Chapter 4
Functions of the Fed
Outline
Overview
Organization of the Fed
Federal Reserve District Banks
Member Banks
Board of Governors
Federal Open Market Committee (FOMC)
Advisory Committees
Integration of Federal Reserve Components
How the Fed Controls Money Supply
Open Market Operations
Role of the Fed’s Trading Desk
How Fed Operations Affect All Interest Rates
Adjusting the Reserve Requirement Ratio
Adjusting the Fed’s Loan Rate
The Fed’s Intervention During the Credit Crisis
Fed Loans to Facilitate Rescue of Bear Stearns
Fed’s Strategy of Quantitative Easing
Perceptions of the Fed’s Intervention During the Crisis
Global Monetary Policy
A Single Eurozone Monetary Policy
Global Central Bank Coordination
2 ❖ Chapter 4: Functions of the Fed
Key Concepts
1. Describe the role and the organization of the Fed.
2. Explain how monetary policy tools are used by the Fed to control economic conditions.
3. Explain why the Fed’s monetary policy can not ignore international conditions.
POINT/COUNTER-POINT:
Should There Be One Global Central Bank?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your
own opinion.
Questions
1. The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed
district banks.
2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to
achieve these goals?
3. Open Market Operations. Explain how the Fed increases the money supply through open market
operations.
4. Policy Directive. What is the policy directive, and who carries it out?
5. The Beige Book. What is the Beige book and why is it important to the FOMC?
6. Reserve Requirements. How is money supply growth affected by an increase in the reserve
requirement ratio?
7. Control of Money Supply. Describe the characteristics that a measure of money should have if it is
to be manipulated by the Fed.
8. FOMC Economic Presentations. What is the purpose of economic presentations during a POMC
meeting?
9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money
supply.
10. Open Market Operations. Why do the Fed’s open market operations have a different effect on
money supply than do transactions between two depository institutions?
11. Discount Window Lending During the Credit Crisis. Explain how and why the Fed extended
its discount window lending to nonbank financial institutions during the credit crisis.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12. The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions
that are near bankruptcy?
13. Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the
Fed during the credit crisis?
14. The Fed’s Impact on Unemployment. Explain how the Fed’s monetary policy affects the
unemployment level.
15. The Fed’s Impact on Home Purchases. Explain how the Fed influences the monthly mortgage
payments on homes. How might the Fed indirectly influence the total demand for homes by
consumers?
16. The Fed’s Impact on Security Prices. Explain how the Fed’s monetary policy may indirectly affect
the prices of equity securities.
17. Impact of FOMC Statement. How might the FOMC statement (following the committee’s meeting)
stabilize financial markets more than if no statement were provided?
18. Fed Facility Programs During the Credit Crisis. Explain how the Fed’s facility programs improved
liquidity in some debt markets.
19. Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the
Consumer Financial Protection Bureau was established, and housed within the Federal Reserve.
Explain the role of this bureau.
20. Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its
independent monetary policy and control over its domestic interest rates.
21. The Fed’s Power. What should be the Fed’s role? Should it be focused only on monetary
policy? Or should it be allowed to engage in the trading of various types of securities in order
to stabilize the financial system when securities markets are suffering from investor fears and
the potential for high default risk?
22. Fed Purchases of Mortgage-Backed Securities Explain the motivation behind the Fed’s policy of
purchasing massive amounts of mortgage-backed securities during the credit crisis. What could this
policy accomplish that its traditional monetary policy might not accomplish?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23. The Fed’s Purchases of Commercial Paper Why and how did the Fed intervene in the commercial
paper market during the credit crisis?
24. The Fed’s Trading of Long-term Treasury Securities Why did the Fed purchase long-term
Treasury securities in 2010, and how did this strategy differ from the Fed’s usual operations?
25. The Fed and TALF What was TALF, and why did the Fed create it?
26. The Fed’s Quantitative Easing Strategies. Explain how the Fed’s “quantitative easing” strategies
differed from the traditional strategy of trading short-term Treasury securities.
Chapter 4: Functions of the Fed ❖ 7
CRITICAL THINKING QUESTION
Fed’s Intervention During the Crisis. The Fed intervened heavily in the credit crisis. Write a short
essay on whether you believe the Fed’s intervention improved conditions in financial markets or made
conditions worse.
ANSWER
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “The Fed’s future monetary policy will be dependent on the economic indicators to be reported
this week.”
b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.”
c. “Inflation will likely increase because real short–term interest rates currently are negative.”
Managing in Financial Markets
As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so
that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve
8 ❖ Chapter 4: Functions of the Fed
implements monetary policy—and that the federal government implements spending and tax policies, or
fiscal policy—to affect economic growth and inflation. However, it is difficult to achieve high economic
growth without igniting inflation. Although the Federal Reserve is often said to be independent of the
administration in office, there is much interaction between monetary and fiscal policies.
Assume that the economy is currently stagnant and that some economists are concerned about the
possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this
year than in the previous five years. Assume that the Federal Reserve chair’s term will expire in four
months and that the president of the United States will have to appoint a new chairman (or reappoint the
existing chair). It is widely known that the existing chair would like to be reappointed. Also assume that
next year is an election year for the administration.
a. Given the circumstances, do you expect that the administration will be more concerned about
increasing economic growth or reducing inflation?
b. Given the circumstances, do you expect that the Fed will be more concerned about increasing
economic growth or reducing inflation?
c. Your firm is relying on you for some insight on how the government will influence economic
conditions and therefore the demand for your firm’s products. Given the circumstances, what is
your forecast of how the government will affect economic conditions?
There is no definite answer, but some possible expectations are as follows. First, both policies
Flow of Funds Exercise
Monitoring the Fed
Recall that Carson Company has obtained substantial loans from finance companies and commercial
banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months.
Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making
acquisitions. The company expects that it will need substantial long-term financing and plans to borrow
Chapter 4: Functions of the Fed ❖ 9
additional funds either through loans or by issuing bonds. The Carson Company is also considering the
issuance of stock to raise funds in the next year.
Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It
subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets.
It recently received an alert from the service that suggested the Fed has been selling large holdings of its
Treasury securities in the secondary Treasury securities market.
a. How should Carson interpret the actions by the Fed? That is, will these actions place upward or
downward pressure on the price of Treasury securities? Explain.
b. Will these actions place upward or downward pressure on Treasury yields? Explain.
c. Will these actions place upward or downward pressure on interest rates? Explain.