Chapter One

Introduction

©2007, The McGraw-Hill Companies, All Rights Reserved

 Why study Financial Markets and
Institutions?

•• They
They are
are the
the cornerstones
cornerstones ofof the
the
overall
overall financial
financial system
system in
in which
which
financial
financial managers
managers operate
operate
•• Individuals
Individuals use
use both
both for
for investing
investing
•• Corporations
Corporations andand governments
governments use use
both
both for
for financing
financing

McGraw-Hill/Irwin 1-3 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Overview of Financial Markets

•• Primary
Primary Markets
Markets versus
versus Secondary
Secondary
Markets
Markets
•• Money
Money Markets
Markets versus
versus Capital
Capital
Markets
Markets
•• Foreign
Foreign Exchange
Exchange Markets
Markets
•• Derivative
Derivative Security
Security markets
markets
McGraw-Hill/Irwin 1-4 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Primary Markets versus Secondary
Markets

•• Primary
Primary Markets
Markets
–– markets
markets inin which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raiseraise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.
(e.g. stocks
stocks and
and
bonds)
bonds)
•• Secondary
Secondary Markets
Markets
–– markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.
(e.g. NYSE,
NYSE, NASDAQ)
NASDAQ)

McGraw-Hill/Irwin 1-5 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Money Markets versus Capital Markets

•• Money
Money Markets
Markets
–– markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g. CD’s,
CD’s, U.S.
U.S.
Treasury
Treasury bills)
bills)
•• Capital
Capital Markets
Markets
–– markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity
(stock)
(stock) instruments
instruments with
with maturities
maturities of
of more
more
than
than one
one year
year

McGraw-Hill/Irwin 1-6 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Money Market Instruments
Outstanding, 1990-2004 ($Bn)
2000
2000

1500
1500

1000
1000

500
500

00
1990
1990 2000
2000 2004
2004
Commercial
Commercialpaper
paper Fed
FedFunds
Fundsand
andRepo
Repo U.S.
U.S.T-bills
T-bills
Negotiable
NegotiableCDs
CDs Banker's
Banker'saccept.
accept.
McGraw-Hill/Irwin 1-7 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Capital Market Instruments
Outstanding, 1990-2004 ($Bn)
20000
20000
15000
15000
10000
10000
5000
5000
00
1990
1990 2000
2000 2004
2004
Corporate
Corporatestocks
stocks Mortgages
Mortgages Corporate
Corporatebonds
bonds
Treasury
TreasurySecurities
Securities State
State&
&Local
LocalGovt.
Govt.bonds
bonds U.S.
U.S.Govt
Govtagencies
agencies
Bank
Bankand
andconsumer
consumerloans
loans

McGraw-Hill/Irwin 1-8 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Foreign Exchange Markets

•• “FX”
“FX” markets
markets deal
deal inin trading
trading oneone currency
currency
for
for another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)
•• The
The “spot”
“spot” FX
FX transaction
transaction involves
involves the
the
immediate
immediate exchange
exchange of of currencies
currencies at at the
the
current
current exchange
exchange rate
rate
•• The
The “forward”
“forward” FXFX transaction
transaction involves
involves the
the
exchange
exchange ofof currencies
currencies at at aa specified
specified date
date in
in
the
the future
future and
and at
at aa specified
specified exchange
exchange rate
rate
McGraw-Hill/Irwin 1-9 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Derivative Security Markets

•• The
The markets
markets in in which
which derivative
derivative
securities
securities trade.
trade.
•• Derivative
Derivative Security
Security
–– An
An agreement
agreement between
between twotwo parties
parties to
to exchange
exchange
aa standard
standard quantity
quantity of
of an
an asset
asset at
at aa
predetermined
predetermined price
price on
on aa specified
specified date
date in
in the
the
future.
future.

McGraw-Hill/Irwin 1-10 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Overview of Financial Institutions

•• Institutions
Institutions that
that perform
perform the the essential
essential
function
function of
of channeling
channeling fundsfunds from
from those
those
with
with surplus
surplus funds
funds toto those
those with
with shortages
shortages
of
of funds
funds (e.g.
(e.g. banks,
banks, thrifts,
thrifts, insurance
insurance
companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds)
funds)
McGraw-Hill/Irwin 1-11 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Users of Funds Suppliers of
(Corporations) Funds
(Households)
Cash

Example: A firm sells shares directly to investors without

going through a financial institution.

McGraw-Hill/Irwin 1-12 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

Cash FI
(Asset Cash
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)

McGraw-Hill/Irwin 1-13 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Types of FIs
•• Commercial
Commercial banks banks
–– depository
depository institutions
institutions whose
whose major
major assets
assets are
are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
•• Thrifts
Thrifts
–– depository
depository institutions
institutions inin the
the form
form of
of savings
savings
and
and loans,
loans, credit
credit unions
unions
•• Insurance
Insurance companies
companies
–– financial
financial institutions
institutions that
that protect
protect individuals
individuals
and
and corporations
corporations from
from adverse
adverse events
events

(continued)
McGraw-Hill/Irwin 1-14 ©2007, The McGraw-Hill Companies, All Rights Reserved
 •• Securities
Securities firms
firms andand investment
investment banksbanks
–– financial
financial institutions
institutions that
that underwrite
underwrite securities
securities
and
and engage
engage inin securities
securities brokerage
brokerage and
and trading
trading
•• Finance
Finance companies
companies
–– financial
financial institutions
institutions that
that make
make loans
loans to
to
individuals
individuals and
and businesses
businesses
•• Mutual
Mutual Funds
Funds
–– financial
financial institutions
institutions that
that pool
pool financial
financial
resources
resources and
and invest
invest in
in diversified
diversified portfolios
portfolios
•• Pension
Pension Funds
Funds
–– financial
financial institutions
institutions that
that offer
offer savings
savings plans
plans for
for
retirement
retirement
McGraw-Hill/Irwin 1-15 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Services Performed by Financial
Intermediaries

•• Monitoring
Monitoring Costs
Costs
•• Liquidity
Liquidity and
and Price
Price Risk
Risk
•• Transaction
Transaction Cost
Cost Services
Services
•• Maturity
Maturity Intermediation
Intermediation
•• Denomination
Denomination Intermediation
Intermediation

McGraw-Hill/Irwin 1-16 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Provided by FIs Benefiting the
Overall Economy

•• Money
Money Supply
Supply Transmission
Transmission
•• Credit
Credit Allocation
Allocation
•• Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers
•• Payment
Payment Services
Services

McGraw-Hill/Irwin 1-17 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Risks Faced by Financial Institutions

•• Interest
Interest Rate
Rate Risk
Risk
•• Foreign
Foreign Exchange
Exchange Risk
Risk
•• Market
Market Risk
Risk
•• Credit
Credit Risk
Risk
•• Liquidity
Liquidity Risk
Risk
•• Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk
•• Technology
Technology Risk
Risk
•• Operational
Operational Risk
Risk
•• Country
Country oror Sovereign
Sovereign Risk
Risk
•• Insolvency
Insolvency Risk
Risk
McGraw-Hill/Irwin 1-18 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Regulation of Financial Institutions

•• FIs
FIs provide
provide vital
vital financial
financial services
services toto
all
all sectors
sectors ofof the
the economy;
economy; therefore,
therefore,
their
their regulation
regulation isis inin the
the public
public interest
interest
•• In
In an
an attempt
attempt to to prevent
prevent their
their failure
failure
and
and the
the failure
failure of
of financial
financial markets
markets
overall
overall

McGraw-Hill/Irwin 1-19 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Globalization of Financial Markets and
Institutions

•• Financial
Financial Markets
Markets became
became more
more
global
global as
as the
the value
value ofof stocks
stocks traded
traded in
in
foreign
foreign markets
markets soared
soared
•• Foreign
Foreign bond
bond markets
markets havehave served
served as
as
aa major
major source
source of
of international
international capital
capital
•• Globalization
Globalization also
also evident
evident in
in the
the
derivative
derivative securities
securities market
market
McGraw-Hill/Irwin 1-20 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of
of Funds:
Funds:
Monitoring
Monitoring Costs-
Costs- aggregation
aggregation of
of funds
funds in
in
an
an FI
FI provides
provides greater
greater incentive
incentive to
to collect
collect aa
firm’s
firm’s information
information andand monitor
monitor actions.
actions. The
The
relatively
relatively large
large size
size of
of the
the FI
FI allows
allows this
this
collection
collection of of information
information to to be
be accomplished
accomplished
at
at aa lower
lower average
average costcost (Economies
(Economies of of scale)
scale)

McGraw-Hill/Irwin 1-21 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Economies
Economies ofof scale
scale means
means the
the concept
concept that
that
cost
cost reduction
reduction in
in trading
trading and
and other
other
transaction
transaction services
services result
result in
in increased
increased
efficiency
efficiency when
when FIs
FIs perform
perform these
these service
service

McGraw-Hill/Irwin 1-22 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of
of Funds:
Funds:
Monitoring
Monitoring Costs-
Costs-
How
Howcan
canFIs
FIsprovide
providethese
theseliquidity
liquidityservice?
service?
how
howcan
canFIs
FIsbe
beconfident
confidentenough
enoughto toguarantee
guaranteethat
that
they
theycan
canprovide
provideliquidity
liquidityservices
servicesto tofund
fundsuppliers
suppliers
when
whenthey
theythemselves
themselvesinvest
investin
inrisky
riskyassets?
assets?
why
whyshould
shouldfund
fundsuppliers
suppliersbelieve
believeFIs
FIspromises
promises
regarding
regardingthe
theliquidity
liquidityand
andsafety
safetyof oftheir
theirinvestment
investment

McGraw-Hill/Irwin 1-23 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of of Funds:
Funds:
Liquidity
Liquidity and
and Price
Price risk
risk –– FIs
FIs provide
provide
financial
financial claims
claims toto household
household savers
savers
with
with superior
superior liquidity
liquidity attributes
attributes and
and
with
with lower
lower price
price risk
risk

McGraw-Hill/Irwin 1-24 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of of Funds:
Funds:
Transaction
Transaction cost
cost services
services –– similar
similar to
to
economies
economies of
of scale
scale in
in information
information
production
production costs,
costs, an
an FI’s
FI’s sixe
sixe can
can result
result
in
in economies
economies of
of scale
scale inin transaction
transaction
costs.
costs.

McGraw-Hill/Irwin 1-25 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of
of Funds:
Funds:

Maturity
Maturity Intermediation
Intermediation –– FI FI can
can better
better
bear
bear risk
risk of
of mismatching
mismatching the the maturities
maturities
of
of their
their assets
assets and
and liabilities.
liabilities.

McGraw-Hill/Irwin 1-26 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting Supplier
Supplier of
of Funds:
Funds:

Denomination
Denomination intermediation
intermediation –FI’s
–FI’s
such
such as
as mutual
mutual fund
fund allows
allows small
small
investors
investors to
to overcome
overcome constraints
constraints to
to
buying
buying assets
assets imposed
imposed byby large
large
minimum
minimum denomination
denomination size.
size.
McGraw-Hill/Irwin 1-27 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting the
the Overall
Overall
Economy:
Economy:
Money
Money Supply
Supply transmission
transmission ––
depository
depository institution
institution are
are the
the conduit
conduit
through
through which
which monetary
monetary policy
policy actions
actions
impact
impact the
the rest
rest of
of the
the financial
financial systems
systems
and
and the
the economy
economy in in general.
general.

McGraw-Hill/Irwin 1-28 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting the
the Overall
Overall
Economy:
Economy:
Credit
Credit allocation
allocation –– FI’s
FI’s are
are often
often viewed
viewed
as
as the
the major
major and
and sometimes
sometimes only
only source
source
of
of financing
financing for
for aa particular
particular sector
sector of
of
the
the economy,
economy, such
such as
as farming
farming and
and
residential
residential real
real state.
state.

McGraw-Hill/Irwin 1-29 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting the
the Overall
Overall
Economy:
Economy:
Intergenerational
Intergenerational wealth
wealth transfer
transfer –FI’s
–FI’s
especially
especially life
life insurance
insurance companies
companies and
and
pension
pension funds,
funds, provide
provide savers
savers with
with the
the
ability
ability to
to transfer
transfer wealth
wealth form
form one
one
generation
generation to to the
the next.
next.

McGraw-Hill/Irwin 1-30 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Services Performed by Financial
Institutions

Services
Services Benefiting
Benefiting thethe Overall
Overall
Economy:
Economy:
Payment
Payment services
services –– the
the efficiency
efficiency with
with
which
which depository
depository institutions
institutions provide
provide
payment
payment services
services directly
directly benefits
benefits the
the
economy.
economy.

McGraw-Hill/Irwin 1-31 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Factors Leading to Significant Growth
in Foreign Markets
•• The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors has
has
increased
increased
•• International
International investors
investors have
have turned
turned toto U.S.
U.S. and
and other
other
markets
markets to
to expand
expand their
their investment
investment opportunities
opportunities
•• Information
Information on on foreign
foreign investments
investments and and markets
markets isis
now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)
•• Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in foreign
foreign
securities
securities with
with low
low transaction
transaction costs
costs
•• Deregulation
Deregulation hashas enhanced
enhanced globalization
globalization of of capital
capital
flows
flows
McGraw-Hill/Irwin 1-32 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Financial market regulations

Financial
Financial instruments
instruments are are subject
subject to
to regulations
regulations
imposed
imposed by by regulatory
regulatory agencies
agencies such
such asas the
the Securities
Securities
and
and Exchange
Exchange Commission
Commission (SEC) (SEC) the
the main
main regulatory
regulatory
of
of securities
securities markets
markets sincesince passage
passage ofof the
the Security
Security Act
Act
of
of 1934
1934 asas well
well as
as the
the exchanges
exchanges on on which
which thethe
instruments
instruments are are traded.
traded. The The main
main emphasis
emphasis off offSEC
SEC
regulations
regulations (as (as stated
stated in in the
the Securities
Securities Act
Act of
of 1933)
1933) isis
on
on full
full disclosure
disclosure of of information
information on on securities
securities issues
issues to
to
actual
actual andand potential
potential investors.
investors.

McGraw-Hill/Irwin 1-33 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Financial market regulations

Those
Those firms
firms planning
planning to to issued
issued new
newstocks
stocksor orbond
bond toto
be
be sold
sold to
to public
public at at large
large (public
(public issues)
issues) are
are required
required
by
by the
the SEC
SEC to to register
register theirtheir securities
securities with
with the
the SEC
SEC
and
and to
to fully
fully describe
describe the the issue
issue and
and any
any risks
risks associated
associated
with
with the
the issue,
issue, in in aa legal
legal document
document called
called aa prospectus.
prospectus.
The
The SEC
SEC also
also monitors
monitors tradingtrading onon the
the major
major
exchanges
exchanges (along
(along with with thethe exchanges
exchanges themselves)
themselves) to to
ensure
ensure that
that stockholders
stockholders and and managers
managers do do not
not trade
trade
on
on the
the basis
basis of of inside
inside information
information about about their
their own
own
firms.
firms. (i.e.,
(i.e., information
information prior prior to
to its
its public
public release).
release).

McGraw-Hill/Irwin 1-34 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Financial market regulations

SEC
SEC regulations
regulations are
are not
not intended
intended to
to protect
protectinvestors
investors
against
against poor
poor investment
investment choices,
choices, but
but rather
ratherto
to ensure
ensure
that
that investors
investors have
havefull
full and
and accurate
accurate information
information
available
available about
about corporate
corporate issues
issues when
when making
making their
their
investment
investment decisions.
decisions.

McGraw-Hill/Irwin 1-35 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Financial market regulations

SEC
SEC regulations
regulations are
are not
not intended
intended to
to protect
protectinvestors
investors
against
against poor
poor investment
investment choices,
choices, but
but rather
ratherto
to ensure
ensure
that
that investors
investors have
havefull
full and
and accurate
accurate information
information
available
available about
about corporate
corporate issues
issues when
when making
making their
their
investment
investment decisions.
decisions.

McGraw-Hill/Irwin 1-36 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Risks Incurred by Financial
Institutions
1.
1. FIs
FIs expand
expand their
their services
services toto non-U.S.
non-U.S. customers
customers or or
even
even domestic
domestic customer
customer ss with
with business
business outside
outside thethe
united
united states,
states, they
they are
are exposed
exposed to to both
both foreign
foreign
exchange
exchange risk
risk and
and country
country or or sovereign
sovereign risk.
risk.
2.
2. FIs
FIs tend
tend to
to mismatch
mismatch the the maturities
maturities of of their
their balance
balance
sheet
sheet assets
assets and
and liabilities
liabilities to
to aa greater
greater oror lesser
lesser extend
extend
and
and are
are thus
thus exposed
exposed to to interest
interest risk.
risk.
3.
3. FIs
FIs actively
actively trade
trade these
these assets
assets andand liabilities
liabilities rather
rather
than
than hold
hold them
them forfor longer
longer term
term investment,
investment, theythey are
are
further
further exposed
exposed to to market
market riskrisk oror assets
assets price
price risk
risk

McGraw-Hill/Irwin 1-37 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Risks Incurred by Financial
Institutions
4.
4. FIs
FIs hold
hold contingent
contingent assets
assets and
and liabilities
liabilities off
off the
the
balance
balance sheet
sheet which
which presents
presents an an additional
additional risk
risk called
called
off
off balance
balance sheet
sheet risk
risk
5.
5. FIs
FIs are
are exposed
exposed to to some
some degree
degree ofof liability
liability
withdrawal
withdrawal or or liquidity
liquidity risk
risk depending
depending on on the
the types
types of
of
claims
claims they
they have
have sold
sold to
to liability
liability holders
holders
6.
6. All
All FIs
FIs are
are exposed
exposed to to technology
technologyriskriskand
and
operational
operational risk
risk because
because the the production
production of of financial
financial
services
services requires
requires thethe use
use of of real
real resources
resources and and back
back
office
office support
support (labor
(labor and
and technology
technology combined
combined to to
provide
provide service
service
McGraw-Hill/Irwin 1-38 ©2007, The McGraw-Hill Companies, All Rights Reserved
 Risks Incurred by Financial
Institutions

7.
7. The
The risk
risk than
than FIFI may
may notnot have
have enough
enough capital
capital
reserves
reserves toto offset
offset aa sudden
sudden loss loss incurred
incurred asas aa result
result of
of
one
one oror more
more of of the
the risk
risk itit faces
faces creates
creates insolvency
insolvency risk
risk
for
for the
the FI.
FI.

McGraw-Hill/Irwin 1-39 ©2007, The McGraw-Hill Companies, All Rights Reserved

 ENTERPRISE RISK
MANAGEMENT
ERM
ERM –– recognizes
recognizes the the importance
importance of of managing
managing the the
combined
combined impact
impact of of the
the full
full spectrum
spectrum oror risk
risk as
as an
an
interrelated
interrelated risk
risk portfolio.
portfolio.
ERM
ERM camecame toto the
the forefront
forefront forfor many
many FIs
FIs during
during andand
after
after financial
financial crisis,
crisis, when
when their
their risk
risk management
management
practices
practices came
came under
under scrutiny.
scrutiny. Many
Many FIsFIs had
had invested
invested
heavily
heavily inin advanced
advanced risk risk measurement
measurement and and
management
management systems
systems only
only toto have
have them
them fail
fail to
to detect
detect
or
or control
control risk
risk exposures
exposures thatthat led
led up
up to
to crisis.
crisis.

McGraw-Hill/Irwin 1-40 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Central
Central bank
bank determine,
determine, implement
implement and andcontrol
controlthethe
monetary
monetary policy
policy inin their
their home
home country.
country.
Federal
Federal Reserve
Reserve (the
(the Fed)
Fed) isis the
the central
central bank
bank of
of the
the
united
united states.
states. Founded
Founded by by congress
congress under
under thethe Federal
Federal
Reserve
Reserve ActAct in
in 1913,
1913, the
the Fed’s
Fed’s original
original duties
duties were
were to to
provide
provide thethe nation
nation with
with aa safer,
safer, more
more flexible,
flexible, and
and
more
more stable
stable monetary
monetary and and financial
financial system.
system.
The
The federal
federal Reserve
Reserve System
System isis anan independent
independent central
central
bank
bank inin that
that its
its decision
decision dodo not
nothave
haveto to ratified
ratifiedbybythethe
president
president or or another
another member
member of of the
the executive
executive branch
branch
of
of the
the U.S.
U.S. Government.
Government.
McGraw-Hill/Irwin 1-41 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate
The
TheFederal
FederalReserve
Reserve System
Systemhashasevolved
evolvedinto
into one
oneof
of the
the
most
mostpowerful
powerfuleconomic
economicbodies
bodiesinin the
theworld
worldand
andwas
was
critical
criticalin
inimplementing
implementingpolicies
policiesto
toaddress
addressthe
the
worldwide
worldwidefinancial
financialcrisis
crisisin
in2008-2009.
2008-2009.even
even in
inthe
the hint
hint
of
ofaa change
changein in interest
interestrate
ratepolicy
policybybyFed
Fed can
can have
have an
an
impact
impacton on markets
markets around
around the
the world.
world.
The
TheDuties
Dutiesincorporate
incorporate 44major
majorfunction
function
1.Conducting
1.Conductingmonetary
monetarypolicy
policy
2.2.Supervising
Supervisingand
andregulating
regulatingdepository
depositoryinstitution
institution
3.3.maintaining
maintainingthe
thestability
stabilityof
ofthe
thefinancial
financialsystem
system
4.
4.Providing
Providingpayment
paymentand
andother
otherfinancial
financialservices
servicesto
tothe
theU.S.
U.S.
government,
government,thethepublic,
public,financial
financialinstitutions
institutionsand
andforeign
foreignofficial
official
institutions.
institutions.
McGraw-Hill/Irwin 1-42 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate
Central
Central bank
bank of of the
the Philippines
Philippines itit established
established on
on July
July
3,
3, 1993,
1993, pursuant
pursuant to to provision
provision of of Republic
Republic Act
Act 7653
7653 or
or
the
the New
New Central
Central BankBank Act
Act ofof 1993.
1993.
In
In 1900,
1900, the
the first
first Philippine
Philippine Commission
Commission passed
passed Act
Act
No.
No. 52,
52, which
which placed
placed allall banks
banks under
underBureau
Bureauof
of the
the
Treasury
Treasury andand authorizing
authorizing the the Insular
Insular Treasurer
Treasurer toto
supervise
supervise and
and examine
examine banks
banks and and all
all banking
banking activity.
activity.
In
In 1929
1929 the
the Department
Department of of Finance
Finance through
through the
the
Bureau
Bureau of of Banking,
Banking, took took over
over bank
bank supervision
supervision

McGraw-Hill/Irwin 1-43 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Roles
Roles and
and responsibilities
responsibilities ofof the
the Banko
Banko Sentral
Sentral
1.
1. Liquidity
Liquidity management
management –– by by formulating
formulating and and
implementing
implementing monetary
monetary policy
policy aimed
aimed at at influencing
influencing
money
money supply,
supply, consistent
consistent with
with its
its primary
primary objective
objectivetoto
maintain
maintain stability.
stability.
2.
2. Currency
Currency issue
issue –– the
the BSP
BSP has
has the
the exclusive
exclusive power
power toto
issue
issue the
the national
national currency.
currency. AllAll notes
notes and
and coins
coins issued
issued
by
by the
the BSP
BSP are
are fully
fully guaranteed
guaranteed by by the
the Government
Government
and
and are
are considered
considered legal
legal tender
tender for
for all
all private
private and
and
public
public debts.
debts.

McGraw-Hill/Irwin 1-44 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Roles
Roles and
and responsibilities
responsibilities of
of the
the Banko
Banko Sentral
Sentral

3.
3. Lender
Lender of
of Last
Last resort
resort –– by
by extending
extending discounts,
discounts,
loans
loans and
and advances
advances toto banking
banking institutions
institutions for
for
liquidity
liquidity purposes.
purposes.
4.
4. Financial
Financial supervision
supervision –– by
by supervising
supervising banks
banks and
and
exercising
exercising regulatory
regulatory powers
powersover
overnon
non bank
bank
institutions
institutions performing
performing quasi-banking
quasi-banking functions
functions

McGraw-Hill/Irwin 1-45 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Roles
Roles and
and responsibilities
responsibilities of
of the
the Banko
Banko Sentral
Sentral
5.
5. Management
Management of of Foreign
Foreign currency
currency reserves
reserves –– by by
maintaining
maintaining sufficient
sufficient international
international reserves
reserves to to meet
meet
any
any foreseeable
foreseeable net
net demands
demands for for foreign
foreign currencies
currencies inin
order
order to
to preserve
preserve the
the international
international stability
stability andand
convertibility
convertibility of
of the
the Philippine
Philippine peso
peso
6.
6. Determination
Determination of of exchange
exchangerate ratepolicy
policy –– by by
determining
determining thethe exchange
exchange rate
rate policy
policy ofof the
the
Philippines.
Philippines. Currently,
Currently, the
the BSP
BSP adheres
adheres to to aa market-
market-
oriented
oriented foreign
foreign exchange
exchange rate
rate policy
policy

McGraw-Hill/Irwin 1-46 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate

7.
7. Being
Being the
the banker,
banker, financial
financial advisor
advisor and
and official
official
depository
depository ofof the
theGovernment,
Government, itsits political
political
subdivisions
subdivisions and
and instrumentalities
instrumentalities and
and GOCCs
GOCCs

McGraw-Hill/Irwin 1-47 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Organization
Organization of of the
the Banko
Banko Sentral
Sentral
 the
the Monetary
Monetary Board
Board ,, which
which exercises
exercises thethe powers
powers
and
and functions
functions of
of the
the BSP,
BSP, such
such as
as the
the conduct
conduct of of
monetary
monetary policy
policy and
and supervision
supervision ofof the
the financial
financial
system
system
 the
the monetary
monetary stability
stability sector,
sector, which
which takes
takescharge
charge of
of
the
the formulation
formulation and
and implementation
implementation of of the
the BSP’s
BSP’s
monetary
monetary policy,
policy, including
including serving
serving the
the banking
banking needs
needs
of
of all
all banks
banks through
through accepting
accepting deposits,
deposits, serving
serving
withdrawals
withdrawals andand extending
extending credit
credit through
through thethe
rediscounting
rediscounting facility
facility
McGraw-Hill/Irwin 1-48 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate
Organization
Organization of
of the
the Banko
Banko Sentral
Sentral


 the
the Supervision
Supervision and
and Examination
Examination Sector,
Sector, which
which
enforces
enforces and
and monitors
monitors compliance
compliance toto banking
banking laws
laws to
to
promote
promote aa sound
sound and
and healthy
healthy banking
banking systems
systems

 the
the resource
resource management
management sector,
sector, which
which serve
serve the
the
human,
human, financial
financial and
and physical
physical resource
resource needs
needs of
of the
the
BSP
BSP

McGraw-Hill/Irwin 1-49 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Organization
Organization of
of the
the Banko
Banko Sentral
Sentral
The
Thepowers
powersandandfunctions
functionsofofBangko
BangkoSentral
Sentralareareexercised
exercisedby
by
its
itsMonetary
MonetaryBoard,
Board,whose
whoseseven
sevenmembers
membersare are appointed
appointedbyby
the
thePresident
Presidentof ofthe
thePhilippines.
Philippines.As Asprovided
providedfor forby
byRA
RA7653
7653oror
new
newcentral
centralbank
bankact,
act,one
oneof
ofthe
thegovernment
governmentsector
sectormembers
membersof of
the
theMonetary
MonetaryBoard
Boardmust
mustaaalso
alsobe
beaamember
memberof ofcabinet.
cabinet.
Members
Membersof ofthe
theMonetary
Monetaryboard
boardareareprohibited
prohibitedfrom
fromholding
holding
certain
certainpositions
positionsininother
othergovernment
governmentagencies
agenciesandandprivate
private
institutions
institutionsthat
thatthe
thegive
giverise
risetotoconflicts
conflictsof
ofinterest.
interest.The
The
members
membershavehavefixed
fixedand
andoverlapping
overlappingterms,
terms,except
exceptfor
forthe
the
cabinet
cabinetsecretary
secretaryrepresenting
representingthetheincumbent
incumbentadministration.
administration.

McGraw-Hill/Irwin 1-50 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
The
The Board
Board of of Governors
Governors of of the
the Federal
Federal Reserve
Reserve
System
System (Also
(Also called
called the
the Federal
Federal Reserve
Reserve Board)
Board) isis aa
seven-member
seven-member board board headquartered
headquartered in in Washington,
Washington,
DC.
DC. Each
Each member
member isis appointed
appointed byby the
the President
President ofof the
the
United
United States
States and
and must
must bebe confirmed
confirmed by by the
the senate.
senate.
Board
Board members
members serve serve aa nonrenewal
nonrenewal 14 14 year
year term.
term.
Board
Board members
members are are often
often individuals
individuals with
with PhDPhD
degrees
degrees in
in economics
economics and/or
and/or an
an extensive
extensive background
background
in
in economic
economic research
research and and political
political service,
service,
particularly
particularly in
in the
the area
area banking.
banking.

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 The Federal Reserve System,
Monetary Policy and Interest Rate
The
The President
President designates
designates two
two members
members of of the
the board
board toto
be
be the
the chair
chair and
and vice
vice chair
chair for
for four
four year
year terms.
terms.
The
The Primary
Primary responsibilities
responsibilities of of the
the Federal
Federal Reserve
Reserve
Board
Board areare the
the Formulation
Formulation and and conduct
conduct of of monetary
monetary
policy
policy and
and the
the supervision
supervision and
and regulation
regulation of of banks.
banks.
All
All seven
seven board
board members
members sit sit on
on the
the Federal
Federal Open
Open
market
market Committee,
Committee, which which makesmakes keykey decisions
decisions
affecting
affecting the
the availability
availability ofof money
money andand credit
credit in
in the
the
economy.
economy.

McGraw-Hill/Irwin 1-52 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
For
For Example,
Example, the the Federal
Federal Reserve
Reserve Board,Board, through through the the
FOMC,
FOMC, can can and
and usually
usually does
does setset money
money supply supply and and
interest
interest rate rate targets.
targets. The
The Federal
Federal Reserve
Reserve Board Board also also set set
bank
bank reservereserve requirements
requirements and and review
review and and approves
approves
the
the discount
discountrate. rate.
The
The FederalFederal Reserve
Reserve Board
Board also also has
has primaryprimary
responsibility
responsibilityfor for the
thesupervision
supervision and andregulation
regulation of: of:
1.All
1.All bank bank holding
holding companies
companies (( their their nonbanknonbank
subsidiaries
subsidiariesand andtheir
their foreign
foreignsubsidiaries)
subsidiaries)
2.
2. State
State Chartered
Chartered banks
banks that
that are are members
members of of the the
Federal
Federal Reserve Reserve System
System (state-chartered
(state-chartered members members
banks?
banks?
McGraw-Hill/Irwin 1-53 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate

2.
2. State
State Chartered
Chartered banks
banks that
that are
are members
members of of the
the
Federal
Federal Reserve
Reserve System
System (state-chartered
(state-chartered members
members
banks?
banks?
3.
3. Edge
Edge Act
Act and
and agreement
agreement corporations
corporations (through
(through
which
which U.S.
U.S. banks
banks conduct
conduct foreign
foreign operations)
operations)

McGraw-Hill/Irwin 1-54 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
The
The Fed
Fed alsoalso share
share supervisory
supervisory and and regulatory
regulatory
responsibilities
responsibilities with with state
state andand other
other federal
federal
supervisors,
supervisors, including
including overseeing
overseeing both both operations
operations ofof
foreign
foreign banks
banks in in the
the United
United States.
States. The
The board
board
approves
approves member
member bankbank mergers
mergers andand acquisitions
acquisitions and
and
specifies
specifies permissible
permissible nonbank
nonbank activities
activities of
of bank
bank
holding
holding companies.
companies. The The board
board isis also
also responsible
responsible for
for
the
the development
development and and administration
administration of of regulations
regulations
governing
governing thethe fair
fair provision
provision ofof consumer
consumer credit
credit (the
(the
Truth
Truth inin Lending
Lending Act,Act, the
the Equal
Equal Credit
Credit opportunity
opportunity
in
in Act)
Act)
McGraw-Hill/Irwin 1-55 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate

The
The Federal
Federal Open
Open market
market Committee
Committee (FOMC)
(FOMC) isis thethe
major
major monetary
monetary policy
policy making
making body
body of of the
the Federal
Federal
Reserve
Reserve System,
System, also
also to
to formulate
formulate policies
policies to to promote
promote
full
full employment,
employment, economic
economic growth,
growth, price
price stability
stability and
and
aa sustainable
sustainable pattern
pattern of
of international
international trade.
trade.
Open
Open Market
Market Operations
Operations –– Purchases
Purchases and and sales
sales of
of
U.S.
U.S. government
government andand federal
federal agency
agency securities
securities by by
Federal
Federal Reserve.
Reserve.

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Functions
Functions Performed
Performed by by The
The Federal
Federal Reserve
Reserve Banks
Banks
 Assistance
Assistance in in the
the conduct
conduct of of Monetary
Monetary Policy
Policy ––
federal
federal reserve
reserve bank
bank president
president serve
serve on
on the
the federal
federal
open
open market
market committee
committee (FOMC).
(FOMC). FRBsFRBs set set and
and
change
change discount
discount rates
rates
 Supervision
Supervision and and Regulation
Regulation –– FRBs FRBs have have
supervisory
supervisory and and regulatory
regulatory authority
authority over over thethe
activities
activities ofof banks
banks and and other
other large
large financial
financial
institutions
institutions located
located in
in their
their district.
district.

McGraw-Hill/Irwin 1-57 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Assistance
Assistance in
in the
the conduct
conduct of
of Monetary
Monetary Policy
Policy

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Supervision
Supervision and
and Regulation
Regulation

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Functions
Functions Performed
Performed byby The
The Federal
Federal Reserve
Reserve Banks
Banks
 Consumer
Consumer protection
protection andand community
community affairs
affairs ––
FRBs
FRBs write
write regulations
regulations to to implements
implements many
many of of the
the
major
major consumer
consumer protection
protection laws laws and
and establish
establish
programs
programs to to promote
promote community
community development
development and and
fair
fair and
and impartial
impartial access
access to
to credit.
credit.
 Government
Government Service
Service –– FRBs FRBs serve
serve asas thethe
commercial
commercial bank
bank for
for the
the U.S.
U.S. treasury
treasury
 New
New Currency
Currency issue
issue –– FRBs
FRBs areare responsible
responsible for
for the
the
collection
collection and
and replacement
replacement of of damaged
damaged currency
currency form
form
circulation
circulation
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 The Federal Reserve System,
Monetary Policy and Interest Rate
Consumer
Consumer protection
protection and
and community
community affairs
affairs

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 The Federal Reserve System,
Monetary Policy and Interest Rate
New
New Currency
Currency Issue
Issue

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Functions
Functions Performed
Performed by by The
The Federal
Federal Reserve
Reserve Banks
Banks
 Check
Check clearing
clearing -- FRBs
FRBs process,
process, route
route and
and transfer
transfer
funds
funds form
form oneone bank
bank toto another
another asas checks
checks clear
clear
through
through federal
federal reserve
reserve system
system
 Wire
Wire transfer
transfer services
services –– FRBs
FRBs and
and their
their member
member
bank
bank are
are linked
linked electronically
electronically through
through the
the federal
federal
reserve
reserve communication
communication systemsystem
 Research
Research service
service –– each
each FRB
FRB hashas aa staff
staff of
of
professional
professional economists
economists who who gather,
gather, analyze
analyze andand
interpret
interpret economic
economic data data and
and developments
developments in in the
the
banking
banking sector
sector in
in their
their district
district and
and economy
economy wide
wide
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 The Federal Reserve System,
Monetary Policy and Interest Rate
Check
Check clearing
clearing

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Check
Check clearing
clearing

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Wire
Wire transfer
transfer services
services

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Research
Research service
service

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 The Federal Reserve System,
Monetary Policy and Interest Rate
What
What isis discount
discount rate?
rate?
The
The interest
interest rate
rate onon loans
loans made
made by
by federal
federal reserve
reserve
banks
banks toto financial
financial institutions.
institutions.

Discount
Discount window
window –– thethe facility
facility through
through which
which federal
federal
reserve
reserve banks
banks issue
issue loans
loans toto financial
financial institutions.
institutions.

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 The Federal Reserve System,
Monetary Policy and Interest Rate
What
What isis Reserves?
Reserves?
Depository
Depository institutions
institutions vault
vault cash
cash plus
plus reserves
reserves
deposited
deposited atat federal
federal reserve
reserve bank.
bank.

What
What isis monetary
monetary base?
base?
Currency
Currency in in circulation
circulation and
and reserves
reserves (depository
(depository
institution
institution reserves
reserves and
and vault
vault cash
cash commercial
commercial bank)
bank)
held
held by
by the
the federal
federal reserve.
reserve. Also
Also referred
referred to
to as
as money
money
base.
base.

McGraw-Hill/Irwin 1-69 ©2007, The McGraw-Hill Companies, All Rights Reserved

 The Federal Reserve System,
Monetary Policy and Interest Rate
Reserve
Reserve Deposits
Deposits
Is
Is any
any bank
bank deposit
deposit that
that isis subject
subject toto reserve
reserve
requirements
requirements imposed
imposed by by the
the federal
federal reserve
reserve bank
bank in
in
the
the united
united states.
states. ItIt include
include transaction
transaction account,
account,
savings
savings account
account and and non-personal
non-personal timetime deposit.
deposit.
transaction
transaction accounts
accounts areare deposit
deposit accounts
accounts that
that are
are
readily
readily available
available toto account
account owner,
owner, such
such as
as aa checking
checking
account
account or
or share
share draft
draft account,
account, and
and may
may bebe accessed
accessed
through
through cash
cash withdrawals,
withdrawals, use use ofof debit
debit cards
cards or
or
checks
checks or
or with
with electronic
electronic transfer.
transfer.

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Reserve
Reserve Deposits
Deposits
Transaction
Transaction accounts
accounts are
are used
used byby both
both individuals
individuals
and
and institutions.
institutions. Non
Non personal
personal time
time deposits
deposits areare
accounts
accounts owned
owned by by institutions,
institutions, not
not anan individuals,
individuals,
that
that pay
pay an
an interest
interest rate
rate and
and have
have aa specified
specified maturity
maturity
date
date before
before which
which the
the depositor
depositor must
must bebe pay
pay aa fee
fee to
to
withdraw
withdraw funds.
funds. Example
Example of of non
non personal
personal time
time
deposit
deposit account
account isis certificate
certificate of
of deposit
deposit owned
owned by by aa
corporation
corporation

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 The Federal Reserve System,
Monetary Policy and Interest Rate
Total
Total Reserve
Reserve can can be
be classified
classified into
into two
two categories:
categories:
1.Required
1.Required reserve reserve –– (reserves
(reserves that
that the
the fed
fed requires
requires
banks
banks to to hold
hold by
by law)
law) are
are reserves
reserves banks
banks must
must hold
hold by
by
law
law to to backback aa portion
portion of of their
their customer
customer transaction
transaction
accounts
accounts (deposit)
(deposit)
Example:
Example:
The
The federal
federal reserve
reserve currently
currently requires
requires up up to
to 10
10 cents
cents
of
of every
every dollardollar of
of transaction
transaction deposit
deposit accounts
accounts at at U.S.
U.S.
commercial
commercial banks banks toto be
be backed
backed with
with reserves.
reserves. thus
thus
require
require reserve reserve expand
expand or or contract
contract with
with the
the level
level of
of
transaction
transaction deposit deposit and
and with
with the
the required
required reserve
reserve
ratio
ratio set
set by
by the
the Federal
Federal Reserve
Reserve Board.
Board.
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 The Federal Reserve System,
Monetary Policy and Interest Rate
Total
Total Reserve
Reserve can
can be
be classified
classified into
into two
two categories:
categories:
1.Required
1.Required reserve
reserve –– (reserves
(reserves thatthat the
the fed
fed requires
requires
banks
banks toto hold
hold by
by law)
law) are
are reserves
reserves banks
banks must
must hold
hold by
by
law
law to
to back
back aa portion
portion of of their
their customer
customer transaction
transaction
accounts
accounts (deposit)
(deposit)
Example:
Example:
Because
Because these
these deposits
deposits earn
earn little
little interest,
interest, bank
bank try
try to
to
keep
keep excess
excess reserves
reserves to
to aa minimum.
minimum. Excess Excess reserve,
reserve, on
on
the
the other
other hand,
hand, may
may bebe lent
lent byby bank
bank toto other
other bank
bank
that
that do
do not
not have
have sufficient
sufficient reserves
reserves on on hand
hand toto meet
meet
their
their required
required level.
level.
McGraw-Hill/Irwin 1-73 ©2007, The McGraw-Hill Companies, All Rights Reserved
 The Federal Reserve System,
Monetary Policy and Interest Rate
Total
Total Reserve
Reserve cancan bebe classified
classified into
into two
two categories:
categories:
2.
2. Excess
Excess reserve
reserve (( additional
additional reserves
reserves over
over and
and above
above
required
required reserves)
reserves) that that banks
banks choose
choose to to hold
hold
themselves.
themselves.
As
As the
the federal
federal reserve
reserve implements
implements monetary
monetary policy,
policy, itit
uses
uses the
the market
market for for excess
excess reserve.
reserve. For
For example,
example, inin the
the
fall
fall of
of 2008,
2008, the
the federal
federal reserve
reserve implemented
implemented several
several
measures
measures to to provide
provide liquidity
liquidity to
to financial
financial market
market that
that
had
had frozen
frozen up up aa result
result of
of the
the financial
financial crisis.
crisis. The
The
liquidity
liquidity facilities
facilities introduced
introduced by by the
the federal
federal reserve
reserve inin
response
response toto the
the crisis
crisis created
created aa large
large quantity
quantity of
of excess
excess
reserve
reserve atat depository
depository institutions.
institutions.
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 The Monetary Policy Tools
Open
Open Market
Market Operations
Operations

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 The Monetary Policy Tools
Open
Open Market
Market Operations
Operations

The
The Federal
Federal Reserve
Reserve purchase
purchase and and sells
sells U.S.
U.S. treasury
treasury
securities
securities on
on the
the open
open market
market in in order
order toto regulate
regulate the
the
supple
supple of
of money
money that
that isis on
on deposit
deposit inin U.S.
U.S. banks,
banks, and
and
therefore
therefore available
available toto loanloan out
out to to businesses
businesses andand
consumers.
consumers. ItIt purchases
purchases treasury
treasury securities
securities to
to increase
increase
the
the supply
supply ofof money
money and and sells
sells them
them to to reduce
reduce thethe
supply
supply of
of money
money

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 The Monetary Policy Tools
Open
Open Market
Market Operations
Operations

Are
Are particularly
particularly important
important because
because they
they are
are the
the
primary
primary determinant
determinant of of changes
changes inin bank
bank excess
excess
reserve
reserve inin the
the banking
banking system
system and
and thus
thus directly
directly
impact
impact the
the size
size of
of the
the money
money supply
supply and
and or
or the
the level
level of
of
interest
interest rate
rate into
into the
the seller
seller account.
account.

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 The Monetary Policy Tools
Discount
Discount Rate
Rate

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 The Monetary Policy Tools
Discount
Discount Rate
Rate

Refers
Refers to
to the
the interest
interest rate
rate changed
changed to to the
the commercial
commercial
banks
banks and
and other
other financial
financial institutions
institutions for
for the
the loans
loans
they
they take
take from
from the
the Federal
Federal Reserve
Reserve bank
bank through
through the
the
discount
discount window
window loanloan process
process and
and also
also refers
refers to
to the
the
interest
interest rate
rate used
used isis discounted
discounted cash
cash flow
flow (DCF)
(DCF)
analysis
analysis to
to determine
determine thethe present
present value
value ofof future
future cash
cash
flows.
flows.

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 The Monetary Policy Tools
Discount
Discount Rate
Rate

For
For two two reason,
reason, the
the Federal
Federal Reserve
Reserve has
has rarely
rarely used
used
the
the discount
discount rate rate asas aa monetary
monetary policy
policytools
tools
11stst itit isis difficult
difficult for
for the
the Fed
Fed toto predict
predict changes
changes inin bank
bank
discount
discount window window borrowing
borrowing when when the
the discount
discount rate
rate
changes.
changes. There There isis no
no guarantee
guarantee that
that banks
banks will
will borrow
borrow
more
more (less) (less) at
at the
the discount
discount window
window in in response
response to to aa
decrease
decrease (increase)(increase) inin the
the discount
discount rate.
rate.

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 The Monetary Policy Tools
Discount
Discount RateRate
For
For twotwo reason,
reason, thethe Federal
Federal Reserve
Reserve has has rarely
rarely used
used
the
the discount
discount rate
rate asas aa monetary
monetary policy
policytools
tools
22ndnd because
because ofof its
its “signaling”
“signaling” importance,
importance, aa discount
discount
rate
rate change
change often
often hashas great
great effects
effects on
on thethe financial
financial
markets.
markets. For For example,
example, the the unexpected
unexpected decrease
decrease in in the
the
Fed’s
Fed’s discount
discount rate
rate (to.
(to. 0.50
0.50 percent)
percent) onon December
December 16, 16,
2008
2008 resulted
resulted inin aa 359.61
359.61 point
point increase
increase in in the
the Dow
Dow
Jones
Jones Industrial
Industrial Average,
Average, one one ofof the
the largest
largest oneone day
day
points
points gains
gains in
in the
the history
history ofof the
the Dow
Dow andand oneone of
of aa
handful
handful of of up
up days
days during
during thethe height
height ofof the
the financial
financial
crisis.
crisis.
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 The Monetary Policy Tools
Reserve
Reserve Requirements
Requirements (Reserve
(Reserve Ratios)
Ratios)
Are
Are the
the amount
amount of of cash
cash that
that banks
banks must
must have
have their
their
vaults
vaults or
or at
at the
the closest
closest Federal
Federal Reserve
Reserve bank,
bank, inin line
line
with
with deposits
deposits made
made byby their
their customers.
customers. Set
Set by
by the
the
Fed’s
Fed’s board
board of of governors.
governors. thisthis requirements
requirements isis usually
usually
set
set as
as aa ratio
ratio of
of transaction
transaction accounts
accounts for
for example,
example, 10 10
percent
percent aa decrease
decrease in in the
the reserve
reserve requirement
requirement ratio
ratio
means
means that
that depository
depository institutions
institutions may
may hold
hold fewer
fewer
reserves
reserves (vault
(vault cash
cash plus
plus reserve
reserve deposits
deposits at
at the
the Fed)
Fed)
against
against their
their transaction
transaction accounts
accounts (deposits).
(deposits).

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