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1.1.1.1.1Chapter Four
The Federal Reserve System, Monetary
Policy, and Interest Rates
1.1.1.2 I. Chapter Outline
1. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview
2. Structure of the Federal Reserve System
a. Organization of the Federal Reserve System
b. Board of Governors of the Federal Reserve System
c. Federal Open Market Committee
d. Functions Performed by Federal Reserve Banks
e. Balance Sheet of the Federal Reserve
3. Monetary Policy Tools
a. Open Market Operations
b. The Discount Rate
c. Reserve Requirements (Reserve Ratios)
4. The Federal Reserve, the Money Supply, and Interest Rates
a. Effects of Monetary Tools on Various Economic Variables
b. Money Supply versus Interest Rate Targeting
5. International Monetary Policies and Strategies
a. Systemwide Rescue Programs Employed During the Financial Crisis
II. Learning Goals
1. Understand the major functions of the Federal Reserve System.
2. Identify the structure of the Federal Reserve System.
3. Identify the monetary policy tools used by the Federal Reserve.
4. Appreciate how monetary policy changes affect key economic variables.
5. Understand how central banks around the world adjusted their monetary policy during the
financial crisis.
1.1.1.3 III. Chapter in Perspective
This chapter presents an overview of the Federal Reserve System, including a brief look at its
history and structure. The major functions performed by the Fed are covered and the balance
sheet of the Fed is examined. The chapter provides the reader with a non-technical explanation
of the effects of monetary policy on interest rates and the economy. The deposit growth
multiplier concept is introduced and a simple ‘transmission mechanism’ depicting the effects of
a change in Fed policy on the economy is presented. Different monetary targets such as
borrowed and non-borrowed reserves and interest rate targets are also discussed.
Intervention into foreign exchange markets is also briefly covered. The new edition also
discusses the Fed’s rescue programs employed during the financial crisis.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Discount rate FRB NY Trading Desk
Discount window Policy directive
Check clearing Repurchase agreement
ACH and Fed Wire Primary credit
Federal Open Market Committee Seasonal credit
Open market operations Secondary credit
Reserves Deposit growth multiplier
Monetary base M1 and M2
Required and excess reserves Foreign exchange intervention
Fed funds rate Borrowed and non-borrowed reserve
targets
Transmission mechanism
Policies of other major central banks
TALF
Quantitative easing
1.1.1.5 V. Teaching Notes
1. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview
The Federal Reserve was created in 1913 in response to a series of U.S. financial panics which
culminated in a particularly severe panic in 1907. The Fed was created to serve as a lender of
last resort, as a bank regulator and as a monitor of the money supply. Current objectives of the
Fed include stimulating sustainable non-inflationary economic growth while keeping
employment high. Not everyone agrees with the dual mandate of the Fed. Monetarists feel that
the Fed’s purpose should be to limit inflation. The Fed also assists in facilitating the nation’s
payment systems. The Fed operates the Fed Wire which facilitates trading of bank reserves and
an Automated Clearing House (ACH), which is a similar payments mechanism for debit and
credit transactions.1 The Fed is largely independent of Congress and the President, at least in the
short run. The Humphrey-Hawkins Act of 1978 however requires the Fed to present their
monetary policy goals and an assessment of how well they are meeting their goals to Congress
twice a year.
1The Clearing House Interbank Payments System (CHIPS) provides yet another payment mechanism. CHIPS is a
private sector electronic network operated by about 100 U.S. and foreign banks to facilitate correspondent services
and international transactions.
The four major functions of the Fed today include: a) conducting monetary policy, b) supervising
and regulating depository institutions, 3) maintaining the stability of the financial system and 4)
providing payment and other financial services to many institutions, including governments.
2. Structure of the Federal Reserve System
a. Organization of the Federal Reserve System
There are 12 Federal Reserve Banks (FRBs) located throughout the country. The structure was
originally intended to disperse power along regional lines throughout the country. To some
extent this dispersion still remains, but the major authority to promulgate and implement
monetary policy now lies in Washington, D.C. with the Board. Each FRB has a nine member
Board of Directors consisting as follows:
Six are elected by member banks in the district, of these six, three are non-bank business
people.
Three are appointed by the Board of Governors of the Federal Reserve System.
FRBs are nonprofit organizations, but they are owned by the member banks in their district. Part
of the independence of the Fed arises because the Fed generates positive net income from
interest and fees so it is not directly dependent on Congressional funding. The Fed now pays
interest on bank reserves and this reduces the profitability of the Fed. If the interest rate paid
increases with the Fed funds rate this could also create a perverse incentive that could
conceivably affect Fed policy because Fed profitability would be reduced if the Fed increased
interest rate targets. The Fed argues that paying interest minimizes reserve volatility.
Teaching Tip: In a bid to stave off negative inflation in Europe the ECB is considering charging
negative deposit rates on bank reserves. This should encourage banks to lend excess reserves
and stimulate the Eucopean economyrather than pay interest.
b. Board of Governors of the Federal Reserve System (BoGov)
The BoGov is comprised of seven members and each member is appointed to a non-renewable
14 year term by the President of the United States and confirmed by the Senate. Terms are
staggered so that one term expires every other January. The President appoints the chairman and
vice-chairman of the board from among BoGov members to four year terms that can be repeated.
The board has two major areas of responsibility; the formulation and conduct of monetary policy
through the FOMC (see below), and the promulgation of bank regulations. The board can
change the discount rate and bank reserve requirements.
c. Federal Open Market Committee (FOMC)
The 12 member FOMC is the body that formulates and conducts monetary policy. Seven of the
12 members are comprised by the BoGov; thus, the BoGov has a controlling vote on the FOMC.
The remaining members are 1) the President of the New York Federal Reserve Bank and 2) four
presidents of other Federal Reserve Banks, chosen on a rotating basis. The FOMC conducts
open market operations to implement monetary policy. Open market operations are the
purchase and sale of U.S. government securities to increase or decrease the level of bank
reserves (money supply) respectively. Open market operations are the most commonly used
policy tool to conduct monetary policy. The results of each FOMC meeting are compiled in the
so called “Beige Book,” which summarizes information on current economic conditions
compiled by the district banks, and from interviews with business leaders and economists, etc.
d. Functions Performed by Federal Reserve Banks
Functions include:
Assisting in the conduct of monetary policy and economic analysis
Supervision and regulation of banks and bank holding companies in their district
The new Wall Street Reform and Consumer Protection Act of July 2010 requires the Fed
to supervise complex financial institutions that could generate systemic risk to the
economy. The Fed (and others) has now been given broader powers to seize or break up
institutions whose actions could harm the economy.
The Fed is now also charged with implementing federal laws designed to protect
consumers in credit and other financial transactions. The Fed is charged with
implementing regulations to ensure compliance, investigating complaints, and ensuring
availability of services to low and moderate income groups and certain geographic
regions.
Provision of government services for the U.S. Treasury
Replacement of old currency and issuance of new currency
Providing check clearing services for a fee
The number of checks cleared peaked at 17 billion in 2000 and has since declined as
alternatives to checks have risen and industry consolidations. In October 2004 the Check
21 Act authorized the use of an electronic image rather than a paper check for settlement.2
This switch was expected to save the banking industry as much as $3 billion per year.
Presumably competition forces banks to pass on the cost savings to customers in the form
of reduced checking fees. Customers will lose the ability to play the float (which can be
several days) as checks may now be very quickly cleared (as soon as deposited), making
them more similar to most debit cards. Customers must take care that sufficient funds are
available at the time the check is spent with most retailers or they could overdraw. For
instance a customer could no longer write a check in the afternoon the day before payday,
knowing that the check will not clear before the payroll deposit the next day. This is a
dubious practice anyway (technically it is kiting, an illegal activity). Customers who run
low balances would be advised to apply for overdraft protection. Banks can no longer
automatically cover overdrafts without written permission of the bank customer.
The Fed ACH (the Fed’s automated clearing house) is now offering same day check
clearing for certain checks converted to electronic images rather than next day settlement.
Providing wire transfer services through the Fed Wire
Providing district economic analysis and research
According to the Financial Services Policy Committee of the Federal Reserve’s 2012 report,
in 2011 more than 85% of noncash payments were electronic. The breakdown was as
follows:
47 billion debit transactions
26 billion credit
22 billion ACH
2 The grounding of cargo aircraft after the September 11, 2001 terrorist attacks also ‘grounded’ millions of checks
waiting to be flown around the country in the clearing and settlement process. This spurred Congress on to passing
the Check 21 law.
9 billion prepaid cards
e. Balance Sheet of the Federal Reserve & Growth due to Financial Crisis
The Federal Reserve’s balance sheet grew 241% from 2007 to 2013 due to the ongoing financial
crisis. Much of the extraordinary growth is due to the Fed’s usage of quantitative easing in an
attempt to support mortgage markets and stimulate growth.
Notice the extraordinary growth in depository institution reserves. Banks have not lent anywhere
near their available capital. Some have argued that this is because the Fed began paying interest
on reserves in October 2008 although this is unlikely to be the main cause. The interest rate is
set to equal the target Fed Funds rate. This may reduce the incentive for banks to lend excess
reserves in the Fed Funds market. Of course loan rates (and thus profits) are higher than the Fed
Funds rate. Nevertheless this is posited as one problem with the effectiveness of Fed policy in
stimulating growth in the economy. The Fed’s lending facilities created more bank reserves, but
did not result in greater lending. Total bank lending turned up in 2013.
The Fed expanded availability of Discount Window borrowing to investment banks in order to
encourage liquidity in the financial system at the start of the financial crisis. Liquidity had been
impaired by the credit crunch spurred by the fallout in the subprime mortgage markets. The Fed
and the Treasury helped arrange a bailout of Bear Stearns by J.P. Morgan Chase. Bear Stearns
was a failing investment bank heavily involved in the mortgage markets and was on the brink of
defaulting on many of its repo arrangements. The Fed took the unprecedented step of
guaranteeing $30 billion of Bear Stearns’ illiquid mortgage assets.3 Even before the bailout of
Bear Stearns the Fed had agreed to swap up to $200 billion of Treasuries it holds for illiquid
mortgage backed securities in an effort to restore liquidity to the markets.4 In particular the short
term repo markets had stopped functioning on worries about failures of underlying mortgages
backing securities, many through CDO structures.
The growth in the balance sheet reflects the Fed’s responses to the financial crisis. At the end of
2007 the Fed created a Term Auction Facility (TAF) extended discount window borrowing on an
auction basis. In March 2008 the Fed facilitated the J.P. Morgan Chase purchase of Bear Stearns
that took some of Bear’s risky assets off their books (and onto the Fed’s). The Fed also created
the Term Securities Lending Facility (TSLF) which swapped Treasury securities for less liquid
and riskier securities and the Primary Dealer Credit Facility (PDCF) which expanded discount
window loans to non-banks. In the fall of 2008 with the collapse of Lehman Brothers and
Goldman-Sachs and Morgan Stanley becoming commercial banks, the Fed created additional
facilities to assist in credit flows. The Fed created the Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility
(CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed
Securities Loan Facility (TALF). The AMLF and the CPFF were created because liquidity
collapsed in the commercial paper market. The MMIFF was created to help stem liquidity
problems in money market mutual funds that resulted when one fund failed. The TALF was
designed to encourage securitization to continue. Slowdowns in securitization reduced the
amount of credit available to borrowers in certain markets. Average weekly lending from the
Fed grew from about $59 million in 2006 to almost $850 billion in late 2008.
3. Monetary Policy Tools
The major process by which the Fed normally impacts the economy is through influencing the
market for bank reserves. Banks trade excess reserves among themselves at the interest rate
called the fed funds rate. The Fed attempts to influence the fed funds rate by either affecting
demand or supply of funds available for lending between banks. Targeting the level of reserves
in the economy is tantamount to targeting the supply of funds available for bank to bank lending
(and by inference, the amount of funds available for lending to non-bank customers). Targeting
interest rates, as the Fed has done since 1993, is the same as influencing the demand for bank
reserves. The Fed cut interest rates 11 times in 2001 to stimulate the weakening economy. The
fed funds target rate was increased 5 times in 2004 from a low of 1% to a year ending high of
3 “The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” by Robin Sidel, Greg Ip, Michael Phillips
and Kate Kelly, The Wall Street Journal Online, March 18, 2008 Page A1.
4 “Fed Offers Lifeline for Spurned Debt,” by Greg Ip, The Wall Street Journal Online, March 12, 2008, Page A1.
2.5% (each increase was 25 basis points). In June 2005 the target fed funds rate was 3.25% but
by August 2006 the target rate had been increased to 5.25% due to inflation fears. In 2007 the
Fed reversed its interest rate policy and began to decrease the Fed funds target. In April 2008 the
Fed funds target was 2.00% and the discount rate was 2.25%. By year end 2008 the Fed funds
target was reduced to between 0 and 0.25% and the discount rate was 0.5%. These rates were
maintained throughout 2009. In Feb 2010 the Fed kept the target Fed funds rate at 0 to 0.25%
but raised the discount rate to 0.75% where both rates remain as of this writing. In November of
2008 the Fed announced it would engage in up to $600 billion of purchases of Treasuries and
mortgage backed securities, a process termed quantitative easing in order to encourage the flow
of credit in the economy. This amount was increased in March 2009 to $1.7 trillion. From the
end of 2008 through the first quarter of 2010 the Fed bought $1.7 trillion of securities. In
November 2010 the Fed announced a new series of bond buying of up to $600 billion in what
has been termed QE2. QE3 began in September of 2012 with the Fed announcing the purchase of
$40 billion Treasuries and $40 billion mortgage backed securities per month. The Fed began
tapering (gradually reducing) the monthly purchases in 2013 and on into 2014 even though the
Fed has repeatedly reiterated that short term interest rates would remain low on into 2015 unless
conditions improved rapidly. The Fed backed away from switching policy when unemployment
fell to or below 6.5% because of slow economic growth and declines in the labor force
participation rate. The Fed also has a target inflation rate of 2%.
The text mentions that Fed policy appears to follow a Taylor rule. A Taylor rule suggest the Fed
should increase interest rates when inflation is above target or if employment is above full
employment and decrease rates when inflation is below target or if the economy is at less than
full employment. Because of expectations and external shocks monetary policy rules must be
applied with discretion.
Ben Bernanke’s term ended in January 2014 and Janet Yellen became the new chairman of the
Fed. Chair Yellen has not changed the policy course set by Bernanke’s board although she is
considered to be ‘doveish’ or more likely to pursue a loose monetary policy for longer than
inflation hawks would.
Current rates & risks over the year, with links to meeting minutes can quickly be found at the
Federal Reserve Monitor of the Wall Street Journal Online website. Levels of M1 and M2 can
be found on the same website under Federal Reserve Data.
a. Open Market Operations
Open market operations are the buying and selling of U.S. government securities by the Fed.
The FOMC drafts a policy directive to change a targeted monetary aggregate such as M1, M2,
M3 or an interest rate target such as the fed funds rate and sends it to the N.Y. Federal Reserve
Bank Trading Desk.5 If the FOMC wishes to increase the money supply the directive will
specify that the Trading Desk is to buy U.S. government securities and credit the seller with
additional reserves at the Fed. In this manner new money is created. If the FOMC wishes to
decrease the money supply, securities will be sold and the buyer will pay for them by having
bank reserves removed from their account. Temporary changes in the money supply can be
enacted by using repurchase agreements. Fed use of a repo will temporarily increase the
money supply; a reverse repo could be used to temporarily reduce bank reserves and the money
supply.
As noted in the text, in March 2009 the Fed announced it would buy $300 billion of long-term
Treasury securities in what would become known as quantitative easing 1. This is unusual in the
size of the announced purchase and in purchasing long term securities. This was the first time
the Fed had done so since the 1960s. The Fed wanted to add liquidity and to keep long term
interest rates down. The Fed also wished to signal that they would do whatever it took to
stabilize the economy.
Teaching Tip: Many students think that the primary method of increasing the money supply is by
printing new money. In actuality, increases in the money supply are usually accomplished by
increasing bank reserves.
Teaching Tip: The U.S. Treasury operates the mints for coins.
Teaching Tip: Part of the importance of the target fed funds rate is that this rate affects other rates
because this interest rate reflects the bank’s cost of short term funds. In particular, the prime rate
usually changes after a change in the fed funds rate.
b. The Discount Rate
Historically, the discount rate is the rate the Federal Reserve Banks charge to make emergency
loans to DIs in fulfilling its role as lender of last resort. The Fed implemented changes in its
discount window policy in January 2003. The changes did two things, 1) raise the cost of
borrowing from the Fed and 2) make it easier for banks to borrow from the Fed. There are now
three lending programs available from the discount window:
1. Primary credit – Primary credit is available to healthy depository institutions (DIs) on a
short term basis. The borrowed funds are not restricted in their use. The rate paid is
typically 1% above the fed funds target rate. As of June 2005, the discount rate was
4.25%. Traditionally the discount rate was kept below the fed funds rate, but banks were
limited to borrowing from the Fed only if they could show they could not borrow from
the private markets (such as the fed funds market).
2. Secondary credit – Short term secondary credit is available to troubled institutions. The
interest rate charged is higher than the rate on primary credit. Secondary credit is
restricted in how the funds may be used. The borrowing bank cannot use secondary
credit to expand the bank’s assets.
5 This is why the President of the N.Y. Fed always sits on the FOMC.
3. Seasonal credit – Seasonal credit is available for institutions that can demonstrate a
pattern of intra-year changes in borrowing needs, usually due to seasonal deposit changes
and loan demand as occurs in agricultural or tourist dependent areas. Seasonal credit is
available on a longer term basis and allows the borrowing institution to carry less liquid
assets which are low earning to meet funds needs.
The discount rate is not usually a direct monetary policy tool and it would be very difficult to
predict the change in borrowing that would result from a change in the discount rate. Changes in
the discount rate have at times however signaled the Fed’s intentions to allow interest rates to
move in one direction or the other. As mentioned earlier, the Fed has now opened up the
discount window to securities brokers and dealers and has decreased the spread between the Fed
funds target rate and the Discount Rate to 25 basis points.
As discussed above with the Fed’s balance sheet, in 2008 the Fed broadened access to the
Discount Window facility through the PDCF. The move was welcomed by securities dealers
whose average daily borrowing was over $30 billion initially. The Fed also lowered the spread
between the discount rate and the target fed funds rate during the crisis to only a quarter of a
point. This move, along with a slowdown in lending in private bank funding markets encouraged
additional borrowing from the discount window. These moves provided liquidity to institutions
but it is less clear that the ultimate goal of stimulating private sector credit growth was achieved.
c. Reserve Requirements (Reserve Ratios)
The third, and least used, monetary policy tool is changes to the reserve requirement ratios.
Banks are required to maintain reserves on deposit at the Fed to back a certain percentage
(basically 10%) of transaction deposits. If this ratio is increased, or if it is imposed on more
types of accounts, banks will have to hold more reserves at the Fed and less money will be
available to flow through the economy. The change in bank deposits is (1 / New reserve
requirement) New excess reserves, assuming no drains.6
If reserves are $2 billion and the Fed increases reserves by 1% or $20 million when banks have a
10% reserve requirement then the predicted increase in bank deposits would equal:
1/0.10 * $20 million = $200 million increase in bank deposits.
If the Fed reduced the reserve requirement to 9% instead then the new level of excess reserves
would be 1% of $2 billion or $20 million. The predicted increase in bank deposits would then
equal:
1/0.09 * $20 million = $222 million
The amount of drains is not very predictable. For instance, decreases in reserve requirements
cannot be guaranteed to lead to increases in the money available for lending if banks choose to
hold higher amounts of excess reserves at the Fed (as they did in the early 1990s and again in
2008.) Changes in the reserve requirement are rarely used as a monetary policy tool. This is
perhaps because it is difficult to predict the effect of changes in the reserve ratio on the money
supply. Changing the ratio frequently would likely impose additional costs on the banking
system which attempts to manage and minimize its excess reserves.
6 The multiplier used assumes that all possible amounts of money (subject to reserve requirements) loaned out are
re-deposited into banks and then re-lent and re-deposited, ad infinitum.
