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SS Organization of the Fed cont'd = Federal Open Market Committee FOMC The FOMC consists of the seven members of the Board of Governors plus the presidents of five Fed district banks

Chapter 4

Functions of the Fed

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning All rights reserved.

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Chapter Outline

# Organization of the Fed

= Monetary policy tools

= |mpact of technical factors on funds

= Fed control of the money supply

= Monetary Control Act of 1980

# Global monetary policy

SS

Organization of the Fed

= The Fed has five major components:

Federal Reserve district banks Member banks

Board of Governors Federal Open Market Committee (FOMC) Advisory committees

SS

Organization of the Fed (cont'd)

= Federal Reserve district banks

There are 12 Federal Reserve district banks

=" The NY bank is the most important Commercial banks that become members of the Fed must

purchase stock in their district banks

=" Pays a maximum dividend of 6% annually Each district bank has nine directors

= Six elected by member banks; three appointed by the Board of Governors

= The nine directors appoint the president of the district bank

District banks clear checks, replace old currency, provide loans

to depository institutions, and conduct research

About 35% of all banks are members

SS Organization of the Fed (cont'd)

= Board of Governors

The Board of Governors consists of seven members Each member is appointed by the President of the

U.S and confirmed by the Senate

Members serve 14-year terms

" Reduces political pressure

=" Terms are staggered so that one term expires in every even- numbered year

Main roles:

" Regulate commercial banks

=" Control monetary policy

SS

Organization of the Fed (cont'd)

= Federal Open Market Committee (FOMC)

The FOMC consists of the seven members of the Board of Governors plus the presidents of five Fed district banks

™" NY plus four others on a rotating basis

Goals: promote high employment, economic growth, and price stability

#" Achieved through control of the money supply

Decisions on changes in monetary policy are forwarded to the Trading Desk (Open Market Desk)

at the NY Fed district bank

SS Organization of the Fed (cont'd)

The Consumer Advisory Council consists of up to 30 members

=" Represents the financial institutions industry and its consumers

The Thrift Institutions Advisory Council consists of

representatives of savings banks, S&Ls, and credit unions

=" Offers views on issues specifically related to thrift institutions

Federal Reserve District Banks

*Conducts open market operations

SS

Monetary Policy Tools

= Open market operations

The FOMC meets 8 times a year

At each meeting, the target money supply growth level and

interest rate level are determined

FOMC meeting agenda

=" Members receive the Beige Book two weeks prior to the meeting

=" Meeting is attended by the Board of Governors, the 12 presidents of

the district banks, and staff members

=" Staff members begin with presentations about current economic conditions and recent economic trends

" Next, each FOMC member can offer recommendations about

whether monetary growth and interest rate target levels should be changed

" Last, voting members vote on monetary policy and interest rates

10

SS Monetary Policy Tools (cont'd)

= Open market operations (cont'd)

Communication to the Trading Desk

=" The FOMC’s decision on target money supply levels is forwarded to the Trading Desk at the NY district bank through

a policy directive

" FOMC objectives are specified in a target range for the

money supply growth

=" The FOMC also specifies a desired target for the federal

funds rate

The federal funds rate is the rate charged by banks on short- term loans to each other

11

SS

Monetary Policy Tools (cont'd)

™ Open market operations (contd)

Role of the Trading Desk

=" The manager of the Trading Desk instructs traders

on the amount of government securities to buy or sell in the secondary market

This is called open market operations

=" The Trading Desk continuously conducts open market operations in response to ongoing changes

in bank deposit levels

12

SS

Monetary Policy Tools (cont'd)

™ Open market operations (cont'd)

Fed purchase of securities

=" Traders at the Trading Desk call government securities

dealers to purchase securities

Dealers provide a list of securities for sale Traders purchase those that are most attractive

=" The total funds of commercial banks increase by the dollar amount of securities purchased by the Fed

A loosening of the money supply

=" To force a decline in the Fed funds rate, the Trading Desk can also purchase Treasury securities

The Fed funds rate will decline along with other interest rates

13

SS Monetary Policy Tools (cont'd)

# Open market operations (cont'd)

Fed sale of securities

=" To decrease the money supply, traders sell government securities to government securities dealers

Sold to the dealer submitting the highest bid

" As dealers pay, their account balances are reduced and the total amount of funds at commercial banks is reduced

A tightening of the money supply

=" To force an increase in the Fed funds rate, the Trading Desk can also sell Treasury securities

14

SS

Monetary Policy Tools (cont'd)

# Open market operations (contd)

Fed use of repurchase agreements

=" Used to increase the aggregate level of bank funds for only a few days

=" The Trading Desk trades repurchase agreements rather than government securities

Purchases Treasury securities with an agreement to sell

back the securities at a specified date in the near future

=" Often used during holidays to correct temporary imbalances

15

a

Monetary Policy Tools (cont'd)

# Open market operations (cont'd)

How open market operations affect interest rates

=" When the Fed uses open market operations to increase bank funds, interest rates are affected because:

The fed funds rate may decline Banks with excess funds may offer new loans at a lower interest rate

Banks may lower interest rates on deposits The yield on Treasury securities may decline

16

SS Monetary Policy Tools (cont'd)

# Open market operations (cont'd)

How open market operations affect interest rates

SS Monetary Policy Tools (cont'd)

™ Open market operations (contd)

Dynamic vs defensive open market

operations

=" Dynamic operations are implemented to increase

or decrease the level of funds

=" Defensive operations offset the impact of other conditions that affect the level of funds

18

SS

Monetary Policy Tools (cont'd)

# Open market operations (cont'd)

Open market operations in response to the Crash

# Stock prices declined by 22 percent on October 19, 1987

The Fed loosened the money supply to provide liquidity The Fed monitored bank deposits to ensure there was no run on deposits

The Fed monitored credit relationships between commercial banks and securities firms

Open market operations in response to the weak economy in 2001

=" The Fed increased money supply growth to stimulate the

economy

" Businesses did not respond to lower interest rates

19

SS Monetary Policy Tools (cont'd)

# Open market operations (cont'd)

Open market operations in response to the

september 11 attack on the United States

=" The FOMC decided to add liquidity to the banking system to prevent a banking crisis

=" The FOMC left the federal funds rate target unchanged

" On September 17, the FOMC reduced the federal funds target rate by 50 basis points just before markets reopened

20

SS Monetary Policy Tools (cont'd)

= Adjusting the discount rate

To increase the money supply, the Fed can

authorize a reduction in the discount rate

=" Encourages depository institutions to borrow from the Fed

To decrease the money supply, the Fed can

increase the discount rate

=" Discouraged borrowing from the Fed

21

SS

Monetary Policy Tools (cont'd)

= Adjusting the discount rate (cont'd)

In January 2003 the Fed classified its loans

as primary or secondary credit

=" Primary credit can be used for any purpose but it available only to financially sound institutions

= Secondary credit is provided to banks that do not qualify for secondary credit

Contains a risk premium above the discount rate

22

SS Monetary Policy Tools (cont'd)

= Adjusting the discount rate (cont'd)

Recently, the Fed has often adjusted the discount rate

to keep it in line with changes in the targeted federal funds rate

In January 2003, the Fed set the discount rate ata

level above the federal funds rate

=" Loans from the Fed serve as a backup source of funds

=" The discount rate no longer serves as a signal about the Fed's monetary policy

23

SS Monetary Policy Tools (cont'd)

= Adjusting the reserve requirement ratio

The reserve requirement ratio is the proportion of bank deposits that must be held as reserves

= Set by the Board of Governors

# Historically set between 8 and 12 percent

Currently 10 percent of transaction accounts

=" Sometimes changed to adjust the money supply

A reduction increases the proportion of bank deposits that can

be lent out

24

SS Monetary Policy Tools (cont'd)

= Adjusting the reserve requirement ratio

(cont'd)

How reserve requirement adjustments affect money growth

# An initial increase in demand deposits as a result

of loosening the money supply multiplies into (1/reserve requirement ratio)

A higher ratio causes an initial injection to multiply by a

smaller amount

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SS Monetary Policy Tools (cont'd)

= Comparison of monetary policy tools

The most frequent monetary policy tool is open

SS 8

Impact of Technical Factors on

Funds

= The volume of funds can change without the

Fed's intervention because of:

Federal Reserve float

= The amount of checks credited to banks’ funds that have not

yet been collected

Currency in circulation

# Staff at the NY Fed and the Board of Governors

provide daily forecasts of how technical factors

will affect the level of funds

27

m"_ 2

Fed Control of the Money Supply

= The Fed must decide what form of money

to manipulate

The optimal form of money should:

" Be controllable by the Fed

#" Have a predictable impact on economic variables

28

M1 is the most narrow form of money

# M2 includes everything in M1 plus savings

accounts and small time deposits, money

market deposit accounts (MMDAs), and other items

= M3 includes everything in M2 plus large time

deposits and other items

29

m" na

Fed Control of the Money Supply

(contd)

= Limitations of controlling money supply

It may be difficult for the Fed to simultaneously control money supply growth and the federal funds rate

™ In October 1979 it focused primarily on the money supply

= In the last several years, the Fed focused on maintaining the federal funds rate within a narrow target range

" In 2000, the Fed reduced its focus on the use of specific

money supply target ranges

M2 remains in the Index of Leading Economic Indicators

30

SS ỒC

Monetary Control Act of 1980

= The Depository Institutions Deregulations

and Monetary Control Act (DIDMCA) of 1980 had two objectives:

To deregulate some aspects of the depository institutions industry

To enhance the Fed's ability to control the money supply

31

SS

Monetary Control Act of 1980

(contd)

DIDMCA mandates that all depository institutions be

subject to the same reserve requirements imposed by

the Fed

Applies to member and nonmember banks

All depository institutions must report their deposit

levels promptly to the Fed

Improves the Fed’s knowledge of the current level of deposits

in the banking system

DIDMCA allowed all depository institutions that offer

transaction accounts to have access to the discount

window

32

SS

Global Monetary Policy

# Central banks of other countries use open

market operations, reserve requirement

adjustment, and adjustments in the interest

rate they charge on loans

= The Fed must consider economic conditions in

other major countries when assessing the U.S

economy

Coordinating monetary policy may be difficult because of conflicts of interest

33

SS Global Monetary Policy (cont'd)

# A single Euro zone monetary policy

On June 1, 2002, the euro replaced the currencies of 12

European countries

The European Central Bank (ECB) sets monetary policy for

all participating countries

=" Objective is to control inflation and to stabilize the value of the euro

Impact of the euro on monetary policy

= The interest rate offered on government securities must be similar across participating countries

=" The euro prevents any single country from using a unique monetary policy

34

SS Global Monetary Policy (cont'd)

= Global central bank coordination

Sometimes central banks of various countries coordinate

efforts for a common cause

=" After September 11, 2001, central banks of various countries

injected money into the banking system to provide more liquidity

" On September 17, 2001, several central banks reduced their interest rates

Sometimes central banks have conflicting objectives

=" If two countries attempt to weaken their currencies simultaneously, the exchange rate is subject to conflicting forces

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