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The Federal Reserve System

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If the Fed offers to pay a higher price for bonds, it will effectively lower bond yields and market interest rates. By buying bonds, the Fed increases bank reserves. – PowerPoint PPT presentation

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Title: The Federal Reserve System


1
The Federal Reserve System
2
Introduction
  • This chapter addresses the following
  • How does government control the amount of money
    in the economy?
  • Which government agency is responsible for
    exercising this control?
  • How are banks and bond markets affected by the
    governments policies?

3
Introduction
  • The feds control over the supply of money is the
    key mechanism of monetary policy.
  • Monetary policy is the use of money and credit
    controls to influence macroeconomic activity.

4
Federal Reserve Banks
  • Each of the twelve (12) Federal Reserve banks act
    as a central banker for the private banks in
    their region.

5
Federal Reserve Banks
  • The Federal Reserve performs the following
    services
  • Clears checks between private banks
  • Holds bank reserves.
  • Provides currency to the public.
  • Provides loans to private banks.

6
The Board of Governors
  • The Fed is controlled by a seven person Board of
    Governors.
  • Each governor is appointed to a 14-year term by
    the President (with confirmation by the U.S.
    Senate).

7
The Board of Governors
  • The long term is intended to give the Fed a
    strong measure of political independence.
  • The President selects one of the governors to
    serve as chairman for a 4-year term.

8
Structure of the Federal Reserve System
9
Monetary Tools
  • The Federal Reserve controls the money supply
    using the following three policy instruments
  • Reserve requirements
  • Discount rates
  • Open-market operations

10
Reserve Requirements
  • The Fed requires banks to keep a minimum amount
    of required reserves.
  • Required reserves The minimum amount of
    reserves a bank is required to hold equal to
    required reserve ratio times transactions
    deposits.

Required reserves required reserve ratio X
total deposits
11
Reserve Requirements
  • The fed directly alters the lending capacity of
    the banking system by changing the reserve
    requirement.

12
Reserve Requirements
  • By changing the reserve requirement, the Fed
    changes the level of excess reserves in the
    banking system.
  • Excess reserves are bank reserves in excess of
    required reserves.

Excess reserves Total reserves Required
reserves
13
Reserve Requirements
  • By raising the required reserve ratio, the Fed
    can immediately reduce the lending capacity of
    the banking system.

14
Reserve Requirements
  • A change in the reserve requirement causes
    changes in
  • Excess reserves.
  • The money multiplier.
  • The lending capacity of the banking system.

15
Impact of an Increased Reserve Requirement
16
The Discount Rate
  • Excess reserves earn no interest.
  • Banks have a tremendous profit incentive to keep
    their reserves as close to their required reserve
    level as possible.

17
Excess Reserves and Borrowings
18
The Federal Funds Market
  • The federal funds market is where a bank that
    finds itself short of reserves can turn to other
    banks for help.
  • The federal funds rate is the interest rate for
    inter-bank reserve loans.

19
The Federal Funds Market
  • Reserves borrowed in this manner are called
    federal funds and are lent for short periods -
    usually overnight.

20
Sale of Securities
  • A bank that is low on reserves can also sell
    securities.
  • Banks use some of their excess reserves to
    purchase government bonds.

21
Discounting
  • Discounting refers to the Federal Reserve lending
    of reserves to private banks.
  • A bank can deal with a reserve shortage by going
    to the Feds discount window to borrow reserves
    directly.

22
Discounting
  • The discount rate is the rate of interest the
    Federal Reserve charges for lending reserves to
    private banks.

23
Discounting
  • By raising or lowering the discount rate, the Fed
    changes the cost of money for banks and the
    incentive to borrow reserves.

24
Open-Market Operations
  • Open-market operations are the principal
    mechanism for directly altering the reserves of
    the banking system.

25
Portfolio Decisions
  • The portfolio decision is the choice of how
    (where) to hold idle funds.
  • People do not hold all their idle funds in
    transactions accounts or cash.

26
Hold Money or Bonds
  • The Feds open-market operation focus on the
    portfolio choices people make.
  • The Fed attempts to influence the choice by
    making bonds more or less attractive, as
    circumstances warrant.

27
Hold Money or Bonds
  • When the Fed buys bonds from the public, it
    increases the flow of deposits (reserves) to the
    banking system.
  • Bond sales by the Fed reduce the flow.
  • Likewise, when the Fed sells bonds, it removes
    money from the banking system.

28
Open Market Operations
Buyers spend account balances
Fed SELLS bonds
Reserves decrease
Sellers deposit bond proceeds
Reserves increase
Fed BUYS bonds
29
The Bond Market
  • Not all of us buy and sell bonds, but a lot of
    consumers and corporations do.
  • A bond is a certificate acknowledging a debt and
    the amount of interest to be paid each year until
    repayment.
  • It is nothing more than an IOU.

30
Bond Yields
  • The current yield paid on a bond is the rate of
    return on a bond.
  • It is the annual interest payment divided by the
    bonds price.

31
Bond Yields
  • A principal objective of Federal Reserve open
    market activity is to alter the price of bonds,
    and therewith their yields.

32
Open Market Activity
  • The less you pay for a bond, the higher its
    yield.
  • Federal Reserve open-market activity alters the
    price of bonds, and their yields.
  • By doing so, the Fed makes bonds a more or less
    attractive alternative to holding money.

33
Open Market Activity
  • Open market operations are Federal Reserve
    purchases and sales of government bonds for the
    purpose of altering bank reserves.

34
Open-Market Purchases
  • If the Fed offers to pay a higher price for
    bonds, it will effectively lower bond yields and
    market interest rates.
  • By buying bonds, the Fed increases bank reserves.

35
Open-Market Purchases
Step 1 FOMC purchases government bonds pays for
bonds with Federal Reserve check
Step 3 Bank deposits check at Fed bank, as a
reserve credit
Step 2 Bond seller deposits Fed check
36
The Fed Funds Rate
  • Fed funds rate act as a market signal of the
    changing reserve flows.
  • If the Fed is pumping more reserves into the
    banking system, the federal funds rate will
    decline.
  • If the Fed is reducing bank reserve by selling
    bonds, the federal funds rate will increase.

37
Volume of Activity
  • The volume of trading in U.S. government
    securities exceeds 100 billion per day.
  • Each dollar in reserves represents approximately
    10 in potential lending due to the money
    multiplier.

38
Is the Fed Losing Control?
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