describe how the Fed influences monetary policy,

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4
Functions of the Fed
■ describe the organizational structure of the Fed,
■ describe how the Fed influences 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.
Chapter Objectives

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Overview
As the central bank of the United States, the Fed conducts monetary policy in an attempt to achieve full employment and price stability (low or zero inflation) in the United States.
Since the Fed’s monetary policy affects interest rates, it has a strong influence on the cost of borrowing by households.
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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Monetary economics
In monetary economics, the quantity theory of money states that the money supply has a direct, proportional relationship to the price level.
If the amount of currency in circulation increased, there would be a proportional increase in the price of goods.
3

Zimbabwe and hyperinflation
On 16 February 2006, the governor of the Reserve Bank of Zimbabwe announced that the government had printed $20.5 trillion ZW in order to buy foreign currency to pay off IMF debt.
As predicted by the quantity theory of money, hyperinflation in Zimbabwe was caused by the Reserve Bank of Zimbabwe’s choice to increase the money supply.
Use of the Zimbabwean dollar as an official currency was effectively abandoned on 12 April 2009.
The Zimbabwean dollar is due to be demonetised (no longer legal tender) by the end of 2015
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See 100 Trillion note. Check out prices on ebay for fun.
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Zimbabwe and hyperinflation
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Organizational Structure of the Fed
Federal Reserve district banks (Exhibit 4.1)
12 Federal Reserve district banks.
New York Fed is considered the most important.
Each Fed district bank has 9 directors.
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Exhibit 4.1 Locations of Federal Reserve District Banks
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Source: Federal Reserve Bulletin.

Organizational Structure of the Fed
Member Banks
All national banks are required to be members of the Fed.
Commercial banks can elect to become member banks if they meet specific requirements of the Board of Governors
Commercial banks purchase stock in their Federal Reserve district bank to become members. The stock pays a maximum dividend of 6% annually
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About 35% of all banks are member banks; these banks account for about 70% of all bank deposits.
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Organizational Structure of the Fed
Board of Governors
The Federal Reserve Board is made up of seven members
Each member is appointed by the President of the U.S. and serves a nonrenewable 14-year term.
One of the seven board members is selected by the President to be the Federal Reserve Chairman for a 4-year renewable term.
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Organizational Structure of the Fed
Federal Open Market Committee (FOMC)
Made up of the seven members of the Board of Governors plus the presidents of five Fed district banks (the New York district bank plus 4 of the other 11 Fed district banks as determined on a rotating basis).
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FOMC sets target fed funds rate
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Interest rates set by the fed
Fed funds rate: Bank to bank lending
Discount rate: Fed to banks lending
Primary rate: Bank to consumer Lending
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The fed encourages banks to borrow from each other before borrowing from the fed.
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Fed funds rate
The fed funds rate: set by the fed and calculated according to basic laws of supply and demand.
Bank to bank lending rate.
The more money banks have in reserves, the lower the rate they can borrow at.
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FOMC meetings and fed funds rate
The Fed uses its authority to set the target federal funds rate as a key tool in its conduct of U.S. monetary policy.
The FOMC meeting statements outline the rationale for a particular interest rate action.
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
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See link for meeting statements
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The Art of Predicting the Federal Reserve
http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
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The Art of Predicting the Federal Reserve
https://www.stlouisfed.org/publications/regional-economist/july-2000/inside-the-briefcase-the-art-of-predicting-the-federal-reserve
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Discount rate
The discount rate: Fed to banks lending rate.
The discount rate covers very short-term loans,
usually overnight
is higher than the funds rate, because the Fed encourages banks to borrow from each other first.
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Primary rate
Within the discount rate are three tiers: primary rate, secondary rate and seasonal rate.
The primary rate is the lowest and given to financial institutions in good standing.
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How the Fed Controls the Money Supply
Open Market Operations – The FOMC meets eight times a year, sets targets for the money supply growth level and the interest rate level, and implements monetary policy.
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
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See link for meeting calendar
Watch a video of a press release
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How the Fed Controls the Money Supply
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.
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How the Fed Controls the Money Supply
Fed purchase of securities – To lower the federal funds rate, traders purchase Treasury securities from dealers. The dealers’ bank account balances increase causing an increase in the supply of funds.
Fed sale of securities – To increase the federal funds rate, traders sell government securities to dealers. As the dealers pay for the securities, their bank balances decrease leading to a decrease in the supply of funds.
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How the Fed Controls the Money Supply
Role of the Fed’s Trading Desk (Cont.)
Control of M1 versus M2 (Exhibit 4.4)
For the Fed’s purposes, 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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M1 is most liquid
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Exhibit 4.4 Comparison of Money Supply Measures
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M1 is most liquid
“Small” time deposits are defined in the U.S. as those under $100,000, while “large” ones are $100,000 or greater in size.
A repurchase agreement is the sale of securities together with an agreement for the seller to buy back the securities at a later date at a higher price. The price difference is the interest paid.
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How the Fed Controls the Money Supply
Adjusting the Reserve Requirement Ratio
The Reserve Requirement is the proportion of bank deposit accounts that must be held as required reserves. 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: (Exhibit 4.5)
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Exhibit 4.5 Illustration of Multiplier Effect
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The $100 million injection would multiply by $100 million divided by .10 = $100 million x 10 = $1 billion.
However, if households hold cash or banks hold excess reserves, money does not multiply as expected.
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Homework
Read Chapter 4
Questions: 1, 2, 3, 4, 6, 9, 10, 14, 15, 16
Interpreting Financial News: a, b, c
Managing in Financial Markets: a, b, c

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