THE FEDERAL RESERVE

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THE FEDERAL RESERVE

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Title: THE FEDERAL RESERVE


1
CHAPTER 2
  • THE FEDERAL RESERVE
  • AND ITS POWERS

2
Early Banking
  • Served the safekeeping function
  • Receipts were used as money
  • With 100 reserves early banks were only
    custodians
  • The lending function and money creation function
    developed with use of fractional reserves
  • Increased risk and bank panics
  • Modern banking is fractional reserve system

3
Early U.S. Banking
  • Bank of North America, 1782, was the first
    American bank
  • Early banks issued bank notes, convertible to
    specie
  • Industrial interest promoted banking agrarian
    and frontier interests disliked banks
  • Bank note issue has poor reputation

4
Early U.S. Central Banking
  • The Bank of the United States (1791-1811) was the
    first U.S. central bank
  • Federal charter
  • Performed both public and private functions
  • Privately owned
  • Publiclycontrolled bank note issue and
    intercountry transactions

5
Early U.S. Central Banking
  • Second Bank of the United States (1816-1832)
  • Central banking functions very unpopular
  • President Jackson vetoed renewal of charter in
    1832

6
Early State Banking
  • States chartered banks
  • Prosperity varied with business cycle
  • No central bank control over loan/note issue
  • Wild expansion/contraction cycles hurt economic
    development
  • State political influences, under capitalization,
    and abuses prevailed
  • Many bank failures in economic downturns
  • Suffolk Bank

7
Federal Banking Legislation
  • National Banking Acts of 1863 and 1864
  • Promoted a safe and uniform currency
  • Aided in financing Civil War
  • Provisions included
  • Federal Charters for national banks
  • Increased capital requirements
  • Established minimum reserve requirements
  • Maximum loan size to single borrower
  • Began issuance of uniform bank notes printed by
    U.S. Treasury, backed by Federal Government

8
Federal Banking Legislation
  • Deposit banking evolved from the National Bank
    Acts
  • State bank notes taxed
  • State banks issued demand deposits instead of
    bank notes

9
Federal Banking Legislation
  • Problems with national banking system
  • Inelastic money supplyno lender of last resort
  • Pyramiding of reserves from small to large banks
    produced financial panics at times
  • Payment and check clearing system inefficient

10
Origins of the Federal Reserve System
  • Prior to 1863, banks issued bank notes that
    functioned like our present day currency but were
    the obligations of individual banks.
  • Because of the risk of failure, some banks notes
    traded at a discount.
  • The quantity of money in circulation fluctuated
    with the business cycle, possibly exaggerating
    those cycles.

11
Origins of the Federal Reserve System (concluded)
  • Demand deposits were not insured, so they were
    often discounted when the bank was distant,
    suspect, or unknown.
  • Further, banks were subject to liquidity problems
    and the economy suffered several recessions and
    crises, culminating in the crash of 1907.
  • These problems lead to the passage of the Federal
    Reserve Act in 1913.

12
The Initial Purposes of the Fed Were to
  • Provide an elastic currency supply (money supply
    control).
  • Serve as a lender of last resort (discount
    window).
  • Provide for a sounder banking system (bank
    regulatory and supervisory powers).
  • Improve the payments system (check clearing and
    promoting payments system technology).

13
Nonmonetary Powers of the Fed
  • Regulation Q -- established the maximum rate that
    depository institutions could pay on deposit
    accounts until it was phased out over the
    1980-1986 period.
  • Securities Credit Regulation -- establishes
    borrowing (margin) limits for buyers of
    securities on margin.
  • Supervision and Examination of State Member Banks
    by Fed.

14
Nonmonetary Powers of the Fed (concluded)
  • Regulation of Bank and Financial Holding
    Companies.
  • Regulation of Payment System.
  • Control of International Banking Activities.
  • Consumer Credit Regulation
  • Fiscal Agent for the U.S. Treasury.
  • Tax and Loan Accounts at depository institutions
    then moved to Fed when Treasury wants to spend it
  • Moral Suasion - Chairman Greenspans speeches
    and testimony before Congress

15
1946 Full Employment Act
  • Stable Dollar
  • Full Employment
  • Economic Growth

16
Federal Reserve System
  • Seven members of the Board of Governors
  • Twelve Regional Federal Reserve Banks (and their
    branches)
  • Thousands of member commercial banks
  • Federal Open Market Committee
  • Board of Governors and 5 Presidents of District
    Banks

17
Organization of the Fed
18
The Fed's Balance Sheet (2000)
Source Board of Governors, Federal Reserve
System.
19
The Fed's Balance Sheet
Primary Asset
  • Important assets include
  • U.S. government and agency securities.
  • cash items in the process of collection (CIPC).
    CIPC minus DACI below is Fed float -- a net loan
    of reserves extended to the banking system.
  • treasury coin.
  • loans to member banks.
  • gold certificates and SDRs.

20
The Fed's Balance Sheet (concluded)
  • Important liabilities include
  • Federal Reserve notes.
  • reserve deposits of depository institutions.
  • deferred availability cash items (DACI).
  • treasury and foreign deposits.
  • capital and surplus.

21
CHECK 21Check Clearing Act for the 21st Century
  • Took effect October 28, 2004
  • Allows financial institutions the option to move
    checks electronically by allowing them to replace
    an original check with a substitute check.
  • A substitute check is a paper reproduction of an
    original check created during the check
    collection and return process from an electronic
    image of the original.
  • The goal of CHECK 21 is to reduce paper.
  • Evolved from 9/11

22
Payments Clearing System
  • Banks hold deposits in other banks and the
    Federal Reserve Banks in order to clear checks.
  • While the physical paper check moves from bank to
    bank, the deposit accounts of banks are merely
    debited or credited.
  • Many checks are cleared locally through clearing
    house associations.
  • Checks drawn on association member banks are
    netted out.

23
Payment System Processes
  • The Federal Reserve Banks are heavily involved in
    the check clearing of out of town checks
  • Most depository institutions either directly or
    indirectly (through other banks) hold reserve
    deposits in the Fed.
  • Checks written on other banks are sent to the Fed
    and, depending on the distance and time needed to
    present the check to the paying bank
  • The reserve account of the check depositing bank
    may receive immediate or delayed (DACI) credit.

24
Payment System Processes
  • Federal Reserve float is created by the double
    counting of clearing-delayed checks.
  • One bank is given credit in its reserve account
    after two days (from DACI)
  • while the check has not yet (CIPC) been presented
    to the paying bank.
  • Float, at any time, is the difference between
    CIPC and DACI, and represents a net credit to the
    reserve account of all depository institutions.
  • Effect of CHECK 21

25
Payment System Processes
  • When a check is cleared and a deposit transfer is
    made at the Fed, the total bank reserves remain
    the same
  • Only the ownership (one bank to another) changes.
  • Payments do not impact money supply
  • Only Feds impact upon bank reserve account
    impacts money supply

26
Three Tools of Federal Reserve Monetary Policy
  • 1. Establishing reserve requirements, the minimum
    proportion (percentage) of bank deposits they
    must keep on deposit at the Fed.
  • Increasing reserve requirements () increases the
    percentage of bank deposits kept in noninterest
    bearing deposits at the Fed and limits bank
    lending.
  • Decreasing reserve requirements () reduces the
    percentage of bank deposits kept in the Fed and
    provides the banking system with excess reserves.

27
Three Tools of Federal Reserve Monetary Policy
(continued)
  • Bank deposits (reserves) in the Fed are needed to
    clear checks and to satisfy reserve requirements.
  • Actual reserves (AR) are balances needed to meet
    check clearing and legal reserve requirements
    including
  • vault cash.
  • noninterest bearing bank deposits in Federal
    Reserve banks.

28
Three Tools of Federal Reserve Monetary Policy
(continued)
  • Required reserves (RR) is the dollar level of
    reserves needed to meet legal reserve
    requirements.
  • Reserve requirements () and the level and type
    of deposits determine the level of required
    reserves in a period.
  • Actual reserves (have) needed for check clearing
    may exceed required reserves (have to have) and
    vice versa
  • Total transactions deposits in the banking system
    increase when a bank uses some of its excess
    reserves to make a loan.

29
Three Tools of Federal Reserve Monetary Policy
(continued)
  • Excess reserves (ER) equals actual minus required
    reserves.
  • Excess reserves may be loaned to customers or
    sold to other banks (federal funds market) by an
    individual bank.
  • If the level of the banking system's Federal
    Reserve borrowed reserves (BR) (Fed loan credited
    to reserve accounts) exceeds the level of excess
    reserves in a period, the banking system is in a
    net borrowed reserve position, is less likely to
    promote lending activities, and interest rates
    are most likely to be increasing.

30
Three Tools of Federal Reserve Monetary Policy
(continued)
  • If the level of level of excess reserves exceeds
    Fed borrowing, the banking system is in a
    net-free reserve position, credit is easier and
    interest rates are generally lower.
  • Many analysts prefer to examine banks net-free
    reserves (Excess Reserves - Borrowed Reserves).

31
Three Tools of Federal Reserve Monetary Policy
(continued)
  • 2. Open market operations affect the level of
    member bank reserves and the monetary base.
  • Buying government securities from the private
    sector, the Fed eventually credits member bank
    deposits, thus increasing the level of bank
    reserves and the banks' ability to make loans and
    expand the money supply.
  • Selling securities (could be any asset) to
    private security dealers or banks, the Fed is
    paid with a bank check which reduces the level of
    member bank actual reserves.

32
Three Tools of Federal Reserve Monetary Policy
(continued)
  • The Federal Reserve usually expands or contracts
    its liabilities by engaging in Open Market
    Operations.
  • When they buy securities, they write a check on
    themselves.
  • The Federal Reserve increases the monetary base
    via the banks reserve accounts whenever it
    acquires more assets.

33
Three Tools of Federal Reserve Monetary Policy
(concluded)
  • 3. Discount Rate Policy -- The rate of interest
    depository institutions pay for borrowing from
    the Fed.
  • Raising the discount rate increases the cost of
    borrowing for needed reserve balances.
  • Lowering the discount rate lowers the cost of
    bank liquidity and encourages lending and money
    supply expansion
  • Rarely used as a tool of monetary policy now.

34
The Federal Reserve and Depository Institutions
  • The Federal Reserve has the ability to regulate
    every deposit-taking financial institution by
    requiring uniform reserve requirements.
  • All depository institutions can borrow through
    the Discount Window.

35
Monetary Base
  • Changes in the assets and liabilities of the
    Federal Reserve System largely determine the
    nations Monetary Base
  • The Monetary Base equals currency in circulation
    plus financial institution deposits at the
    Federal Reserve.
  • The Federal Reserve increases the monetary base
    via the banks reserve account whenever it
    acquires more assets. It decreases the monetary
    base when it sells assets.

36
Impacts of FederalReserve Policy
  • Expansionary monetary policy
  • Open market operations -- purchase securities --
    increase bank excess reserves and the monetary
    base.
  • Reserve requirements -- reduce reserve
    requirements -- increase excess reserves and
    increase the deposit expansion multiplier.
  • Discount rate -- reduce the rate -- reduce the
    cost of borrowing reserves.
  • Expands the money supply reduces interest rates.

37
Impacts of FederalReserve Policy (concluded)
  • Restrictive monetary policy
  • Open market operations -- sell securities, reduce
    bank reserves and the monetary base.
  • Reserve requirements -- increase reserve
    requirements, reduces excess reserves and the
    deposit expansion multiplier.
  • Discount rate -- increase the discount rate and
    the cost of borrowing reserve deficiencies.
  • Reduce the money supply or its growth rate
    increase interest rates.

38
Other Tools of Federal Reserve Monetary Policy
  • Moral Suasion - Chairman of the Federal Reserve
    System makes a speech or testifies before
    Congress
  • Regulation of Banks
  • International Activities arising from acting as
    the Agent of the United States Government in
    International Finance

39
Conclusion
  • The Federal Reserve System
  • Monetary Base
  • Tools of the Fed
  • Set Reserve Requirements
  • Open Market Operations
  • Discount Rate Policy
  • Regulation of Banks
  • Effects of Monetary Policy