The Federal Reserve, Money, and

Interest Rates

Structure of the Federal Reserve

Introduction

Much of the information in the lecture comes from The Federal Reserve's web page.  The page is an excellent source for learning about how the Federal Reserve (Fed) affects our economy.  The Fed is the most important economic player in the world.  The Fed controls the money supply and credit conditions in the United States, which in turn has a major impact on the global economy.  The Fed is "quasi governmental".   The Federal Reserve is privately owned.  It develops policy positions independently of the federal government after presidential appointments of certain key members.  The Chairman of the Board of Governors and of the main policy determining committee is Alan Greenspan.

If you desire more information than is contained in this lecture or than is available at the Federal Reserve's web page, you may order The Federal Reserve System: Purposes and Functions from the Federal Reserve or may access an Adobe Acrobat file at the Fed's web page.  This book is an excellent introduction to the Fed.
 

The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.

Today the Federal Reserve's duties fall into four general areas:

  1. conducting the nation's monetary policy;
  2. supervising and regulating banking institutions and protecting the credit rights of consumers;
  3. maintaining the stability of the financial system; and
  4. providing certain financial services to the U.S. government, the  public, financial institutions, and foreign official institutions.
Study Question:
According the Federal Reserve, what four general areas comprise the Federal Reserve's duties?

The Board of Governors of the Federal Reserve System

On December 23, 1913, the Federal Reserve System, which serves as the nation's central bank, was created by an Act of Congress. The System consists of

  1. a seven member Board of Governors with headquarters in Washington, D.C., and
  2. twelve Reserve Banks located in major cities throughout the United States.
Appointments to the Board
The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14 year terms of office.  Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term.  The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.

Representation
Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. In making appointments, the President is directed by law to select a "fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country."  These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.

Responsibilities
The primary responsibility of the Board members is the formulation of monetary policy. The seven Board members constitute a majority of the 12 member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. The other Bank presidents serve one year terms on a rotating basis. By statute the FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman.

The monetary policy tools of the Federal Reserve System

  1. The Board sets reserve requirements
  2. The Board shares the responsibility with the Reserve Banks for discount rate policy
  3. open market operations
In addition to monetary policy responsibilities, the Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the System, bank holding companies, international banking facilities in the United States, Edge Act and agreement corporations, foreign activities of member banks, and the U.S. activities of foreign owned banks. The Board also sets margin requirements, which limit the use of credit for purchasing or carrying securities.

In addition, the Board plays a key role in assuring the smooth functioning and continued development of the nation's vast payments system .

Another area of Board responsibility is the development and administration of regulations that implement major federal laws governing consumer credit such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act and the Truth in Savings Act .

Meetings
The Board usually meets several times a week. Meetings are conducted in compliance with the Government in the Sunshine Act, and many meetings are open to the public. If the Board has convened to consider confidential financial information, however, the sessions are closed to public observation.

Contacts within Government
As they carry out their duties, members of the Board routinely confer with officials of other government agencies, representatives of banking industry groups, officials of the central banks of other countries, members of Congress and academicians. For example, they meet frequently with Treasury officials and the Council of Economic Advisers to help evaluate the economic climate and to discuss objectives for the nation's economy.  Governors also discuss the international monetary system with central bankers of other countries and are in close contact with the heads of the U.S. agencies that make foreign loans and conduct foreign financial transactions.

Regional Federal Reserve Banks

The map below gives the location of the twelve district Federal Reserve banks

U.S. Map

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) is the most important monetary policy making body of the Federal Reserve System. It is responsible for formulation of a policy designed to promote:

  1. economic growth
  2. full employment
  3. stable prices
  4. and a sustainable pattern of international trade and payments.
The FOMC makes key decisions regarding the conduct of open market operations—purchases and sales of U.S. government and federal agency securities—which affect the provision of reserves to depository institutions and, in turn, the cost and availability of money and credit in the U.S. economy.  The FOMC also directs System operations in foreign currencies.

Membership
The FOMC is composed of the seven members of the Board of Governors and five Reserve Bank presidents. The president of the Federal Reserve Bank of New York serves on a continuous basis; the presidents of the other Reserve Banks serve one year terms on a rotating basis beginning January 1 of each year. Rotation is such that each year one member is elected to the Committee by the boards of directors of Reserve Banks in each of the following groups: (1) Boston, Philadelphia, and Richmond; (2) Cleveland and Chicago; (3) Atlanta, St. Louis, and Dallas; and (4) Minneapolis, Kansas City, and San Francisco.

Organization
By statute, the FOMC determines its own organization. Each year at its first meeting, the Committee elects its Chairman and Vice Chairman and selects staff officers to serve the Committee for the coming year.  Traditionally, the Chairman of the Board of Governors is elected Chairman and the president of the Federal Reserve Bank of New York is elected Vice Chairman. Staff officers are selected from among the officers and employees of the Board of Governors and the Federal Reserve Banks.

Meetings
By law, the FOMC must meet at least four times each year in Washington, D.C. Since 1980, eight regularly scheduled meetings have been held each year at intervals of five to eight weeks. If circumstances require consultation or consideration of an action between these regular meetings, members may be called on to participate in a special meeting or a telephone conference, or to vote on a proposed action by telegram or telephone. At each regularly scheduled meeting, the Committee votes on the policy to be carried out during the interval between meetings. At least  twice a year, the Committee also votes on its long-run policy objectives for growth in key money and debt aggregates.

Attendance at meetings is restricted because of the confidential nature of the information discussed, and is limited to Committee members, nonmember Reserve Bank presidents, staff officers, the Manager of the System Open Market Account, and a small number of Board and Reserve Bank staff.

The Decision Making Process
Before each regularly scheduled meeting of the FOMC, System staff prepare written reports on past and prospective economic and financial developments which are sent to Committee members and to nonmember Reserve Bank presidents. Reports prepared by the Manager of the System Open Market Account on operations in the domestic open market and in foreign currencies since the last regular meeting are also distributed. At the meeting itself, staff officers present oral reports on the current and prospective business situation, on conditions in financial markets, and on international financial developments. In its discussions, the Committee considers such factors as trends in prices and wages, employment and production, consumer income and spending, residential and commercial construction, business investment and inventories, foreign exchange markets, interest rates, money and credit aggregates, and fiscal policy. The Manager of the System Open Market Account also reports on account transactions since the previous meeting.

After these reports, the Committee members and other Reserve Bank presidents turn to policy. Typically, each participant expresses his or her own views on the state of the economy and prospects for the future, and on the appropriate direction for monetary policy. Then each makes a more explicit recommendation on policy for the coming inter meeting period (and for the longer run, if under consideration). Finally, the Committee must reach a consensus regarding the appropriate course for policy, which is incorporated in a directive to the Federal Reserve Bank of New York—the Bank which executes transactions for the System Open Market Account. The directive is cast in terms designed to provide guidance to the Manager in the conduct of day today open market operations. The directive sets forth the Committee's objectives for long-run growth of certain key monetary and credit aggregates. It also sets forth operating guidelines for the degree of ease or restraint to be sought in reserve conditions and expectations with regard to short-term rates of growth in the monetary aggregates. Policy is implemented with emphasis on supplying reserves in a manner consistent with these objectives and with the nation's broader economic objectives.

Effects of Policy
Depository institutions are required to maintain reserves in certain proportions against various types of their checkable deposits. Open market operations directly affect the level of reserves in the banking system.  Federal Reserve purchases of securities add to reserves; sales withdraw reserves from the System. If reserves increase, depository institutions will generally acquire new loans and investments, which will tend to exert downward pressure on interest rates.

Open market operations as directed by the FOMC are the major tool used to influence the total amount of money and credit available in the economy.  The Federal Reserve attempts to provide enough reserves to encourage expansion of money and credit in keeping with the goals of price stability and sustainable growth in economic activity.

Reports
By law, the Board of Governors must keep a record of the actions taken by the FOMC on all questions of policy and to include in its annual report to Congress the vote on and reasons for each action. To provide this information on a timely basis, minutes are prepared after each meeting and are released to the public a few days after the next regularly scheduled FOMC meeting.

Twice a year, as required in the Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978, the Board submits a written report to Congress on the state of the economy and the course of monetary policy, and the Chairman is called on to testify on this report.

[Some of the remainder of the lecture is redundant with the above information which was gleaned from the Federal Reserve's web site.  The material below comes from my lecture notes which have been developed over the years]

The Federal Reserve's Policy Tools

used by the Fed to adjust the reserves of the banking system to influence money and credit

Legal Required Reserves

rules that state the amount of reserves depository institutions must keep on hand to back bank deposits

Changing reserve requirements is rarely used as policy tool because of the effect changes the requirement can have on bank profitability.

Discount Window

Banks which keep reserves with the Fed may borrow from the Fed if the individual bank does not have enough reserves to meet requirements at the end of the business day.  The bank is said to go to the "discount window".

the discount rate is the rate of interest the Fed charges for these loans

The discount rate is indicative of the direction of Federal Reserve policy.

Open Market Operations

purchases and sales of federal government securities by the Fed as directed by the FOMC to control the money supply

Policy decisions are made by the FOMC and are carried out by the New York branch.

Open market operations are used on a daily basis to influence credit and the money supply,  They are how most monetary policy is operationalized.


 


 
Study Question:
Outline the Fed's three policy tools.  Explain how each may be manipulated to increase the money supply.  Which tool is most important to the Fed?  Why?

Interest Rate Determination

If the Federal Reserve offers to purchase securities, it will offer a higher price than market price to entice the holders of those bonds to sell the bonds.  The Fed's primary goal is not to make a profit.  The Fed's goal is to increase the money supply to stimulate economic growth -- if the Fed is buying bonds.  Hence, in the very act of purchasing the bonds the Fed is carrying out policy consistent with its overall goal of easing monetary and credit conditions in the economy.

If the Federal Reserve attempts to sell securities, it will lower the price of the bond below the market price to entice people to purchase the bonds.  The Fed's primary goal is not to make a profit.  The Fed's goal is to decrease the money supply to curb economic growth -- if the Fed is selling bonds.  Hence, in the very act of selling the bonds the Fed is carrying out policy consistent with its overall goal of tightening monetary and credit conditions in the economy.

This may also be shown through graphical analysis.


 
Study Question:
Fully describe and explain how the Fed conducts open market operations and how these operations affect the money supply.  How do these operations affect interest rates?