Finance 100 Week 2 Financial Problems /Business & Finance

Federal Reserve System

L E A R N I N G O BJ E C T I V E S

After studying this chapter, you should be able to do the following: LO 4.1 Discuss how the Federal Reserve System (Fed) responded to the recent fi nancial

crisis and Great Recession.

LO 4.2 Identify three weaknesses of the national banking system that existed before the Federal Reserve System was created.

LO 4.3 Describe the Federal Reserve System and identify the fi ve major components into which it is organized.

LO 4.4 Identify and describe the policy instruments used by the Fed to carry out monetary policy.

LO 4.5 Discuss the Fed’s supervisory and regulatory functions. LO 4.6 Identify important Fed service functions. LO 4.7 Identify specifi c examples of foreign countries that use central banking systems to

regulate money supply and implement monetary policy.

W H E R E W E H AV E B E E N . . . In Chapter 3 we discussed the types and roles of fi nancial institutions that have evolved in

the United States to meet the needs of individuals and businesses and help the fi nancial sys-

tem operate effi ciently. We also described the traditional diff erences between commercial

banking and investment banking, followed by coverage of the functions of banks (all depos-

itory institutions) and the banking system. By now you also should have an understanding of

the structure and chartering of commercial banks, the availability of branch banking, and the

use of bank holding companies. You also should now have a basic understanding of the bank

balance sheet and how the bank management process is carried out in terms of liquidity and

capital management. Selected information also was provided on international banking and

several foreign banking systems.

W H E R E W E A R E G O I N G . . . The last two chapters in Part 1 address the role of policy makers in the fi nancial system and

how international trade and fi nance infl uence the U.S. fi nancial system. In Chapter 5 you will

have the opportunity to review economic objectives that direct policy-making activities. We

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 77

then briefl y review fi scal policy and how it is administered through taxation and expenditure

plans. This is followed by a discussion of the policy instruments employed by the U.S.

Treasury and how the Treasury carries out its debt management activities. You will then see

how the money supply is changed by the banking system, as well as develop an understand-

ing of the factors that aff ect bank reserves. The monetary base and the money multiplier also

will be described and discussed. Chapter 6 focuses on how currency exchange rates are

determined and how international trade is fi nanced.

H O W T H I S C H A P T E R A P P L I E S TO M E . . .

Actions taken by the Fed impact your ability to borrow money and the cost of, or interest

rate on, that money. When the Fed is taking an easy monetary stance, money becomes

more easily available, which in turn leads to a lower cost. Such an action, in turn, will

likely result in lower interest rates on your credit card, your new automobile loan, and

possibly your interest rate on a new mortgage loan. Actions by the Fed also infl uence eco-

nomic activity and the type and kind of job opportunities that may be available to you. For

example, a tightening of monetary policy in an eff ort to control infl ation may lead to an

economic slowdown.

While many individuals know that the Federal Reserve System is the central bank of the

United States, what the Fed does and how it operates are less clear. Stephen H. Axilrod

comments,

There must be almost as many images of the Fed as an institution and of the wellsprings of its actions as there are viewers. Mine, born of a particular experience, is a generally benign one. It is of an unbiased, honest, straightforward institution that quite seriously and carefully carries out its congressionally given mandates. . . . It is of course through the window of monetary policy that the public chiefl y sees and judges the Fed.1

This chapter focuses on understanding the structure and functions of the Fed. Chapter 5 describes

how the Fed administers monetary policy in cooperation with fi scal policy and Treasury

operations to carry out the nation’s economic objectives.

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession CRISIS As previously noted, the 2007–2008 fi nancial crisis and the 2008–2009 Great Reces-

sion combined to create a “perfect fi nancial storm.” Many government offi cials, politicians,

fi nancial institution executives, and business professionals felt during the midst of the

fi nancial storm that both the U.S. and world fi nancial systems were on the verge of collapse

in 2008. The Federal Reserve System (Fed), the central bank of the United States, is responsible for setting monetary policy and regulating the banking system. Direct actions

and involvement by the Fed were critical in government and related institutional eff orts to

avoid fi nancial collapse.

The federal government has historically played an active role in encouraging home own-

ership by supporting liquid markets for home mortgages. If banks and other lenders originate

home mortgages and then “hold” the mortgages, new mortgage funds are not readily available.

However, when banks and other lenders are able to sell their mortgages in a secondary mortgage

market to other investors, the proceeds from the sales can be used to make new mortgage loans. In

Federal Reserve System (Fed) U.S. central bank that sets monetary

policy and regulates banking

system

1Stephen H. Axilrod, Inside the Fed, (Cambridge: The MIT Press, 2009), p. 159.

78 CHAPTER 4 Federal Reserve System

1938, the president and Congress created the Federal National Mortgage Association (Fannie Mae) to support the fi nancial markets by purchasing home mortgages from banks and, thus, freeing-up funds that could be lent to other borrowers. Fannie Mae was converted to a government-

sponsored enterprise (GSE), or “privatized,” in 1968 by making it a public, investor-owned com-

pany. The Government National Mortgage Association (Ginnie Mae) was created in 1968 as a government-owned corporation. Ginnie Mae issues its own debt securities to obtain funds that

are invested in mortgages made to low to moderate income home purchasers. The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970, also as a government-owned corporation to aid the mortgage markets by purchasing and holding mortgage loans. In 1989,

Freddie Mac also became a GSE when it became a public, investor-owned company.

Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage

purchases and holdings. Ginnie Mae purchases Federal Housing Administration (FHA)

and Department of Veterans Aff airs (VA) federally insured mortgages, packages them into

mortgage-backed securities that are sold to investors. Ginnie Mae guarantees the payment

of interest and principal on the mortgages held in the pool. Fannie Mae purchases individual

mortgages or mortgage pools from fi nancial institutions and packages or repackages them into

mortgage-backed securities as ways to aid development of the secondary mortgage markets.

Freddie Mac purchases and holds mortgage loans.

As housing prices continued to increase, these mortgage-support activities by Ginnie

Mae, Fannie Mae, and Freddie Mac aided the government’s goal of increased home own-

ership. However, after the housing price bubble burst in mid-2006 and housing-related jobs

declined sharply, mortgage borrowers found it more diffi cult to meet interest and principal

payments, causing the values of mortgage-backed securities to decline sharply. To make the

housing-related developments worse, Fannie Mae and Freddie Mac held large amounts of low

quality, subprime mortgages that had higher likelihoods of loan defaults. As default rates on

these mortgage loans increased, both Fannie and Freddie suff ered cash and liquidity crises.

To avoid a meltdown, the Federal Reserve provided rescue funds in July 2008, and the U.S.

government assumed control of both fi rms in September 2008.

The Federal Reserve, sometimes with the aid of the U.S. Treasury, helped a number of

fi nancial institutions on the verge of failing, due to the collapse in value of mortgage-backed

securities, to merge with other fi rms. Examples included the Fed’s eff orts in aiding the March

2008 acquisition of Bear Stearns by the JPMorgan Chase bank and the sale of Merrill Lynch

to Bank of America during the latter part of 2008. However, Lehman Brothers, a major invest-

ment bank, was allowed to fail in September 2008. Shortly after the Lehman bankruptcy and

the Merrill sale, American International Group (AIG), the largest insurance fi rm in the United

States, was “bailed out” by the Federal Reserve with the U.S. government receiving an own-

ership interest in the company. Like Merrill, Fannie, and Freddie, AIG was considered “too

large to fail,” due to the potential impact of this on the global fi nancial markets.

In addition to direct intervention, the Fed also engaged in quantitative easing actions to

help avoid a fi nancial system collapse in 2008, and to stimulate economic growth after the

2008–09 recession. We will discuss the Fed’s quantitative easing actions later in the chapter.

DISCUSSION QUESTION 1 Do you support the Fed’s decision to bail out selected fi nancial institutions that were suff ering fi nancial distress in 2008?

4.2 The U.S. Banking System Prior to the Fed In Chapter 1, when we discussed the characteristics of an eff ective fi nancial system, we

said that one basic requirement was a monetary system that effi ciently carried out the fi n-

ancial functions of creating and transferring money. While we have an effi cient monetary

system today, this was not always the case. To understand the importance of the Federal

Reserve System, it is useful to review briefl y the weaknesses of the banking system that gave

rise to the establishment of the Fed. The National Banking Acts passed in 1863 and 1864

provided for a national banking system. Banks could receive national charters, capital and

reserve requirements on deposits and banknotes were established, and banknotes could be

Federal National Mortgage Association (Fannie Mae) created to support the fi nancial markets by

purchasing home mortgages from

banks so that the proceeds could be

lent to other borrowers

Government National Mortgage Association (Ginnie Mae) created to issue its own debt securities to

obtain funds that are invested in

mortgages made to low to moderate

income home purchasers

Federal Home Loan Mortgage Corporation (Freddie Mac) formed to support mortgage

markets by purchasing and holding

mortgage loans

4.2 The U.S. Banking System Prior to the Fed 79

issued only against U.S. government securities owned by the banks but held with the U.S.

Treasury Department. These banknotes, backed by government securities, were supposed to

provide citizens with a safe and stable national currency. Improved bank supervision also was

provided for with the establishment of the Offi ce of the Comptroller of the Currency under

the control of the U.S. Treasury.

Weaknesses of the National Banking System Although the national banking system overcame many of the weaknesses of the prior systems

involving state banks, it lacked the ability to carry out other central banking system activities

that are essential to a well-operating fi nancial system. Three essential requirements include

(1) an effi cient national payments system, (2) an elastic or fl exible money supply that can

respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help

alleviate liquidity problems when they arise. The fi rst two requirements relate directly to the

transferring and creating money functions. The third requirement relates to the need to main-

tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the

ability to meet depositor withdrawals and to pay other liabilities as they come due. All three

of these required elements were defi cient until the Federal Reserve System was established.

The payments system under the National Banking Acts was based on an extensive net-

work of banks with correspondent banking relationships. It was costly to transfer funds from

region to region, and the check clearing and collection process sometimes was quite long.

Checks written on little-known banks located in out-of-the-way places often were discoun-

ted or were redeemed at less than face value. For example, let’s assume that a check written

on an account at a little-known bank in the western region of the United States was sent to

pay a bill owed to a fi rm in the eastern region. When the fi rm presented the check to its local

bank, the bank might record an amount less than the check’s face value in the fi rm’s checking

account. The amount of the discount was to cover the cost of getting the check cleared and

presented for collection to the bank located in the western region. Today, checks are processed

or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3

that the current U.S. payments system allows checks to be processed either directly or indirectly.

The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3

or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.

A second weakness of the banking system under the National Banking Acts was that the

money supply could not be easily expanded or contracted to meet changing seasonal needs

and/or changes in economic activity. As noted, banknotes could be issued only to the extent

that they were backed by U.S. government securities. Note issues were limited to 90 percent

of the par value, as stated on the face of the bond, or the market value of the bonds, whichever

was lower. When bonds sold at prices considerably above their par value, the advantage of

purchasing bonds as a basis to issue notes was eliminated.2

For example, if a $1,000 par value bond was available for purchase at a price of $1,100,

the banks would not be inclined to make such a purchase since a maximum of $900 in notes

could be issued against the bond, in this case 90 percent of par value. The interest that the

bank could earn from the use of the $900 in notes would not be great enough to off set the high

price of the bond. When government bonds sold at par or at a discount, on the other hand,

the potential earning power of the note issues would be quite attractive and banks would be

encouraged to purchase bonds for note issue purposes. The volume of national bank notes,

thus the money supply, therefore depended on the government bond market rather than on the

seasonal, or cyclical, needs of the nation for currency.

A third weakness of the national banking system involved the arrangement for holding

reserves and the lack of a central authority that could lend to banks experiencing temporary

liquidity problems. A large part of the reserve balances of banks was held as deposits with

large city banks, in particular with large New York City banks. Banks outside of the large

cities were permitted to keep part of their reserves with their correspondent large city banks.

Certain percentages of deposits had to be retained in their own vaults. These were the only

2A bond’s price will diff er from its stated or face value if the interest rate required in the marketplace is diff erent from

the interest rate stated on the bond certifi cate. Bond valuation calculations are discussed in Chapter 10.

80 CHAPTER 4 Federal Reserve System

alternatives for holding reserve balances. During periods of economic stress, the position of

these large city banks was precarious because they had to meet the demand for deposit with-

drawals by their own customers as well as by the smaller banks. The frequent inability of the

large banks to meet such deposit withdrawal demands resulted in extreme hardship for the

smaller banks whose reserves they held. A mechanism for providing loans to banks to help

them weather short-term liquidity problems is crucial to a well-functioning banking system.

The Movement to Central Banking A central bank is a government-established organization responsible for supervising and regulating the banking system and for creating and regulating the money supply. While central

bank activities may diff er somewhat from country to country, central banks typically play an

important role in a country’s payments system. It is also common for a central bank to lend

money to its member banks, hold its own reserves, and be responsible for creating money.

Even though the shortcomings of the national banking system in terms of the payments

system, infl exible money supply, and illiquidity were known, opposition to a strong central

banking system still existed in the United States during the late 1800s. The vast western fron-

tiers and the local independence of the southern areas during this period created distrust of

centralized fi nancial control. This distrust deepened when many of the predatory practices of

large corporate combinations were being made public by legislative commissions and invest-

igations around the turn of the century.

The United States was one of the last major industrial nations to adopt a permanent sys-

tem of central banking. However, many fi nancial and political leaders had long recognized the

advantages of such a system. These supporters of central banking were given a big boost by

the fi nancial panic of 1907. The central banking system adopted by the United States under the

Federal Reserve Act of 1913 was, in fact, a compromise between the system of independently

owned banks in this country and the single central bank systems of such countries as Canada,

Great Britain, and Germany. This compromise took the form of a series of central banks, each

representing a specifi c region of the United States. The assumption was that each central bank

would be more responsive to the particular fi nancial problems of its region.

4.3 Structure of the Federal Reserve System The Federal Reserve System is the central bank of the United States and is responsible for

setting monetary policy and regulating the banking system. It is important to understand that

the Fed did not replace the system that existed under the National Banking Acts of 1863 and

1864 but, rather, it was superimposed on the national banking system created by these acts.

Certain provisions of the National Banking Acts, however, were modifi ed to permit greater

fl exibility of operations.

The Fed system consists of fi ve components:

Member banks

Federal Reserve District Banks

Board of Governors

Federal Open Market Committee

Advisory committees

These fi ve components are depicted in Figure 4.1.

Member Banks The Federal Reserve Act provided that all national banks were to become members of the

Fed. In addition, state-chartered banks were permitted to join the system if they could show

central bank federal government agency that facilitates the operation

of the fi nancial system and

regulates the money supply

4.3 Structure of the Federal Reserve System 81

evidence of a satisfactory fi nancial condition. The Federal Reserve Act also required that all

member banks purchase capital stock of the Reserve Bank of their district up to a maximum

of 6 percent of their paid-in capital and surplus. In practice, however, member banks have had

to pay only 3 percent; the remainder is subject to call at the discretion of the Fed. Member

banks are limited to a maximum of 6 percent dividends on the stock of the Reserve Bank that

they hold. The Reserve Banks, therefore, are private institutions owned by the many member

banks of the Fed.

State-chartered banks are permitted to withdraw from membership with the Fed six

months after written notice has been submitted to the Reserve Bank of their district. In such

cases, the stock originally purchased by the withdrawing member is canceled and a refund is

made for all money paid in.

Exercises

General

Supervision

Compose

BOARD OF GOVERNORS

(7 Appointed Members)

Consumer Advisory

Council

Federal Advisory

Council

Thrift Institutions

Advisory Council

approves discount rates as part

of monetary policy

companies

consumer finance

Banks

FEDERAL RESERVE BANKS

(12 Districts)

depository institutions and lend

to them at the discount window

transfer funds for depository

institutions

and cash balances

COMMITTEE

(Board of Governors and

is the primary instrument of

monetary policy

Advise

ADVISORY

COMMITTEE

MEMBER

BANKS

Own

FIGURE 4.1 Organization of the Federal Reserve System

Commercial Banks as Providers of Small Business Credit

The 1980s and 1990s were diffi cult for the banking industry in the

United States. Many savings and loan associations (S&Ls) failed,

and there were many mergers involving S&Ls and commercial

banks. Furthermore, many of the consolidations involved small

commercial banks that traditionally tended to specialize in small

business lending. As a result, concern has been expressed about

where, or even whether, small businesses are able to obtain loans

and other forms of business credit.

In contrast, the fi rst part of the decade of the 2000s was char-

acterized by Fed monetary policy that emphasized liquidity and low

interest rates in an eff ort to stimulate economic recovery after the

dot-com and the tech bubbles burst at the beginning of the decade

and in reaction to the September 11, 2001, terrorist attack. Even after

the U.S. economy began recovering, the Fed maintained an easy

monetary policy. Then came the real estate price bubble burst, fol-

lowed by the 2007–08 fi nancial crisis and 2008–09 Great Recession.

During the crisis, the availability of bank loans for small businesses

virtually dried up. There now is an ongoing eff ort to encourage

banks to increase the availability of loan funds to small businesses.

Small Business Practice

82 CHAPTER 4 Federal Reserve System

Approximately 3,500, or about one-third, of the nation’s commercial banks are members of

the Fed. This includes all commercial banks with national charters plus, roughly, one-fi fth of the

state-chartered banks. These member banks hold approximately three-fourths of the deposits of

all commercial banks. National banks control about three-fi fths of the total assets of all FDIC-

insured commercial banks, and the state-chartered banks that belong to the Fed control another

one-fourth of total assets. Even these fi gures understate the importance of the Federal Reserve in

the nation’s fi nancial system. As indicated in Chapter 3, the Monetary Control Act of 1980 gen-

erally eliminated distinctions between banks that are members of the Fed and other depository

institutions by applying comparable reserve and reporting requirements to all these institutions.

Federal Reserve District Banks The Federal Reserve Act of 1913 provided for the establishment of 12 Federal Reserve dis-

tricts. Each district is served by a Federal Reserve Bank. Figure 4.1 indicates that district

banks have a wide range of responsibilities, including holding reserve balances for depository

institutions and lending to them at the prevailing discount (interest) rate. The district banks

also issue new currency and withdraw damaged currency from circulation, as well as collect

and clear checks and transfer funds for depository institutions. The boundaries of the districts

and the cities where district banks are located are shown in Figure 4.2.

Directors and Off icers Each Reserve Bank has corporate offi cers and a board of directors. The selection of offi cers and directors is unlike that of other corporations. Each

Reserve Bank has on its board nine directors, who must be residents of the district in which

they serve. The directors serve terms of three years, with appointments staggered so that three

directors are appointed each year. To ensure that the various economic elements of the Federal

Reserve districts are represented, the nine members of the board of directors are divided into

three groups: Class A, Class B, and Class C.

DE MD

TX OK

ND MT

MA RI

VA WV

OHINIL

TN SCAL

Buffalo

New York

Boston Cleveland

Detroit

Chicago

Charlotte

Atlanta

Birmingham

Jacksonville

Miami

New OrleansSanAntonio

Dallas

Little Rock

Houston

St. Louis

Omaha

Minneapolis

Kansas City

Seattle

Portland

Los Angeles

Salt Lake City Denver

Helena

Richmond

San Francisco

Philadelphia Pittsburgh

El Paso

Baltimore

Board of Governors of the Federal Reserve System

Federal Reserve Bank cities

Federal Reserve Branch cities

Louisville

Memphis Nashville

Cincinnati

FIGURE 4.2 The Federal Reserve System

Source: Board of Governors of the Federal Reserve System.

4.3 Structure of the Federal Reserve System 83

Both Class A and Class B directors are elected by the member banks of the Federal

Reserve district. The Class A directors represent member banks of the district, and the Class

B directors represent nonbanking interests. These nonbanking interests are commerce, agri-

culture, and industry. The Class C directors are appointed by the Board of Governors of the

Federal Reserve System. These persons may not be stockholders, directors, or employees of

existing banks.

The majority of the directors of the Reserve Banks are elected by the member banks of

each district. However, the three nonbanking members of each board appointed by the Board

of Governors of the Federal Reserve System are in a more strategic position than the other

board members. One member appointed by the Board of Governors is designated chairperson

of the board of directors and Federal Reserve agent, and a second member is appointed deputy

chairperson. The Federal Reserve agent is the Board of Governor’s representative at each

Reserve Bank. He or she is responsible for maintaining the collateral that backs the Federal

Reserve notes issued by each Reserve Bank.

Each Reserve Bank also has a president and fi rst vice president, who are appointed

by its board of directors and approved by the Board of Governors. A Reserve Bank may

have several additional vice presidents. The president is responsible for executing policies

established by the board of directors and for the general administration of Reserve Bank

aff airs. All other offi cers and personnel of the Reserve Bank are subject to the authority of

the president.

Federal Reserve Branch Banks In addition to the 12 Reserve Banks, 25 branch banks have been established. These branch banks are for the most part in geographical areas

not conveniently served by the Reserve Banks themselves. For this reason, the geograph-

ically large western Federal Reserve districts have most of the Reserve Branch Banks. The

San Francisco district has four, the Dallas district has three, and the Atlanta district has fi ve

branch banks. The New York Federal Reserve district, on the other hand, has only one branch

bank, while the Boston district has no branches. The cities in which Reserve Banks and their

branches are located are also shown in Figure 4.2.

Board of Governors The Fed Board of Governors, or formally the Board of Governors (BOG), of the Federal Reserve System, is composed of seven members and is responsible for setting monetary policy.

Each member is appointed for a term of 14 years. The purpose of the 14-year term undoubtedly

was to reduce political pressure on the BOG. Board members can be of any political party, and

there is no specifi c provision concerning the qualifi cations a member must have. All members

are appointed by the president of the United States with the advice and consent of the Senate.

One member is designated as the chairperson and another as the vice chairperson.

The appointive power of the president and the ability of Congress to alter its structure

make the BOG a dependent political structure. However, it enjoys much independence in

its operations. The Board of Governors of the Federal Reserve System is, in fact, one of the

most powerful monetary organizations in the world. The chair of the board plays an especially

infl uential role in policy formulation. Because the board attempts to achieve its goals without

political considerations, disagreement between the administration in power and the board is

common. From time to time, pressures from Congress or the president have undoubtedly infl u-

enced the board’s decisions, but its semi-independence generally prevails.

Figure 4.1 illustrates how the Board of Governors establishes monetary policy. The

Fed BOG sets reserve requirements and reviews and approves the discount rate actions of the

12 district banks. The Fed BOG also operates through the Federal Open Market Committee to

control the money supply as a means of meeting monetary policy objectives. We will explore

these monetary policy instruments in more detail later in the chapter.

In addition to setting the nation’s monetary policy, the board directs and coordinates

the activities of the 12 Reserve Banks under its jurisdiction. The board is responsible for

approving the applications of state-chartered banks applying for membership in the system

and for recommending the removal of offi cers and directors of member banks when they

break rules established by the Fed and other regulatory authorities. In addition, the board

Fed Board of Governors seven- member board of the Federal

Reserve that sets monetary policy

84 CHAPTER 4 Federal Reserve System

implements many of the credit control devices that have come into existence since the mid-1960s,

such as the Truth in Lending Act, the Equal Credit Opportunity Act, and the Home Mortgage Disclosure Act.

The BOG staff conducts economic research, compiles economic data, and prepares publi-

cations that provide consumer and regulatory information. The board and all 12 of the Reserve

Banks engage in intensive research in monetary matters.

Federal Open Market Committee As early as 1922, eff orts were made to coordinate the timing of purchases and sales of secur-

ities by the Federal Reserve Banks to achieve desirable national monetary policy objectives.

The Federal Open Market Committee (FOMC), with the additional powers granted to it by

the Banking Act of 1935, has full control over all open-market operations of the Reserve Banks. As noted in Figure 4.1, this committee consists of the seven members of the Fed

BOG plus fi ve presidents (one of whom must be from New York) of Reserve Banks. The

FOMC conducts open-market operations through the process of buying and selling U.S.

government and other securities. These activities represent the primary method for carrying

out monetary policies.

Advisory Committees Figure 4.1 indicates that the Federal Reserve System has three major advisory committees.

The Federal Advisory Council provides advice and general information on banking-related

issues to the BOG. Each of the 12 Federal Reserve districts elects one member to serve on the

council. The membership of the Consumer Advisory Council is composed of representatives

from depository institutions and their customers and, as the committee title suggests, provides

advice relating to consumer issues. The Thrift Institutions Advisory Council consists of mem-

bers from S&Ls, savings banks, and credit unions and provides advice on issues that directly

aff ect thrift institutions.

Role of the Chair of the Fed Board of Governors Special authority attaches to the chairperson of any board. The chair of the Board of Gov-

ernors of the Federal Reserve System is no exception. The holder of that position is gener-

ally recognized as the most powerful infl uence on monetary policy in the nation. As for any

chairperson, the chair’s power derives in large measure from the personality, experience, and

leadership of the individual. ETHICAL High moral and ethical standards are a must for the chairperson of the Fed BOG.

A successful chair must have the confi dence and trust of the president and Congress, bank

offi cers, business leaders, foreign offi cials, and the general public. While the Fed has tried in

recent years to make its activities and intentions more transparent, the impact of Fed actions

are not often felt until many months afterward. Constituents must trust the chair will do what

is right for the economy and society. Unethical behavior on the part of a Fed BOG chair would

not be tolerated. High-quality reputation matters!

While there have been a total of 15 Fed chairs, we focus on the seven most recent chairs

beginning with the early 1950s. The chairs, along with the period served, are, as follows:

1. William McChesney Martin Jr. (1951–1970) 2. Arthur Burns (1970–1978) 3. G. William Miller (1978–1979) 4. Paul Volcker (1979–1987) 5. Alan Greenspan (1987–2006) 6. Ben Bernanke (2006–2014) 7. Janet Yellen (2014–present)

4.3 Structure of the Federal Reserve System 85

William Martin’s tenure as chair has been the longest in Fed history. He focused on main-

taining the Fed’s independence from Congress and the president. The 1970s were a particularly

diffi cult decade from an economic standpoint in the United States. Infl ation was increasing at

a rapid rate. Oil price shocks occurred in 1973–1974 and again in 1978–1979. Wage and price

controls were tried with no success. Arthur Burns served as chair throughout most the 1970s

until his term expired in 1978. President Jimmy Carter nominated William Miller as chair, but

he served only one year. By 1979, public confi dence in Carter was very low. Reactions in the

fi nancial markets in New York City also suggested concern over whether the president could

control infl ation.

In July 1979, Paul Volcker’s name had surfaced as a possible chair of the Fed who could

ably fi ght infl ation in the United States. Volcker was an economist who had served as president

of the New York Federal Reserve Bank and was well known on Wall Street. Volcker also had

served in government positions in the Kennedy, Johnson, and Nixon administrations, and he

had worked as well as in commercial banking with Chase Manhattan.

While Volcker had impressive credentials, some of the comments gathered by the Carter

administration included, “rigidly conservative . . . very right-wing . . . arbitrary and arrogant . . .

not a team player.”3 While the Fed is legally independent from the White House, it is normal

for the Fed chair to work with a president’s economic advisors in a joint eff ort to reach certain

economic objectives. Of course, there are times when it might be in the best interest of the

people if the Fed pursues its own direction in applying monetary policy to achieve objectives

such as lower infl ation.

History shows that under the guidance of Paul Volcker, a restrictive Fed policy brought

down the double-digit infl ation of the 1970s and the early 1980s. Volcker dominated the board

during his tenure, and the Federal Open Market Committee consistently responded to his

leadership. When Volcker resigned as chairman in June 1987, the fi nancial markets reacted

negatively. The U.S. dollar fell relative to other currencies, and U.S. government and corporate

bond prices fell. Why? In a word—uncertainty; that is, uncertainty about the future direction

of monetary policy. Volcker was a known infl ation fi ghter. In contrast, the policies of the

incoming Fed chair, Alan Greenspan, were unknown.

Greenspan was viewed as a conservative economist. He served as an economics advisor

to President Gerald Ford and as a business consultant. Greenspan’s fi rst big test was the stock

market crash of October 1987. He responded by immediately pumping liquidity into the bank-

ing system. The result was avoidance of monetary contraction and asset devaluation of the

kind that followed the stock market crash of 1929. A reversal of policy occurred in mid-

1988 when interest rates were raised to fi ght increasing infl ation. A relatively mild recession

occurred during 1990–1991. However, infl ation has been kept below the 3 percent level since

then. During Greenspan’s service as chair of the Fed BOG, there was real economic growth

in the U.S. economy, interest rates declined to historic lows, and stock prices reached all-time

highs. A 1996 survey of more than two hundred chief executive offi cers of the largest U.S.

corporations gave overwhelming support for the “good job” that Greenspan was doing. Since

then, the business and fi nancial sectors of the United States have maintained their strong sup-

port of Greenspan’s Fed leadership. In 2004, Greenspan was nominated by President George

W. Bush and confi rmed by the U.S. Senate for a fi fth and fi nal four-year term as chair of the

Fed. A Fed policy of high monetary liquidity and low interest rates was established during the

early part of the decade of the 2000s in response to an economic downturn that was exacer-

bated by the September 11, 2001, terrorist attack. This easy money policy was continued

through Greenspan’s tenure, which lasted through January 2006.

Ben Bernanke became chair of the Fed BOG in February 2006. It was only a few months

before the housing price bubble burst and the economy started slowing down. Bernanke was

responsible for establishing monetary policy that helped guide the United States through the

“perfect fi nancial storm” involving the 2007–08 fi nancial crisis, which had placed the U.S.

economic system on the verge of collapse,4 and the subsequent 2008–09 Great Recession. Ben

Bernanke led the setting of monetary policy until early 2014.

3William Greider, Secrets of the Temple: How the Federal Reserve Runs the Country, (New York: Simon and Schuster,

1987), p. 35. 4For an interesting personal experience perspective of working with the Fed chairs, see Stephen H. Axilrod, Inside the

Fed, (Cambridge: The MIT Press, 2009).

86 CHAPTER 4 Federal Reserve System

Janet Yellen assumed offi ce in February 2014. Prior to becoming chair of the Fed BOG,

she served as vice chair from October 2010 until she was appointed Fed BOG chair. Yellen

is viewed as being a Keynesian economist who favors the use of monetary policy to manage

economic activity over the business cycle. She inherited from Ben Bernanke the Fed’s easy

monetary policy developed to address the 2007–2009 fi nancial and economic crises. She also

participated in the subsequent continuing quantitative easing policies during her role as vice

chair. However, after seven years of easy money policies, the Fed moved in December 2015

to start increasing interest rates.

DISCUSSION QUESTION 2 How would you evaluate the performance of Janet Yellen as chair of the Fed BOG?

LEARNING ACTIVITY Each of the 12 Federal Reserve Banks has its own website and tries to specialize in spe- cifi c types of information. Go to the Federal Reserve Bank of San Francisco’s website, http://www.frbsf.org, and the Federal Reserve Bank of Minneapolis’s website, http:// www.minneapolisfed.org, and identify the types of consumer and economic information they provide.

4.4 Monetary Policy Functions and Instruments Overview of Responsibilities The primary responsibility of the Fed is to formulate monetary policy, which involves reg- ulating the growth of the supply of money and, therefore, regulating its cost and availability.

By exercising its infl uence on the monetary system of the United States, the Fed performs a

unique and important function: promoting economic stability. It is notable that the system’s

broad powers to aff ect economic stabilization and monetary control were not present when the

Fed came into existence in 1913. At that time, the system was meant to do the following: help

the money supply contract and expand as dictated by economic conditions, serve as bankers’

banks in times of economic crisis, provide a more eff ective check-clearance system, and estab-

lish a more eff ective regulatory system. Many of these responsibilities initially fell to the 12

Reserve Banks, but as the scope of responsibility for the monetary system was broadened,

power was concentrated with the BOG. Today the responsibilities of the Fed may be described

as relating to monetary policy, supervision and regulation, and services provided for depository

institutions and the government.

Public discussions of Fed operations are almost always directed toward dynamic actions that stimulate or repress economic activity or the level of prices. However, we should recognize that this area is but a minor part of the continuous operation of the Fed-

eral Reserve System. Far more signifi cant in terms of time and eff ort are the defensive

and accommodative responsibilities. Defensive activities are those that contribute to the smooth, everyday functioning of the economy. Unexpected developments and shocks occur

continually in the economy; unless these events are countered by appropriate monetary

actions, disturbances may develop. Large, unexpected shifts of capital out of or into the

country and very large fi nancing eff orts by big corporations may signifi cantly alter the

reserve positions of the banks. Similarly, buyouts and acquisitions of one corporation by

another, supported by bank fi nancing, also aff ect reserve positions. In our competitive mar-

ket system, unexpected developments contribute to the vitality of our economy. Monetary

policy, however, has a special responsibility to absorb these events smoothly and prevent

many of their traumatic short-term eff ects. The accommodative function of the nation’s monetary system is the one with which we are the most familiar. Meeting the credit needs

of individuals and institutions, clearing checks, and supporting depository institutions rep-

resent accommodative activities.

monetary policy formulated by the Fed to regulate money supply

growth

defensive activities Fed activities that off set unexpected monetary

developments and contribute to the

smooth, everyday functioning of

the economy

accommodative function Fed eff orts to meet credit needs of

individuals and institutions,

clearing checks, and supporting

depository institutions

dynamic actions Fed actions that stimulate or repress economic

activity or the level of prices

4.4 Monetary Policy Functions and Instruments 87

The basic policy instruments of the Fed that allow it to increase or decrease the money

supply are, as follows:

• Changing reserve requirements

• Changing the discount rate

• Conducting open-market operations

In recent years, the Fed has also engaged in a nontraditional monetary policy:

• Quantitative easing

We will fi rst cover the traditional policy instruments and then discuss the use of quantitative

easing.

The Fed sets reserve requirements for depository institutions (i.e., banks), sets the interest

rate at which to lend to banks, and executes open-market operations. By setting reserve

requirements, the Fed establishes the maximum amount of deposits the banking system can

support with a given level of reserves. The amount of reserves can be aff ected directly through

open-market operations, thereby causing a contraction or expansion of deposits by the bank-

ing system. Discount or interest rate policy on loans to banks also aff ects the availability of

reserves to banks and infl uences the way they adjust to changes in their reserve positions. Thus

the Fed has a set of tools that, together, enables it to infl uence the size of the money supply to

attain the Fed’s broader economic objectives.

Reserve Requirements The banking system of the United States is a fractional reserve system because banks are required by the Fed to hold reserves equal to a specifi ed percentage of their deposits. Bank reserves are defi ned as vault cash and deposits held at the Reserve Banks. Required reserves are the minimum amount of bank reserves that must be held by banks. The required reserves ratio is the percentage of deposits that must be held as reserves. If a depository institution has reserves in excess of the required amount, it may lend them out. This is how institutions earn a

return, and it is also a way in which the money supply is expanded. In our system of fractional

reserves, control of the volume of checkable deposits depends primarily on reserve management.

In Chapter 5 the mechanics of money supply expansion and contraction are explained in detail.

The banking system has excess reserves when bank reserves are greater than required reserves. The closer to the required minimum the banking system maintains its reserves, the

tighter the control the Fed has over the money creation process through its other instruments.

If the banking system has close to the minimum of reserves (that is, if excess reserves are near

zero), then a reduction of reserves forces the system to tighten credit. If substantial excess

reserves exist, the pressure of reduced reserves is not felt so strongly. When reserves are added

to the banking system, depositories may expand their lending but are not forced to do so. How-

ever, since depositories earn low interest rates on reserves, profi t maximizing motivates them

to lend out excess reserves to the fullest extent consistent with their liquidity requirements.

When interest rates are high, this motivation is especially strong.

The ability to change reserve requirements is a powerful tool the Fed uses infrequently.

For a number of reasons, the Fed prefers to use open-market operations to change reserves

rather than change reserve requirements. If reserve requirements are changed, the maximum

amount of deposits that can be supported by a given level of reserves changes. It is possible

to contract total deposits and the money supply by raising reserve requirements while holding

the dollar amount of reserves constant. Lowering reserve requirements provides the basis for

expanding money and credit.

It has been argued that “changing reserve requirements” is too powerful a tool and that

its use as a policy instrument would destabilize the banking system. The institutional arrange-

ments through which the banking system adjusts to changing levels of reserves might not

respond as effi ciently to changing reserve requirements. Another advantage of open-market

operations is that they can be conducted quietly, while changing reserve requirements requires

a public announcement. The Fed feels that some of its actions would be opposed if public

attention were directed toward them.

fractional reserve system reserves must be held equal to a certain

percentage of bank deposits

bank reserves vault cash and deposits held at Federal Reserve

Banks

required reserves the minimum amount of total reserves that a

depository institution must hold

required reserves ratio percentage of deposits that must be held as

reserves

excess reserves the amount by which total reserves are greater

than required reserves

88 CHAPTER 4 Federal Reserve System

Changing reserve requirements has been used as a policy instrument on occasion. In the

late 1930s, the nation’s banks were in an overly liquid position because of excessive reserves.

Banks had large amounts of loanable funds that businesses did not wish, or could not qualify,

to borrow because of the continuing depression. The reserves were so huge that the Fed could

no longer resolve the situation through its other policy instruments. Therefore, it increased

reserve requirements substantially to absorb excess reserves in the banking system.

Reserve requirements were lowered during World War II in order to ensure adequate credit

to fi nance the war eff ort. But they were raised again in the postwar period to absorb excess

reserves. In the 1950s and early 1960s, reserve requirements were lowered on several occasions

during recessions. In each case, the lowering made available excess reserves to encourage bank

lending, ease credit, and stimulate the economy. By using this policy tool, the Fed was publicly

announcing its intention to ease credit, in hopes of instilling confi dence in the economy.

In the late 1960s and 1970s, reserve requirements were selectively altered to restrain

credit, because the banking system was experimenting with new ways to get around Fed con-

trols. Banks were using more-negotiable certifi cates of deposit, Eurodollar borrowings, and

other sources of reserve funds. This prompted the Fed to impose restraint on the banks by

manipulating the reserve requirements on specifi c liabilities.

The evolution of the banking system eventually led Congress to pass the Depository Insti- tutions Deregulation and Monetary Control Act (DIDMCA) of 1980, which made signifi cant changes in reserve requirements throughout the fi nancial system. Up to this time the Fed

had control over the reserve requirements of its members only. Nonmember banks were sub-

ject to reserve requirements established by their own states, and there was considerable vari-

ation among states. As checks written on member banks were deposited in nonmember banks

and vice versa, funds moved among banks whose deposits were subject to diff erent reserve

requirements. This reduced the Fed’s control over the money supply.

The 1980 act applies uniform reserve requirements to all banks with certain types of

accounts. For banks that were members of the Fed, these requirements are, in general, lower

now than they were prior to the act. In general, for approximately the fi rst $50 million of

transaction account deposits at a depository institution, the reserve requirement is 3 percent.

For deposits over approximately $50 million, the reserve requirement is 10 percent, which

was reduced from 12 percent in April 1992. The “break point” between the 3 percent and the

10 percent rates is subject to change each year based on the percentage change in transaction

accounts held by all depository institutions. In general, transaction accounts include deposits

against which the account holder is permitted to make withdrawals to make payments to third

parties or others. Accounts that restrict the amount of withdrawals per month are considered

to be savings accounts rather than transaction accounts.

Banks and other depository institutions with large transaction account balances, thus,

are required to hold a proportionately higher percentage of reserves. Let’s illustrate this point

under the assumption that the reserve requirement will be 3 percent on the fi rst $50 million of

transaction account balances and 10 percent on amounts over $50 million. Assume that First

Bank has $50 million in transaction accounts while Second Bank has $100 million. What are

the dollar amounts of required reserves for each bank? What percentage of required reserves

to total transaction deposits must be held by each bank? Following are the calculations:

Bank Account Amount Reserve

Percentage Reserve Requirement

Amount First Bank $50 million 3% $1.5 million

0 10% 0

Total $50 million $1.5 million

Percent ($1.5 million/$50 million) = 3.0%

Second Bank $50 million 3% $1.5 million

50 10% 5.0

Total $100 million $6.5 million

Percent ($6.5 million/$100 million) = 6.5%

4.4 Monetary Policy Functions and Instruments 89

Notice that while First Bank was required to hold reserves of only 3 percent against its

$50 million in transaction account balances, Second Bank had to hold reserves of 6.5 percent

of its $100 million in transaction accounts. Depository institutions with even larger transaction

account balances will have to hold proportionately higher reserves. As a result, their percent-

age of reserves to total transactions accounts will be closer to 10 percent.

A change in reserve requirement percentages on large transaction account balances has

the most impact. For example, if the reserve requirement for transaction balances greater than

$50 million is increased from 10 percent to 12 percent, Second Bank would have reserve

requirements of $7.5 million—or 7.5 percent of its $100 million in transaction accounts. The

required reserves on the second $50 million increase to $6 million, which is the result of

multiplying $50 million times 12 percent. Adding the $1.5 million on the fi rst $50 million

in transaction accounts and the $6 million on the second $50 million results in total required

reserves of $7.5 million, which is 7.5 percent of the total transaction accounts of $100 million.

Thus, it should be evident that even a small change in reserve requirements is likely to have a

major impact on the money supply and economic activity.

Discount Rate Policy The Fed serves as a lender to depository institutions. Banks can go to the Fed’s “discount

window” and borrow funds to meet reserve requirements, depositor withdrawal demands, and

even business loan demands. The Fed discount rate is the interest rate that a bank or other depository institution must pay to borrow from its regional Federal Reserve Bank. The Federal

Reserve Banks currently off er three discount window programs referred to as primary credit,

secondary credit, and seasonal credit. The primary credit rate is the Fed’s main discount win- dow program and, in practice, its rate is used interchangeably with the term “discount rate.” While

each Fed Bank sets its own discount rate, the rates have been similar across all 12 Reserve Banks

in recent years. The Fed sets the interest rate on these loans to banks and, thus, can infl uence the

money supply by raising or lowering the cost of borrowing from the Fed. Higher interest rates

will discourage banks from borrowing, while lower rates will encourage borrowing. Increased

borrowing will allow banks to expand their assets and deposit holdings, and vice versa. Loans to depository institutions by the Reserve Banks may take two forms. One option

allows the borrowing institution to receive an advance, or loan, secured by its own promissory

note together with “eligible paper” it owns. In the second option, the borrower may discount—

or sell to the Reserve Bank—its eligible paper, which includes securities of the U.S. govern-

ment and federal agencies, promissory notes, mortgages of acceptable quality, and bankers’

acceptances. This discounting process underlies the use of the terms “discount window” and

“discount rate policy.”

Discount rate policy was originally intended to work in the following fashion. If the

Fed wanted to cool an infl ationary boom, it would raise the discount rate. An increase in

the discount rate would lead to a general increase in interest rates for loans, decreasing the

demand for short-term borrowing for additions to inventory and accounts receivable. This, in

turn, would lead to postponing the building of new production facilities and, therefore, to a

decreased demand for capital goods. As a consequence, the rate of increase in income would

slow down. In time, income would decrease and with it the demand for consumer goods.

Holders of inventories fi nanced by borrowed funds would liquidate their stocks in an already

weak market. The resulting drop in prices would tend to stimulate the demand for, and reduce

the supply of, goods. Thus economic balance would be restored. A reduction in the discount

rate was expected to have the opposite eff ect.

Discount policy is no longer a major instrument of monetary policy and, in fact, is now

regarded more as an adjustment or fi ne-tuning mechanism. As an adjustment mechanism, the

discount arrangement does provide some protection to depository institutions in that other

aggressive control actions may be temporarily moderated by the ability of banks to borrow.

For example, the Fed may take a strong restrictive position through open-market operations.

Individual banks may counter the pressure by borrowing from their Reserve Banks. The

Reserve Banks are willing to tolerate what appears to be an avoidance of their eff orts while

banks are adjusting to the pressure being exerted. Failure to reduce their level of borrowing

can always be countered by additional Fed open-market actions.

Fed discount rate interest rate that a bank must pay to borrow from its

regional Federal Reserve Bank

primary credit rate interest rate used in practice to refl ect the

discount rate charged by Reserve

Banks for loans to depository

institutions

90 CHAPTER 4 Federal Reserve System

Figure 4.3 shows year-end Fed discount rates charged by Federal Reserve Banks to depository institutions to borrow at the discount window beginning in the early 1980s and

continuing through 2015. Interest rates for adjustment credit are plotted through 2002 and refl ect the rate on short-term loans made available to depository institutions that had tempor-

ary needs for funds not available through “reasonable” alternative sources. Beginning in 2003,

the discount window interest rate refl ects the primary credit rate. Primary credit is available

ordinarily for overnight loans to depository institutions in generally sound fi nancial condition.

In response to the fi nancial crisis and the beginning of the Great Recession, the primary credit

rate was lowered to 1.25 percent by the end of 2008 and reduced further to .50 percent in 2009.

In 2010, the primary credit rate was increased to .75 percent and was held at that level through

most of 2015 in support of the Fed’s easy money policy and quantitative easing eff orts.

For comparative purposes, year-end bank prime rates, discussed in Chapter 3, are also plot-

ted in Figure 4.3. Recall that the prime rate is the interest rate charged by banks for short-term

loans to their highest quality business customers. The Fed discount rate and the bank prime rate

generally “track” each other over time. Both interest rate series peaked in the early 1980s when

infl ation rates were also very high in the United States. The downward trend in the prime rate has

generally continued as infl ation rates have also declined. In response to the fi nancial crisis and

the Great Recession, the prime rate was reduced to 3.25 percent by the end of 2008 and remained

at that level through most of 2015. In December 2015, the bank prime rate was increased by

.25 percent to 3.50 percent in response to the Fed increasing the primary credit rate.

Notice that the Fed’s lending rate to depository institutions was consistently lower than

the bank prime lending rate throughout the time period shown in Figure 4.3. Of course, in

order to make profi ts, banks must be able to borrow from depositors, and sometimes from the

Fed, at rates lower than the rates the banks lend at. The determinants of interest rates will be

discussed in detail in Chapter 8.

Open-Market Operations The most-used instrument of monetary policy is open-market operations; that is the buying and selling of securities in the “open market” by the Fed through its Federal Open Market

Committee (FOMC) to alter bank reserves. The Fed can purchase securities to put additional

reserves at the disposal of the banking system or sell securities to reduce bank reserves. You

open-market operations buying and selling of securities by the

Federal Reserve to alter the supply

of money

Interest Rates

Fed Discount Rate/

Primary Credit Rate

Bank Prime Rate

1994 1996 1998 20001992199019881986198419821980 2002 2004 2006 2008 2010 2012 2014 2016

FIGURE 4.3 Fed Lending Rate Versus Bank Prime Rate Changes, 1980–2015

4.4 Monetary Policy Functions and Instruments 91

might ask, “Where does the Fed get securities to sell?” A brief look at the Fed’s balance sheet

will help provide an answer.

The Fed’s assets are primarily held in the form of U.S. Treasury, government agency, and

mortgage-backed securities, which generally represent over 85 percent of total assets. Coins

and cash in the process of collection are about 2 percent of total assets. The remainder is assets

that include gold certifi cates and Fed premises. Federal Reserve notes (recall our discussion of

fi at money in Chapter 2) represent nearly 90 percent of the Fed’s total liabilities and capital.

Deposits in the form of depository institution reserves held at the Reserve Banks are about

7 percent of the total. Other liabilities, particularly U.S. Treasury deposits and capital in the

form of stock purchased by member banks and surplus earned from operations, make up the

remaining total liabilities and capital.

The original Federal Reserve Act did not provide for open-market operations. However,

to maintain stability in the money supply, this policy instrument developed out of Reserve

Bank experiences during the early years of Fed operations. Unfortunately, these early eff orts

were not well coordinated. Reserve Banks bought government securities with funds at their

disposal to earn money for meeting expenses and to make a profi t and pay dividends on the

stock held by member banks. All 12 Reserve Banks usually bought and sold the securities

in the New York market. At times, their combined sales were so large that they upset the

market. Furthermore, the funds used to buy the bonds ended up in New York member banks

and enabled them to reduce their borrowing at the Reserve Bank of New York. This made it

diffi cult for the Reserve Bank of New York to maintain eff ective credit control in its area. As a

result, an open-market committee was set up to coordinate buying and selling of government

bonds. The Federal Open Market Committee was legally established in 1933. In 1935 its

present composition was established: the Federal Reserve BOG plus fi ve of the presidents of

the 12 Reserve Banks, who serve on a rotating basis.

Open-market operations have become the most important and eff ective means of mon-

etary and credit control. These operations can take funds out of the market and, thus, raise

short-term interest rates and help restrain infl ationary pressures, or they can provide for easy

money conditions and lowered short-term interest rates. Of course, such monetary ease will

not necessarily start business on the recovery road after a recession. When used with discount

rate policy, open-market operations are basically an eff ective way of restricting credit or mak-

ing it more easily available.

Open-market operations diff er from discount operations in that they increase or decrease

bank reserves at the initiative of the Fed, not of individual banking institutions. The process,

in simplifi ed form, works as follows. If the Federal Open Market Committee wants to buy

government securities, it contacts dealers to ask for off ers and then accepts the best off ers that

meet its needs. The dealers receive wire transfers of credit for the securities from the Reserve

Banks. These credits are deposited with member banks. The member banks, in turn, receive

credit for these deposits with their Reserve Banks, thus adding new bank reserves that form

the basis for additional credit expansion. The Fed usually restricts its purchases to U.S. govern-

ment securities primarily because of their liquidity and safety.

If the Fed wants to reduce bank reserves, it sells government securities to the dealers.

The dealers pay for them by a wire transfer from a depository to a Reserve Bank. The Reserve

Bank then deducts the amount from the reserves of the depository institution.

Open-market operations do not always lead to an immediate change in the volume of

deposits. This is especially true when bonds are sold to restrict deposit growth. As bonds

are sold by the Reserve Banks, some banks lose reserves and are forced to borrow from their

Reserve Bank. Since they are under pressure from the Fed to repay the loans, they use funds

from maturing loans to repay the Reserve Bank. Thus, credit can be gradually restricted as a

result of the adjustments banks must make to open-market operations.

Quantitative Easing Quantitative easing (QE) is a nontraditional monetary policy approach to stimulate eco- nomic activity when conventional monetary policy methods are ineff ective. The Fed engages

in purchasing fi nancial assets from banks and other fi nancial institutions with newly created

money, resulting in larger bank excess reserves and increased money supply and liquidity. In

quantitative easing (QE) a nontraditional monetary policy

approach to stimulate economic

activity

92 CHAPTER 4 Federal Reserve System

response to the fi nancial crisis and the Great Recession that has been followed by relatively

slow economic growth, the Fed has engaged in three rounds (QE1, QE2, and QE3) of quan-

titative easing. QE1 was initiated in late 2008 when the Fed began buying large amounts of

mortgage-backed securities and Treasury securities from banks. These actions helped avoid

a fi nancial system collapse and contributed to the recovery from the Great Recession. How-

ever, slowing economic activity in 2010 led to the Fed announcing QE2, which provided

for the purchase of an additional $600 billion of Treasury securities. In an eff ort to provide

further monetary liquidity to encourage economic growth, QE3 was initiated in September

2012 when the Fed stated it planned to purchase $40 billion in mortgage-backed securities per

month for the foreseeable future. In December 2015, the Fed announced it was commencing a

money policy normalization process that would lead to higher interest rates.

DISCUSSION QUESTION 3 Did the Fed maintain an easy monetary policy for too many years after the Great Recession?

Implementation of Monetary Policy Monetary policy has traditionally focused either on trying to control the rate of change or

growth in the money supply (such as M1) or by targeting a level for a specifi c type of interest

rate. One interest rate that the Fed’s FOMC could focus on is the federal funds rate, which is the rate on overnight loans from banks with excess reserves to banks that have defi cit reserves.

Open-market purchases of securities add to bank reserves and increase the money supply.

Sales of securities lower reserves and the money supply. However, when the target is the

money supply, interest rates may fl uctuate widely, because the demand for money may change

relative to a specifi c money supply target. Furthermore, a focus on the money supply might

not produce the desired impact on gross domestic product because of changes in the velocity

of money, as we saw in Chapter 2.

In recent years, the Fed, through its FOMC, has chosen to focus on setting target interest

rate levels for the federal funds rate as the primary means of carrying out monetary policy.

Banks with excess reserves lend to banks that need to borrow funds to meet reserve require-

ments. Interest rates, such as the federal funds rate, refl ect the intersection of the demand for

reserves and the supply of reserves. Open-market purchases of securities cause the federal

funds rate to fall, whereas sales of securities cause the rate to rise. Of course, while the FOMC

can set targets for federal funds rates, actual federal funds rates are determined in the market

by banks with excess reserves and banks that need to borrow reserves to meet their minimum

reserve requirement.

The Fed uses its open-market operations to provide liquidity to the banking system in

times of emergency and distress. For example, the stock market crash on October 19, 1987,

caused concern about a possible economic collapse. The Fed, through FOMC open-market

purchases, moved quickly to increase the money supply. The terrorist attacks on September

11, 2001, caused widespread concern about the near-term ability of stock and other fi nan-

cial markets to function properly with a related possibility of economic collapse. The FOMC

moved quickly to provide liquidity to the banking system, and to encourage renewed confi d-

ence in the fi nancial system by reducing the target rate for federal funds on September 17,

2001, from 3.5 percent to 3.0 percent.

In 2001, the FOMC further lowered its target for the federal funds rate to 2.5 percent

on October 2, to 2.0 percent on November 2, and fi nally to 1.75 percent on December 11. A

target rate reduction to 1.25 percent occurred on November 6, 2002, and this was followed

by a further reduction in the target rate to 1.0 percent on June 25, 2003. As the U.S. economy

began growing, concern shifted to the possibility of renewed infl ation, causing the Fed to

begin increasing the target for the federal funds rate in 2004.

Although the target for the federal funds rate was 5.25 percent at the end of 2006, target

rates were reduced quickly as the 2007–08 fi nancial crisis developed and the 2008–09 Great

Recession began. In December 2008, the FOMC established a near-zero target federal funds

rate range, between 0.00 and 0.25 percent. This 0.00–0.25 percent target was subsequently

maintained until December 2015 when the target federal funds rate range was increased to

0.25–0.50 as the initial step toward monetary policy normalization. Actual federal funds

rate data collected by the St. Louis Fed Reserve Bank shows a close correlation between

federal funds rate interest rate on overnight loans from banks with

excess reserves to banks that have

defi cit reserves

4.5 Fed Supervisory and Regulatory Functions 93

the target and observed rates over the 2008–2015 time period. Eff ective December year-end

federal funds rates ranged from 0.07 to 0.24 percent. The 0.24 percent occurred in Decem-

ber 2015 when the FOMC announced an increase in its target for the federal funds rate.

As a result of the severity of the 2007–08 fi nancial crisis and the beginning of the Great

Recession, the Fed took unusual steps to avoid a possible fi nancial collapse. In addition

to setting target federal rates at near zero levels in December 2008, the Fed engaged in a

nontraditional monetary activity called quantitative easing in late 2008. As discussed in

the previous section, the Fed aggressively purchased U.S. Treasury, government agency,

and mortgage-backed securities from banks and other fi nancial institutions so as to provide

even more monetary liquidity in the fi nancial system. Round two of quantitative easing was

implemented in 2010 and round three in 2012 in an eff ort to encourage economic growth

through further monetary liquidity.

LEARNING ACTIVITY Go to the St. Louis Federal Reserve Bank’s website, http://www.stlouisfed.org, and fi nd the current Fed discount rate (primary credit rate) charged by Federal Reserve Banks on loans to depository institutions. Describe recent changes or trends in the discount or primary credit rate.

4.5 Fed Supervisory and Regulatory Functions A strong and stable banking system is vital to the growth and the stability of the entire eco-

nomy. The supervision of commercial banks and other depository institutions is primarily

concerned with the safety and soundness of individual institutions. It involves oversight to

ensure that depository institutions are operated carefully. Depository institution regulation

relates to the issuance of specifi c rules or regulations that govern the structure and conduct

of operations.

Specific Supervisory Responsibilities On-site examination of commercial banks is one of the Fed’s most important responsib-

ilities. This function is shared with the federal Offi ce of the Comptroller of the Currency

(OCC), the Federal Deposit Insurance Corporation (FDIC), and state regulatory agencies.

Although the Federal Reserve is authorized to examine all member banks, in practice it

limits itself to state-chartered member banks and all bank holding companies. It cooperates

with state examining agencies to avoid overlapping examining authority. The OCC directs

its attention to nationally chartered banks, and the FDIC supervises insured nonmember

commercial banks.

In addition to these three federal banking supervisory agencies, two federal agencies are

primarily responsible for supervising and regulating depository institutions that are not commer-

cial banks. The National Credit Union Administration (NCUA) supervises and regulates credit

unions, and the Offi ce of Thrift Supervision (OTS) oversees S&Ls and other savings institutions.

The examination generally entails (1) an appraisal of the soundness of the institution’s assets;

(2) an evaluation of internal operations, policies, and management; (3) an analysis of key fi nan-

cial factors, such as capital and earnings; (4) a review for compliance with all banking laws and

regulations; and (5) an overall determination of the institution’s fi nancial condition.

The Federal Reserve conducts on-site inspections of parent bank holding companies and

their nonbank subsidiaries. These inspections include a review of nonbank assets and funding

activities to ensure compliance with the Bank Holding Company Act.

The Federal Reserve has broad powers to regulate the overseas activities of member

banks and bank holding companies. Its aim is to allow U.S. banks to be fully competitive

with institutions of host countries in fi nancing U.S. trade and investment overseas. Along

with the OCC and the FDIC, the Federal Reserve also has broad oversight authority to

94 CHAPTER 4 Federal Reserve System

supervise all federal and state-licensed branches and agencies of foreign banks operating in

the United States.

Specific Regulatory Responsibilities The Federal Reserve has legal responsibility for the administration of the Bank Holding Com-

pany Act of 1956, the Bank Merger Act of 1960, and the Change in Bank Control Act of

1978. Under these acts, the Fed approves or denies the acquisitions of banks and other closely

related nonbanking activities by bank holding companies. Furthermore, it permits or rejects

changes of control and mergers of banks and bank holding companies.

The Federal Reserve is responsible for writing rules or enforcing a number of major

laws that off er consumers protection in their fi nancial dealings. In 1968 Congress passed the

Consumer Credit Protection Act, which requires the clear explanation of consumer credit costs and garnishment procedures (taking wages or property by legal means) and prohibits

overly high-priced credit transactions. Regulation Z, which was drafted by a Federal Reserve task force, enacts the Truth in Lending section of the act. The purpose of the law and Reg-

ulation Z is to make consumers aware of, and able to compare, the costs of alternate forms

of credit. Regulation Z applies to consumer fi nance companies, credit unions, sales fi nance

companies, banks, S&Ls, residential mortgage brokers, credit card issuers, department stores,

automobile dealers, hospitals, doctors, dentists, and any other individuals or organizations that

extend or arrange credit for consumers.

The law requires a breakdown of the total fi nance charge and the annual percentage rate

of charge. The fi nance charge includes all loan costs, including not only interest or discount

but service charges, loan fees, fi nder fees, insurance premiums, and points (an additional loan

charge). Fees for such items as taxes not included in the purchase price, licenses, certifi cates of

title, and the like may be excluded from the fi nance charge if they are itemized and explained

separately. Figure 4.4 lists the Truth in Lending and other consumer protection acts that fall under Fed jurisdiction.

In addition to consumer protection laws, the Federal Reserve, through the Community

Reinvestment Act of 1977, encourages depository institutions to help meet the credit needs

of their communities for housing and other purposes, while maintaining safe and sound oper-

ations. This is particularly true in neighborhoods of families with low or moderate income.

Consumer Credit Protection Act 1968 act requiring clear explanation

of consumer credit costs and

prohibiting overly high-priced

credit transactions

Regulation Z enacts Truth in Lending section of the Consumer

Credit Protection Act with intent to

make consumers able to compare

costs of alternate forms of credit

• The Truth in Lending section of the Consumer Credit Protection Act requires disclosure of the finance charge and the annual percentage rate of credit along with certain other costs and terms

to permit consumers to compare the prices of credit from different sources. This act also limits

liability on lost or stolen credit cards.

• The Fair Credit Billing Act sets up a procedure for the prompt correction of errors on a revolving charge account and prevents damage to credit ratings while a dispute is being settled.

• The Equal Credit Opportunity Act prohibits discrimination in the granting of credit on the basis of sex, marital status, race, color, religion, national origin, age, or receipt of public assistance.

• The Fair Credit Reporting Act sets up a procedure for correcting mistakes on credit records and requires that records be used only for legitimate business purposes.

• The Consumer Leasing Act requires disclosure of information to help consumers compare the cost and terms of one lease of consumer goods with another and to compare the cost of leasing

versus buying on credit or for cash.

• The Real Estate Settlement Procedures Act requires disclosure of information about the services and costs involved at the time of settlement when property is transferred from seller to buyer.

• The Electronic Fund Transfer Act provides a basic framework regarding the rights, liabilities, and responsibilities of consumers who use electronic transfer services and of the financial institutions

that offer them.

• The Federal Trade Commission Improvement Act authorizes the Federal Reserve BOG to identify unfair or deceptive acts or practices on the part of banks and to issue regulations to

prohibit them.

Source: The Federal Reserve System Purposes & Functions, Board of Governors of the Federal Reserve System, Washington, D.C.

FIGURE 4.4 Consumer Protection Responsibilities of the Federal Reserve System

4.6 Fed Service Functions 95

LEARNING ACTIVITY Go to the Federal Reserve Board of Governor’s website, http://www.federalreserve.gov, and fi nd the Fed’s list of regulations. Write a brief summary about the materials on Regulation Z.

4.6 Fed Service Functions The Reserve Banks provide a wide range of important services to depository institutions and

to the U.S. government. The most important of these services is the payments mechanism, a

system whereby billions of dollars are transferred each day. Other services include electronic

fund transfers, net settlement facilities, safekeeping and transfer of securities, and serving as

fi scal agent for the United States.

The Payments Mechanism An effi cient payments mechanism is necessary for the monetary system to carry out the

fi nancial function of transferring money, which in turn is a requirement for an eff ective

fi nancial system. For a review of how checks have traditionally been processed through the

banking system, refer to Figure 3.4 in Chapter 3. Recall that banks can clear checks either

directly with one another or indirectly through bank clearinghouses. Checks also can be

processed or cleared through the Federal Reserve Banks. The payments mechanism admin-

istered by the Fed also includes providing currency and coin and electronic funds transfers.

Electronic forms of payment are replacing the check as a payment method. Included

alternatives are credit cards, debit cards, and online account transfers. Furthermore, instead of

transporting and sorting paper checks, more and more banks electronically process the checks

they receive.

Coin and Currency Even though the movement toward a cashless society continues, the United States remains highly dependent on currency and coin to conduct transactions. The

Fed is responsible for ensuring that the economy has an adequate supply of cash to meet the

public’s demand. Currency and coin are put into or retired from circulation by the Reserve

Banks, which use depository institutions for this purpose. Virtually all currency in circulation

is in the form of Federal Reserve notes. These notes are printed by the Bureau of Engraving

and Printing of the U.S. Treasury.

Check Clearance and Collection One of the Fed’s important contributions to the smooth fl ow of fi nancial interchange is to facilitate the clearance and collection of checks of

The Fed and the Consumer

The Fed aff ects personal fi nance in several ways. First, the Fed

controls the money supply. Actions that severely restrict the sup-

ply of money may lead to an economic recession. Too rapid a

growth in the money supply may result in infl ation and a decrease

in purchasing power. Should the Fed act to slow down or reduce

the growth rate of the money supply, there will be growing con-

straints on the ability of banks to lend as their excess reserves

decline. This may result in higher loan rates, as loanable funds

become scarcer. This could help bank savers, however, as banks

and other depository institutions may raise the interest they pay

on saving accounts and CDs to attract more funds that they will

later lend to others.

The Fed acts in other ways to maintain people’s trust and

confi dence in the banking system. As this chapter discusses, the

Fed has supervisory power over many banks to ensure they have

adequate capital and reserves and are following regulations. The

Fed’s Regulation Z requires lenders to tell borrowers the annual

percentage rate on the loans they receive. The Fed clears checks

by transporting them between banking centers and by debiting and

crediting bank balances with the Fed.

Personal Financial Planning

96 CHAPTER 4 Federal Reserve System

the depository institutions of the nation. Each Reserve Bank serves as a clearinghouse for all

depository institutions in its district, provided that they agree to pay the face value on checks

forwarded to them for payment. Today, nearly all the checks processed for collection by Federal

Reserve Banks are received as electronic check images.

Let’s illustrate how the check-clearing process traditionally took place through Reserve

Banks. Assume that the owner of a business in Sacramento, California, places an order for

merchandise with a distributor in San Francisco. The order is accompanied by a check drawn

on the owner’s bank in Sacramento. The distributor deposits the check with its bank in San

Francisco, at which time the distributor receives a corresponding credit to its account with the

bank. The distri-butor’s bank will send the check to the Reserve Bank of its district, also loc-

ated in San Francisco. The Reserve Bank will forward the check to the bank in Sacramento on

which the check was drawn. The adjustment of accounts is accomplished at the Reserve Bank

through an alternate debit and credit to the account of each bank involved in the transaction.

The San Francisco bank, which has honored the check of its customer, will receive an increase

in its reserves with the Reserve Bank, while the bank in Sacramento will have its reserves

decreased by a corresponding amount. The bank in Sacramento will then reduce the account

of the business on which the check was written. Notice that the exchange takes place without

any transfer of currency.

Check Clearance Among Federal Reserve Districts If an order was also placed by the Sacramento fi rm with a distributor of goods in Chicago, the check would be

subject to an additional step in being cleared through the Fed. The Chicago distributor, like

the San Francisco distributor, deposits the check with the bank of its choice and, in turn, re-

ceives an increase in its account. The Chicago bank deposits the check for collection with the

Reserve Bank of Chicago, which forwards the check to the Reserve Bank of San Francisco.

The Reserve Bank of San Francisco, of course, then presents the check for payment to the

bank on which it was drawn. Thus, there are two routes of check clearance: the intradistrict settlement, in which the transaction takes place entirely within a single Federal Reserve dis- trict, and the interdistrict settlement, in which there are relationships between banks of two Federal Reserve districts.

As described, Reserve Banks are able to minimize the actual fl ow of funds by increas-

ing or decreasing reserves of the participating depository institutions. In the same way, the

Interdistrict Settlement Fund eliminates the fl ow of funds between the Reserve Banks needed

to make interdistrict settlements. The Interdistrict Settlement Fund in Washington, D.C., has

a substantial deposit from each of the Reserve Banks. These deposit credits are alternately

increased or decreased, depending on the clearance balance of the day’s activities on the part

of each Reserve Bank. At a certain hour each day, each Reserve Bank informs the Interdistrict

Settlement Fund by direct wire of the amount of checks it received the previous day that were

drawn upon depository institutions in other Federal Reserve districts. The deposit of each

Reserve Bank with the Interdistrict Settlement Fund is increased or decreased according to the

balance of the day’s check-clearance activities.

Check Clearance Through Federal Reserve Branch Banks Branch banks of the Reserve Banks enter into the clearance process in a very important way. If a check is

deposited with a depository located closer to a Reserve Branch Bank than to a Reserve Bank,

the branch bank, in eff ect, takes the place of the Reserve Bank. The Federal Reserve facilitates

the check-clearing services of the Reserve Banks and their branches by maintaining a small

group of regional check-processing centers.

Check Routing In the past, a many employees at the 12 Reserve Banks were engaged in check clearing. Fundamental to the clearance process was the need to read the system of

symbols and numerals shown in Figure 4.5. Although these symbols are slightly diff erent from conventional numbers, they are easily read and are referred to as the magnetic ink

character recognition (MICR) line. Information about the clearance process is printed on

the lower part of the check. In addition to the clearance symbol, banks include a symbol for

each customer’s account. Banks also continue to include the older check routing symbol in

4.6 Fed Service Functions 97

the upper right-hand corner of their checks. Today, banks can keep an image of a check and

process payment electronically through automated clearing houses (ACHs). Banks now also

have several ways to clear checks.

Transfer of Credit The Fed provides for the transfer of hundreds of millions of dollars in depository balances

around the country daily. The communication system called Fedwire may be used by depos-

itory institutions to transfer funds for their own accounts, to move balances at correspondent

banks, and to send funds to another institution on behalf of customers.

Other Service Activities A large portion of Fed employees hold jobs directly related to the Fed’s role as fi scal agent for the U.S. government. The services include holding the Treasury’s checking accounts; assist-

ing in the collection of taxes; transferring money from one region to another; and selling,

redeeming, and paying interest on federal securities. The federal government makes most of

its payments to the public from funds on deposit at the Reserve Banks. The Fed also acts as

fi scal agent for foreign central banks and international organizations such as the International

Monetary Fund.

J. C. MORRISON 1765 SHERIDAN DRIVE

YOUR CITY, U.S.A. 12345

PAY TO THE

ORDER OF $

One Wall Street New York, New York 10015

SAMPLE – VOID DOLLARS

Drawee Bank

(Irving Trust Company)

FOR

1-67

210

1 2 9

State or City

(New York City)

Check

Serial Number

Customer’s Account Number

Federal Reserve District

Federal Reserve Bank

of New York

Immediate Credit Availability

in New York

Routing Number Check Digit (8)

ABA Bank Number (0067)

Routing Symbol (0210)

FIGURE 4.5 Traditional Use of Check Routing Symbols

98 CHAPTER 4 Federal Reserve System

4.7 Central Banks in Other Countries GLOBAL Central banks in other developed countries, like the U.S. Fed, are responsible for regu-

lating the country’s money supply, safeguarding the country’s currency, and carrying out the

country’s monetary policy. Most other countries have a single central bank with branches that

diff er from the Fed’s 12 Reserve Banks. Of course, the Fed BOG has eff ectively centralized

control of U.S. monetary policy.

Empirical evidence shows a link between central bank independence from government inter-

vention and infl ation and economic growth rates. In countries where central banks are relatively

independent from their governments, there have generally been lower infl ation rates and higher

economic growth rates than in countries where central banks are closely tied to their governments.

Three economically important foreign central banks are those of the United Kingdom,

Japan, and the European Monetary Union. The central bank in the United Kingdom is the Bank of England (BOE). It was created well before the formation of the Federal Reserve System in 1913. The BOE is managed by a governor and fi ve additional offi cers, all of whom are appointed

for fi ve-year terms. The BOE governor reports to the chancellor, who has fi nal responsibility for

setting monetary policy. In contrast with the United States, commercial banks in Great Britain

are not required to hold reserves at the Bank of England. Also, recall from Chapter 3 that Great

Britain does not legally separate commercial banking and investment banking activities.

The central bank of Japan, called the Bank of Japan (BOJ), was created in 1947. The top offi cial of the BOJ is the governor, who heads the Policy Board, which is the central decision-

making authority. The governor and some members of the board are appointed by the Japanese

equivalent of the U.S. Congress, and other board members are appointed by the fi nance minister.

Japanese commercial banks, like their U.S. counterparts, are required to hold reserves on deposit

with the BOJ, and banks can borrow at an offi cial discount rate from the BOJ.

The European Central Bank (ECB) conducts monetary policy for the European coun- tries that belong to the European Monetary Union and also have adopted the euro as their com-

mon currency. Eleven European countries joined in 1999 and Greece was admitted in 2001.

Euro notes and coins were offi cially introduced at the beginning of 2002, and all 12 individual

national currencies were withdrawn as legal tender by July 1, 2002. The number of “eurozone”

members has recently increased to 19 countries. The ECB, which is headquartered in Frank-

furt, Germany, is responsible for controlling infl ation and for managing the value of the euro

relative to other currencies. The ECB structure is somewhat similar to the U.S. Fed’s in that

the national central banks of the euro countries operate much like the 12 Federal Reserve

District Banks. Like the Fed BOG, the governing council of the ECB includes governors from

some of the national central banks. Each national central bank is responsible for managing

payment systems and furnishing currency and credit in its home country.

LEARNING ACTIVITY Go to the European Central Bank’s website, http://www.ecb.int, and fi nd information on how that bank is structured and how it operates.

European Central Bank (ECB) conducts monetary policy for the

European countries that adopted the

euro as their common currency

Applying Finance To… • Institutions and Markets Depository institutions, commercial banks, S&Ls, savings banks, and credit unions comprise the banking sys-

tem. The Fed is the U.S. central bank, which supervises and regulates

the banking system. The Fed, along with depository institutions, cre-

ates and transfers money. Monetary policy actions of the Fed aff ect the

primary fi nancial markets for debt obligations, infl uencing the availabil-

ity of bank loans and the interest rates that must be paid on those loans.

• Investments Securities markets, both primary and secondary, are also aff ected by Fed actions. An increase in reserve requirements will

restrict the amount of individual savings that would be available to make

loans. Other Fed actions may cause banks to raise loan interest rates, and

cause the economy to slow down and security prices to decline. When

the Fed raises the discount rate, banks react to protect their profi t mar-

gins by raising their lending rates to individuals and businesses.

• Financial Management Financial management activities are directly aff ected by Fed monetary policy actions. A tightening of monetary

policy makes it more diffi cult and costly for businesses to borrow

funds. To the extent that economic activity also declines, it is more

diffi cult for fi nancial managers to sell new stocks and bonds in the

primary securities markets. Of course, an easing of monetary policy

will make it easier for fi nancial managers to raise fi nancial capital and

they will be able to do so at lower interest rates.

Review Questions 99

Summary LO 4.1 The Federal Reserve System (Fed) responded to the recent fi n- ancial crisis and Great Recession by providing rescue funds to some

fi nancial institutions and by helping other fi nancially weak institu-

tions merge with stronger institutions. These actions were necessary

to keep many fi nancial institutions from failing due to liquidity crises

caused by precipitous declines in the values of the home mortgage

loans and mortgage-backed securities that they held because of mort-

gage loan defaults.

LO 4.2 The national banking system that existed before the Federal Reserve System was created lacked an effi cient national payments

system for transferring money, a fl exible money supply that can

respond to changes in the demand for money, and a lending/

borrowing mechanism to help alleviate liquidity problems when

they arise.

LO 4.3 The Federal Reserve System is the central bank of the United States and is responsible for setting monetary policy and regulating

the banking system. The Fed is organized into fi ve major components:

(1) member banks, (2) Federal Reserve District Banks, (3) Board

of Governors, (4) Federal Open Market Committee, and (5) advisory

committees.

LO 4.4 The policy instruments used by the Fed to carry out monetary policy are changing reserve requirements, changing the discount rate,

and conducting open-market operations. In recent years, the Fed has

also engaged in a nontraditional monetary policy called quantitative

easing. Banks are required by the Fed to hold reserves equal to a

specifi ed percentage of their deposits. An increase in the required

reserves ratio reduces bank reserves, and vice versa. The Fed dis-

count rate is the interest rate that a bank must pay to borrow from its

regional Reserve Bank. Higher discount rates will discourage money

supply expansion, and vice versa. Open-market operations involves

the buying and selling of securities in the open market by the Fed

through its FOMC to alter bank reserves. The purchasing of securities

increases bank reserves, and vice versa. Quantitative easing involves

the purchasing of securities from banks and other fi nancial institu-

tions to increase the money supply and liquidity.

LO 4.5 The Fed is authorized to supervise and examine member bank assets, operations, fi nancial conditions, and compliance with banking

laws and regulations. In practice, the Fed focuses on examination of

state-chartered member banks and all bank holding companies. Nation-

ally chartered banks are examined by the Offi ce of the Comptroller of

the Currency. The Fed has legal responsibility for administering several

banking laws and is responsible for enforcing laws, such as the Con-

sumer Credit Protection Act of 1968, that help consumers understand

the costs of alternative forms of credit.

LO 4.6 Reserve Banks provide a range of services to depository insti- tutions and to the U.S. government. The most important service is the

payments mechanism for transferring money throughout the banking

system. Other services include electronic funds transfers, safekeep-

ing and transfer of securities, and serving as fi scal agent for the U.S.

government.

LO 4.7 Foreign countries that use central banking systems, like the Fed in the United States, to regulate money supply and set monetary

policy include the United Kingdom (Bank of England), Japan (Bank

of Japan), and euro-member countries (European Central Bank).

There is some similarity between the Fed operating with 12 Federal

Reserve Banks that represent diff erent districts in the United States

and the European Central Bank operating with central banks from

each eurozone member.

Key Terms accommodative function

bank reserves

central bank

Consumer Credit Protection

Act

defensive activities

dynamic actions

European Central Bank (ECB)

excess reserves

Fed Board of Governors

Fed discount rate

federal funds rate

Federal Home Loan Mortgage

Corporation (Freddie Mac)

Federal National Mortgage

Association (Fannie Mae)

Federal Reserve System (Fed)

fractional reserve system

Government National Mortgage

Association (Ginnie Mae)

monetary policy

open-market operations

primary credit rate

quantitative easing (QE)

Regulation Z

required reserves

required reserves ratio

Review Questions 1. (LO 4.1) Identify some of the institutional participants in the mortgage markets.

2. (LO 4.1) What actions did the Fed take to help avoid a fi nancial system collapse in 2008–09?

3. (LO 4.2) Describe the weaknesses of the national banking system that was in place prior to passage of the Federal Reserve

Act of 1913.

4. (LO 4.2) What functions and activities do central banks usually perform?

5. (LO 4.3) Describe the organizational structure of the Federal Reserve System in terms of its fi ve major components.

6. (LO 4.3) Explain how the banking interests of large, medium, and small businesses are represented on the board of directors of each

Reserve Bank.

100 CHAPTER 4 Federal Reserve System

Exercises 1. You are a resident of Seattle, Washington, and maintain a check- ing account with a bank in that city. You have just written a check

on that bank to pay your tuition. Describe the process by which the

banking system enables your college to collect the funds from your

bank.

2. As the executive of a bank or thrift institution you are faced with an intense seasonal demand for loans. Assuming that your loanable

funds are inadequate to take care of the demand, how might your

Reserve Bank help you with this problem?

3. The Federal Reserve Board of Governors has decided to ease mon- etary conditions to counter early signs of an economic downturn.

Because price infl ation has been a burden in recent years, the Board is

eager to avoid any action that the public might interpret as a return to

infl ationary conditions. How might the Board use its various powers

to accomplish the objective of monetary ease without drawing unfa-

vorable publicity to its actions?

4. An economic contraction (recession) is now well under way, and the Fed plans to use all facilities at its command to halt the decline.

Describe the measures that it may take.

5. You have recently retired and are intent on extensive travel to many of the exotic lands you have only read about. You will be receiving

not only a pension check and Social Security check but also dividends

and interest from several corporations. You are concerned about the

deposit of these checks during your several months of absence, and

you have asked your banker if there is an arrangement available to

solve this problem. What alternative might the banker suggest?

6. The prime rate, and other interest rates, off ered by banks often change in the same direction as a change in the Fed’s target for the

federal funds rate. As an employee of a Federal Reserve District Bank

you have been told that your district bank will be increasing its dis-

count rate early next week. Expectations are that an increase in the

discount rate will lead to an increase in the federal funds rate, which

will lead to an increase in the prime rate and other bank lending rates.

You have been thinking about buying a new automobile for the past

couple of months. Given this information of a planned discount rate

increase, you are considering buying your new automobile before the

end of the week. What are the ethical issues, if any, involved in this

scenario? What would you do?

Problems 1. A new bank has vault cash of $1 million and $5 million in deposits held at its Federal Reserve District Bank.

a. If the required reserves ratio is 8 percent, what dollar amount of deposits can the bank have?

b. If the bank holds $65 million in deposits and currently holds bank reserves such that excess reserves are zero, what required re-

serves ratio is implied?

2. Assume a bank has $5 million in deposits and $1 million in vault cash. If the bank holds $1 million in excess reserves and the required

reserves ratio is 8 percent, what level of deposits are being held?

3. A bank has $110 million in deposits and holds $10 million in vault cash.

a. If the required reserves ratio is 10 percent, what dollar amount of reserves must be held at the Federal Reserve Bank?

7. (LO 4.3) What is a Reserve Branch Bank? How many such branches exist, and where are most of them located?

8. (LO 4.3) How are members of the Board of Governors of the Federal Reserve System appointed? To what extent are they subject

to political pressures?

9. (LO 4.3) Discuss the structure, functions, and importance of the Federal Open Market Committee.

10. (LO 4.3) Identify the seven individuals who served as chairs of the Fed Board of Governors since the early 1950s. Indicate each indi-

vidual’s approximate time and length of service as chair.

11. (LO 4.4) Distinguish among the dynamic, defensive, and accom- modative responsibilities of the Fed.

12. (LO 4.4) Identify and briefl y describe the three traditional instru- ments that may be used by the Fed to set monetary policy.

13. (LO 4.4) Describe what is meant by quantitative easing by the Fed. 14. (LO 4.4) Reserve Banks have at times been described as bankers’ banks because of their lending powers. What is meant by this statement?

15. (LO 4.4) Describe the two “targets” that the Fed can use when establishing monetary policy. Which target has the Fed focused on in

recent years?

16. (LO 4.5) Explain the usual procedures for examining national banks. How does this process diff er from the examination of member

banks of the Federal Reserve System holding state charters?

17. (LO 4.5) What federal agencies are responsible for supervising and regulating depository institutions that are not commercial banks?

18. (LO 4.5) Describe the objectives of the Consumer Credit Pro- tection Act of 1968. What is the Truth in Lending section of the act?

What is Regulation Z?

19. (LO 4.6) Explain the process by which the Federal Reserve Banks provide the economy with currency and coin.

20. (LO 4.6) Describe how a check drawn on a commercial bank but deposited for collection in another bank in a distant city might be

cleared through the facilities of the Federal Reserve System.

21. (LO 4.6) What is the special role of the Federal Reserve Inter- district Settlement Fund in the check-clearance process?

22. (LO 4.6) In what way do the Reserve Banks serve as fi scal agents for the U.S. government?

23. (LO 4.7) Briefl y describe and compare the central banks in the United Kingdom, Japan, and Economic Monetary Union.

Problems 101

b. How would your answer in Part (a) change if the required reserves ratio was increased to 12 percent?

4. A bank has $10 million in vault cash and $110 million in deposits. If total bank reserves were $15 million with $2 million considered to

be excess reserves, what required reserves ratio is implied?

5. The Friendly National Bank holds $50 million in reserves at its Federal Reserve District Bank. The required reserves ratio is

12 percent.

a. If the bank has $600 million in deposits, what amount of vault cash would be needed for the bank to be in compliance with the

required reserves ratio?

b. If the bank holds $10 million in vault cash, determine the re- quired reserves ratio that would be needed for the bank to avoid a

reserves defi cit.

c. If the Friendly National Bank experiences a required reserves defi cit, what actions can it take to be in compliance with the exist-

ing required reserves ratio?

6. Assume that banks must hold a 2 percent reserve percentage against transaction account balances up to and including $40 mil-

lion. For transaction accounts above $40 million, the required reserve

percentage is 8 percent. Also assume that Dell National Bank has

transaction account balances of $200 million.

a. Calculate the dollar amount of required reserves that Dell National Bank must hold.

b. What percentage of Dell’s total transaction account balance must be held in the form of required reserves?

7. Assume that the Fed decides to increase the required reserve per- centage on transaction accounts above $40 million from 8 percent

to 10 percent. All other information remains the same as given in

Problem 6, including the transaction account balances held by Dell

National Bank.

a. What would be the dollar amount of required reserves? b. What percentage of total transaction account balances held by Dell would be held as required reserves?

8. Show how your answers in Problem 6 would change if the Fed lowered the cut-off between the 2 percent rate and the 8 percent rate

from $40 million in transaction account balances down to $20 million.

9. Challenge Problem You have been asked to assess the impact of possible changes in reserve requirement components on the dollar

amount of reserves required. Assume the reserve percentages are set

at 2 percent on the fi rst $50 million of transaction account amounts,

4 percent on the second $50 million, and 10 percent on transaction

amounts over $100 million. First National Bank has transaction

account balances of $100 million, while Second National Bank’s

transaction balances are $150 million and Third National Bank’s

transaction balances are $250 million.

a. Determine the dollar amounts of required reserves for each of the three banks.

b. Calculate the percentage of reserves to total transactions accounts for each of the three banks.

c. The central bank wants to slow the economy by raising the re- serve requirements for member banks. To do so, the reserve per-

centages will be increased to 12 percent on transaction balances

above $100 million. Simultaneously, the 2 percent rate will apply

on the fi rst $25 million. Calculate the reserve requirement amount

for each of the three banks after these changes have taken place.

d. Show the dollar amount of changes in reserve requirement amounts for each bank. Calculate the percentage of reserve require-

ment amounts to transaction account balances for each bank.

e. Which of the two reserve requirement changes discussed in (c) causes the greatest impact on the dollar amount of reserves for

all three of the banks?

f. Now assume that you could either (1) lower the transactions account amount for the lowest category from $50 million down

to $25 million or (2) increase the reserve percentage from

10 percent to 12 percent on transactions account amounts over

$200 million. Which choice would you recommend if you were

trying to achieve a moderate slowing of economic activity?

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