Chapter 4
Functions of the Fed
Outline
Overview
Organizational Structure of the Fed
Federal Reserve District Banks
Fed Control of the Money Supply
Decision Process
Role of the Fed’s Trading Desk
The Fed’s Intervention During the Credit Crisis
Fed Loans to Facilitate Rescue of Bear Stearns
Global Monetary Policy
A Single Eurozone Monetary Policy
Global Central Bank Coordination
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Key Concepts
1. Describe the role and the organization of the Fed.
POINT/COUNTER-POINT:
Should There Be One Global Central Bank?
POINT: Yes. One global central bank could serve all countries in the manner that the European Central
Bank now serves several European countries. If there was a single central bank, there could be a single
monetary policy across all countries.
COUNTER-POINT: No. A global central bank could create a global monetary policy only if there was a
single currency used throughout the world. Moreover, all countries would not agree on the monetary
policy that is appropriate.
Questions
1. The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed
district banks.
ANSWER: Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and
2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to
achieve these goals?
ANSWER: The main goals of the FOMC are to promote high employment, economic growth, and
price stability.
3. Open Market Operations. Explain how the Fed increases the money supply through open market
operations.
Chapter 4: Functions of the Fed ❖ 3
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?
ANSWER: The Beige book is a consolidated report of regional economic conditions in each of the 12
6. Fed’s Lending Facility. Describe the purpose of the Fed’s lending facility.
ANSWER: The Fed maintains a lending facility in which it provides short-term loans (usually
overnight) to depository institutions.
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 the economic presentations made during a
POMC meeting?
ANSWER: Economic presentations offer the FOMC information about the prevailing economic
9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money
supply.
ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository
institutions, which will cause a reduction in the account balances of these institutions.
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?
ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution,
11. Fed’s Indirect Influence on Many Types of Interest Rates The Fed focuses its control on
the federal funds rate, yet indirectly influences many other types of interest rates. Explain.
ANSWER: Since banks now have more funds available, they may want to use their excess
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12. The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions
that are near bankruptcy?
ANSWER: The Fed might argue that the credit crisis is a threat to the financial system and that it
13. Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the
Fed during the credit crisis?
ANSWER: Some supporters of a government rescue would argue that the credit crisis would be
14. The Fed’s Impact on Unemployment. Explain how the Fed’s monetary policy affects the
unemployment level.
ANSWER: The Fed’s monetary policy affects interest rates, which affect the cost of borrowing by
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?
ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on
16. The Fed’s Impact on Security Prices. Explain how the Fed’s monetary policy may indirectly affect
the prices of equity securities.
ANSWER: The Fed’s monetary policy influences the aggregate demand for products and services,
17. Impact of FOMC Statement. How might the FOMC statement (issued following the committee’s
meeting) stabilize financial markets more than if no statement were provided?
Chapter 4: Functions of the Fed ❖ 5
ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the
18. Fed Facility Programs During the Credit Crisis. Explain how the Fed’s facility programs improved
liquidity in some debt markets.
ANSWER: The Fed established facilities that provided loans to financial institutions that were willing
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.
ANSWER: The bureau is responsible for regulating financial products and services, including online
protect consumers from deceptive practices than waiting for Congress to pass new laws.
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.
ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the
21. The Fed’s Power. What should be the Fed’s role? Should it focus only on monetary policy?
Or should it engage in the trading of various types of securities in an attempt to stabilize the
financial system when securities markets are suffering from investor fears and the potential
for high credit (default) risk?
ANSWER: This is open ended, as there is no perfect answer. Students should recognize that
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 2008 credit crisis. What could
this policy accomplish that its traditional monetary policy might not accomplish?
ANSWER
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23. The Fed’s Purchases of Commercial Paper Why and how did the Fed intervene in the commercial
paper market during the credit crisis?
ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial
paper it had issued, investors feared that other financial institutions with large holdings of
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?
ANSWER: The Fed’s purchases of long-term Treasury securities differed from its normal
open market operations, which focus on short-term Treasury securities. By purchasing long-
25. The Fed and TALF What was TALF, and why did the Fed create it?
ANSWER: TALF was the term asset–backed facility that the Fed created in 2008 to provide
financing to financial institutions purchasing high-quality bonds backed by consumer, credit
26. The Fed’s Quantitative Easing Strategies. Explain how the Fed’s “quantitative easing” strategies
differed from the traditional strategy of buying short-term Treasury securities.
ANSWER: The quantitative easing strategies were unique because they were not solely focused
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CRITICAL THINKING QUESTION
Fed’s Intervention During the Crisis. The Fed intervened heavily in the credit crisis. Write a short
essay explaining whether you believe the Fed’s intervention improved conditions in financial markets or
made conditions worse.
ANSWER
The Fed infused the financial system with a massive amount of funds, which is what caused market
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.”
The Fed makes policy decisions based on expectations about economic conditions, and its
expectations are influenced by the economic indicators.
c. “Inflation will likely increase because real short-term interest rates currently are negative.”
Negative real short-term interest rates imply that the inflation rate exceeds the existing nominal
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
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implements monetary policy, whereas the federal government implements spending and tax policies,
(fiscal policy) to affect economic growth and inflation. However, it is difficult to achieve high economic
growth without igniting inflation. Although the Fed is often said to be independent of the administration
in office, there is much interaction between monetary and fiscal policies.
a. Given the circumstances, do you expect that the administration will be more concerned about
increasing economic growth or reducing inflation?
While answers may vary among students, the administration is normally most concerned with
b. Given the circumstances, do you expect that the Fed will be more concerned about increasing
economic growth or reducing inflation?
The Fed tends to focus on maintaining a low level of inflation, because of the possibility that
c. Your firm is relying on you for some insight into 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
may focus on economic growth for political or other reasons. In this case, there is a high
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.
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.
The actions will place downward pressure on Treasury securities prices, because of an increase
b. Will these actions place upward or downward pressure on Treasury yields? Explain.
The actions will place upward pressure on Treasury yields, because a lower price is paid for the
securities.
c. Will these actions place upward or downward pressure on interest rates? Explain.
The actions will place upward pressure on interest rates because there would be a reduction in