FED- Conduct of Monetary Policy Tools

It is important to understand the conduct of monetary policy because it not only affects the money supply and interest rates, but also the level of economic activity and the national well-being.

The Federal Reserve System’s Balance Sheet

ASSETS
Government Securities: US Treasuries
Discount Loans: Loans made through the Discount Window

LIABILITIES
Currency in Circulation: Amount of currency in the hands of the public (outside banks)
Reserves: Bank deposits at the Fed + currency physically held by banks (called vault cash)

TOOL 1: Open Market Operations

The central bank’s purchase and sale of US Treasuries is the most important monetary policy tool because it is the primary determinant of changes in reserves in the banking system and interest rates.

An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply.
An open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply.

TOOL 2: Discount Lending

Discount lending is another tool that the Fed can use to affect the amount of reserves.

A discount loan leads to an expansion of reserves, which can be lent out as deposits, thereby leading to an expansion of the monetary base and the money supply.
When a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply.

TOOL 3: Reserve Requirements

Reserve requirements are the regulations making it obligatory for depository institutions to keep a certain fraction of their deposits as reserves with the Fed. Reserves can be further classified into required and excess reserves. Required reserves are those that the Fed requires the banks to hold and excess reserves are the additional reserves that the bank chooses to hold.

Supply and Demand in the Market for Reserves

Demand Curve

To derive the demand curve for reserves, we need to ask what happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes. As the federal funds rate decreases, the opportunity cost of holding excess reserves falls, and therefore, holding everything else constant, the quantity of reserves demanded rises. This is why the demand for reserves (Rd) is downward sloping.

Supply Curve

The Supply of reserves (Rs) can be broken down into two components. First, the amount of reserves that are supplied by the Fed’s open market operations are called nonborrowed reserves. And second, the amount of reserves borrowed from the Fed (discount loans) are referred to as borrowed reserves.

The cost of borrowing discount loans is the discount rate (Id). Because borrowing federal funds is a substitute for taking out discount loans from the Fed, if the federal funds rate (Iff) is below the discount rate (Id), then banks will not forr from the Fed and discount loans will be zero because borrowing from the federal funds market is cheaper. Therefore, as long as IffId, then banks will borrow more from the discount window at the lower Id and lend the proceeds in the federal funds market at the higher Iff. The result is a flat supply curve. Refer to Figure 1.

Figure 1







How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

Open Market Operations

An open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise. Refer to Figure 2.

Figure 2



Discount Lending

The effect of discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section.

Vertical Section

Most changes in the discount rate have no effect on the federal funds rate. Refer to Panel (a) in Figure 3.

Horizontal Section

If the demand curve interests the supply curve in the flat section, then the federal funds rate is affected. Refer to Panel (b) in Figure 3.

Figure 3



Reserve Requirements

When the required reserve ratio increases, required reserves increase, and hence the quantity of reserves demanded increases for any given interest rate. Refer to Figure 4.

When the Fed raises reserve requirements, the federal funds rate rises.
When the Fed decreases reserve requirements, it leads to a fall in the federal funds rate.

Figure 4



Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.

Conclusion

This post primarily examined how the Federal Reserve System can use open market operations, discount lending and reserve requirements to conduct its monetary policy. Refer to my previous post- Fed-Structure of the Federal Reserve System- to understand the basic structure of the Fed.

Don’t forget to visit my other sites:
Technical Analysis Base Website at http://www.technicalanalysisbase.com and
Technical Analysis Base Blog at http://technicalanalysisbase.blogspot.com

Sanjeet Parab
____________________________________

FED- Structure of the Federal Reserve System

The most important players in the world’s financial markets are the government authorities in charge of monetary policy- the central banks. In this post I will focus on the structure of the Federal Reserve System, the most important central bank in the world.

Formal Structure of the Federal Reserve System

The FRS is comprised of Federal Reserve banks, the Board of Governors of the FRS, the Federal Open Market Committee (FOMC), the Federal Advisory Council and member commercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the FED (open market operations, the discount rate, and reserve requirements).

Figure 1




Federal Reserve Banks

A glance at American political history should help you understand the motivations behind the structure of the FED. Before the 20th century, a major characteristic of American politics was the fear of centralized power. This fear and the traditional American distrust of moneyed interest were the reason behind open public hostility towards central banks. The bank panics of 1907 that resulted in widespread bank failures finally convinced detractors that a lender of last resort was necessary to prevent substantial losses. To address the fear of centralized authority, Congress wrote an elaborate system of checks and balance into the Federal Reserve Act of 1913, which created the Federal Reserve System with its 12 regional Federal Reserve banks.

Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The three largest Federal Reserve banks in terms of assets are those of New York, Chicago and San Francisco. Their combined holding is 50% of the assets of the Federal Reserve System with New York holding about 25%.

Each of the Federal Reserve banks is a quasi-public institution owned by the private commercial banks in the district who are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. Together, these nine directors appoint the president of the bank (subject to the approval of the Board of Governors).

The directors of a district bank are classified into A, B and C categories. The three A directors are professional bankers, B directors are prominent leaders from industry, labor, agriculture, or the consumer sector, and C directors are appointed by the Board of Governors to represent the public interest. The design for choosing directors is intended to ensure that al constituencies of the American public are represented.

Member Banks

All national banks are required to be members of the Federal Reserve System. Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks. Nonmember banks were subject to reserve requirements determined by their states. Because no interest is paid on reserves deposited at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, resulting in declining membership.

To prevent this declining membership, the Depository Institutions Deregulation and Monetary Control Act of 1980 stated that all depository institutions are subject to the same requirements to keep deposits at the Fed. This legislation put member and nonmember banks on equal footing in terms of reserve requirements.

Board of Governors of the Federal Reserve System

The seven-member Board of Governors leads the Federal Reserve System. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors serve one nonrenewable 14-year term, with one governor’s term expiring every other year. The governors are required to come from different Federal Reserve districts to prevent the interest of one region of the country from being overrepresented.

Federal Open Market Committee

The FOMC usually meets eight times a year and makes decisions regarding the conduct of open market operations. The committee consists of the seven member of the Board of Governors, the present of FRB New York, and presents of four other Federal Reserve banks. The chairman of the Board of Governors also presides as the chairman of the FOM.

Because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for policy making in the Federal Reserve System.

Informal Structure of the Federal Reserve System

As envisioned in 1913, the Federal Reserve System was to be a highly decentralized system designed to function as 12 separate, cooperating central banks. In the original plan, the Fed was not responsible for the health of the economy through its control of the money supply and its ability to affect interest rates. Over time, it has acquired the responsibility for promoting a stable economy, and this responsibility has caused the FRS to evolve slowly into a more unified central bank. Figure 2 depicts the informal structure of the FRS.

Figure 2



Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.

Conclusion

This post primarily examined the structure of the Federal Reserve System. In my next post, Conduct of Monetary Policy Tools, I will look into how the three monetary policy tools affect national money supply and the federal funds rate.

Don’t forget to visit my other sites:
Technical Analysis Base Website at http://www.technicalanalysisbase.com and
Technical Analysis Base Blog at http://technicalanalysisbase.blogspot.com

Sanjeet Parab
_____________________________________