The Federal Reserve System and Monetary Policy

The Federal Reserve System

• The Federal Reserve (The Fed)
  • The central bank of the United States
  • Created in 1913 after a series of bank failures in 1907.
  • Purpose:
    • To ensure the health of the nation’s banking system.
    • Conduct monetary policy by setting the money supply

The Fed’s Organization

• The Federal Reserve System consists of 12 regional Federal Reserve Banks located in major cities around the country.
  • The presidents of these banks are chosen by each bank’s board of directors.
  • Jobs of regional banks:
    • Monitors each bank’s financial condition.
    • Facilitates bank transactions by clearing checks.
    • Acts as a bank’s bank.
    • Lender of last resort (Discount Loans)

Board of Governors

• The Fed’s organization also includes a Board of Governors with 7 members who serve 14-year terms.
  • Governors are appointed by the President and confirmed by the Senate.
  • The chairman:
    • Directs the Fed staff
    • Presides over board meetings
    • Testifies regularly about Fed policy in front of congressional committees.
    • Appointed by the president (4-year term)

Federal Open Market Committee (FOMC)

• The FOMC consists of:
  • 7 members of the Board of Governors
  • 5 of the twelve regional bank presidents
    • All twelve regional presidents attend each FOMC meeting, but only five get to vote
  • The FOMC meets about every 6 weeks in Washington, D.C.
    • They discuss conditions in the macro-economy and consider changes in monetary policy.

Monetary Policy Tools

• The Fed has 3 tools for monetary policy:
  1. Discount Loans
  2. Reserve requirements
  3. Open market operations
     • These tools are used to change the Fed Funds Target Interest Rate

Discount Loans

• Discount Rate = Interest rate on the loans that the Fed makes to banks
  • Higher discount rate → Reduces the money supply
  • Smaller discount rate → Increases the money supply
• Lender of Last Resort, but not a very powerful tool for monetary policy

Reserve Requirements

• Government regulation on the minimum amount banks must hold in reserves
  • Increase in reserve requirement → Decreases money supply
  • A decrease in reserve requirement → Increases money supply
  • Used rarely for monetary policy because it can disrupt the business of banking

Open Market Operations

• Purchase and sale of U.S. government bonds by the Fed
  • To increase the money supply → The Fed buys U.S. government bonds
  • To reduce the money supply → The Fed sells U.S. government bonds
  • Most often used monetary policy tool

Federal Funds Rate

• Key element in Open Market Operations:

  • The federal funds target interest rate (Fed Funds Rate)
  • Interest rate at which banks make overnight loans to one another
    • Lender → has excess reserves
    • Borrower → needs reserves
  • A change in the federal funds rate changes other interest rates

• When the Fed uses Open Market Operations:

  • Can order a decrease in the Fed Funds Rate
    • The Fed buys bonds in Fed Funds market » Supply curve increases → lower interest rate
    • Causes an increase in money supply
  • Can order an increase in the Fed Funds Rate
    • The Fed sells bonds in Fed Funds market » Supply curve decreases → higher interest rate
    • Causes a decrease in money supply
  • Inflation Targeting ~ 3% per year