THE FED
SSEMA2 Explain the role and functions of the Federal Reserve System.
b. Describe the organization of the Federal Reserve System (12 Districts, Federal Open Market Committee (FOMC), and Board of Governors).
b. Describe the organization of the Federal Reserve System (12 Districts, Federal Open Market Committee (FOMC), and Board of Governors).
The Federal Reserve System is unique among the world’s central banks for its decentralized structure and its public/private nature. In the Federal Reserve Act of 1913, Congress called for a decentralized structure with a maximum of 12 district banks located throughout the country. The district banks are the private part of the system and the Board of Governors is the public part. District banks operate under the direction of a private board representing banking, business and community organizations throughout the district. A selection committee of non-banker board members select the president of the district banks. The president and his or her professional staff are employees of the district and run the day-to-day operations of the district banks. The President of the United States nominates members of the Board of Governors and the U.S. Senate confirms them. They are the public part of the system. The Federal Open Market Committee (FOMC) is the monetary policy making body of the Federal Reserve System. When fully staffed, the FOMC includes the seven members of the Board of Governors and the 12 district bank presidents. Only five of the twelve district bank presidents are voting members of the FOMC at any one time. The New York District president always votes. The other four voting spots rotate among the remaining eleven district presidents. The image below shows the geographic location of the districts and Board of Governors.
c. Define monetary policy
According to the Federal Reserve’s 2016 edition of Purposes and Functions, “monetary policy is the Federal Reserve’s actions, as a central bank, to achieve three goals specified by Congress: maximum employment, stable prices, and moderate long-term interest rates in the United States.”
d. Define the tools of monetary policy including reserve requirement, discount rate, open market operations, and interest on reserves.
According to the Federal Reserve Board of Governors, there are currently seven tools of monetary policy available to the Federal Open Market Committee. For the purposes of this course in economics, students must define four of these tools.
Reserve Requirement: The Federal Reserve requires most financial institutions to keep a percentage of customer deposits in vault cash or as a deposit in their account with the Federal Reserve. Banks cannot lend these reserves. In theory, if the Federal Reserve raised or lowered the reserve requirement, it would change the supply of money in the economy. However, the Federal Reserve rarely uses this tool.
Interest on Required and Excess Reserves: On October 1, 2008, Congress authorized the Federal Reserve to begin paying interest on the required and excess reserves of financial institutions. Prior to this change, financial institutions gained no return on their required reserves, acting as an implicit tax. Now, they earn a return on required reserves as well as any excess reserves they want to hold with the Federal Reserve. Financial institutions weigh the choice between earning interest on excess reserves from the Fed with the option to earn interest by loaning excess reserves to customers. If the Federal Reserve changes the interest rate on excess reserves, it changes the incentive financial institutions have to keep their reserves with the Fed, increasing or decreasing the money supply.
Discount Rate: One role the Federal Reserve plays in the economy is the “lender of last resort.” If financial institutions cannot borrow from each other, they may need to borrow from the Federal Reserve. The interest rate charged by the Fed, when lending to a financial institution, is the Discount Rate. When the Fed raises or lowers the discount rate, it is sending a signal to financial institutions telling them to increase or decrease their lending activity, affecting the money supply.
Open Market Operations: At each Federal Open Market Committee meeting, members vote to raise, lower, or maintain their target for an interest rate called the Federal Funds Rate (FFR). The FFR is the rate financial institutions charge each in the overnight lending market. The Fed targets the rate by buying or selling government bonds through primary dealers in the open market. As the FFR rises or falls, the incentives for financial institutions to borrow from each other changes, affecting the money supply.
Reserve Requirement: The Federal Reserve requires most financial institutions to keep a percentage of customer deposits in vault cash or as a deposit in their account with the Federal Reserve. Banks cannot lend these reserves. In theory, if the Federal Reserve raised or lowered the reserve requirement, it would change the supply of money in the economy. However, the Federal Reserve rarely uses this tool.
Interest on Required and Excess Reserves: On October 1, 2008, Congress authorized the Federal Reserve to begin paying interest on the required and excess reserves of financial institutions. Prior to this change, financial institutions gained no return on their required reserves, acting as an implicit tax. Now, they earn a return on required reserves as well as any excess reserves they want to hold with the Federal Reserve. Financial institutions weigh the choice between earning interest on excess reserves from the Fed with the option to earn interest by loaning excess reserves to customers. If the Federal Reserve changes the interest rate on excess reserves, it changes the incentive financial institutions have to keep their reserves with the Fed, increasing or decreasing the money supply.
Discount Rate: One role the Federal Reserve plays in the economy is the “lender of last resort.” If financial institutions cannot borrow from each other, they may need to borrow from the Federal Reserve. The interest rate charged by the Fed, when lending to a financial institution, is the Discount Rate. When the Fed raises or lowers the discount rate, it is sending a signal to financial institutions telling them to increase or decrease their lending activity, affecting the money supply.
Open Market Operations: At each Federal Open Market Committee meeting, members vote to raise, lower, or maintain their target for an interest rate called the Federal Funds Rate (FFR). The FFR is the rate financial institutions charge each in the overnight lending market. The Fed targets the rate by buying or selling government bonds through primary dealers in the open market. As the FFR rises or falls, the incentives for financial institutions to borrow from each other changes, affecting the money supply.
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