THE FEDERAL RESERVE

1
CHAPTER 2

• THE FEDERAL RESERVE
• AND ITS POWERS

2
Early Banking

• Served the safekeeping function
• Receipts were used as money
• With 100 reserves early banks were only
  custodians
• The lending function and money creation function
  developed with use of fractional reserves
• Increased risk and bank panics
• Modern banking is fractional reserve system

3
Early U.S. Banking

• Bank of North America, 1782, was the first
  American bank
• Early banks issued bank notes, convertible to
  specie
• Industrial interest promoted banking agrarian
  and frontier interests disliked banks
• Bank note issue has poor reputation

4
Early U.S. Central Banking

• The Bank of the United States (1791-1811) was the
  first U.S. central bank
• Federal charter
• Performed both public and private functions
• Privately owned
• Publiclycontrolled bank note issue and
  intercountry transactions

5
Early U.S. Central Banking

• Second Bank of the United States (1816-1832)
• Central banking functions very unpopular
• President Jackson vetoed renewal of charter in
  1832

6
Early State Banking

• States chartered banks
• Prosperity varied with business cycle
• No central bank control over loan/note issue
• Wild expansion/contraction cycles hurt economic
  development
• State political influences, under capitalization,
  and abuses prevailed
• Many bank failures in economic downturns
• Suffolk Bank

7
Federal Banking Legislation

• National Banking Acts of 1863 and 1864
• Promoted a safe and uniform currency
• Aided in financing Civil War
• Provisions included
• Federal Charters for national banks
• Increased capital requirements
• Established minimum reserve requirements
• Maximum loan size to single borrower
• Began issuance of uniform bank notes printed by
  U.S. Treasury, backed by Federal Government

8
Federal Banking Legislation

• Deposit banking evolved from the National Bank
  Acts
• State bank notes taxed
• State banks issued demand deposits instead of
  bank notes

9
Federal Banking Legislation

• Problems with national banking system
• Inelastic money supplyno lender of last resort
• Pyramiding of reserves from small to large banks
  produced financial panics at times
• Payment and check clearing system inefficient

10
Origins of the Federal Reserve System

• Prior to 1863, banks issued bank notes that
  functioned like our present day currency but were
  the obligations of individual banks.
• Because of the risk of failure, some banks notes
  traded at a discount.
• The quantity of money in circulation fluctuated
  with the business cycle, possibly exaggerating
  those cycles.

11
Origins of the Federal Reserve System (concluded)

• Demand deposits were not insured, so they were
  often discounted when the bank was distant,
  suspect, or unknown.
• Further, banks were subject to liquidity problems
  and the economy suffered several recessions and
  crises, culminating in the crash of 1907.
• These problems lead to the passage of the Federal
  Reserve Act in 1913.

12
The Initial Purposes of the Fed Were to

• Provide an elastic currency supply (money supply
  control).
• Serve as a lender of last resort (discount
  window).
• Provide for a sounder banking system (bank
  regulatory and supervisory powers).
• Improve the payments system (check clearing and
  promoting payments system technology).

13
Nonmonetary Powers of the Fed

• Regulation Q -- established the maximum rate that
  depository institutions could pay on deposit
  accounts until it was phased out over the
  1980-1986 period.
• Securities Credit Regulation -- establishes
  borrowing (margin) limits for buyers of
  securities on margin.
• Supervision and Examination of State Member Banks
  by Fed.

14
Nonmonetary Powers of the Fed (concluded)

• Regulation of Bank and Financial Holding
  Companies.
• Regulation of Payment System.
• Control of International Banking Activities.
• Consumer Credit Regulation
• Fiscal Agent for the U.S. Treasury.
• Tax and Loan Accounts at depository institutions
  then moved to Fed when Treasury wants to spend it
  
• Moral Suasion - Chairman Greenspans speeches
  and testimony before Congress

15
1946 Full Employment Act

• Stable Dollar
• Full Employment
• Economic Growth

16
Federal Reserve System

• Seven members of the Board of Governors
• Twelve Regional Federal Reserve Banks (and their
  branches)
• Thousands of member commercial banks
• Federal Open Market Committee
• Board of Governors and 5 Presidents of District
  Banks

17
Organization of the Fed
18
The Fed's Balance Sheet (2000)
Source Board of Governors, Federal Reserve
System.
19
The Fed's Balance Sheet
Primary Asset

• Important assets include
• U.S. government and agency securities.
• cash items in the process of collection (CIPC).
  CIPC minus DACI below is Fed float -- a net loan
  of reserves extended to the banking system.
• treasury coin.
• loans to member banks.
• gold certificates and SDRs.

20
The Fed's Balance Sheet (concluded)

• Important liabilities include
• Federal Reserve notes.
• reserve deposits of depository institutions.
• deferred availability cash items (DACI).
• treasury and foreign deposits.
• capital and surplus.

21
CHECK 21Check Clearing Act for the 21st Century

• Took effect October 28, 2004
• Allows financial institutions the option to move
  checks electronically by allowing them to replace
  an original check with a substitute check.
• A substitute check is a paper reproduction of an
  original check created during the check
  collection and return process from an electronic
  image of the original.
• The goal of CHECK 21 is to reduce paper.
• Evolved from 9/11

22
Payments Clearing System

• Banks hold deposits in other banks and the
  Federal Reserve Banks in order to clear checks.
• While the physical paper check moves from bank to
  bank, the deposit accounts of banks are merely
  debited or credited.
• Many checks are cleared locally through clearing
  house associations.
• Checks drawn on association member banks are
  netted out.

23
Payment System Processes

• The Federal Reserve Banks are heavily involved in
  the check clearing of out of town checks
• Most depository institutions either directly or
  indirectly (through other banks) hold reserve
  deposits in the Fed.
• Checks written on other banks are sent to the Fed
  and, depending on the distance and time needed to
  present the check to the paying bank
• The reserve account of the check depositing bank
  may receive immediate or delayed (DACI) credit.

24
Payment System Processes

• Federal Reserve float is created by the double
  counting of clearing-delayed checks.
• One bank is given credit in its reserve account
  after two days (from DACI)
• while the check has not yet (CIPC) been presented
  to the paying bank.
• Float, at any time, is the difference between
  CIPC and DACI, and represents a net credit to the
  reserve account of all depository institutions.
• Effect of CHECK 21

25
Payment System Processes

• When a check is cleared and a deposit transfer is
  made at the Fed, the total bank reserves remain
  the same
• Only the ownership (one bank to another) changes.
• Payments do not impact money supply
• Only Feds impact upon bank reserve account
  impacts money supply

26
Three Tools of Federal Reserve Monetary Policy

• 1. Establishing reserve requirements, the minimum
  proportion (percentage) of bank deposits they
  must keep on deposit at the Fed.
• Increasing reserve requirements () increases the
  percentage of bank deposits kept in noninterest
  bearing deposits at the Fed and limits bank
  lending.
• Decreasing reserve requirements () reduces the
  percentage of bank deposits kept in the Fed and
  provides the banking system with excess reserves.

27
Three Tools of Federal Reserve Monetary Policy
(continued)

• Bank deposits (reserves) in the Fed are needed to
  clear checks and to satisfy reserve requirements.
• Actual reserves (AR) are balances needed to meet
  check clearing and legal reserve requirements
  including
• vault cash.
• noninterest bearing bank deposits in Federal
  Reserve banks.

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Three Tools of Federal Reserve Monetary Policy
(continued)

• Required reserves (RR) is the dollar level of
  reserves needed to meet legal reserve
  requirements.
• Reserve requirements () and the level and type
  of deposits determine the level of required
  reserves in a period.
• Actual reserves (have) needed for check clearing
  may exceed required reserves (have to have) and
  vice versa
• Total transactions deposits in the banking system
  increase when a bank uses some of its excess
  reserves to make a loan.

29
Three Tools of Federal Reserve Monetary Policy
(continued)

• Excess reserves (ER) equals actual minus required
  reserves.
• Excess reserves may be loaned to customers or
  sold to other banks (federal funds market) by an
  individual bank.
• If the level of the banking system's Federal
  Reserve borrowed reserves (BR) (Fed loan credited
  to reserve accounts) exceeds the level of excess
  reserves in a period, the banking system is in a
  net borrowed reserve position, is less likely to
  promote lending activities, and interest rates
  are most likely to be increasing.

30
Three Tools of Federal Reserve Monetary Policy
(continued)

• If the level of level of excess reserves exceeds
  Fed borrowing, the banking system is in a
  net-free reserve position, credit is easier and
  interest rates are generally lower.
• Many analysts prefer to examine banks net-free
  reserves (Excess Reserves - Borrowed Reserves).

31
Three Tools of Federal Reserve Monetary Policy
(continued)

• 2. Open market operations affect the level of
  member bank reserves and the monetary base.
• Buying government securities from the private
  sector, the Fed eventually credits member bank
  deposits, thus increasing the level of bank
  reserves and the banks' ability to make loans and
  expand the money supply.
• Selling securities (could be any asset) to
  private security dealers or banks, the Fed is
  paid with a bank check which reduces the level of
  member bank actual reserves.

32
Three Tools of Federal Reserve Monetary Policy
(continued)

• The Federal Reserve usually expands or contracts
  its liabilities by engaging in Open Market
  Operations.
• When they buy securities, they write a check on
  themselves.
• The Federal Reserve increases the monetary base
  via the banks reserve accounts whenever it
  acquires more assets.

33
Three Tools of Federal Reserve Monetary Policy
(concluded)

• 3. Discount Rate Policy -- The rate of interest
  depository institutions pay for borrowing from
  the Fed.
• Raising the discount rate increases the cost of
  borrowing for needed reserve balances.
• Lowering the discount rate lowers the cost of
  bank liquidity and encourages lending and money
  supply expansion
• Rarely used as a tool of monetary policy now.

34
The Federal Reserve and Depository Institutions

• The Federal Reserve has the ability to regulate
  every deposit-taking financial institution by
  requiring uniform reserve requirements.
• All depository institutions can borrow through
  the Discount Window.

35
Monetary Base

• Changes in the assets and liabilities of the
  Federal Reserve System largely determine the
  nations Monetary Base
• The Monetary Base equals currency in circulation
  plus financial institution deposits at the
  Federal Reserve.
• The Federal Reserve increases the monetary base
  via the banks reserve account whenever it
  acquires more assets. It decreases the monetary
  base when it sells assets.

36
Impacts of FederalReserve Policy

• Expansionary monetary policy
• Open market operations -- purchase securities --
  increase bank excess reserves and the monetary
  base.
• Reserve requirements -- reduce reserve
  requirements -- increase excess reserves and
  increase the deposit expansion multiplier.
• Discount rate -- reduce the rate -- reduce the
  cost of borrowing reserves.
• Expands the money supply reduces interest rates.

37
Impacts of FederalReserve Policy (concluded)

• Restrictive monetary policy
• Open market operations -- sell securities, reduce
  bank reserves and the monetary base.
• Reserve requirements -- increase reserve
  requirements, reduces excess reserves and the
  deposit expansion multiplier.
• Discount rate -- increase the discount rate and
  the cost of borrowing reserve deficiencies.
• Reduce the money supply or its growth rate
  increase interest rates.

38
Other Tools of Federal Reserve Monetary Policy

• Moral Suasion - Chairman of the Federal Reserve
  System makes a speech or testifies before
  Congress
• Regulation of Banks
• International Activities arising from acting as
  the Agent of the United States Government in
  International Finance

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Conclusion

• The Federal Reserve System
• Monetary Base
• Tools of the Fed
• Set Reserve Requirements
• Open Market Operations
• Discount Rate Policy
• Regulation of Banks
• Effects of Monetary Policy