The Federal Reserve

Richard Slevinsky4/7/03

Outline

HistoryOrganization & FunctionsPolicies & Concerns

U.S. Bank History

First Bank of United StatesEst. after birth of U.S. (1791)Second Bank of U.S. (Est. 1816)Charters of both not renewed by President Jackson (1836)

De-centralized banking from 1836-18631,400 bank institutions, up to 1,600 note typesInefficient, subject to counterfeiting

Move Toward Centralization

Civil War: National Currency Act (1863)

Reserves maintained / notes redeemed at principal locations (main cites)Allowed for chartering of national banks

Panic of 19072nd and 3rd largest banks in country closedDepositors withdrew funds (run on banks)JP Morgan et al., backed remaining banks to restore depositor faith

Reform

Bankers realized reform needed. Washington not easily convincedAldrich-Vreeland Act

Est. commission to study banking systems and adapt changes if applicable.

Aldrich PlanContained several ideas of Federal ReserveLack of central authorityUniform discount rate

Federal Reserve Established

Created by Federal Reserve Act, 1913Purposes:

To provide the country with an elastic currencyCentralize bank reservesProvide multi-regional check / currency clearing system, to reflect country’s regions and growthProvide banking facilities for the federal government

Organization of the “Fed”

Main components of the Federal Reserve

Federal Reserve Board of GovernorsFederal Reserve BanksFederal Open Market Committee (FOMC)

Board of GovernorsSeven member Federal Reserve Board

14-year terms• One new term begins every two years (on 2/1, even-numbered years)• Member who serves a full-term cannot be appointed

again• A member finishing out another’s term may be

reappointed.Nominated by President, confirmed by Senate

Federal Reserve Board has a Chairman and Vice-Chairman

Both nominated by President, confirmed by Senate.Serve 4-year terms

Today’s Members

Chairman: Alan GreenspanVice-Chairman: Robert W. Ferguson, Jr.Other members:

Edward M. GramlichSusan Schmidt BiesMark W. OlsonBen S. BernackeDonald L. Kohn

Federal Reserve Banks

12 regional reserve banksEach bank with own 9-member board of directors • One person from each bank’s board selected

for the Federal Advisory Board, meeting in Washington 4 times a year.

ResponsibilitiesDistribution of currency (paper and coin)Supervise BanksDept. of Treasury functions

Federal Reserve Bank Districts

FOMC

Composed of the 7-member Board of Governors and 5 Reserve Bank presidents

Reserve Bank of NY is always a memberOther FRB presidents serve one-year terms

Implements national monetary policyDetermines the Fed’s open-market transactions

Determines holdings of foreign currencies

Policies

The Federal Reserve has three main tools to execute its monetary policy

Open market operations – the purchase and sale of government securitiesReserve requirements – the required cash reserve a financial institution must keep at the FedThe discount rate – rate at which the Fed lends funds to banks

Open Market OperationsThe Fed controls bank reserves by buying/selling U.S. Treasury and federal securities

Controls money supplyEffects banks’ lending capacity, and ratesBuying from a bank increases that banks’ lending capacity increases money supplyBy selling securities, the Fed effectively re-acquires what it issued before reduces money supplyBank interest rates can be controlled for short periods of time in this way

Reserve requirements

Seldom used by Fed to control bank reservesSmall change in requirements translates to massive changes in the dollar reserve requirementBanks are obligated to deposit in the Fed a specified percentage of its liabilities

Discount Rate

Interest rate charged to banks on loans they receive from Federal Reserve Bank

Lending facility called discount window

3 types of loansPrimary: loaned to stable institutionsSecondary: liquidity needs, financial difficultiesSeasonal: Repeating intra-year fluctuations, loaned to agricultural banks, seasonal resort lenders.

Discount Rate HistoryDISCOUNT RATE

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

1/1/70 10/17/74 8/2/79 5/17/84 3/2/89 12/16/93 10/1/98 7/17/03

Date

Perc

en

t

Other Fed rolesFight inflation

Discipline monetary growth and credit growth• Through interest rates

Monitor Gross National Product (GNP) andUnemployment

DebtCheck Congressional spending/incomeTrade deficitsStrength of dollarFed is more flexible than Congress

Other Fed roles

Check GNP growthIf falling below 1%

• Ease reserve constraints• Lower interest rates• Counter rising unemployment

If rising above 5%• Strengthen reserve constraints• Raise interest rates• Monitor inflation

Ideal: around 3%• Fed policies remain the same

Fed & Foreign Currency

Aim – intervene in foreign currency markets when conditions not ideal

Intervention through NY foreign exchange markets.

If dollar falling – Fed purchases dollar (sells other currencies)If dollar rising – Sale of dollar (for other currencies)

Swap Network

Reciprocal short-term credit management between Fed and other foreign central banks

Fed can borrow currencies from foreign country for intervention operationsWorks both ways