CH 4

The Fed and Monetary Policy

 Part 2 The Fed and Monetary Policy

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 4 Functions of the Fed

Chapter Objectives

 Describe how the Fed (Central Banks) influences

monetary policy,
 Describe the tools the Fed (Central Banks) uses to
influence monetary policy
 explain how the Fed revised its lending role in response
to the credit crisis,
 explain how monetary policy is used in other countries.

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3
Functions of the Federal Reserve System

 Effective Monetary Policy

 U.S. Central Bank In International Area
 Facilitate Efficient Payments System
 Regulate Banks and Bank Holding Co.
 Enforce Consumer Credit Laws

4
Organization of the Federal Reserve

 Member Banks
 Must meet requirements of the Federal Reserve
Board of Governors to be a member bank
 Nationally chartered banks must be member
banks
 State chartered banks may be member banks
 35% of banks controlling 70% of all deposits are
members
 Overview

As the central bank of the United States, the Fed conducts

national monetary policy in an attempt to achieve full
employment and price stability (low or zero inflation) in the
United States.
1. Since the Fed’s monetary policy affects interest rates, it
has a strong influence on the cost of borrowing by
households.
2. Monetary policy also affects the cost of borrowing by
businesses and thereby influences how much money
businesses are willing to borrow to support or expand
their operations.

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 Exhibit 4.1 Locations of Federal Reserve District
Banks

Source: Federal Reserve Bulletin.

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Fed’s Influence on Economy

 Fed influences liquidity (supply of loanable funds) in money market to

influence:

Liquidity, Goals of
Business and Consumer
Money Supply Growth
Borrowing/Spending
and Price Stability
Interest Rates Job Growth
Tools of Monetary Policy

Open
Market Op.

Tools of
Monetary
Policy

Discount
Reserve Req.
Rate
 How the Fed Controls the Money Supply:

1. Open Market Operations - The (Federal Open Market

Committee) FOMC meets eight times a year, sets targets for the
money supply growth level and the interest rate level, and
implements monetary policy.
a. Pre-meeting economic report (Beige book) - a consolidated report
of regional economic conditions in each district.
b. Economic presentations - Presentations include data and trends for
wages, consumer prices, unemployment, GDP, business inventories,
foreign exchange rates, interest rates, and financial market
conditions.
c. FOMC decisions - each member can offer recommendations
regarding the federal funds rate target.
d. FOMC Statement - a statement that summarizes their conclusion.
e. Minutes of FOMC Meeting - provided to the public and are also
accessible on Federal Reserve websites.
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 How the Fed Controls the Money Supply:

2. Role of the Fed’s Trading Desk

If a change in monetary policy is appropriate, the FOMC
decision is forwarded to the Trading Desk (Open Market
Desk) at the NY Fed through a policy directive.
a. Fed purchase of securities – To lower the federal funds rate,
traders purchase Treasury securities from securities dealers
(dealers’ ask quote) in the secondary market. The dealers’ bank
account balances increase causing an increase in the supply of
funds.
The purchase of government securities has a different impact than
a purchase by another investor.

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 Open market operations and interest
rates
 Fed purchase of securities results in an injection of
additional funds into the bank system
 Shifts supply of federal funds to the right
 Lowers federal funds rate
 Lower rates spread to other money market securities

-More funds available for money market

and bank lending
 How the Fed Controls the Money Supply:

2. Role of the Fed’s Trading Desk

If a change in monetary policy is appropriate, the FOMC
decision is forwarded to the Trading Desk (Open Market
Desk) at the NY Fed through a policy directive.
b. Fed sale of securities – To increase the federal funds rate,
traders sell government securities to government securities
dealers. As the dealers pay for the securities, their bank
balances decrease leading to a decrease in the supply of funds.
c. Fed trading of repurchase agreements – The Fed may wish
to increase the aggregate level of bank funds for only a few
days to ensure adequate liquidity in the banking system.
Purchases Treasury securities from government securities
dealers with an agreement to sell back the securities at a
specified date in the near future. First the level of funds rises as
the securities are sold then reduced when the dealers
repurchase.
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 How the Fed Controls the Money Supply

2. Role of the Fed’s Trading Desk (Cont.)

d. Control of M1 versus M2
 The optimal form of money should (1) be controllable by the
Fed and (2) have a predictable impact on economic variables
when adjusted by the Fed.
 M1 includes currency held by the public and checking deposits
(such as demand deposits, NOW accounts, and automatic
transfer balances) at depository institutions.
 M2 includes everything in M1 as well as savings accounts and
small time deposits, MMDAs, and some other items.
 M3 includes everything in M2 in addition to large time deposits
and other items.

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 Exhibit 4.4 Comparison of Money Supply Measures

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 How the Fed Controls the Money Supply:

2. Role of the Fed’s Trading Desk (Cont.)

e. Dynamic versus defensive Open Market Operations
 Dynamic operations are implemented to increase or
decrease the level of funds
 Defensive operations offset the impact of other conditions
that affect the level of funds: For ex., if the Fed expects a
large inflow of cash into banks, it could offset this inflow
by selling some Treasury securities.

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 How Fed Operations Affect All Interest Rates

■ Even though most interest rates are market determined,

the Fed can have a strong influence on these rates by
controlling the supply of loanable funds.
■ Open Market Operations in Response to the Economy
a. 2001–2003: The Fed frequently used open market operations to
reduce interest rates during this period of weak economic
conditions.
b. 2004–2007: The Fed’s concern shifted from a weak economy to
high inflation as the economy improved. They used a policy of
raising IR.
c. 2008: The Fed used open market operations to reduce interest
rates in an attempt to stimulate the economy when economic
conditions weakened due to the credit crisis.

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 Adjusting the Reserve Requirement Ratio

■ The Reserve Requirement is the proportion of bank

deposit accounts that must be held as required reserves
or funds held in reserve. This has historically been set
between 8 and 12 percent of transaction accounts.
■ By reducing the reserve requirement, the Board
increases the proportion of a bank’s deposits that can be
lent out. The lower the reserve requirement, the greater
the lending capacity of a depository institution.
■ Impact of Reserve Requirements on Money Growth:
Leakages occur when households hold cash or banks
hold excess reserves. In these cases, the money does
not multiply as expected.
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 Exhibit 4.5 Illustration of Multiplier Effect

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 Adjusting the Fed’s Loan Rate

1. Before 2003, the Fed set its loan rate (then called the
“discount rate”) at low levels when it wanted to
encourage banks to borrow, since this activity increased
the amount of funds injected into the financial system.
2. Since 2003, the Fed’s rate on short-term loans to
depository institutions has been called the primary credit
lending rate, which is set slightly above the federal
funds rate (the rate charged on short-term loans
between depository institutions). So, no longer used to
control the money supply.

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 The Fed’s Lending Role During the Credit Crisis

1. During the crisis, the Fed provided funding through the

discount window:
a. Normally, depository institutions use the federal funds market rather
than the Fed’s discount window to borrow short-term funds. But not
during the credit crisis of 2008.

2. Facilities created by the Fed:

a. In 2008, the Fed created various facilities that provided loans to
financial institutions that purchased particular types of debt
securities. In 2010, the Fed closed most of these facilities.
b. Term Asset-Backed Security Loan Facility (TALF) – The idea
was to support the issuance of asset-backed securities (ABS)
collateralized by student loans, auto loans, credit card loans.
created to provide financing to financial institutions purchasing
high-quality bonds backed by consumer loans, credit card loans,
21 or automobile loans.
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 Global Monetary Policy

■ Each country has its own central bank that

controls the money supply and monetary policy
a. Central banks of other industrialized countries use open
market operations and reserve requirement adjustments as
monetary policy tools.
b. The Fed must consider economic conditions in other
countries when assessing the U.S. economy.

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 Global Monetary Policy

■ A Single Eurozone Monetary Policy

a. The European Central Bank (ECB), based in Frankfurt, is
responsible for setting monetary policy for all European
countries that use the euro. The ECB’s monetary goals are price
and currency stability.
b. Impact of the Euro on Monetary Policy
i. Any changes in the money supply affect all European
countries that use the euro.
ii. Prevents participating countries from solving local economic
problems using their own unique economic policies.

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 Global Central Bank Coordination

1. In some cases, the central banks of various countries

coordinate their efforts for a common cause.
2. Global Monetary Policy during the Credit Crisis
a. August-October 2008: stock market prices in the United States,
Canada, China, France, Germany, Italy, Japan, Mexico, Russia,
Spain, and many other countries declined by more than 25
percent.
b. The targeted interest rate level by various central banks have
changed over time.

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 Exhibit 4.7 Targeted Interest Rates by Central Banks
over Time

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 SUMMARY

 The key components of the Federal Reserve System are

the Board of Governors and the Federal Open Market
Committee. The Board of Governors determines the
reserve requirements on account balances at depository
institutions. It is also an important subset of the Federal
Open Market Committee (FOMC), which determines
U.S. monetary policy. The FOMC’s monetary policy has
a major influence on interest rates and other economic
conditions.
 The Fed uses open market operations (the buying and
selling of securities) as a means of adjusting the money
supply. The Fed purchases securities to increase the
money supply and sells them to reduce the money
supply.
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 SUMMARY (Cont.)

 Each country has its own central bank, which is

responsible for conducting monetary policy to achieve
economic goals such as low inflation and low
unemployment. Sixteen countries in Europe have
adopted a single currency, which means that all of these
countries are subject to the same monetary policy.

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