Lesson 9.3: The Federal Reserve

The Federal Reserve Board (FRB)

The Federal Reserve Act of 1913 established the Federal Reserve System as the central bank of the United States.
- Purpose: to provide the nation with a safer, more flexible, and more stable monetary and financial system.
- The law sets out the purposes, structure, and functions of the system and outlines aspects of its operations and accountability.
The Federal Reserve Board (FRB) directs the Federal Reserve System.
- The FRB consists of 12 regional Federal Reserve Banks and hundreds of national and state banks that belong to the system.
- The FRB determines monetary policy and takes actions to implement its policies.
- The FRB's decisions are a critical aspect of the U.S. economy because it determines how much money is available for businesses and consumers to spend.
The Federal Reserve System is also called the Federal Reserve Bank, or simply the Fed. The most common acronym on the exam for the system is FRB.
The FRB's most important duty is twofold:
- Conduct the nation's monetary policy to promote maximum employment.
- Promote a stable price environment, keeping inflation under control.
The FRB performs these functions by managing the money supply
- The amount of cash available within the U.S. economy, called monetary policy.
Milton Friedman, PhD, is considered the founder of monetarism (or monetarist) theory. Much of the work of the Federal Reserve is based on his theories.
Increasing the money supply expands the economy and creates jobs, but if the economy expands too quickly (overheats), it may trigger high levels of inflation.
- High inflation is hard on the consumer, hurting the same people that a healthy economy is meant to help.
The FRB has a number of tools at its disposal.
- Diagnostic tools (those that are used to “read” the economy)
- Direct tools (those that directly impact the economy).
- Diagnostic tools are like a ruler or a level, used to measure the economy.
- The direct tools are like a wrench, used to loosen or tighten the money supply.

Diagnostic Tools of the Federal Reserve

Though the FRB has several diagnostic tools to measure the health of the economy, one of the most important diagnostic tools of the FRB is the measures of money supply: M1, M2, and M3.
M1 is the measure of the most readily available money to spend:
- Cash (actual cash and coinage) and money in demand deposit accounts (DDAs), such as checking accounts.
- This is the money that is closest to being spent and turned into economic activity.
M2 consists of M1 plus “consumer savings deposits:
- Those assets that are easily moved to a DDA and spent.
- Among the consumer savings deposits are savings accounts, retail (nonnegotiable) CDs, money market funds, and overnight repurchase agreements (repos).
- M1 is also part of M2.
M3 consists of M2 plus “large time deposits:
- Those assets that are a bit harder to move into a DDA and spend.
- Examples include negotiable (jumbo) CDs and multiday repos.
- M2 is part of M3; by extension, so is M1 because it is part of M2.
Figure 9.4: Federal Reserve Board's Diagnostic Tools
- M1: Cash and demand deposits
- M2: M1+ Consumer savings deposits
- M3: M2 + Large-denomination time deposits

Example:

Seabird Airlines has money in a long-term CD that it is saving to purchase a new airliner.
When the CD matures, Seabird will deposit the money into a checking account in preparation for purchasing the new plane.
What effect will this have on the money supply?
- The funds are moved from M3 to M1, so M1 increases, but M3 does not change because M1 is a component of M3, so the funds never left M3.

Direct Tools of the FRB

In addition to its diagnostic tools, the FRB has several direct tools that it can use to influence the money supply.

Federal Open-Market Operations

The FRB, acting as an agent for the U.S. Treasury Department, influences the money supply by buying and selling U.S. government securities (Treasury bills, notes, and bonds) in the open market.
- These actions will expand or contract the money supply, depending on which they are doing (buying or selling).
- The Federal Open Market Committee (FOMC) meets regularly to direct the government's open-market operations.
When the Fed wants to expand (loosen) the money supply, it buys securities from banks.
- The securities come out of the economy, and money goes into the economy through the bank.
- The increase of reserves (cash) allows banks to make more loans and effectively lowers interest rates.
- By buying securities, the Fed pumps money into the banking system, expanding the money supply and reducing rates.
When the Fed wants to contract (tighten) the money supply, it sells securities to banks.
- Now, cash comes out of the respective banks (to pay for the securities) and the securities go in as each sale is charged against a bank's reserve (cash) balance.
- This reduces the bank's ability to lend money, which tightens credit and effectively raises interest rates.
- By selling securities, the Fed pulls money out of the system, contracting the money supply and increasing rates.
The following list outlines the FRB's buying or selling of securities in the open market and its impact on the economy. Open-market operations like these are the most frequently used tools of the FRB:
- Buying
  - Securities come out of the economy, and money goes in.
  - The money supply goes up, interest rates go down, borrowing and spending for consumers is easier, and the economy expands.
- Selling
  - Securities go into the economy, and money comes out.
  - The money supply goes down, interest rates go up, borrowing and spending for consumers becomes more difficult, and the economy contracts.

Regulation T Deposit Requirement

As part of the FRB's regulatory authority, the Fed set the minimum amount an investor must deposit when using credit to buy a security.
- Under Regulation T, the current initial deposit is 50% of the purchase price.
- If the FRB lowered the initial deposit requirement and allowed more borrowing, the extra cash available would likely raise stock prices.
  - This would result in more merger activity, as well as investors using the additional wealth to make purchases, expanding the economy.
- Increasing the amount required at purchase (thus limiting credit) would have the opposite effect, slowing the economy.
- In practice, the Fed leaves Regulation T requirements as they are. The current 50% requirement has been in place since 1974.

The Discount Rate

Banks that need additional capital to meet their reserve requirement may borrow money from the Federal Reserve System.
- This is often done through a repo. In a repo, the Fed holds some of the bank's assets (usually loans the bank holds) as collateral for a short-term loan, usually overnight, though sometimes longer. This increases the bank's cash reserves.
- The interest rate the Fed charges the bank for these short-term loans is the discount rate.
- When you hear news stories about the Federal Reserve raising or lowering interest rates, it is the discount rate they are referring too.
- The discount rate is seen as the base rate for the nation. Raising the discount rate tends to lift interest rates throughout the economy.
- Lowering the discount rate tends to cause rates to drop overall.

The Reserve Requirement

The reserve requirement is the amount a bank must maintain on deposit with the Federal Reserve.
- Reserves dropping below this number indicate that the bank may have insufficient cash to meet depositors' demands.
- Lowering this number frees up cash at the banks to fund loan activity, expanding the economy.
- Raising this number decreases the amount available for loans.
- Because changes in the reserve requirement have a dramatic impact throughout the banking system, hitting all the banks at once, the Fed rarely changes the reserve requirement.

The Four Prominent Interest Rates

The cost of doing business is closely linked to the cost of money.
- The cost of money is called interest.
- The supply and demand of money determines the rate of interest that must be paid to borrow it.
  - When the money available for loans exceeds demand, interest rates fall;
  - When the demand for money exceeds the supply, interest rates rise.
- The level of a specific interest rate can be tied to one or more benchmark rates, such as the federal funds rate, the prime rate, the broker call loan rate, and the discount rate.

Federal Funds Rate

The federal funds rate is the rate that the commercial money center banks charge each other for overnight loans of 1 million or more.
- It is considered a barometer of the direction of short-term interest rates, which fluctuate constantly, and it can be the most volatile rate in the economy.

Prime Rate

The prime rate is the interest rate that large U.S. money center commercial banks charge their most creditworthy corporate borrowers for unsecured loans.
- Each bank sets its own prime rate, with larger banks generally setting a rate that other banks use or follow.
- Banks lower their prime rates when the FRB (or Fed) eases the money supply, and they raise rates when the Fed contracts the money supply.

Broker Call Loan Rate

The broker loan rate is the interest rate that banks charge broker-dealers (BDs) on money they borrow to lend to margin account customers.
- Margin accounts allow customers to purchase securities without paying in full. The amount not paid is essentially loaned to the customer by banks and BDs.
- The broker loan rate is also known as the call loan rate or call money rate.
- The broker loan rate usually is a percentage point or so above other short-term rates.
- Broker call loans are callable on a 24-hour notice.

Discount Rate

The discount rate (covered earlier in this unit) is the rate the Federal Reserve charges for short-term loans to member banks.
- The discount rate also indicates the direction of FRB monetary policy a decreasing rate indicates an easing of FRB policy, and an increasing rate indicates a tightening of FRB policy.
The discount rate is the only rate of these four set by a unit of the federal government. The other three are set by the bank that is making the loan.

Example

If the FRB wants to ease its monetary policy to allow consumers to borrow more easily, it can lower the discount rate.
- This allows member banks to borrow from the FRB at a lower rate, which in turn allows consumers to borrow money at a lower rate from the member banks.
- Consumers' ability to borrow at lower interest rates helps to fuel the economy because consumers are now able to purchase more goods and services.

Federal Reserve Policy Tactics

Easy Money Policy:
- To expand credit during a recession to stimulate a slow economy:
  - Buy U.S. government securities in the open market
  - Lower the discount rate
  - Lower reserve requirements
Tight Money Policy:
- To tighten credit to slow economic expansion and prevent inflation:
  - Sell U.S. government securities in the open market
  - Raise the discount rate
  - Raise reserve requirements

Knwoledge Check 9.3

Question 1: Which of the following is added to M2 to arrive at M3?
- Large time deposits
Question 2: Which of the following actions of the Federal Reserve Board (FRB) would likely have the effect of causing interest rates to increase?
- II. Raising the reserve requirements
- III. Raising the discount rate