Module 11

Structure and Functions of the Federal Reserve System

*Bank safety was a primary reason for establishing the Federal Reserve System *structure : designed to allay fears about concentrating financial power at the federal level. +The entire structure of the Federal Reserve is set up to get the most support from across the nation and to keep elected officials at an arm's length. Keeping politics as much as possible out of the money supply is the goal for most central banks.

Which of the following is not one of the Federal Reserve's tools for changing the money supply and interest rates?

*Changing the prime rate:The prime rate is determined by market forces, so the Fed can try to shift supply and demand to move this interest rate, but the Fed does not set this rate directly. Buying and selling bonds in the open market Changing the required reserve ratio Changing the discount rate

two sources of bank failures

- One reason why banks fail is a liquidity problem—a lack of ready cash to meet large withdrawals by the public. - other problem is insolvency—having assets whose value is not enough to cover liabilities, such as deposits.

Federal Reserve Functions

1 Sets monetary policy through decisions that affect the flow of money and credit 2. Contribute to the safety and soundness of the financial system by supervising and regulating banks 3.bank for depository institutions and the government and makes sure the payment system works efficiently

The Silver National Bank of Spring Gulch, Nevada, has checkable deposits of $225,000 and total reserves of $75,000. The reserve ratio is 25%. What is the money multiplier for this system?

4

Mars has a reserve requirement rate (RRRR) of 15%. Assuming banks lend out the maximum possible and households hold no cash, what is the money multiplier?

6.67 is 1/RR 1/.15

What is the largest liability for most banks?

Checkable deposit accounts

Which of the following will prevent expansion of the money supply from reaching its potential maximum?

Currency withdrawals by the public

True or false. Bank reserves may increase when the Fed buys bonds directly from a bank, but not when the Fed buys bonds from the public.

False; Bank reserves increase either way

Two deposit insurance agencies

Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC), were created in 1935. These two insurance corporations were designed to protect bank depositors, not banks or bank stockholders, from insolvency.

What did goldsmiths develop?

Fractional reserve banking

If John Brown deposits $500 in cash in his checking account at the Smith City National Bank on the same day that Leslie Evans takes out a $2,500 loan from that bank, how will these two transactions affect the money supply? (Ignore any multiplier effects.)

It will increase initially by $2,500.

Which of the following is not one of the original functions of the Federal Reserve System?

Regulating the supply of money and the availability of credit in the United States

Who does the Federal Reserve Board of Governors include?

Seven members appointed by the U.S. president for 14-year staggered terms

True or false. The first two attempts at central banks were also private banks, but concerns about corruption led Congress to seek a different structure for the U.S. central bank.

TRUE; The Bank of the United States, established in 1791, was privately owned but chartered by the federal government. Its charter expired in 1811. In 1816, the Second Bank of the United States was created, but its charter was not renewed in 1835.

Humphrey-Hawkins Act

The Humphrey-Hawkins act created the dual mandate of the Fed. Even though these two goals conflict with each other, the Fed is required by law to try for both.

The Silver National Bank of Spring Gulch, Nevada, has checkable deposits of $250,000 and total reserves of $75,000. The reserve ratio is 25%. How much can the Silver National Bank lend?

The Silver National Bank can lend $12,500.

What is currently the main function of the Federal Reserve?

To manage the money supply to promote economic growth, high employment, and a stable price level

Why did Congress create the Federal Reserve (the U.S. Central Bank)?

To regulate lending practices and act as a "lender of last resort"

True or false. The United States is divided into 12 Federal Reserve districts, each with its own Reserve Bank.

True

Changes in the reserve ratio

affect excess reserves

discount rate

affects the level of bank borrowing from the Fed.

reserve ratio (rr)

aka the liquidity ratio, is the fraction of deposits that banks are required to hold in reserves (1)RR = BR = rrXD (2)D= 1rrXBR 2. Newly created checkable deposits are equal to the initial excess reserves multiplied by the money multiplier

Banks

are an intermediary in the lending business, gathering up small sums from depositors and lending larger amounts to borrowers. Banks pay some interest to depositors, charge more interest to borrowers, and make their profit out of the difference.

Reserves

are bank assets that can be used to pay depositors when funds are requested

__________ simplified the problem of matching lenders with borrowers

banks

When the Fed uses the monetary tools to increase bank reserves,

banks may not increase lending, so the policy is not always effective.

If the Fed is seeking to expand the availability of credit in order to increase aggregate demand, it will most likely

buy bonds in the open market.

Bank reserves increase when the Fed

buys bonds in the open market, and decrease when the Fed sells bonds in the open market.

Expansionary monetary policy is effective when the Fed _________ bonds in the open market and makes appropriate changes to the discount rate and the federal funds target rate. These changes cause bank reserves to _________ , which leads to ________ borrowing and spending. As a result, aggregate demand shifts to the _______ and equilibrium output __________

buys; The Fed buys bonds in the open market to pursue expansionary monetary policy. increase; The Fed can increase bank reserves by purchasing bonds. more; If banks have more reserves, they are able to finance more loans. right; Aggregate demand shifts to the right when businesses and consumers are able to borrow and spend more. increases; Equilibrium output increases when aggregate demand shifts to the right.

When a bank lends out a portion of its customers' deposits, it is

called fractional reserve banking.

dual mandate

create full-employment and price stability

If the economy is experiencing both high unemployment and high inflation, the Fed can use monetary policy to solve

either high unemployment or high inflation, but cannot solve both at once; If the Fed pursues expansionary monetary policy, it can reduce unemployment; if it pursues contractionary monetary policy, it can reduce inflation.

If a bank sells a bond and uses the proceeds to make a loan, it has

exchanged one asset for another.

True or false. Changes in the discount rate bring about large changes in bank reserves, lending, the money supply, and spending, so the discount rate is the Fed's preferred monetary tool.

false; Changes in the discount rate are used more as a signal of the direction of upcoming policy.

True or false. Because changing the required reserve ratio is such a powerful tool, the Fed uses this option most often to bring about desired changes in the money supply.

false; Changing the required reserve ratio is too powerful and uncertain.

True or false. The Federal Reserve System was established in the U.S. Constitution, so Congress cannot take away the powers assigned to it.

false; Congress passed the Federal Reserve Act in 1913 and created the Fed. The Federal Reserve is aware that Congress has the power to change the laws concerning it and is prepared to lobby for its position on any proposed legislation.

True or false. The Federal Open Market Committee (FOMC) consists of the 12 Federal Reserve Bank presidents, one from each district.

false; Membership of the FOMC reflects a compromise between centralized and decentralized power.

True or false. When the Fed lowered the interest rate to near zero in 2008 through mid-2015, investment spending responding sharply and equilibrium output quickly returned to the full-employment level.

false; The economy recovered very slowly because reducing interest rates did not have a significant effect on borrowing and spending.

One way for banks to correct a shortage of required reserves is to borrow reserves from each other as well as from the Fed. Loans between banks are made in the ____ market. If the interest rate in this market drops below the target rate set by the Fed, the Fed will ______ bonds to adjust reserves and cause the rate to rise. The Fed typically lowers the target rate if the economy is experiencing higher than normal ___________.

federal funds;Banks borrow reserves from each other in the federal funds market and the interest rate in this market is called the federal funds rate. sell; Bank reserves are reduced when the Fed sells bonds, so the supply of federal funds decreases, causing the equilibrium price in this market to go up. unemployment;The Fed lowers this rate by pumping reserves into the system, which leads to more borrowing and spending and can potentially help to reduce unemployment.

Board of Governors

governing body of the Federal Reserve System. Seven members are appointed by the president for 14-year staggered terms, with no more than one governor from any of the 12 districts. Most governors have a background in law, banking, or economics. The chair of the Fed is chosen by the president from among the sitting governors for a 4-year, renewable term.

Open market operations

involve buying and selling bonds to affect banks' reserves +can be reversed if necessary and can be done without any fanfare. ~ expansionary

The chair of the Federal Reserve Board of Governors

is chosen by the president from among the sitting governors for a 4-year, renewable term.

balance sheet of a bank lists ....

its assets in order of liquidity (from most liquid to least liquid), its liabilities (or claims against it to be paid in the future), and its net worth +The fact that it balances says nothing about how well the bank is doing. To determine the bank's condition, we must look at some individual assets and liabilities.

Public Loans

liabilities of households and businesses who borrowed the money

What are the interest-earning assets of a bank?

loans

The formula to increase the money supply is

m(∆D)m(∆D), when m is the money multiplier and DD is deposits.

Federal Reserve System

major source of bank reserves, including cash in the form of Federal Reserve notes +has the power to create reserves and set the required reserve ratio ~ established in 1913 *Congress created the Fed in response to two perceived needs. The first was to regulate banks to keep them from making risky loans that threatened the safety of deposits. The second was for a "lender of last resort" to rescue basically sound banks that were threatened with failure and bankruptcy because of temporary economic conditions. +Later, a third role was established: managing the size of the money supply so as to promote economic growth, high employment, and a stable price level. This final role is now the Fed's most important function, but it was not part of the original design of the system.

The functions of the Federal Reserve include setting ________ policy, supervising and regulating ________ and serving as a bank for _________ .

monetary banks federal government

Fed has three ways to influence the money supply

open market operations, changes in the discount rate, and changes in the reserve ratio

Fed uses the money supply and interest rates to affect...

output, employment, and the price level

balance sheet

provides a picture of a firm's financial situation +assets equal liabilities plus net worth. A balance sheet must always balance

Government bonds

range from T-bills (short-term obligations) to notes (medium term) to bonds (long term); are liabilities of the U.S. Treasury

When the Fed sells bonds to a bank, the bank's reserves are

reduced, so bank loans must fall.

excess reserves

reserves above the level required by law +A bank can expand loans as long as it has excess reserves

If the Fed's goal is to slow spending in order to reduce inflationary pressures, it can use the monetary tools to accomplish this goal. Specifically, the Fed would _______ bonds in the open market, _____ the discount rate, and/or ______ the required reserve ratio in order to lower the money supply or reduce the rate of growth in the money supply.

sell raise raise

The Federal Reserve Board of Governors includes ____ members, each appointed by the president to serve _________ terms. The chair of the Board of Governors is appointed to serve _________ year term. ___________ was appointed in 2013 to replace _________

seven 14 4 Yellen Bernanke

T-account (partial balance sheet)

shows changes in assets or liabilities resulting from one or more transactions

Federal Open Market Committee (FOMC),

supervises the conduct of monetary policy. The FOMC consists of the Board of Governors plus the presidents of five district banks, always including the president of the New York Federal Reserve Bank. When the FOMC meets regularly to decide changes in bank reserves and the money supply, all district bank presidents attend.

Fractional reserve banking

the practice of holding a fraction of money deposited as reserves and lending the rest. This means that only a fraction of bank deposits are actually backed by cash and available for withdrawal. It also means that the money supply can be far larger than the actual amount of currency in circulation.

money multiplier

the ratio between the maximum increase in the money supply and a given increase in excess reserves. It equals the reciprocal of the reserve ratio. The money multiplier depends only on the ratio of required reserves to checkable deposits.

True or false. Fractional reserve banking is the practice of holding a fraction of money deposited as reserves and lending the rest.

true

True or false. When all the excess reserves in the banking system have been used up, the money supply stops expanding.

true;

True or false. The Fed's most frequently used monetary tool is buying and selling government bonds in the open market.

true; The Fed's preferred tool is open market operations.

True or false. The Fed's dual mandate is to maintain both full employment and price stability.

true; This dual mandate was formalized with legislation passed in the 1970s.

True or false. The Fed changes the discount rate to signal the direction of monetary policy rather than as a direct tool for changing the money supply.

true;banks have many other options for obtaining reserves, so they will not necessarily alter the amount of reserves they borrow when this rate changes.