Ch. 14

Open Market Purchases

An open market purchase occurs when the Fed buys securities with money that did not "exist" prior to the transaction, causing bank reserves to rise and, ultimately, the money supply to increase.

Open Market Sales

An open market sale occurs when the Fed sells securities, causing bank reserves to fall and, ultimately, the money supply to decrease.

Hold Depsitory Institutions' Reserves

Banks are required to keep reserves against customer deposits either in their vaults or in reserve accounts at the Fed. The Federal Reserve banks maintain these accounts -for member banks in their respective districts.

The Discount Rate

Banks borrow funds when needed to make loans to customers or to meet their reserve requirements. There are two major places where banks can go to acquire loans: the federal funds market, where it borrows excess reserves from another bank, or the Fed. At both places, the bank will pay an interest rate. The rate it pays for a loan in the federal funds market is called the federal funds rate, while the rate it pays for a loan from the Fed is called the discount rate. When a bank borrows at the Fed's discount window, the money supply increases.

The Spread Between the Discount Rate and the Federal Funds Rate

Even when the discount rate is lower than the federal funds rate, a bank may still choose to borrow in the federal funds market, for several reasons. First, the bank may know that the Fed is hesitant to extend loans to banks that want to take advantage of profit-making opportunities. Second, the bank may not want to deal with the Fed bureaucracy that regulates it, particularly if Fed officials interpret a request for a loan as mismanagement. Third, the bank may realize that acquiring a loan from the Fed is a privilege and not a right, and the bank doesn't want to abuse this privilege. A decrease in the discount rate relative to the federal funds rate increases bank borrowings from the Fed, causing reserves to rise and, ultimately, an increase in the money supply, and vice versa.

The Required Reserve Ration

The Fed can also influence the money supply by changing the required reserve ratio. Recall that banks must hold a specified percentage of all deposits on reserve; this requirement limits the amount by which banks may expand the money supply. If the Fed increases the reserve ratio, the simple deposit multiplier will be smaller, thereby further limiting the amount by which banks may expand the money supply. If the Fed decreases the reserve ratio, the simple deposit multiplier will be larger, thereby enabling banks to expand the money supply by a greater amount.

Supervise Member Banks

The Fed can examine the books of member commercial banks to see whether they are maintaining established banking standards, and can pressure them to do so.

The Fed, the Discount Rate, and the Federal Funds Rate

The Fed doesn't have direct control over the federal funds rate, but because the federal funds rate is a market interest rate determined by the supply of and demand for reserves, the Fed can affect it by using open market operations to change the supply of funds.

Serve as the Government's Banker

The Fed holds the government's (U.S. Treasury's) primary checking account.

Serve as a Lender of Last Resort

The Fed serves as the "lender of last resort" for banks suffering liquidity problems.

Which tool does the Fed prefer to use?

The Fed today uses open market operations much more than it uses the other two tools, because open market operations allow the Fed to control the size of the transaction, they can easily be reversed, and they can be implemented quickly.

Supply the Economy with paper Money (Federal Reserve Notes)

The Federal Reserve banks have Federal Reserve Notes on hand to meet the needs of banks and the public.

Serve as a Piscal Agent for the Treasury

The U.S. Treasury often auctions Treasury securities to help pay the government's bills. The Fed aids the Treasury in conducting the weekly auctions. There is a difference between the U.S. Treasury and the Fed. The U.S. Treasury manages the financial affairs of the government, but, except for coins, does not issue money; the Fed's job is to provide a stable monetary framework for the economy.

Provide Check-Clearing Services

The check-clearing process is the process by which funds change hands when checks are written. The Fed provides such services. The Fed is sometimes known as the "bankers bank".

Federal Open Market Committee

The major policy-making group within the Fed, the ____ is made up of the seven governors plus five presidents of Federal Reserve District Banks (the president of the New York Fed has a permanent seat; the other four places rotate among the remaining 11 Federal Reserve District Bank presidents). The FOMC has the authority to conduct open market operations. It is the responsibility of the New York Fed to carry out orders.

Open Market Operations

When the Fed engages in open market operations when it either buys or sells U.S. government securities (T-bills) in the financial markets.

The Board of Governors

controls and coordinates the activities of the Federal Reserve System. The seven governors are appointed by the president and confirmed by the Senate to staggered 14-year (non-renewable) terms. The president designates one member of the board as the chair for a four-year, renewable term.

Conduct Monetary Policy by Controlling the Money Supply

using the reserve requirement, discount rate, and open market operations.