Federal Reserve System and Monetary Policy

Federal Reserve System and Monetary Policy

Interest on Required and Excess Reserves

  • The Federal Reserve pays interest on both required and excess reserves held by financial institutions.

  • Required Reserves: The minimum amount of reserves a bank must hold against deposits, as mandated by the Federal Reserve.

  • Excess Reserves: Any reserves held by banks beyond the required minimum.

  • Banks have the incentive to choose between earning interest on excess reserves held with the Federal Reserve or loaning those reserves to customers.

  • Changes in the interest rate on excess reserves can influence the amount of reserves banks hold, thereby affecting the money supply.

Discount Rate

  • Definition: The Discount Rate is the interest rate charged by the Federal Reserve when lending to financial institutions.

  • The Federal Reserve acts as the "lender of last resort"; financial institutions unable to borrow from one another may seek loans from the Fed.

  • Adjustments to the Discount Rate signal financial institutions on how to adjust their lending activities, ultimately impacting the money supply.

Related Rates

  • Discount Rate: Rate at which the Fed lends to banks.

  • Fed Funds Rate: Rate at which banks lend reserves to each other overnight.

  • Prime Interest Rate: Rate that banks offer to their most credit-worthy customers.

Open Market Operations

  • The Federal Reserve targets the Federal Funds Rate (FFR) by buying or selling government bonds on the open market.

  • Changes in FFR influence borrowing between financial institutions, affecting the overall money supply.

  • Federal Open Market Committee (FOMC): Committee that meets to decide on adjustments to the FFR. Decisions include raising, lowering, or maintaining the target FFR.

  • Open market operations are the most frequently used tool for monetary policy.

Monetary Policy Types
Contractionary Policy (Tight Money)

  • Actions:

    • Fed sells bonds

    • Raises the Discount Rate

    • Raises Reserve Requirement (%)

    • Increases interest on reserves

  • Effects:

    • Less money available for lending

    • Fed Funds Rate rises

    • Decreased borrowing leads to reduced spending and lower prices.

    • Multiplier effect diminishes available loanable money.

Expansionary Policy (Loose Money)

  • Actions:

    • Fed buys bonds

    • Lowers the Discount Rate

    • Lowers Reserve Requirement (%)

    • Decreases interest on reserves

  • Effects:

    • More money available for lending

    • Fed Funds Rate drops

    • Increased borrowing stimulates spending and raises prices.

    • Multiplier effect amplifies loanable money availability.

Economic Context of Monetary Policy

  • Expansionary Policy: Implemented during economic contractions to stimulate growth.

  • Contractionary Policy: Used during periods of economic recovery or expansion.

  • Economic indicators (e.g., GDP, CPI, unemployment rate) signal the current phase of the business cycle.

Federal Reserve System Characteristics

Public Characteristics

  1. Creation: Established by an act of Congress, making it subject to dissolution through further congressional action.

  2. Governance: Composed of a Board of Governors appointed by the President and confirmed by the Senate, serving 14-year terms.

    • New member terms begin every two years on even-numbered years.

  3. Leadership: The Chairman and Vice Chairman are nominated by the President from amongst Board members for 4-year terms.

  4. Fiscal Agent: The Federal Reserve acts as the fiscal agent for the U.S. government.

  5. Currency: U.S. paper currency is called a Federal Reserve Note, backed mainly by government securities.

  6. Profits: Profits from the Federal Reserve are remitted to the U.S. government; for instance, in 2011, over $79 billion was transferred to the U.S. Treasury.

Private Characteristics

  1. Decentralized Structure: There are 12 district banks across the United States.

  2. Board of Directors: Each district bank has a board consisting of:

    • Two-thirds elected by member banks in the district (private control).

    • One-third elected by the Board of Governors (public control).

  3. FOMC Membership: Five district bank presidents serve as voting members of the FOMC at any time. The New York Fed president is always a voting member.

  4. Corporate Organization: Each district Federal Reserve Bank operates as a private corporation, self-financed through earnings on securities and services (like check clearing).

Monetary Policy Goals

  • The Federal Reserve aims to fulfill three key objectives mandated by Congress:

    1. Maximum Employment.

    2. Stable Prices.

    3. Moderate Long-Term Interest Rates.

Reserve Requirement

  • The Federal Reserve mandates that financial institutions maintain a certain percentage of customer deposits as reserves in vault cash or in their Federal Reserve accounts.

  • These reserves cannot be used for lending.

  • The Reserve Requirement tool is infrequently utilized.