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9.3 The Federal Reserve System
Learning Objectives
- Explain the primary functions of central banks.
- Describe how the Federal Reserve System is structured and governed.
- Identify and explain the tools of monetary policy.
- Describe how the Fed creates and destroys money when it buys and sells federal government bonds.
The
Federal Reserve System of the United States, or Fed, is the U.S. central
bank. Japan’s central bank is the Bank of Japan; the European Union has
established the European Central Bank. Most countries have a central
bank. A central bank
performs five primary functions: (1) it acts as a banker to the central
government, (2) it acts as a banker to banks, (3) it acts as a
regulator of banks, (4) it conducts monetary policy, and (5) it supports
the stability of the financial system.
For the
first 137 years of its history, the United States did not have a true
central bank. While a central bank was often proposed, there was
resistance to creating an institution with such enormous power. A series
of bank panics slowly increased support for the creation of a central
bank. The bank panic of 1907 proved to be the final straw. Bank failures
were so widespread, and depositor losses so heavy, that concerns about
centralization of power gave way to a desire for an institution that
would provide a stabilizing force in the banking industry. Congress
passed the Federal Reserve Act in 1913, creating the Fed and giving it
all the powers of a central bank.
Structure of the Fed
In
creating the Fed, Congress determined that a central bank should be as
independent of the government as possible. It also sought to avoid too
much centralization of power in a single institution. These potentially
contradictory goals of independence and decentralized power are evident
in the Fed’s structure and in the continuing struggles between Congress
and the Fed over possible changes in that structure.
In an effort to decentralize power, Congress designed the Fed as a system of 12 regional banks, as shown in Figure 9.8 "The 12 Federal Reserve Districts and the Cities Where Each Bank Is Located".
Each of these banks operates as a kind of bankers’ cooperative; the
regional banks are owned by the commercial banks in their districts that
have chosen to be members of the Fed. The owners of each Federal
Reserve bank select the board of directors of that bank; the board
selects the bank’s president.
Figure 9.8 The 12 Federal Reserve Districts and the Cities Where Each Bank Is Located
Several
provisions of the Federal Reserve Act seek to maintain the Fed’s
independence. The board of directors for the entire Federal Reserve
System is called the Board of Governors. The seven members of the board
are appointed by the president of the United States and confirmed by the
Senate. To ensure a large measure of independence from any one
president, the members of the Board of Governors have 14-year terms. One
member of the board is selected by the president of the United States
to serve as chairman for a four-year term.
As
a further means of ensuring the independence of the Fed, Congress
authorized it to buy and sell federal government bonds. This activity is
a profitable one that allows the Fed to pay its own bills. The Fed is
thus not dependent on a Congress that might otherwise be tempted to
force a particular set of policies on it. The Fed is limited in the
profits it is allowed to earn; its “excess” profits are returned to the
Treasury.
It
is important to recognize that the Fed is technically not part of the
federal government. Members of the Board of Governors do not legally
have to answer to Congress, the president, or anyone else. The president
and members of Congress can certainly try to influence the Fed, but
they cannot order it to do anything. Congress, however, created the Fed.
It could, by passing another law, abolish the Fed’s independence. The
Fed can maintain its independence only by keeping the support of
Congress—and that sometimes requires being responsive to the wishes of
Congress.
In
recent years, Congress has sought to increase its oversight of the Fed.
The chairman of the Federal Reserve Board is required to report to
Congress twice each year on its monetary policy, the set of policies
that the central bank can use to influence economic activity.
Powers of the Fed
The
Fed’s principal powers stem from its authority to conduct monetary
policy. It has three main policy tools: setting reserve requirements,
operating the discount window and other credit facilities, and
conducting open-market operations.
Reserve Requirements
The
Fed sets the required ratio of reserves that banks must hold relative
to their deposit liabilities. In theory, the Fed could use this power as
an instrument of monetary policy. It could lower reserve requirements
when it wanted to increase the money supply and raise them when it
wanted to reduce the money supply. In practice, however, the Fed does
not use its power to set reserve requirements in this way. The reason is
that frequent manipulation of reserve requirements would make life
difficult for bankers, who would have to adjust their lending policies
to changing requirements.
The
Fed’s power to set reserve requirements was expanded by the Monetary
Control Act of 1980. Before that, the Fed set reserve requirements only
for commercial banks that were members of the Federal Reserve System.
Most banks are not members of the Fed; the Fed’s control of reserve
requirements thus extended to only a minority of banks. The 1980 act
required virtually all banks to satisfy the Fed’s reserve requirements.
The Discount Window and Other Credit Facilities
A
major responsibility of the Fed is to act as a lender of last resort to
banks. When banks fall short on reserves, they can borrow reserves from
the Fed through its discount window. The discount rate is the interest rate charged by the Fed when it lends reserves to banks. The Board of Governors sets the discount rate.
Lowering
the discount rate makes funds cheaper to banks. A lower discount rate
could place downward pressure on interest rates in the economy. However,
when financial markets are operating normally, banks rarely borrow from
the Fed, reserving use of the discount window for emergencies. A
typical bank borrows from the Fed only about once or twice per year.
Instead
of borrowing from the Fed when they need reserves, banks typically rely
on the federal funds market to obtain reserves. The federal funds market is a market in which banks lend reserves to one another. The federal funds rate
is the interest rate charged for such loans; it is determined by banks’
demand for and supply of these reserves. The ability to set the
discount rate is no longer an important tool of Federal Reserve policy.
To
deal with the recent financial and economic conditions, the Fed greatly
expanded its lending beyond its traditional discount window lending. As
falling house prices led to foreclosures, private investment banks and
other financial institutions came under increasing pressure. The Fed
made credit available to a wide range of institutions in an effort to
stem the crisis. In 2008, the Fed bailed out two major housing finance
firms that had been established by the government to prop up the housing
industry—Fannie Mae (the Federal National Mortgage Association) and
Freddie Mac (the Federal Home Mortgage Corporation). Together, the two
institutions backed the mortgages of half of the nation’s mortgage
loans.Sam Zuckerman, “Feds Take Control of Fannie Mae, Freddie Mac,” The San Francisco Chronicle, September 8, 2008, p. A-1.
It also agreed to provide $85 billion to AIG, the huge insurance firm.
AIG had a subsidiary that was heavily exposed to mortgage loan losses,
and that crippled the firm. The Fed determined that AIG was simply too
big to be allowed to fail. Many banks had ties to the giant institution,
and its failure would have been a blow to those banks. As the United
States faced the worst financial crisis since the Great Depression, the
Fed took center stage. Whatever its role in the financial crisis of
2007–2008, the Fed remains an important backstop for banks and other
financial institutions needing liquidity. And for that, it uses the
traditional discount window, supplemented with a wide range of other
credit facilities. The Case in Point in this section discusses these new
credit facilities.
Open-Market Operations
The Fed’s ability to buy and sell federal government bonds has proved to be its most potent policy tool. A bond
is a promise by the issuer of the bond (in this case the federal
government) to pay the owner of the bond a payment or a series of
payments on a specific date or dates. The buying and selling of federal
government bonds by the Fed are called open-market operations.
When the Fed buys or sells government bonds, it adds or subtracts
reserves from the banking system. Such changes affect the money supply.
Suppose
the Fed buys a government bond in the open market. It writes a check on
its own account to the seller of the bond. When the seller deposits the
check at a bank, the bank submits the check to the Fed for payment. The
Fed “pays” the check by crediting the bank’s account at the Fed, so the
bank has more reserves.
The
Fed’s purchase of a bond can be illustrated using a balance sheet.
Suppose the Fed buys a bond for $1,000 from one of Acme Bank’s
customers. When that customer deposits the check at Acme, checkable
deposits will rise by $1,000. The check is written on the Federal
Reserve System; the Fed will credit Acme’s account. Acme’s reserves thus
rise by $1,000. With a 10% reserve requirement, that will create $900
in excess reserves and set off the same process of money expansion as
did the cash deposit we have already examined. The difference is that
the Fed’s purchase of a bond created new reserves with the stroke of a
pen, where the cash deposit created them by removing $1,000 from
currency in circulation. The purchase of the $1,000 bond by the Fed
could thus increase the money supply by as much as $10,000, the maximum
expansion suggested by the deposit multiplier.
Figure 9.9
Where
does the Fed get $1,000 to purchase the bond? It simply creates the
money when it writes the check to purchase the bond. On the Fed’s
balance sheet, assets increase by $1,000 because the Fed now has the
bond; bank deposits with the Fed, which represent a liability to the
Fed, rise by $1,000 as well.
When
the Fed sells a bond, it gives the buyer a federal government bond that
it had previously purchased and accepts a check in exchange. The bank
on which the check was written will find its deposit with the Fed
reduced by the amount of the check. That bank’s reserves and checkable
deposits will fall by equal amounts; the reserves, in effect, disappear.
The result is a reduction in the money supply. The Fed thus increases
the money supply by buying bonds; it reduces the money supply by selling
them.
Figure 9.10 "The Fed and the Flow of Money in the Economy"
shows how the Fed influences the flow of money in the economy. Funds
flow from the public—individuals and firms—to banks as deposits. Banks
use those funds to make loans to the public—to individuals and firms.
The Fed can influence the volume of bank lending by buying bonds and
thus injecting reserves into the system. With new reserves, banks will
increase their lending, which creates still more deposits and still more
lending as the deposit multiplier goes to work. Alternatively, the Fed
can sell bonds. When it does, reserves flow out of the system, reducing
bank lending and reducing deposits.
Figure 9.10 The Fed and the Flow of Money in the Economy
Individuals and firms (the public) make
deposits in banks; banks make loans to individuals and firms. The Fed
can buy bonds to inject new reserves into the system, thus increasing
bank lending, which creates new deposits, creating still more lending as
the deposit multiplier goes to work. Alternatively, the Fed can sell
bonds, withdrawing reserves from the system, thus reducing bank lending
and reducing total deposits.
The
Fed’s purchase or sale of bonds is conducted by the Open Market Desk at
the Federal Reserve Bank of New York, one of the 12 district banks.
Traders at the Open Market Desk are guided by policy directives issued
by the Federal Open Market Committee (FOMC). The FOMC consists of the
seven members of the Board of Governors plus five regional bank
presidents. The president of the New York Federal Reserve Bank serves as
a member of the FOMC; the other 11 bank presidents take turns filling
the remaining four seats.
The
FOMC meets eight times per year to chart the Fed’s monetary policies.
In the past, FOMC meetings were closed, with no report of the
committee’s action until the release of the minutes six weeks after the
meeting. Faced with pressure to open its proceedings, the Fed began in
1994 issuing a report of the decisions of the FOMC immediately after
each meeting.
In
practice, the Fed sets targets for the federal funds rate. To achieve a
lower federal funds rate, the Fed goes into the open market buying
securities and thus increasing the money supply. When the Fed raises its
target rate for the federal funds rate, it sells securities and thus
reduces the money supply.
Traditionally,
the Fed has bought and sold short-term government securities; however,
in dealing with the condition of the economy in 2009, wherein the Fed
has already set the target for the federal funds rate at near zero, the
Fed has announced that it will also be buying longer term government
securities. In so doing, it hopes to influence longer term interest
rates, such as those related to mortgages.
Key Takeaways
- The Fed, the central bank of the United States, acts as a bank for other banks and for the federal government. It also regulates banks, sets monetary policy, and maintains the stability of the financial system.
- The Fed sets reserve requirements and the discount rate and conducts open-market operations. Of these tools of monetary policy, open-market operations are the most important.
- Starting in 2007, the Fed began creating additional credit facilities to help stabilize the financial system.
- The Fed creates new reserves and new money when it purchases bonds. It destroys reserves and thus reduces the money supply when it sells bonds.
Try It!
Suppose the Fed sells $8 million worth of bonds.
- How do bank reserves change?
- Will the money supply increase or decrease?
- What is the maximum possible change in the money supply if the required reserve ratio is 0.2?
Case in Point: Fed Supports the Financial System by Creating New Credit Facilities
Well
before most of the public became aware of the precarious state of the
U.S. financial system, the Fed began to see signs of growing financial
strains and to act on reducing them. In particular, the Fed saw that
short-term interest rates that are often quite close to the federal
funds rate began to rise markedly above it. The widening spread was
alarming, because it suggested that lender confidence was declining,
even for what are generally considered low-risk loans. Commercial paper,
in which large companies borrow funds for a period of about a month to
manage their cash flow, is an example. Even companies with high credit
ratings were having to pay unusually high interest rate premiums in
order to get funding, or in some cases could not get funding at all.
To
deal with the drying up of credit markets, in late 2007 the Fed began
to create an alphabet soup of new credit facilities. Some of these were
offered in conjunction with the Department of the Treasury, which had
more latitude in terms of accepting some credit risk. The facilities
differed in terms of collateral used, the duration of the loan, which
institutions were eligible to borrow, and the cost to the borrower. For
example, the Primary Dealer Credit Facility (PDCF) allowed primary
dealers (i.e., those financial institutions that normally handle the
Fed’s open market operations) to obtain overnight loans. The Term
Asset-Backed Securities Loan Facility (TALF) allowed a wide range of
companies to borrow, using the primary dealers as conduits, based on
qualified asset-backed securities related to student, auto, credit card,
and small business debt, for a three-year period. Most of these new
facilities were designed to be temporary. Starting in 2009 and 2010, the
Fed began closing a number of them or at least preventing them from
issuing new loans.
The
common goal of all of these various credit facilities was to increase
liquidity in order to stimulate private spending. For example, these
credit facilities encouraged banks to pare down their excess reserves
(which grew enormously as the financial crisis unfolded and the economy
deteriorated) and to make more loans. In the words of Fed Chairman Ben
Bernanke:
“Liquidity
provision by the central bank reduces systemic risk by assuring market
participants that, should short-term investors begin to lose confidence,
financial institutions will be able to meet the resulting demands for
cash without resorting to potentially destabilizing fire sales of
assets. Moreover, backstopping the liquidity needs of financial
institutions reduces funding stresses and, all else equal, should
increase the willingness of those institutions to lend and make
markets.”
The
legal authority for most of these new credit facilities came from a
particular section of the Federal Reserve Act that allows the Board of
Governors “in unusual and exigent circumstances” to extend credit to a
wide range of market players.
Sources:
Ben S. Bernanke, “The Crisis and the Policy Response” (Stemp Lecture,
London School of Economics, London, England, January 13, 2009); Richard
DiCecio and Charles S. Gascon, “New Monetary Policy Tools?” Federal Reserve Bank of St. Louis Monetary Trends, May 2008; Federal Reserve Board of Governors Web site at http://www.federalreserve.gov/monetarypolicy/default.htm.
Answer to Try It! Problem
- Bank reserves fall by $8 million.
- The money supply decreases.
- The maximum possible decrease is $40 million, since ∆D = (1/0.2) × (−$8 million) = −$40 million.
http://www.theartof12.blogspot.com/2014/07/federal-reserve-private-jewish-bank.html
Money isn't and yet every so called U.S. Citizen not only pays interest on the CRIMINAL FRAUD, indeed get to be killed just like that for the killing fun.
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