125220 Week 8 Topic 10: US Federal Reserve Bank/Functions

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125220 Week 8 Topic 10: US Federal Reserve Bank/Functions
2015-10-19 10:36:56
125220 Topic 10

US Fed Reserve
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  1. Why study the US Fed & its banking system?
    • Due to prominence of US economic system & its influence on world financial markets (e.g. NZ’s L/T rates), we need to understand how its central bank, the Federal Reserve (the Fed) operates.
    • Many other developed countries have similar systems/structures
  2. 5 major components of US Fed
    • • Federal Reserve District banks
    • • Member banks
    • • Board of Governors (BOG)
    • • Federal Open Market committee (FOMC)
    • • Advisory Committees
  3. 1. Federal Reserve District banks (12)
    • – clear cheques & issue & replace currency
    • – hold reserve balances of banks & provide loans through discount window (at discount rate) to depository FIs needing funds
    • – evaluate proposed mergers & applications for banks to expand their activities
    • – act as liaisons between business community & the Federal Reserve System
    • – Non-profit organisations- "quasipublic"-owned by member banks
    • – Operate under general supervision of Board of Governors
    • – examine bank holding companies & state chartered member banks
    • – collect data on local business conditions
  4. Who owns the Federal Reserve?
    • The Federal Reserve System fulfills its public mission as an independent entity within government. It is not "owned" by anyone & is not a private, profit-making institution.
    • Federal Reserve derives authority from US Congress and is subject to oversight by the Congress as well. 
    • Seen as "independent within the govt"
    • 12 regional Fed Reserve banks established as 'operating arms' of nation's central banking system, structure of private corporations
  5. Who owns the Federal Reserve Banks?
    • • Six of the directors are elected by the member banks of the respective Federal Reserve District (District), and three of the directors are appointed by the Board of Governors.
    • • Most Reserve Banks have at least one Branch, and each Branch has its own board of directors. A majority of the directors on a Branch board are appointed by the Reserve Bank, and the remaining Branch directors are appointed by the Board of Governors
  6. 2. Member banks
    • • any bank with a national charter must be a member of Fed Reserve System (FRS), as well, a few state banks- must buy stock in their district Fed Reserve Bank.
    • • Banks chartered by the states are not required but can join (approx. 1/3). Note there are banks with only a state charter.
    • • So there are two types of banks in USA- approx. 34% of US banks - members of FRS
    • • All types of banks must keep bank reserves at their district Fed bank. – Since GFC, the Fed currently pays 0.25% interest on these
  7. 3. Board of Governors (BOG) or Fed Reserve Board
    • • Have control over monetary policy by setting reserve requirements & approve Fed discount rates + BOG influence in FOMC.
    • • setting credit controls e.g. set margin on stock purchases
    • • establish & administer consumer finance regulations
    • • 7 members appointed by US president for 14 year terms (& confirmed by Senate) & meets regularly
    • • Note Ben Bernanke’s (former head) term expires in Jan 31 2020
    • • regulate commercial banks & oversee district banks
  8. Reserve requirements
    The amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks
  9. 4. Federal Open Market Committee (FOMC)
    • • the 12 voting members are the 7 Board Governors, plus five other presidents Fed Reserve Banks (NY + four of remaining Banks) with other Fed presidents present but non-voting.
    • • 2014 Chairman of FOMC is Janet Yellan = chairman of BOG
    • • meets about every 6 weeks (8×) in Washington to review economic conditions & determine suitable MP to improve economic conditions.
  10. 4. FOMC 
    "Main goals"
    • • Main goals- to promote high employment, economic growth & price stability
    • • Most important way the Fed controls money supply
  11. 4. FOMC continued
    • • FOMC issues policy directive about monetary aggregates & interest rates to Trading Desk /Open Market Desk at NY Fed
    • District bank.
    • • Where open market operations = buy or sell govt. securities.
    • • Fed Reserve account manager interprets directive (considers level of bank reserves) then notifies primary dealers from major banks & investment banks to put in offers.
  12. 5. Advisory committees
    • • make recommendations to the Federal Reserve banks about economic & banking-related issues.
    • • Consists of one member from each district & meets with Consumer & Thrift Institutions Advisory Councils.
    • • Also there are committees that report directly to BOG i.e. Federal Advisory committee
  13. Monetary Policy Tools
    • Principal target of tools = reserves of banking system = mainly balances held by banks at Fed Reserve banks+ currency & coin.
    • 1980 law required all banks & other deposit-taking FIs such as S & Loans to hold same reserve requirements
  14. Monetary Policy Tools
    The Board of Governors can affect the banks’ demand for reserves through
    • –Adjustment of Reserve Asset Ratio (RAR).
    • –Adjustment of the Discount Window: Banks can borrow reserves from the Fed so that they can loan out more to customers (due to RAR).
    • –Federal Open Market Committee.
    • –Moral suasion or ‘jawboning’
  15. Link between Bank Reserves & Money Supply
    • Total reserves = required reserves + excess reserves where
    • • required reserves are holdings of cash & deposits at the Fed that a depository institution must hold to back the public’s deposits. These vary according to type & amount of funds.
    • • excess is amount left over after deducting required reserves from total legal reserves

    No interest paid on reserves (changed to a small rate during GFC) so excess reserves kept to a minimum by bankers, but it is very difficult to judge requirement exactly day by day & penalties for being short are severe.

    Banks hold contractual balances to meet daily transactions as they need to be in credit with local Fed bank at day end.
  16. Link between Bank Reserves & Money Supply part 2
    • The amount of excess reserves as affected by the Fed affects the banking system ability to create money
    • The banks have to meet legal required reserves over a longer time period
    • e.g., an injection of $100 million by the Fed by buying govt securities or making more loans available
    • - with RAR of 12% ⇒ maximum volume of new deposits & loans of $833 million as banks try to get rid of excess reserves.

    However, the Fed does not change reserve requirements frequently (since 1960 average of two per year) because of large impact on the amounts of deposits & new loans as well on rate of increase in money supply
  17. Changes in Fed Reserve’s Discount Rate
    • • Depository institutions can borrow reserves from discount window of Fed Reserve bank in its region. However, frequent borrowing is discouraged.
    • • Discount rate = interest charge p.a. levied on the FIs borrowing from their discount window at fed bank.
    • • Borrowing from Fed’s discount window increases the total reserves available to banking system.
    • • Increase discount rate ⇒ more costly to borrow reserves. Other things being equal ⇒ decline in loans from discount window.
    • • Changes in the discount rate is also used infrequently (except during GFC!). Discount window is seen as safety valve for system as it offers loans to FIs
  18. Changes in Fed Reserve’s Discount Rate
    Part 2
    • • Limitations of discount rate & reserve requirements ⇒ reliance on open market operations as primary tool.
    • • The FOMC has the means to affect supply of bank reserves by directing the Trading Desk at New York Fed Reserve district bank to carry out open market operations OMOs) either
    • (1) outright purchase or sales of securities (buying & selling of T- bills)
    • (2) repurchases
  19. Changes in Fed Reserve’s Discount Rate
    Part 3
    • • OMOs can affect reserves & interest rates by controlling the supply of loanable funds,
    • e.g. Fed buys govt securities ⇒reserves increase ⇒ increase bank reserves ⇒influences market-determined rates ⇒ increase in lending as banks offer new loans at lower rates

    • • ⇒ may lower deposit rates as banks with excess funds
    • • ⇒ investors may look for other alternatives such as Treasury or other debt securities
    • • ⇒ drive yields down & may encourage potential borrowers (companies & individuals) to borrow
    • • ⇒ lower unemployment as companies expand along with lower interest rates
    • • ⇒ looser monetary policy
  20. Control of Money Supply Growth
    • • Reserves that come from OMO through Fed purchase of Govt. securities = non-borrowed reserves (also reserves through changes in other factors on the Fed’s balance sheet).
    • • Reserves that come from the Fed’s discount window are borrowed reserves.
    • • If Fed wants to influence growth of money base it does so by manipulating reserves through mechanism of borrowed reserves.
    • • It has greater control over borrowed reserves by influencing demand & supply for discount loans through discount window,
    • whereas OMO often used as defensive transactions against fluctuations in monetary base.
  21. Control of Money Supply Growth
    Part 2
    • • By late 1960s control of non-borrowed reserves became noneffective ⇒ use of discount window.
    • • Then this stopped being a good mechanism (Fed was acting too late). So it went back to targeting monetary aggregates through OMO.
    • • Over the last few years Fed has been increasing the discount window again to slow growth, but again it is argued that the Fed is moving too late.
    • • These changes of focus reflect changing economic philosophies, for example, one can tell whether the FOMC is dominated by Keynesians or Monetarists by looking at their actions.
  22. Control of money supply growth
    Part 3
    In short, the Federal Reserve System was set up to provide money supply, be a lender of the last resort, improve bank supervision & payments system.

    But it has expanded its responsibilities to imposing reserve requirements on non-bank FIs offering cheques, drafting anti-discriminatory & disclosure regulations for consumers and for electronic funds transfer, regulating securities market credit, & regulating international banking and activities of bank holding companies.

    Actions during GFC- bank support thru discount window, widening to access for investment banks, & buying Treasury bills – printing money
  23. Fedwatching
    • • As the Fed influences the broad changes that occur in interest rates, prices of securities & availability of credit, economists & financial analysts analyse its actions
    • • So if they predict correctly, can make appropriate adjustments e.g., in borrowing or lending.
    • • Even in NZ there are articles in the paper speculating whether the Fed will raise interest rates.
  24. Essentially comprises 3 analytical techniques:
    • 1. Make projections using variables the Fed uses e.g. GNP, inflation, one or more measures of the money supply.
    • 2. Forecasting & interpretation of bank reserves position & the Fed's OMO (money market indicator the federal funds rate usually changes first).
    • 3. The projection of interest rates in money & capital markets
  25. Global Monetary Policy
    • • The central banks of the developed countries tend to have similar goals of low inflation (price stability) & economic growth (low unemployment).
    • • They tend to use similar tools of open market operations, reserve requirements & adjustments in interest rates they charge on loans (Not NZ).
    • • These monetary tools affect interest rates that then influence economic conditions.
    • • With the abandonment of fixed exchange rates & the increasing integration of global money & capital markets, there is the need for the Fed to consider their impact on Fed policy-making.
    • • As well, because of the way countries are integrated, there is the need for the Fed to consider the existing economic conditions of other major countries & co-ordinate its activities with other central banks.

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