    (that will mature in less than a year) are
    generally considered a banks secondary reserves
  • These can be quickly converted to cash without
    loss if a bank suddenly needs money

10
Deposition Expansion
Hypothetical Deposit Expansion with 10 Percent
Reserve Requirement
Deposits (thousands)
Reserves 100.0
10.0
90.0
9.0 81.0

8.1 72.9
7.29
65.61
6.661 59.05

5.904 53.541
5.354 48.186

4.819 43.368
4.337
39.031
3.903 To save space
the rest of the calculations are omitted
1,000.00
100.00

11
Deposit Expansion Multiplier(DEM)
1
DEM
Reserve Ratio
Assume a RR of 25
Assume a RR of 10
1
1
4
10

DEM

DEM
.10
.25
When RR increases DEM decreases
When RR decreases DEM increases
12
Three Modifications of the Deposit Expansion
Multiplier
  • Not every dollar of deposit expansion will
    actually be redeposited again and lent out
    repeatedly
  • Some people may choose to hold or spend some
    money as currency
  • It is also possible that some banks will carry
    excess reserves
  • This is not likely in times of high inflation

13
Three Modifications of the Deposit Expansion
Multiplier
  • There are leakages of dollars to foreign
    countries
  • This is caused mainly by our foreign trade
    imbalance
  • The Deposit Expansion Multiplier is, in reality,
    quite a bit lower than if we based it solely on
    the reserve ratio
  • If the reserve ration tells us it is 10, perhaps
    its only 6

14
Cash, Checks, and Electronic Money
  • Increasingly, money is changing hands
    electronically
  • Today, more than 1.7 trillion a day is
    transferred electronically
  • About 600 billion of these transfers are carried
    out by the Federal Reserves electronic network
  • About 1.1 trillion are done by the Clearing
    House Interbank Payment System (CHIPS) which is
    owned by 11 big New York Banks

15
Cash, Checks, and Electronic Money
  • Does all this mean that we are well on our way to
    a checkless, cashless society?
  • Yes and no
  • We still carry out nearly 85 percent of our
    monetary transactions in cash
  • When the total dollars actually spent is
    considered, cash covers less than 1 percent of
    the total value
  • Electronic transfers account for five out of
    every six dollars that move in the economy

16
The Tools of Monetary Policy
  • The most important job of the Fed is to control
    the rate of growth of the money supply
  • This effort focuses on the reserves held by
    financial institutions
  • The most important policy tool to do this is
    open-market operations

17
How Open-Market Operations Work
  • Open-Market operations are the buying and selling
    of U.S. government securities
  • U.S. government securities are treasury bills,
    notes, certificates, and bonds
  • The Fed buys and sells securities that have
    already been marketed by the treasury
  • The total value of all outstanding U.S.
    government securities is more than 4.0 trillion.
    This is our national debt
  • What open market operations consist of, then, is
    the buying and selling of chunks of the national
    debt

18
The Federal Open-Market Committee (FOMC)
  • Open-market operations are conducted by the
    Federal Open-Market Committee (FOMC)
  • This committee consist of 12 people
  • Eight permanent members the board of Governors
    and the president of the New York Federal Reserve
    District Bank
  • The other four are presidents of the other 11
    Federal Reserve District Banks
  • They serve on a rotating basis

19
The Federal Open-Market Committee (FOMC)
  • The FOMC meets about once every six weeks to
    decide what policy to follow
  • To fight recessions, the FOMC buys securities
  • This increases the rate of growth of the money
    supply
  • To fight inflation, the FOMC sells securities
  • This decreases the rate of growth of the money
    supply

20
Borrowing Reserve Deposits
  • The discount rate is the interest rate paid by
    member banks when they borrow reserve deposits
    (RD) at their Federal Reserve District Bank
  • The federal funds rate is the interest rate banks
    charge each other for borrowing reserve deposits
    (RD) from each other
  • This is higher than the discount rate
  • Banks borrow to maintain their required reserves
    (RR)
  • Banks tend to borrow reserve deposits from each
    other because they may not like to call attention
    to the fact they are having to borrow reserve
    deposits

21
Changing Reserve Requirements
  • The Federal Reserve Board has the power to change
    reserve requirements within the legal limits of 8
    and 14 percent for checkable deposits
  • Changing reserve requirements is the ultimate
    weapon and is rarely used

22
Changing Reserve Requirements
  • To fight inflation, before the Board would take
    the drastic step of raising reserve requirements
  • The District Banks would raise the discount rate
  • The FOMC will be actively selling securities
  • Credit will be getting tighter
  • The chairman will be publicly warning that the
    banks are advancing too many loans

23
Changing Reserve Requirements
  • If the money supply is still growing too rapidly
    the Fed reaches for its biggest stick and
    raises
  • reserve requirements
  • This weapon is so rarely used because it is
    simply too powerful
  • If the reserve requirement on demand deposits
    were raised by just one half of 1 percent, the
    nations banks and thrift institutions would have
    to come up with nearly 4 billion in reserves
  • This would drastically reduce the nations money
    supply

24
Summary The Tools of Monetary Policy
  • To fight recession, the Fed will
  • Lower the discount rate
  • Buy securities on the open market
  • Lower reserve requirements
  • This would be done only as a last resort
  • To fight inflation, the Fed will
  • Raise the discount rate
  • Sell securities on the open market
  • Raise reserve requirements
  • This would be done only as a last resort