The Role of the “Fed”

and Regulatory Agencies

Lesson 1 The Federal Reserve System

Aim: What important role does the Federal

Reserve Bank serve?

Do Now: Identify why the level of interest rates in

the economy has an impact on the activity in that economy.

The Federal Reserve (Fed) Bank

Do Now answer: When interest rates are low it is cheaper to borrow money and invest it or to purchase all manner of goods and services. This helps the economy grow.

The Federal Reserve (Fed) Bank

The Federal Reserve (Fed)

The Fed is an independent agency of the U.S. Government. Its structure assures that its actions are not dominated by a political party or a geographical area.

Early History of the Fed

Goals of the Federal Reserve System

The Federal Reserve was commissioned to make decisions to achieve the following goals for the US economy:

1. Price Level

Stability (low

inflation)

2. High Employ-

ment (low unemploy-

ment)

3. Promote Economic Growth

4. Stability in Foreign Exchange

Rates

Functions of the Federal Reserve System

The Federal Reserve works to achieve the above goals through the following functions:

1. Adjust monetary policy to reduce the risk of inflationMonetary policy: How the Fed influences the amount of money and credit in the U.S. economy. Controlling the supply of money in the financial system can create economic prosperity, while avoiding recessions, and ensure price stability, while avoiding inflation. The Fed can either inject money into the economy or take it out to help stimulate or slow down the economy.

Additional Functions of the Federal Reserve System

Regulate federally chartered banks and bank holding companies

Provide the mechanism for clearing checks and processing transactions

Additional Functions of the Federal Reserve System

• Lender of Last Resort to Commercial Banks: The Fed acts as the Lender of Last Resort to institutions that do not have any other means of borrowing and are experiencing financial difficulty.

• It is required to lend money to these institutions when private institutions will not because they are considered very risky and near collapse.

Additional Functions of the Federal Reserve System

• The Fed will lend to these institutions because, if it did not, their failure would dramatically affect the economy.

• Commercial banks avoid borrowing from the Fed because such action indicates that the bank is experiencing a financial crisis.

Structure of the Federal Reserve

The structure of the Fed is based on the concept that

control of monetary

policy should not be

politically or geographically concentrated /

dominated.

Structure of the Federal ReserveChairperson - Appointed by the President of the US. Serves 4 year

term. Janet Yellen is the current chairperson.

7 Members of Board of Governors - Appointed by President. Each serves 14 year terms. Terms are staggered.

12 District Banks - Each district bank is headed by a President who is elected by the other member banks. District Banks: NY, San Francisco,

Kansas City, Cleveland, Boston, Philadelphia, Richmond, Atlanta, St. Louis, Dallas, Chicago and Minneapolis.

Federal Open Market Committee (FOMC) - A group that formulates monetary policy by setting a target for the Federal funds rate. The FOMC is made up of the 7 members of the boards of governors, the NY Federal Reserve President and 4

rotating District Bank Presidents.

How the Federal Reserve Controls Monetary Policy

Reserve requirements: Raising or lowering the amount of reserves (the % of deposits banks are required to keep in non-interest bearing accounts) that banks are required to hold. Increasing reserves requirement means banks have to hold onto more money, which tends to tighten credit, making fewer funds available for lending.

How the Federal Reserve Exercises Monetary Policy

Open Market Operations: When the Fed buys from or sells government securities to primary dealers in order to increase or decrease the amount of money in the banking system.Primary dealers: A bank or broker-dealer that is able to buy and sell directly with the Federal Reserve. They act as market makers. Primary Dealers are very large banks such as JP Morgan, Goldman Sachs, and UBS. A full list of the primary dealers can be found on the Federal Reserve Bank of New York’s website: http://www.newyorkfed.org/markets/pridealers_listing.html

How the Federal Reserve Controls Monetary Policy

Note on interest rates: If the economy is not running efficiently, the Fed can cut the interest rate in order to encourage borrowing. If the economy is too strong, the Fed can raise rates, which discourages borrowing. Too much money in the banking system can be negative and lead to inflation.

To Decrease the Money Supply: The Fed will sell bonds and securities. This reduces the dollars in the economy

because they sell bonds in exchange for dollars.

To Increase the Money Supply: The Fed will buy existing bonds. This increases

the money supply because it injects dollars into the economy.

Open Market Operations in a RECESSION

US Economy is in a recession.

Fed buys treasury securities to inject money into the economy

The funds appear as credits in the accounts of security dealers

Reserves in the system increase and dollars in the economy increase

Fed Funds rate and cost of borrowing decrease

More people will borrow!

Loan rates decrease

Gross Domestic Product (GDP) will increase

Open Market Operations during INFLATION

US economy is experiencing inflation

Fed sells treasury securities to extract money from the economy

The funds appear as debits in the accounts of Security Dealers

Reserves in the system decrease and $ in the economy decrease

Fed Funds rate and cost of borrowing increase

Loan rates increase

Fewer people will borrow

Price levels will start moving back to normal

Lesson Summary1. How does the level of interest rates in the economy

relate to economic activity?

2. What are the major objectives of the Federal Reserve Bank?

3. What is the primary mechanism by which the Fed controls the amount of money and credit in the economy?

4. How do the Fed maintain its independence from political influences?

5. How many Federal Reserve Bank districts are there?

6. What important role does Federal Reserve Bank serve?

Web Challenge #1Challenge: To combat the grave effects of the Great Recession, the Federal Open Market Committee (FOMC) embarked on a new strategy by conducting several rounds of quantitative easing.

What is quantitative easing? How many rounds were conducted, and in what dollar amounts? What do proponents of the program say it accomplished? What do critics cite as the primary risk with this program?

Web Challenge #2Challenge: The governors of the different Federal Reserve districts don’t all agree on the state of the economy or the best course of action that the Fed should take. Identify at least one currently sitting Fed governor who has recently expressed that he or she disagrees with the Fed’s current course. Why does he or she think it’s incorrect?

Hint: A dissenting governor will often make his or her views heard during a speech he or she has been invited to give.

Web Challenge #3Challenge: Every six weeks the Chairperson of the Federal Reserve reports to Congress. Research the last visit made. What was the most notable parts of the Chairperson’s testimony? Was the better Chairperson’s assessment of the economy better or worse than the markets were expecting? How did the markets react to the testimony?

Web Challenge #4Challenge: Earlier, we listed four distinct goals of the Fed. There is a lot of discussion about whether it has too many objectives. Critics argue that in trying to accomplish too many things, it may cause more harm than good.

Research the one or two true “mandates” critics argue the Fed should focus on exclusively. What are they and why are they the most important? What do you think? Why do or don’t you agree?