The Federal Reserve System
The Federal Reserve System
Powers of the Fed
Reserve Requirements
The Fed sets the required ratio of reserves that banks must hold relative to their deposit liabilities. In theory, the Fed could use this power as an instrument of monetary policy. It could lower reserve requirements when it wanted to increase the money
supply and raise them when it wanted to reduce the money supply. In practice, however, the Fed does not use its power to set reserve requirements in this way. The reason is that frequent manipulation of reserve requirements would make life difficult
for bankers, who would have to adjust their lending policies to changing requirements.
The Fed's power to set reserve requirements was expanded by the Monetary Control Act of 1980. Before that, the Fed set reserve requirements only for commercial
banks that were members of the Federal Reserve System. Most banks are not members of the Fed; the Fed's control of reserve requirements thus extended to only a minority of banks. The 1980 act required virtually all banks to satisfy the Fed's reserve
requirements.
The Discount Window and Other Credit Facilities
A major responsibility of the Fed is to act as a lender of last resort to banks. When banks fall short on reserves, they can borrow reserves from the Fed through its discount window. The discount rate is the interest rate charged by the
Fed when it lends reserves to banks. The Board of Governors sets the discount rate.
Lowering the discount rate makes funds cheaper to banks. A lower discount rate could place downward pressure on interest rates in the economy. However, when
financial markets are operating normally, banks rarely borrow from the Fed, reserving use of the discount window for emergencies. A typical bank borrows from the Fed only about once or twice per year.
Instead of borrowing from the Fed when
they need reserves, banks typically rely on the federal funds market to obtain reserves. The federal funds market is a market in which banks lend reserves to one another. The federal
funds rate is the interest rate charged for such loans; it is determined by banks' demand for and supply of these reserves. The ability to set the discount rate is no longer an important tool of Federal Reserve policy.
To deal with the recent financial and economic conditions, the Fed greatly expanded its lending beyond its traditional discount window lending. As falling house prices led to foreclosures, private investment banks and other financial institutions
came under increasing pressure. The Fed made credit available to a wide range of institutions in an effort to stem the crisis. In 2008, the Fed bailed out two major housing finance firms that had been established by the government to prop up the housing
industry - Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation). Together, the two institutions backed the mortgages of half of the nation's mortgage loans. It also agreed to provide $85 billion to AIG, the huge insurance firm. AIG had a subsidiary that was heavily exposed to mortgage loan losses, and that crippled the
firm. The Fed determined that AIG was simply too big to be allowed to fail. Many banks had ties to the giant institution, and its failure would have been a blow to those banks. As the United States faced the worst financial crisis since the Great
Depression, the Fed took center stage. Whatever its role in the financial crisis of 2007–2008, the Fed remains an important backstop for banks and other financial institutions needing liquidity. And for that, it uses the traditional discount window,
supplemented with a wide range of other credit facilities. The Case in Point in this section discusses these new credit facilities.
Open-Market Operations
The Fed's ability to buy and sell federal government bonds has proved to be its most potent policy tool. A bond is a promise by the issuer of the bond (in this case the federal government) to pay the owner of the bond a payment or a series
of payments on a specific date or dates. The buying and selling of federal government bonds by the Fed are called
open-market operations. When the Fed buys or sells government bonds, it adds or subtracts reserves from the banking system. Such changes affect the money supply.
Suppose the Fed buys a government bond in the open market. It
writes a check on its own account to the seller of the bond. When the seller deposits the check at a bank, the bank submits the check to the Fed for payment. The Fed "pays" the check by crediting the bank's account at the Fed, so the bank has more
reserves.
The Fed's purchase of a bond can be illustrated using a balance sheet. Suppose the Fed buys a bond for $1,000 from one of Acme Bank's customers. When that customer deposits the check at Acme, checkable deposits will rise by $1,000.
The check is written on the Federal Reserve System; the Fed will credit Acme's account. Acme's reserves thus rise by $1,000. With a 10% reserve requirement, that will create $900 in excess reserves and set off the same process of money expansion as
did the cash deposit we have already examined. The difference is that the Fed's purchase of a bond created new reserves with the stroke of a pen, where the cash deposit created them by removing $1,000 from currency in circulation. The purchase of
the $1,000 bond by the Fed could thus increase the money supply by as much as $10,000, the maximum expansion suggested by the deposit multiplier.
Figure 9.9
Where does the Fed get $1,000 to purchase the bond? It simply creates the money when it writes the check to purchase the bond. On the Fed's balance sheet, assets increase by $1,000 because the Fed now has the bond; bank deposits with the Fed, which
represent a liability to the Fed, rise by $1,000 as well.
When the Fed sells a bond, it gives the buyer a federal government bond that it had previously purchased and accepts a check in exchange. The bank on which the check was written will
find its deposit with the Fed reduced by the amount of the check. That bank's reserves and checkable deposits will fall by equal amounts; the reserves, in effect, disappear. The result is a reduction in the money supply. The Fed thus increases the
money supply by buying bonds; it reduces the money supply by selling them.
Figure 9.10 "The Fed and the Flow of Money in the Economy" shows how the Fed influences the flow of money in the economy. Funds flow from the public - individuals and
firms - to banks as deposits. Banks use those funds to make loans to the public - to individuals and firms. The Fed can influence the volume of bank lending by buying bonds and thus injecting reserves into the system. With new reserves, banks will
increase their lending, which creates still more deposits and still more lending as the deposit multiplier goes to work. Alternatively, the Fed can sell bonds. When it does, reserves flow out of the system, reducing bank lending and reducing deposits.
Figure 9.10 The Fed and the Flow of Money in the Economy
Individuals
and firms (the public) make deposits in banks; banks make loans to
individuals and firms. The Fed can buy bonds to inject new reserves into
the system, thus increasing bank lending, which creates new deposits,
creating still more lending as the deposit multiplier goes to work.
Alternatively, the Fed can sell bonds, withdrawing reserves from the
system, thus reducing bank lending and reducing total deposits.
The Fed's purchase or sale of bonds is conducted by the Open Market Desk at the Federal Reserve Bank of New York, one of the 12 district banks. Traders at the Open Market Desk
are guided by policy directives issued by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Board of Governors plus five regional bank presidents. The president of the New York Federal Reserve Bank serves as a
member of the FOMC; the other 11 bank presidents take turns filling the remaining four seats.
The FOMC meets eight times per year to chart the Fed's monetary policies. In the past, FOMC meetings were closed, with no report of the committee's
action until the release of the minutes six weeks after the meeting. Faced with pressure to open its proceedings, the Fed began in 1994 issuing a report of the decisions of the FOMC immediately after each meeting.
In practice, the Fed sets
targets for the federal funds rate. To achieve a lower federal funds rate, the Fed goes into the open market buying securities and thus increasing the money supply. When the Fed raises its target rate for the federal funds rate, it sells securities
and thus reduces the money supply.
Traditionally, the Fed has bought and sold short-term government securities; however, in dealing with the condition of the economy in 2009, wherein the Fed has already set the target for the federal funds rate at near zero, the Fed has announced
that it will also be buying longer term government securities. In so doing, it hopes to influence longer term interest rates, such as those related to mortgages.