Federal Reserve System
L E A R N I N G O B J E C T I V E S
After studying this chapter, you should be able to do the following: LO 4.1 Discuss how the Federal Reserve System (Fed) responded to the recent fi nancial
crisis and Great Recession.
LO 4.2 Identify three weaknesses of the national banking system that existed before the Federal Reserve System was created.
LO 4.3 Describe the Federal Reserve System and identify the fi ve major components into which it is organized.
LO 4.4 Identify and describe the policy instruments used by the Fed to carry out monetary policy.
LO 4.5 Discuss the Fed’s supervisory and regulatory functions. LO 4.6 Identify important Fed service functions. LO 4.7 Identify specifi c examples of foreign countries that use central banking systems to
regulate money supply and implement monetary policy.
W H E R E W E H A V E B E E N . . . In Chapter 3 we discussed the types and roles of fi nancial institutions that have evolved in
the United States to meet the needs of individuals and businesses and help the fi nancial sys-
tem operate effi ciently. We also described the traditional diff erences between commercial
banking and investment banking, followed by coverage of the functions of banks (all depos-
itory institutions) and the banking system. By now you also should have an understanding of
the structure and chartering of commercial banks, the availability of branch banking, and the
use of bank holding companies. You also should now have a basic understanding of the bank
balance sheet and how the bank management process is carried out in terms of liquidity and
capital management. Selected information also was provided on international banking and
several foreign banking systems.
W H E R E W E A R E G O I N G . . . The last two chapters in Part 1 address the role of policy makers in the fi nancial system and
how international trade and fi nance infl uence the U.S. fi nancial system. In Chapter 5 you will
have the opportunity to review economic objectives that direct policy-making activities. We
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4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 77
then briefl y review fi scal policy and how it is administered through taxation and expenditure
plans. This is followed by a discussion of the policy instruments employed by the U.S.
Treasury and how the Treasury carries out its debt management activities. You will then see
how the money supply is changed by the banking system, as well as develop an understand-
ing of the factors that aff ect bank reserves. The monetary base and the money multiplier also
will be described and discussed. Chapter 6 focuses on how currency exchange rates are
determined and how international trade is fi nanced.
H O W T H I S C H A P T E R A P P L I E S T O M E . . .
Actions taken by the Fed impact your ability to borrow money and the cost of, or interest
rate on, that money. When the Fed is taking an easy monetary stance, money becomes
more easily available, which in turn leads to a lower cost. Such an action, in turn, will
likely result in lower interest rates on your credit card, your new automobile loan, and
possibly your interest rate on a new mortgage loan. Actions by the Fed also infl uence eco-
nomic activity and the type and kind of job opportunities that may be available to you. For
example, a tightening of monetary policy in an eff ort to control infl ation may lead to an
While many individuals know that the Federal Reserve System is the central bank of the
United States, what the Fed does and how it operates are less clear. Stephen H. Axilrod
There must be almost as many images of the Fed as an institution and of the wellsprings of its actions as there are viewers. Mine, born of a particular experience, is a generally benign one. It is of an unbiased, honest, straightforward institution that quite seriously and carefully carries out its congressionally given mandates. . . . It is of course through the window of monetary policy that the public chiefl y sees and judges the Fed.1
This chapter focuses on understanding the structure and functions of the Fed. Chapter 5 describes
how the Fed administers monetary policy in cooperation with fi scal policy and Treasury
operations to carry out the nation’s economic objectives.
4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession CRISIS As previously noted, the 2007–2008 fi nancial crisis and the 2008–2009 Great Reces-
sion combined to create a “perfect fi nancial storm.” Many government offi cials, politicians,
fi nancial institution executives, and business professionals felt during the midst of the
fi nancial storm that both the U.S. and world fi nancial systems were on the verge of collapse
in 2008. The Federal Reserve System (Fed), the central bank of the United States, is responsible for setting monetary policy and regulating the banking system. Direct actions
and involvement by the Fed were critical in government and related institutional eff orts to
avoid fi nancial collapse.
The federal government has historically played an active role in encouraging home own-
ership by supporting liquid markets for home mortgages. If banks and other lenders originate
home mortgages and then “hold” the mortgages, new mortgage funds are not readily available.
However, when banks and other lenders are able to sell their mortgages in a secondary mortgage
market to other investors, the proceeds from the sales can be used to make new mortgage loans. In
Federal Reserve System (Fed) U.S. central bank that sets monetary
policy and regulates banking
1 Stephen H. Axilrod, Inside the Fed, (Cambridge: The MIT Press, 2009), p. 159.
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78 C H A P T E R 4 Federal Reserve System
1938, the president and Congress created the Federal National Mortgage Association (Fannie Mae) to support the fi nancial markets by purchasing home mortgages from banks and, thus, freeing-up funds that could be lent to other borrowers. Fannie Mae was converted to a government-
sponsored enterprise (GSE), or “privatized,” in 1968 by making it a public, investor-owned com-
pany. The Government National Mortgage Association (Ginnie Mae) was created in 1968 as a government-owned corporation. Ginnie Mae issues its own debt securities to obtain funds that
are invested in mortgages made to low to moderate income home purchasers. The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970, also as a government-owned corporation to aid the mortgage markets by purchasing and holding mortgage loans. In 1989,
Freddie Mac also became a GSE when it became a public, investor-owned company.
Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage
purchases and holdings. Ginnie Mae purchases Federal Housing Administration (FHA)
and Department of Veterans Aff airs (VA) federally insured mortgages, packages them into
mortgage-backed securities that are sold to investors. Ginnie Mae guarantees the payment
of interest and principal on the mortgages held in the pool. Fannie Mae purchases individual
mortgages or mortgage pools from fi nancial institutions and packages or repackages them into
mortgage-backed securities as ways to aid development of the secondary mortgage markets.
Freddie Mac purchases and holds mortgage loans.
As housing prices continued to increase, these mortgage-support activities by Ginnie
Mae, Fannie Mae, and Freddie Mac aided the government’s goal of increased home own-
ership. However, after the housing price bubble burst in mid-2006 and housing-related jobs
declined sharply, mortgage borrowers found it more diffi cult to meet interest and principal
payments, causing the values of mortgage-backed securities to decline sharply. To make the
housing-related developments worse, Fannie Mae and Freddie Mac held large amounts of low
quality, subprime mortgages that had higher likelihoods of loan defaults. As default rates on
these mortgage loans increased, both Fannie and Freddie suff ered cash and liquidity crises.
To avoid a meltdown, the Federal Reserve provided rescue funds in July 2008, and the U.S.
government assumed control of both fi rms in September 2008.
The Federal Reserve, sometimes with the aid of the U.S. Treasury, helped a number of
fi nancial institutions on the verge of failing, due to the collapse in value of mortgage-backed
securities, to merge with other fi rms. Examples included the Fed’s eff orts in aiding the March
2008 acquisition of Bear Stearns by the JPMorgan Chase bank and the sale of Merrill Lynch
to Bank of America during the latter part of 2008. However, Lehman Brothers, a major invest-
ment bank, was allowed to fail in September 2008. Shortly after the Lehman bankruptcy and
the Merrill sale, American International Group (AIG), the largest insurance fi rm in the United
States, was “bailed out” by the Federal Reserve with the U.S. government receiving an own-
ership interest in the company. Like Merrill, Fannie, and Freddie, AIG was considered “too
large to fail,” due to the potential impact of this on the global fi nancial markets.
In addition to direct intervention, the Fed also engaged in quantitative easing actions to
help avoid a fi nancial system collapse in 2008, and to stimulate economic growth after the
2008–09 recession. We will discuss the Fed’s quantitative easing actions later in the chapter.
DISCUSSION QUESTION 1 Do you support the Fed’s decision to bail out selected fi nancial institutions that were suff ering fi nancial distress in 2008?
4.2 The U.S. Banking System Prior to the Fed In Chapter 1, when we discussed the characteristics of an eff ective fi nancial system, we
said that one basic requirement was a monetary system that effi ciently carried out the fi n-
ancial functions of creating and transferring money. While we have an effi cient monetary
system today, this was not always the case. To understand the importance of the Federal
Reserve System, it is useful to review briefl y the weaknesses of the banking system that gave
rise to the establishment of the Fed. The National Banking Acts passed in 1863 and 1864
provided for a national banking system. Banks could receive national charters, capital and
reserve requirements on deposits and banknotes were established, and banknotes could be
Federal National Mortgage Association (Fannie Mae) created to support the fi nancial markets by
purchasing home mortgages from
banks so that the proceeds could be
lent to other borrowers
Government National Mortgage Association (Ginnie Mae) created to issue its own debt securities to
obtain funds that are invested in
mortgages made to low to moderate
income home purchasers
Federal Home Loan Mortgage Corporation (Freddie Mac) formed to support mortgage
markets by purchasing and holding
Copyright © 2017 John Wiley & Sons, Inc.
4.2 The U.S. Banking System Prior to the Fed 79
issued only against U.S. government securities owned by the banks but held with the U.S.
Treasury Department. These banknotes, backed by government securities, were supposed to
provide citizens with a safe and stable national currency. Improved bank supervision also was
provided for with the establishment of the Offi ce of the Comptroller of the Currency under
the control of the U.S. Treasury.
Weaknesses of the National Banking System Although the national banking system overcame many of the weaknesses of the prior systems
involving state banks, it lacked the ability to carry out other central banking system activities
that are essential to a well-operating fi nancial system. Three essential requirements include
(1) an effi cient national payments system, (2) an elastic or fl exible money supply that can
respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help
alleviate liquidity problems when they arise. The fi rst two requirements relate directly to the
transferring and creating money functions. The third requirement relates to the need to main-
tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the
ability to meet depositor withdrawals and to pay other liabilities as they come due. All three
of these required elements were defi cient until the Federal Reserve System was established.
The payments system under the National Banking Acts was based on an extensive net-
work of banks with correspondent banking relationships. It was costly to transfer funds from
region to region, and the check clearing and collection process sometimes was quite long.
Checks written on little-known banks located in out-of-the-way places often were discoun-
ted or were redeemed at less than face value. For example, let’s assume that a check written
on an account at a little-known bank in the western region of the United States was sent to
pay a bill owed to a fi rm in the eastern region. When the fi rm presented the check to its local
bank, the bank might record an amount less than the check’s face value in the fi rm’s checking
account. The amount of the discount was to cover the cost of getting the check cleared and
presented for collection to the bank located in the western region. Today, checks are processed
or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3
that the current U.S. payments system allows checks to be processed either directly or indirectly.
The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3
or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.
A second weakness of the banking system under the National Banking Acts was that the
money supply could not be easily expanded or contracted to meet changing seasonal needs
and/or changes in economic activity. As noted, banknotes could be issued only to the extent
that they were backed by U.S. government securities. Note issues were limited to 90 percent
of the par value, as stated on the face of the bond, or the market value of the bonds, whichever
was lower. When bonds sold at prices considerably above their par value, the advantage of
purchasing bonds as a basis to issue notes was eliminated. 2
For example, if a $1,000 par value bond was available for purchase at a price of $1,100,
the banks would not be inclined to make such a purchase since a maximum of $900 in notes
could be issued against the bond, in this case 90 percent of par value. The interest that the
bank could earn from the use of the $900 in notes would not be great enough to off set the high
price of the bond. When government bonds sold at par or at a discount, on the other hand,
the potential earning power of the note issues would be quite attractive and banks would be
encouraged to purchase bonds for note issue purposes. The volume of national bank notes,
thus the money supply, therefore depended on the government bond market rather than on the
seasonal, or cyclical, needs of the nation for currency.
A third weakness of the national banking system involved the arrangement for holding
reserves and the lack of a central authority that could lend to banks experiencing temporary
liquidity problems. A large part of the reserve balances of banks was held as deposits with
large city banks, in particular with large New York City banks. Banks outside of the large
cities were permitted to keep part of their reserves with their correspondent large city banks.
Certain percentages of deposits had to be retained in their own vaults. These were the only
2 A bond’s price will diff er from its stated or face value if the interest rate required in the marketplace is diff erent from
the interest rate stated on the bond certifi cate. Bond valuation calculations are discussed in Chapter 10.
Copyright © 2017 John Wiley & Sons, Inc.
80 C H A P T E R 4 Federal Reserve System
alternatives for holding reserve balances. During periods of economic stress, the position of
these large city banks was precarious because they had to meet the demand for deposit with-
drawals by their own customers as well as by the smaller banks. The frequent inability of the
large banks to meet such deposit withdrawal demands resulted in extreme hardship for the
smaller banks whose reserves they held. A mechanism for providing loans to banks to help
them weather short-term liquidity problems is crucial to a well-functioning banking system.
The Movement to Central Banking A central bank is a government-established organization responsible for supervising and regulating the banking system and for creating and regulating the money supply. While central
bank activities may diff er somewhat from country to country, central banks typically play an
important role in a country’s payments system. It is also common for a central bank to lend
money to its member banks, hold its own reserves, and be responsible for creating money.
Even though the shortcomings of the national banking system in terms of the payments
system, infl exible money supply, and illiquidity were known, opposition to a strong central
banking system still existed in the United States during the late 1800s. The vast western fron-
tiers and the local independence of the southern areas during this period created distrust of
centralized fi nancial control. This distrust deepened when many of the predatory practices of
large corporate combinations were being made public by legislative commissions and invest-
igations around the turn of the century.
The United States was one of the last major industrial nations to adopt a permanent sys-
tem of central banking. However, many fi nancial and political leaders had long recognized the
advantages of such a system. These supporters of central banking were given a big boost by
the fi nancial panic of 1907. The central banking system adopted by the United States under the
Federal Reserve Act of 1913 was, in fact, a compromise between the system of independently
owned banks in this country and the single central bank systems of such countries as Canada,
Great Britain, and Germany. This compromise took the form of a series of central banks, each
representing a specifi c region of the United States. The assumption was that each central bank
would be more responsive to the particular fi nancial problems of its region.
4.3 Structure of the Federal Reserve System The Federal Reserve System is the central bank of the United States and is responsible for
setting monetary policy and regulating the banking system. It is important to understand that
the Fed did not replace the system that existed under the National Banking Acts of 1863 and
1864 but, rather, it was superimposed on the national banking system created by these acts.
Certain provisions of the National Banking Acts, however, were modifi ed to permit greater
fl exibility of operations.
The Fed system consists of fi ve components:
Federal Reserve District Banks
Board of Governors
Federal Open Market Committee
These fi ve components are depicted in Figure 4.1.
Member Banks The Federal Reserve Act provided that all national banks were to become members of the
Fed. In addition, state-chartered banks were permitted to join the system if they could show
central bank federal government agency that facilitates the operation
of the fi nancial system and
regulates the money supply
Copyright © 2017 John Wiley & Sons, Inc.
4.3 Structure of the Federal Reserve System 81
evidence of a satisfactory fi nancial condition. The Federal Reserve Act also required that all
member banks purchase capital stock of the Reserve Bank of their district up to a maximum
of 6 percent of their paid-in capital and surplus. In practice, however, member banks have had
to pay only 3 percent; the remainder is subject to call at the discretion of the Fed. Member
banks are limited to a maximum of 6 percent dividends on the stock of the Reserve Bank that
they hold. The Reserve Banks, therefore, are private institutions owned by the many member
banks of the Fed.
State-chartered banks are permitted to withdraw from membership with the Fed six
months after written notice has been submitted to the Reserve Bank of their district. In such
cases, the stock originally purchased by the withdrawing member is canceled and a refund is
made for all money paid in.
BOARD OF GOVERNORS
(7 Appointed Members)
approves discount rates as part
of monetary policy
FEDERAL RESERVE BANKS
depository institutions and lend
to them at the discount window
transfer funds for depository
and cash balances
(Board of Governors and
is the primary instrument of
FIGURE 4.1 Organization of the Federal Reserve System
Commercial Banks as Providers of Small Business Credit
The 1980s and 1990s were diffi cult for the banking industry in the
United States. Many savings and loan associations (S&Ls) failed,
and there were many mergers involving S&Ls and commercial
banks. Furthermore, many of the consolidations involved small
commercial banks that traditionally tended to specialize in small
business lending. As a result, concern has been expressed about
where, or even whether, small businesses are able to obtain loans
and other forms of business credit.
In contrast, the fi rst part of the decade of the 2000s was char-
acterized by Fed monetary policy that emphasized liquidity and low
interest rates in an eff ort to stimulate economic recovery after the
dot-com and the tech bubbles burst at the beginning of the decade
and in reaction to the September 11, 2001, terrorist attack. Even after
the U.S. economy began recovering, the Fed maintained an easy
monetary policy. Then came the real estate price bubble burst, fol-
lowed by the 2007–08 fi nancial crisis and 2008–09 Great Recession.
During the crisis, the availability of bank loans for small businesses
virtually dried up. There now is an ongoing eff ort to encourage
banks to increase the availability of loan funds to small businesses.
Small Business Practice
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82 C H A P T E R 4 Federal Reserve System
Approximately 3,500, or about one-third, of the nation’s commercial banks are members of
the Fed. This includes all commercial banks with national charters plus, roughly, one-fi fth of the
state-chartered banks. These member banks hold approximately three-fourths of the deposits of
all commercial banks. National banks control about three-fi fths of the total assets of all FDIC-
insured commercial banks, and the state-chartered banks that belong to the Fed control another
one-fourth of total assets. Even these fi gures understate the importance of the Federal Reserve in
the nation’s fi nancial system. As indicated in Chapter 3, the Monetary Control Act of 1980 gen-
erally eliminated distinctions between banks that are members of the Fed and other depository
institutions by applying comparable reserve and reporting requirements to all these institutions.
Federal Reserve District Banks The Federal Reserve Act of 1913 provided for the establishment of 12 Federal Reserve dis-
tricts. Each district is served by a Federal Reserve Bank. Figure 4.1 indicates that district
banks have a wide range of responsibilities, including holding reserve balances for depository
institutions and lending to them at the prevailing discount (interest) rate. The district banks
also issue new currency and withdraw damaged currency from circulation, as well as collect
and clear checks and transfer funds for depository institutions. The boundaries of the districts
and the cities where district banks are located are shown in Figure 4.2.
Directors and Off icers Each Reserve Bank has corporate offi cers and a board of directors. The selection of offi cers and directors is unlike that of other corporations. Each
Reserve Bank has on its board nine directors, who must be residents of the district in which
they serve. The directors serve terms of three years, with appointments staggered so that three
directors are appointed each year. To ensure that the various economic elements of the Federal
Reserve districts are represented, the nine members of the board of directors are divided into
three groups: Class A, Class B, and Class C.
Salt Lake City
Board of Governors of the Federal Reserve System
Federal Reserve Bank cities
Federal Reserve Branch cities
FIGURE 4.2 The Federal Reserve System
Source: Board of Governors of the Federal Reserve System.
Copyright © 2017 John Wiley & Sons, Inc.
4.3 Structure of the Federal Reserve System 83
Both Class A and Class B directors are elected by the member banks of the Federal
Reserve district. The Class A directors represent member banks of the district, and the Class
B directors represent nonbanking interests. These nonbanking interests are commerce, agri-
culture, and industry. The Class C directors are appointed by the Board of Governors of the
Federal Reserve System. These persons may not be stockholders, directors, or employees of
The majority of the directors of the Reserve Banks are elected by the member banks of
each district. However, the three nonbanking members of each board appointed by the Board
of Governors of the Federal Reserve System are in a more strategic position than the other
board members. One member appointed by the Board of Governors is designated chairperson
of the board of directors and Federal Reserve agent, and a second member is appointed deputy
chairperson. The Federal Reserve agent is the Board of Governor’s representative at each
Reserve Bank. He or she is responsible for maintaining the collateral that backs the Federal
Reserve notes issued by each Reserve Bank.
Each Reserve Bank also has a president and fi rst vice president, who are appointed
by its board of directors and approved by the Board of Governors. A Reserve Bank may
have several additional vice presidents. The president is responsible for executing policies
established by the board of directors and for the general administration of Reserve Bank
aff airs. All other offi cers and personnel of the Reserve Bank are subject to the authority of
Federal Reserve Branch Banks In addition to the 12 Reserve Banks, 25 branch banks have been established. These branch banks are for the most part in geographical areas
not conveniently served by the Reserve Banks themselves. For this reason, the geograph-
ically large western Federal Reserve districts have most of the Reserve Branch Banks. The
San Francisco district has four, the Dallas district has three, and the Atlanta district has fi ve
branch banks. The New York Federal Reserve district, on the other hand, has only one branch
bank, while the Boston district has no branches. The cities in which Reserve Banks and their
branches are located are also shown in Figure 4.2.
Board of Governors The Fed Board of Governors, or formally the Board of Governors (BOG), of the Federal Reserve System, is composed of seven members and is responsible for setting monetary policy.
Each member is appointed for a term of 14 years. The purpose of the 14-year term undoubtedly
was to reduce political pressure on the BOG. Board members can be of any political party, and
there is no specifi c provision concerning the qualifi cations a member must have. All members
are appointed by the president of the United States with the advice and consent of the Senate.
One member is designated as the chairperson and another as the vice chairperson.
The appointive power of the president and the ability of Congress to alter its structure
make the BOG a dependent political structure. However, it enjoys much independence in
its operations. The Board of Governors of the Federal Reserve System is, in fact, one of the
most powerful monetary organizations in the world. The chair of the board plays an especially
infl uential role in policy formulation. Because the board attempts to achieve its goals without
political considerations, disagreement between the administration in power and the board is
common. From time to time, pressures from Congress or the president have undoubtedly infl u-
enced the board’s decisions, but its semi-independence generally prevails.
Figure 4.1 illustrates how the Board of Governors establishes monetary policy. The
Fed BOG sets reserve requirements and reviews and approves the discount rate actions of the
12 district banks. The Fed BOG also operates through the Federal Open Market Committee to
control the money supply as a means of meeting monetary policy objectives. We will explore
these monetary policy instruments in more detail later in the chapter.
In addition to setting the nation’s monetary policy, the board directs and coordinates
the activities of the 12 Reserve Banks under its jurisdiction. The board is responsible for
approving the applications of state-chartered banks applying for membership in the system
and for recommending the removal of offi cers and directors of member banks when they
break rules established by the Fed and other regulatory authorities. In addition, the board
Fed Board of Governors seven- member board of the Federal
Reserve that sets monetary policy
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84 C H A P T E R 4 Federal Reserve System
implements many of the credit control devices that have come into existence since the mid-1960s,
such as the Truth in Lending Act, the Equal Credit Opportunity Act, and the Home Mortgage Disclosure Act.
The BOG staff conducts economic research, compiles economic data, and prepares publi-
cations that provide consumer and regulatory information. The board and all 12 of the Reserve
Banks engage in intensive research in monetary matters.
Federal Open Market Committee As early as 1922, eff orts were made to coordinate the timing of purchases and sales of secur-
ities by the Federal Reserve Banks to achieve desirable national monetary policy objectives.
The Federal Open Market Committee (FOMC), with the additional powers granted to it by
the Banking Act of 1935, has full control over all open-market operations of the Reserve Banks. As noted in Figure 4.1, this committee consists of the seven members of the Fed
BOG plus fi ve presidents (one of whom must be from New York) of Reserve Banks. The
FOMC conducts open-market operations through the process of buying and selling U.S.
government and other securities. These activities represent the primary method for carrying
out monetary policies.
Advisory Committees Figure 4.1 indicates that the Federal Reserve System has three major advisory committees.
The Federal Advisory Council provides advice and general information on banking-related
issues to the BOG. Each of the 12 Federal Reserve districts elects one member to serve on the
council. The membership of the Consumer Advisory Council is composed of representatives
from depository institutions and their customers and, as the committee title suggests, provides
advice relating to consumer issues. The Thrift Institutions Advisory Council consists of mem-
bers from S&Ls, savings banks, and credit unions and provides advice on issues that directly
aff ect thrift institutions.
Role of the Chair of the Fed Board of Governors Special authority attaches to the chairperson of any board. The chair of the Board of Gov-
ernors of the Federal Reserve System is no exception. The holder of that position is gener-
ally recognized as the most powerful infl uence on monetary policy in the nation. As for any
chairperson, the chair’s power derives in large measure from the personality, experience, and
leadership of the individual. ETHICAL High moral and ethical standards are a must for the chairperson of the Fed BOG.
A successful chair must have the confi dence and trust of the president and Congress, bank
offi cers, business leaders, foreign offi cials, and the general public. While the Fed has tried in
recent years to make its activities and intentions more transparent, the impact of Fed actions
are not often felt until many months afterward. Constituents must trust the chair will do what
is right for the economy and society. Unethical behavior on the part of a Fed BOG chair would
not be tolerated. High-quality reputation matters!
While there have been a total of 15 Fed chairs, we focus on the seven most recent chairs
beginning with the early 1950s. The chairs, along with the period served, are, as follows:
1. William McChesney Martin Jr. (1951–1970) 2. Arthur Burns (1970–1978) 3. G. William Miller (1978–1979) 4. Paul Volcker (1979–1987) 5. Alan Greenspan (1987–2006) 6. Ben Bernanke (2006–2014) 7. Janet Yellen (2014–present)
Copyright © 2017 John Wiley & Sons, Inc.
4.3 Structure of the Federal Reserve System 85
William Martin’s tenure as chair has been the longest in Fed history. He focused on main-
taining the Fed’s independence from Congress and the president. The 1970s were a particularly
diffi cult decade from an economic standpoint in the United States. Infl ation was increasing at
a rapid rate. Oil price shocks occurred in 1973–1974 and again in 1978–1979. Wage and price
controls were tried with no success. Arthur Burns served as chair throughout most the 1970s
until his term expired in 1978. President Jimmy Carter nominated William Miller as chair, but
he served only one year. By 1979, public confi dence in Carter was very low. Reactions in the
fi nancial markets in New York City also suggested concern over whether the president could
control infl ation.
In July 1979, Paul Volcker’s name had surfaced as a possible chair of the Fed who could
ably fi ght infl ation in the United States. Volcker was an economist who had served as president
of the New York Federal Reserve Bank and was well known on Wall Street. Volcker also had
served in government positions in the Kennedy, Johnson, and Nixon administrations, and he
had worked as well as in commercial banking with Chase Manhattan.
While Volcker had impressive credentials, some of the comments gathered by the Carter
administration included, “rigidly conservative . . . very right-wing . . . arbitrary and arrogant . . .
not a team player.” 3 While the Fed is legally independent from the White House, it is normal
for the Fed chair to work with a president’s economic advisors in a joint eff ort to reach certain
economic objectives. Of course, there are times when it might be in the best interest of the
people if the Fed pursues its own direction in applying monetary policy to achieve objectives
such as lower infl ation.
History shows that under the guidance of Paul Volcker, a restrictive Fed policy brought
down the double-digit infl ation of the 1970s and the early 1980s. Volcker dominated the board
during his tenure, and the Federal Open Market Committee consistently responded to his
leadership. When Volcker resigned as chairman in June 1987, the fi nancial markets reacted
negatively. The U.S. dollar fell relative to other currencies, and U.S. government and corporate
bond prices fell. Why? In a word—uncertainty; that is, uncertainty about the future direction
of monetary policy. Volcker was a known infl ation fi ghter. In contrast, the policies of the
incoming Fed chair, Alan Greenspan, were unknown.
Greenspan was viewed as a conservative economist. He served as an economics advisor
to President Gerald Ford and as a business consultant. Greenspan’s fi rst big test was the stock
market crash of October 1987. He responded by immediately pumping liquidity into the bank-
ing system. The result was avoidance of monetary contraction and asset devaluation of the
kind that followed the stock market crash of 1929. A reversal of policy occurred in mid-
1988 when interest rates were raised to fi ght increasing infl ation. A relatively mild recession
occurred during 1990–1991. However, infl ation has been kept below the 3 percent level since
then. During Greenspan’s service as chair of the Fed BOG, there was real economic growth
in the U.S. economy, interest rates declined to historic lows, and stock prices reached all-time
highs. A 1996 survey of more than two hundred chief executive offi cers of the largest U.S.
corporations gave overwhelming support for the “good job” that Greenspan was doing. Since
then, the business and fi nancial sectors of the United States have maintained their strong sup-
port of Greenspan’s Fed leadership. In 2004, Greenspan was nominated by President George
W. Bush and confi rmed by the U.S. Senate for a fi fth and fi nal four-year term as chair of the
Fed. A Fed policy of high monetary liquidity and low interest rates was established during the
early part of the decade of the 2000s in response to an economic downturn that was exacer-
bated by the September 11, 2001, terrorist attack. This easy money policy was continued
through Greenspan’s tenure, which lasted through January 2006.
Ben Bernanke became chair of the Fed BOG in February 2006. It was only a few months
before the housing price bubble burst and the economy started slowing down. Bernanke was
responsible for establishing monetary policy that helped guide the United States through the
“perfect fi nancial storm” involving the 2007–08 fi nancial crisis, which had placed the U.S.
economic system on the verge of collapse, 4 and the subsequent 2008–09 Great Recession. Ben
Bernanke led the setting of monetary policy until early 2014.
3 William Greider, Secrets of the Temple: How the Federal Reserve Runs the Country, (New York: Simon and Schuster,
1987), p. 35. 4 For an interesting personal experience perspective of working with the Fed chairs, see Stephen H. Axilrod, Inside the
Fed, (Cambridge: The MIT Press, 2009).
Copyright © 2017 John Wiley & Sons, Inc.
86 C H A P T E R 4 Federal Reserve System
Janet Yellen assumed offi ce in February 2014. Prior to becoming chair of the Fed BOG,
she served as vice chair from October 2010 until she was appointed Fed BOG chair. Yellen
is viewed as being a Keynesian economist who favors the use of monetary policy to manage
economic activity over the business cycle. She inherited from Ben Bernanke the Fed’s easy
monetary policy developed to address the 2007–2009 fi nancial and economic crises. She also
participated in the subsequent continuing quantitative easing policies during her role as vice
chair. However, after seven years of easy money policies, the Fed moved in December 2015
to start increasing interest rates.
DISCUSSION QUESTION 2 How would you evaluate the performance of Janet Yellen as chair of the Fed BOG?
LEARNING ACTIVITY Each of the 12 Federal Reserve Banks has its own website and tries to specialize in spe- cifi c types of information. Go to the Federal Reserve Bank of San Francisco’s website, http://www.frbsf.org, and the Federal Reserve Bank of Minneapolis’s website, http:// www.minneapolisfed.org, and identify the types of consumer and economic information they provide.
4.4 Monetary Policy Functions and Instruments Overview of Responsibilities The primary responsibility of the Fed is to formulate monetary policy, which involves reg- ulating the growth of the supply of money and, therefore, regulating its cost and availability.
By exercising its infl uence on the monetary system of the United States, the Fed performs a
unique and important function: promoting economic stability. It is notable that the system’s
broad powers to aff ect economic stabilization and monetary control were not present when the
Fed came into existence in 1913. At that time, the system was meant to do the following: help
the money supply contract and expand as dictated by economic conditions, serve as bankers’
banks in times of economic crisis, provide a more eff ective check-clearance system, and estab-
lish a more eff ective regulatory system. Many of these responsibilities initially fell to the 12
Reserve Banks, but as the scope of responsibility for the monetary system was broadened,
power was concentrated with the BOG. Today the responsibilities of the Fed may be described
as relating to monetary policy, supervision and regulation, and services provided for depository
institutions and the government.
Public discussions of Fed operations are almost always directed toward dynamic actions that stimulate or repress economic activity or the level of prices. However, we should recognize that this area is but a minor part of the continuous operation of the Fed-
eral Reserve System. Far more signifi cant in terms of time and eff ort are the defensive
and accommodative responsibilities. Defensive activities are those that contribute to the smooth, everyday functioning of the economy. Unexpected developments and shocks occur
continually in the economy; unless these events are countered by appropriate monetary
actions, disturbances may develop. Large, unexpected shifts of capital out of or into the
country and very large fi nancing eff orts by big corporations may signifi cantly alter the
reserve positions of the banks. Similarly, buyouts and acquisitions of one corporation by
another, supported by bank fi nancing, also aff ect reserve positions. In our competitive mar-
ket system, unexpected developments contribute to the vitality of our economy. Monetary
policy, however, has a special responsibility to absorb these events smoothly and prevent
many of their traumatic short-term eff ects. The accommodative function of the nation’s monetary system is the one with which we are the most familiar. Meeting the credit needs
of individuals and institutions, clearing checks, and supporting depository institutions rep-
resent accommodative activities.
monetary policy formulated by the Fed to regulate money supply
defensive activities Fed activities that off set unexpected monetary
developments and contribute to the
smooth, everyday functioning of
accommodative function Fed eff orts to meet credit needs of
individuals and institutions,
clearing checks, and supporting
dynamic actions Fed actions that stimulate or repress economic
activity or the level of prices
Copyright © 2017 John Wiley & Sons, Inc.
4.4 Monetary Policy Functions and Instruments 87
The basic policy instruments of the Fed that allow it to increase or decrease the money
supply are, as follows:
• Changing reserve requirements
• Changing the discount rate
• Conducting open-market operations
In recent years, the Fed has also engaged in a nontraditional monetary policy:
• Quantitative easing
We will fi rst cover the traditional policy instruments and then discuss the use of quantitative
The Fed sets reserve requirements for depository institutions (i.e., banks), sets the interest
rate at which to lend to banks, and executes open-market operations. By setting reserve
requirements, the Fed establishes the maximum amount of deposits the banking system can
support with a given level of reserves. The amount of reserves can be aff ected directly through
open-market operations, thereby causing a contraction or expansion of deposits by the bank-
ing system. Discount or interest rate policy on loans to banks also aff ects the availability of
reserves to banks and infl uences the way they adjust to changes in their reserve positions. Thus
the Fed has a set of tools that, together, enables it to infl uence the size of the money supply to
attain the Fed’s broader economic objectives.
Reserve Requirements The banking system of the United States is a fractional reserve system because banks are required by the Fed to hold reserves equal to a specifi ed percentage of their deposits. Bank reserves are defi ned as vault cash and deposits held at the Reserve Banks. Required reserves are the minimum amount of bank reserves that must be held by banks. The required reserves ratio is the percentage of deposits that must be held as reserves. If a depository institution has reserves in excess of the required amount, it may lend them out. This is how institutions earn a
return, and it is also a way in which the money supply is expanded. In our system of fractional
reserves, control of the volume of checkable deposits depends primarily on reserve management.
In Chapter 5 the mechanics of money supply expansion and contraction are explained in detail.
The banking system has excess reserves when bank reserves are greater than required reserves. The closer to the required minimum the banking system maintains its reserves, the
tighter the control the Fed has over the money creation process through its other instruments.
If the banking system has close to the minimum of reserves (that is, if excess reserves are near
zero), then a reduction of reserves forces the system to tighten credit. If substantial excess
reserves exist, the pressure of reduced reserves is not felt so strongly. When reserves are added
to the banking system, depositories may expand their lending but are not forced to do so. How-
ever, since depositories earn low interest rates on reserves, profi t maximizing motivates them
to lend out excess reserves to the fullest extent consistent with their liquidity requirements.
When interest rates are high, this motivation is especially strong.
The ability to change reserve requirements is a powerful tool the Fed uses infrequently.
For a number of reasons, the Fed prefers to use open-market operations to change reserves
rather than change reserve requirements. If reserve requirements are changed, the maximum
amount of deposits that can be supported by a given level of reserves changes. It is possible
to contract total deposits and the money supply by raising reserve requirements while holding
the dollar amount of reserves constant. Lowering reserve requirements provides the basis for
expanding money and credit.
It has been argued that “changing reserve requirements” is too powerful a tool and that
its use as a policy instrument would destabilize the banking system. The institutional arrange-
ments through which the banking system adjusts to changing levels of reserves might not
respond as effi ciently to changing reserve requirements. Another advantage of open-market
operations is that they can be conducted quietly, while changing reserve requirements requires
a public announcement. The Fed feels that some of its actions would be opposed if public
attention were directed toward them.
fractional reserve system reserves must be held equal to a certain
percentage of bank deposits
bank reserves vault cash and deposits held at Federal Reserve
required reserves the minimum amount of total reserves that a
depository institution must hold
required reserves ratio percentage of deposits that must be held as
excess reserves the amount by which total reserves are greater
than required reserves
Copyright © 2017 John Wiley & Sons, Inc.
88 C H A P T E R 4 Federal Reserve System
Changing reserve requirements has been used as a policy instrument on occasion. In the
late 1930s, the nation’s banks were in an overly liquid position because of excessive reserves.
Banks had large amounts of loanable funds that businesses did not wish, or could not qualify,
to borrow because of the continuing depression. The reserves were so huge that the Fed could
no longer resolve the situation through its other policy instruments. Therefore, it increased
reserve requirements substantially to absorb excess reserves in the banking system.
Reserve requirements were lowered during World War II in order to ensure adequate credit
to fi nance the war eff ort. But they were raised again in the postwar period to absorb excess
reserves. In the 1950s and early 1960s, reserve requirements were lowered on several occasions
during recessions. In each case, the lowering made available excess reserves to encourage bank
lending, ease credit, and stimulate the economy. By using this policy tool, the Fed was publicly
announcing its intention to ease credit, in hopes of instilling confi dence in the economy.
In the late 1960s and 1970s, reserve requirements were selectively altered to restrain
credit, because the banking system was experimenting with new ways to get around Fed con-
trols. Banks were using more-negotiable certifi cates of deposit, Eurodollar borrowings, and
other sources of reserve funds. This prompted the Fed to impose restraint on the banks by
manipulating the reserve requirements on specifi c liabilities.
The evolution of the banking system eventually led Congress to pass the Depository Insti- tutions Deregulation and Monetary Control Act (DIDMCA) of 1980, which made signifi cant changes in reserve requirements throughout the fi nancial system. Up to this time the Fed
had control over the reserve requirements of its members only. Nonmember banks were sub-
ject to reserve requirements established by their own states, and there was considerable vari-
ation among states. As checks written on member banks were deposited in nonmember banks
and vice versa, funds moved among banks whose deposits were subject to diff erent reserve
requirements. This reduced the Fed’s control over the money supply.
The 1980 act applies uniform reserve requirements to all banks with certain types of
accounts. For banks that were members of the Fed, these requirements are, in general, lower
now than they were prior to the act. In general, for approximately the fi rst $50 million of
transaction account deposits at a depository institution, the reserve requirement is 3 percent.
For deposits over approximately $50 million, the reserve requirement is 10 percent, which
was reduced from 12 percent in April 1992. The “break point” between the 3 percent and the
10 percent rates is subject to change each year based on the percentage change in transaction
accounts held by all depository institutions. In general, transaction accounts include deposits
against which the account holder is permitted to make withdrawals to make payments to third
parties or others. Accounts that restrict the amount of withdrawals per month are considered
to be savings accounts rather than transaction accounts.
Banks and other depository institutions with large transaction account balances, thus,
are required to hold a proportionately higher percentage of reserves. Let’s illustrate this point
under the assumption that the reserve requirement will be 3 percent on the fi rst $50 million of
transaction account balances and 10 percent on amounts over $50 million. Assume that First
Bank has $50 million in transaction accounts while Second Bank has $100 million. What are
the dollar amounts of required reserves for each bank? What percentage of required reserves
to total transaction deposits must be held by each bank? Following are the calculations:
Bank Account Amount Reserve
Percentage Reserve Requirement
Amount First Bank $50 million 3% $1.5 million
0 10% 0
Total $50 million $1.5 million
Percent ($1.5 million/$50 million) = 3.0%
Second Bank $50 million 3% $1.5 million
50 10% 5.0
Total $100 million $6.5 million
Percent ($6.5 million/$100 million) = 6.5%
Copyright © 2017 John Wiley & Sons, Inc.
4.4 Monetary Policy Functions and Instruments 89
Notice that while First Bank was required to hold reserves of only 3 percent against its
$50 million in transaction account balances, Second Bank had to hold reserves of 6.5 percent
of its $100 million in transaction accounts. Depository institutions with even larger transaction
account balances will have to hold proportionately higher reserves. As a result, their percent-
age of reserves to total transactions accounts will be closer to 10 percent.
A change in reserve requirement percentages on large transaction account balances has
the most impact. For example, if the reserve requirement for transaction balances greater than
$50 million is increased from 10 percent to 12 percent, Second Bank would have reserve
requirements of $7.5 million—or 7.5 percent of its $100 million in transaction accounts. The
required reserves on the second $50 million increase to $6 million, which is the result of
multiplying $50 million times 12 percent. Adding the $1.5 million on the fi rst $50 million
in transaction accounts and the $6 million on the second $50 million results in total required
reserves of $7.5 million, which is 7.5 percent of the total transaction accounts of $100 million.
Thus, it should be evident that even a small change in reserve requirements is likely to have a
major impact on the money supply and economic activity.
Discount Rate Policy The Fed serves as a lender to depository institutions. Banks can go to the Fed’s “discount
window” and borrow funds to meet reserve requirements, depositor withdrawal demands, and
even business loan demands. The Fed discount rate is the interest rate that a bank or other depository institution must pay to borrow from its regional Federal Reserve Bank. The Federal
Reserve Banks currently off er three discount window programs referred to as primary credit,
secondary credit, and seasonal credit. The primary credit rate is the Fed’s main discount win- dow program and, in practice, its rate is used interchangeably with the term “discount rate.” While
each Fed Bank sets its own discount rate, the rates have been similar across all 12 Reserve Banks
in recent years. The Fed sets the interest rate on these loans to banks and, thus, can infl uence the
money supply by raising or lowering the cost of borrowing from the Fed. Higher interest rates
will discourage banks from borrowing, while lower rates will encourage borrowing. Increased
borrowing will allow banks to expand their assets and deposit holdings, and vice versa. Loans to depository institutions by the Reserve Banks may take two forms. One option
allows the borrowing institution to receive an advance, or loan, secured by its own promissory
note together with “eligible paper” it owns. In the second option, the borrower may discount—
or sell to the Reserve Bank—its eligible paper, which includes securities of the U.S. govern-
ment and federal agencies, promissory notes, mortgages of acceptable quality, and bankers’
acceptances. This discounting process underlies the use of the terms “discount window” and
“discount rate policy.”
Discount rate policy was originally intended to work in the following fashion. If the
Fed wanted to cool an infl ationary boom, it would raise the discount rate. An increase in
the discount rate would lead to a general increase in interest rates for loans, decreasing the
demand for short-term borrowing for additions to inventory and accounts receivable. This, in
turn, would lead to postponing the building of new production facilities and, therefore, to a
decreased demand for capital goods. As a consequence, the rate of increase in income would
slow down. In time, income would decrease and with it the demand for consumer goods.
Holders of inventories fi nanced by borrowed funds would liquidate their stocks in an already
weak market. The resulting drop in prices would tend to stimulate the demand for, and reduce
the supply of, goods. Thus economic balance would be restored. A reduction in the discount
rate was expected to have the opposite eff ect.
Discount policy is no longer a major instrument of monetary policy and, in fact, is now
regarded more as an adjustment or fi ne-tuning mechanism. As an adjustment mechanism, the
discount arrangement does provide some protection to depository institutions in that other
aggressive control actions may be temporarily moderated by the ability of banks to borrow.
For example, the Fed may take a strong restrictive position through open-market operations.
Individual banks may counter the pressure by borrowing from their Reserve Banks. The
Reserve Banks are willing to tolerate what appears to be an avoidance of their eff orts while
banks are adjusting to the pressure being exerted. Failure to reduce their level of borrowing
can always be countered by additional Fed open-market actions.
Fed discount rate interest rate that a bank must pay to borrow from its
regional Federal Reserve Bank
primary credit rate interest rate used in practice to refl ect the
discount rate charged by Reserve
Banks for loans to depository
Copyright © 2017 John Wiley & Sons, Inc.
90 C H A P T E R 4 Federal Reserve System
Figure 4.3 shows year-end Fed discount rates charged by Federal Reserve Banks to depository institutions to borrow at the discount window beginning in the early 1980s and
continuing through 2015. Interest rates for adjustment credit are plotted through 2002 and refl ect the rate on short-term loans made available to depository institutions that had tempor-
ary needs for funds not available through “reasonable” alternative sources. Beginning in 2003,
the discount window interest rate refl ects the primary credit rate. Primary credit is available
ordinarily for overnight loans to depository institutions in generally sound fi nancial condition.
In response to the fi nancial crisis and the beginning of the Great Recession, the primary credit
rate was lowered to 1.25 percent by the end of 2008 and reduced further to .50 percent in 2009.
In 2010, the primary credit rate was increased to .75 percent and was held at that level through
most of 2015 in support of the Fed’s easy money policy and quantitative easing eff orts.
For comparative purposes, year-end bank prime rates, discussed in Chapter 3, are also plot-
ted in Figure 4.3. Recall that the prime rate is the interest rate charged by banks for short-term
loans to their highest quality business customers. The Fed discount rate and the bank prime rate
generally “track” each other over time. Both interest rate series peaked in the early 1980s when
infl ation rates were also very high in the United States. The downward trend in the prime rate has
generally continued as infl ation rates have also declined. In response to the fi nancial crisis and
the Great Recession, the prime rate was reduced to 3.25 percent by the end of 2008 and remained
at that level through most of 2015. In December 2015, the bank prime rate was increased by
.25 percent to 3.50 percent in response to the Fed increasing the primary credit rate.
Notice that the Fed’s lending rate to depository institutions was consistently lower than
the bank prime lending rate throughout the time period shown in Figure 4.3. Of course, in
order to make profi ts, banks must be able to borrow from depositors, and sometimes from the
Fed, at rates lower than the rates the banks lend at. The determinants of interest rates will be
discussed in detail in Chapter 8.
Open-Market Operations The most-used instrument of monetary policy is open-market operations; that is the buying and selling of securities in the “open market” by the Fed through its Federal Open Market
Committee (FOMC) to alter bank reserves. The Fed can purchase securities to put additional
reserves at the disposal of the banking system or sell securities to reduce bank reserves. You
open-market operations buying and selling of securities by the
Federal Reserve to alter the supply
Fed Discount Rate/
Primary Credit Rate
Bank Prime Rate
1994 1996 1998 20001992199019881986198419821980 2002 2004 2006 2008 2010 2012 2014 2016
FIGURE 4.3 Fed Lending Rate Versus Bank Prime Rate Changes, 1980–2015
Copyright © 2017 John Wiley & Sons, Inc.
4.4 Monetary Policy Functions and Instruments 91
might ask, “Where does the Fed get securities to sell?” A brief look at the Fed’s balance sheet
will help provide an answer.
The Fed’s assets are primarily held in the form of U.S. Treasury, government agency, and
mortgage-backed securities, which generally represent over 85 percent of total assets. Coins
and cash in the process of collection are about 2 percent of total assets. The remainder is assets
that include gold certifi cates and Fed premises. Federal Reserve notes (recall our discussion of
fi at money in Chapter 2) represent nearly 90 percent of the Fed’s total liabilities and capital.
Deposits in the form of depository institution reserves held at the Reserve Banks are about
7 percent of the total. Other liabilities, particularly U.S. Treasury deposits and capital in the
form of stock purchased by member banks and surplus earned from operations, make up the
remaining total liabilities and capital.
The original Federal Reserve Act did not provide for open-market operations. However,
to maintain stability in the money supply, this policy instrument developed out of Reserve
Bank experiences during the early years of Fed operations. Unfortunately, these early eff orts
were not well coordinated. Reserve Banks bought government securities with funds at their
disposal to earn money for meeting expenses and to make a profi t and pay dividends on the
stock held by member banks. All 12 Reserve Banks usually bought and sold the securities
in the New York market. At times, their combined sales were so large that they upset the
market. Furthermore, the funds used to buy the bonds ended up in New York member banks
and enabled them to reduce their borrowing at the Reserve Bank of New York. This made it
diffi cult for the Reserve Bank of New York to maintain eff ective credit control in its area. As a
result, an open-market committee was set up to coordinate buying and selling of government
bonds. The Federal Open Market Committee was legally established in 1933. In 1935 its
present composition was established: the Federal Reserve BOG plus fi ve of the presidents of
the 12 Reserve Banks, who serve on a rotating basis.
Open-market operations have become the most important and eff ective means of mon-
etary and credit control. These operations can take funds out of the market and, thus, raise
short-term interest rates and help restrain infl ationary pressures, or they can provide for easy
money conditions and lowered short-term interest rates. Of course, such monetary ease will
not necessarily start business on the recovery road after a recession. When used with discount
rate policy, open-market operations are basically an eff ective way of restricting credit or mak-
ing it more easily available.
Open-market operations diff er from discount operations in that they increase or decrease
bank reserves at the initiative of the Fed, not of individual banking institutions. The process,
in simplifi ed form, works as follows. If the Federal Open Market Committee wants to buy
government securities, it contacts dealers to ask for off ers and then accepts the best off ers that
meet its needs. The dealers receive wire transfers of credit for the securities from the Reserve
Banks. These credits are deposited with member banks. The member banks, in turn, receive
credit for these deposits with their Reserve Banks, thus adding new bank reserves that form
the basis for additional credit expansion. The Fed usually restricts its purchases to U.S. govern-
ment securities primarily because of their liquidity and safety.
If the Fed wants to reduce bank reserves, it sells government securities to the dealers.
The dealers pay for them by a wire transfer from a depository to a Reserve Bank. The Reserve
Bank then deducts the amount from the reserves of the depository institution.
Open-market operations do not always lead to an immediate change in the volume of
deposits. This is especially true when bonds are sold to restrict deposit growth. As bonds
are sold by the Reserve Banks, some banks lose reserves and are forced to borrow from their
Reserve Bank. Since they are under pressure from the Fed to repay the loans, they use funds
from maturing loans to repay the Reserve Bank. Thus, credit can be gradually restricted as a
result of the adjustments banks must make to open-market operations.
Quantitative Easing Quantitative easing (QE) is a nontraditional monetary policy approach to stimulate eco- nomic activity when conventional monetary policy methods are ineff ective. The Fed engages
in purchasing fi nancial assets from banks and other fi nancial institutions with newly created
money, resulting in larger bank excess reserves and increased money supply and liquidity. In
quantitative easing (QE) a nontraditional monetary policy
approach to stimulate economic
Copyright © 2017 John Wiley & Sons, Inc.
92 C H A P T E R 4 Federal Reserve System
response to the fi nancial crisis and the Great Recession that has been followed by relatively
slow economic growth, the Fed has engaged in three rounds (QE1, QE2, and QE3) of quan-
titative easing. QE1 was initiated in late 2008 when the Fed began buying large amounts of
mortgage-backed securities and Treasury securities from banks. These actions helped avoid
a fi nancial system collapse and contributed to the recovery from the Great Recession. How-
ever, slowing economic activity in 2010 led to the Fed announcing QE2, which provided
for the purchase of an additional $600 billion of Treasury securities. In an eff ort to provide
further monetary liquidity to encourage economic growth, QE3 was initiated in September
2012 when the Fed stated it planned to purchase $40 billion in mortgage-backed securities per
month for the foreseeable future. In December 2015, the Fed announced it was commencing a
money policy normalization process that would lead to higher interest rates.
DISCUSSION QUESTION 3 Did the Fed maintain an easy monetary policy for too many years after the Great Recession?
Implementation of Monetary Policy Monetary policy has traditionally focused either on trying to control the rate of change or
growth in the money supply (such as M1) or by targeting a level for a specifi c type of interest
rate. One interest rate that the Fed’s FOMC could focus on is the federal funds rate, which is the rate on overnight loans from banks with excess reserves to banks that have defi cit reserves.
Open-market purchases of securities add to bank reserves and increase the money supply.
Sales of securities lower reserves and the money supply. However, when the target is the
money supply, interest rates may fl uctuate widely, because the demand for money may change
relative to a specifi c money supply target. Furthermore, a focus on the money supply might
not produce the desired impact on gross domestic product because of changes in the velocity
of money, as we saw in Chapter 2.
In recent years, the Fed, through its FOMC, has chosen to focus on setting target interest
rate levels for the federal funds rate as the primary means of carrying out monetary policy.
Banks with excess reserves lend to banks that need to borrow funds to meet reserve require-
ments. Interest rates, such as the federal funds rate, refl ect the intersection of the demand for
reserves and the supply of reserves. Open-market purchases of securities cause the federal
funds rate to fall, whereas sales of securities cause the rate to rise. Of course, while the FOMC
can set targets for federal funds rates, actual federal funds rates are determined in the market
by banks with excess reserves and banks that need to borrow reserves to meet their minimum
The Fed uses its open-market operations to provide liquidity to the banking system in
times of emergency and distress. For example, the stock market crash on October 19, 1987,
caused concern about a possible economic collapse. The Fed, through FOMC open-market
purchases, moved quickly to increase the money supply. The terrorist attacks on September
11, 2001, caused widespread concern about the near-term ability of stock and other fi nan-
cial markets to function properly with a related possibility of economic collapse. The FOMC
moved quickly to provide liquidity to the banking system, and to encourage renewed confi d-
ence in the fi nancial system by reducing the target rate for federal funds on September 17,
2001, from 3.5 percent to 3.0 percent.
In 2001, the FOMC further lowered its target for the federal funds rate to 2.5 percent
on October 2, to 2.0 percent on November 2, and fi nally to 1.75 percent on December 11. A
target rate reduction to 1.25 percent occurred on November 6, 2002, and this was followed
by a further reduction in the target rate to 1.0 percent on June 25, 2003. As the U.S. economy
began growing, concern shifted to the possibility of renewed infl ation, causing the Fed to
begin increasing the target for the federal funds rate in 2004.
Although the target for the federal funds rate was 5.25 percent at the end of 2006, target
rates were reduced quickly as the 2007–08 fi nancial crisis developed and the 2008–09 Great
Recession began. In December 2008, the FOMC established a near-zero target federal funds
rate range, between 0.00 and 0.25 percent. This 0.00–0.25 percent target was subsequently
maintained until December 2015 when the target federal funds rate range was increased to
0.25–0.50 as the initial step toward monetary policy normalization. Actual federal funds
rate data collected by the St. Louis Fed Reserve Bank shows a close correlation between
federal funds rate interest rate on overnight loans from banks with
excess reserves to banks that have
defi cit reserves
Copyright © 2017 John Wiley & Sons, Inc.
4.5 Fed Supervisory and Regulatory Functions 93
the target and observed rates over the 2008–2015 time period. Eff ective December year-end
federal funds rates ranged from 0.07 to 0.24 percent. The 0.24 percent occurred in Decem-
ber 2015 when the FOMC announced an increase in its target for the federal funds rate.
As a result of the severity of the 2007–08 fi nancial crisis and the beginning of the Great
Recession, the Fed took unusual steps to avoid a possible fi nancial collapse. In addition
to setting target federal rates at near zero levels in December 2008, the Fed engaged in a
nontraditional monetary activity called quantitative easing in late 2008. As discussed in
the previous section, the Fed aggressively purchased U.S. Treasury, government agency,
and mortgage-backed securities from banks and other fi nancial institutions so as to provide
even more monetary liquidity in the fi nancial system. Round two of quantitative easing was
implemented in 2010 and round three in 2012 in an eff ort to encourage economic growth
through further monetary liquidity.
LEARNING ACTIVITY Go to the St. Louis Federal Reserve Bank’s website, http://www.stlouisfed.org, and fi nd the current Fed discount rate (primary credit rate) charged by Federal Reserve Banks on loans to depository institutions. Describe recent changes or trends in the discount or primary credit rate.
4.5 Fed Supervisory and Regulatory Functions A strong and stable banking system is vital to the growth and the stability of the entire eco-
nomy. The supervision of commercial banks and other depository institutions is primarily
concerned with the safety and soundness of individual institutions. It involves oversight to
ensure that depository institutions are operated carefully. Depository institution regulation
relates to the issuance of specifi c rules or regulations that govern the structure and conduct
Specific Supervisory Responsibilities On-site examination of commercial banks is one of the Fed’s most important responsib-
ilities. This function is shared with the federal Offi ce of the Comptroller of the Currency
(OCC), the Federal Deposit Insurance Corporation (FDIC), and state regulatory agencies.
Although the Federal Reserve is authorized to examine all member banks, in practice it
limits itself to state-chartered member banks and all bank holding companies. It cooperates
with state examining agencies to avoid overlapping examining authority. The OCC directs
its attention to nationally chartered banks, and the FDIC supervises insured nonmember
In addition to these three federal banking supervisory agencies, two federal agencies are
primarily responsible for supervising and regulating depository institutions that are not commer-
cial banks. The National Credit Union Administration (NCUA) supervises and regulates credit
unions, and the Offi ce of Thrift Supervision (OTS) oversees S&Ls and other savings institutions.
The examination generally entails (1) an appraisal of the soundness of the institution’s assets;
(2) an evaluation of internal operations, policies, and management; (3) an analysis of key fi nan-
cial factors, such as capital and earnings; (4) a review for compliance with all banking laws and
regulations; and (5) an overall determination of the institution’s fi nancial condition.
The Federal Reserve conducts on-site inspections of parent bank holding companies and
their nonbank subsidiaries. These inspections include a review of nonbank assets and funding
activities to ensure compliance with the Bank Holding Company Act.
The Federal Reserve has broad powers to regulate the overseas activities of member
banks and bank holding companies. Its aim is to allow U.S. banks to be fully competitive
with institutions of host countries in fi nancing U.S. trade and investment overseas. Along
with the OCC and the FDIC, the Federal Reserve also has broad oversight authority to
Copyright © 2017 John Wiley & Sons, Inc.
94 C H A P T E R 4 Federal Reserve System
supervise all federal and state-licensed branches and agencies of foreign banks operating in
the United States.
Specific Regulatory Responsibilities The Federal Reserve has legal responsibility for the administration of the Bank Holding Com-
pany Act of 1956, the Bank Merger Act of 1960, and the Change in Bank Control Act of
1978. Under these acts, the Fed approves or denies the acquisitions of banks and other closely
related nonbanking activities by bank holding companies. Furthermore, it permits or rejects
changes of control and mergers of banks and bank holding companies.
The Federal Reserve is responsible for writing rules or enforcing a number of major
laws that off er consumers protection in their fi nancial dealings. In 1968 Congress passed the
Consumer Credit Protection Act, which requires the clear explanation of consumer credit costs and garnishment procedures (taking wages or property by legal means) and prohibits
overly high-priced credit transactions. Regulation Z, which was drafted by a Federal Reserve task force, enacts the Truth in Lending section of the act. The purpose of the law and Reg-
ulation Z is to make consumers aware of, and able to compare, the costs of alternate forms
of credit. Regulation Z applies to consumer fi nance companies, credit unions, sales fi nance
companies, banks, S&Ls, residential mortgage brokers, credit card issuers, department stores,
automobile dealers, hospitals, doctors, dentists, and any other individuals or organizations that
extend or arrange credit for consumers.
The law requires a breakdown of the total fi nance charge and the annual percentage rate
of charge. The fi nance charge includes all loan costs, including not only interest or discount
but service charges, loan fees, fi nder fees, insurance premiums, and points (an additional loan
charge). Fees for such items as taxes not included in the purchase price, licenses, certifi cates of
title, and the like may be excluded from the fi nance charge if they are itemized and explained
separately. Figure 4.4 lists the Truth in Lending and other consumer protection acts that fall under Fed jurisdiction.
In addition to consumer protection laws, the Federal Reserve, through the Community
Reinvestment Act of 1977, encourages depository institutions to help meet the credit needs
of their communities for housing and other purposes, while maintaining safe and sound oper-
ations. This is particularly true in neighborhoods of families with low or moderate income.
Consumer Credit Protection Act 1968 act requiring clear explanation
of consumer credit costs and
prohibiting overly high-priced
Regulation Z enacts Truth in Lending section of the Consumer
Credit Protection Act with intent to
make consumers able to compare
costs of alternate forms of credit
• The Truth in Lending section of the Consumer Credit Protection Act requires disclosure of the finance charge and the annual percentage rate of credit along with certain other costs and terms
to permit consumers to compare the prices of credit from different sources. This act also limits
liability on lost or stolen credit cards.
• The Fair Credit Billing Act sets up a procedure for the prompt correction of errors on a revolving charge account and prevents damage to credit ratings while a dispute is being settled.
• The Equal Credit Opportunity Act prohibits discrimination in the granting of credit on the basis of sex, marital status, race, color, religion, national origin, age, or receipt of public assistance.
• The Fair Credit Reporting Act sets up a procedure for correcting mistakes on credit records and requires that records be used only for legitimate business purposes.
• The Consumer Leasing Act requires disclosure of information to help consumers compare the cost and terms of one lease of consumer goods with another and to compare the cost of leasing
versus buying on credit or for cash.
• The Real Estate Settlement Procedures Act requires disclosure of information about the services and costs involved at the time of settlement when property is transferred from seller to buyer.
• The Electronic Fund Transfer Act provides a basic framework regarding the rights, liabilities, and responsibilities of consumers who use electronic transfer services and of the financial institutions
that offer them.
• The Federal Trade Commission Improvement Act authorizes the Federal Reserve BOG to identify unfair or deceptive acts or practices on the part of banks and to issue regulations to
Source: The Federal Reserve System Purposes & Functions, Board of Governors of the Federal Reserve System, Washington, D.C.
FIGURE 4.4 Consumer Protection Responsibilities of the Federal Reserve System
Copyright © 2017 John Wiley & Sons, Inc.
4.6 Fed Service Functions 95
LEARNING ACTIVITY Go to the Federal Reserve Board of Governor’s website, http://www.federalreserve.gov, and fi nd the Fed’s list of regulations. Write a brief summary about the materials on Regulation Z.
4.6 Fed Service Functions The Reserve Banks provide a wide range of important services to depository institutions and
to the U.S. government. The most important of these services is the payments mechanism, a
system whereby billions of dollars are transferred each day. Other services include electronic
fund transfers, net settlement facilities, safekeeping and transfer of securities, and serving as
fi scal agent for the United States.
The Payments Mechanism An effi cient payments mechanism is necessary for the monetary system to carry out the
fi nancial function of transferring money, which in turn is a requirement for an eff ective
fi nancial system. For a review of how checks have traditionally been processed through the
banking system, refer to Figure 3.4 in Chapter 3. Recall that banks can clear checks either
directly with one another or indirectly through bank clearinghouses. Checks also can be
processed or cleared through the Federal Reserve Banks. The payments mechanism admin-
istered by the Fed also includes providing currency and coin and electronic funds transfers.
Electronic forms of payment are replacing the check as a payment method. Included
alternatives are credit cards, debit cards, and online account transfers. Furthermore, instead of
transporting and sorting paper checks, more and more banks electronically process the checks
Coin and Currency Even though the movement toward a cashless society continues, the United States remains highly dependent on currency and coin to conduct transactions. The
Fed is responsible for ensuring that the economy has an adequate supply of cash to meet the
public’s demand. Currency and coin are put into or retired from circulation by the Reserve
Banks, which use depository institutions for this purpose. Virtually all currency in circulation
is in the form of Federal Reserve notes. These notes are printed by the Bureau of Engraving
and Printing of the U.S. Treasury.
Check Clearance and Collection One of the Fed’s important contributions to the smooth fl ow of fi nancial interchange is to facilitate the clearance and collection of checks of
The Fed and the Consumer
The Fed aff ects personal fi nance in several ways. First, the Fed
controls the money supply. Actions that severely restrict the sup-
ply of money may lead to an economic recession. Too rapid a
growth in the money supply may result in infl ation and a decrease
in purchasing power. Should the Fed act to slow down or reduce
the growth rate of the money supply, there will be growing con-
straints on the ability of banks to lend as their excess reserves
decline. This may result in higher loan rates, as loanable funds
become scarcer. This could help bank savers, however, as banks
and other depository institutions may raise the interest they pay
on saving accounts and CDs to attract more funds that they will
later lend to others.
The Fed acts in other ways to maintain people’s trust and
confi dence in the banking system. As this chapter discusses, the
Fed has supervisory power over many banks to ensure they have
adequate capital and reserves and are following regulations. The
Fed’s Regulation Z requires lenders to tell borrowers the annual
percentage rate on the loans they receive. The Fed clears checks
by transporting them between banking centers and by debiting and
crediting bank balances with the Fed.
Personal Financial Planning
Copyright © 2017 John Wiley & Sons, Inc.
96 C H A P T E R 4 Federal Reserve System
the depository institutions of the nation. Each Reserve Bank serves as a clearinghouse for all
depository institutions in its district, provided that they agree to pay the face value on checks
forwarded to them for payment. Today, nearly all the checks processed for collection by Federal
Reserve Banks are received as electronic check images.
Let’s illustrate how the check-clearing process traditionally took place through Reserve
Banks. Assume that the owner of a business in Sacramento, California, places an order for
merchandise with a distributor in San Francisco. The order is accompanied by a check drawn
on the owner’s bank in Sacramento. The distributor deposits the check with its bank in San
Francisco, at which time the distributor receives a corresponding credit to its account with the
bank. The distri-butor’s bank will send the check to the Reserve Bank of its district, also loc-
ated in San Francisco. The Reserve Bank will forward the check to the bank in Sacramento on
which the check was drawn. The adjustment of accounts is accomplished at the Reserve Bank
through an alternate debit and credit to the account of each bank involved in the transaction.
The San Francisco bank, which has honored the check of its customer, will receive an increase
in its reserves with the Reserve Bank, while the bank in Sacramento will have its reserves
decreased by a corresponding amount. The bank in Sacramento will then reduce the account
of the business on which the check was written. Notice that the exchange takes place without
any transfer of currency.
Check Clearance Among Federal Reserve Districts If an order was also placed by the Sacramento fi rm with a distributor of goods in Chicago, the check would be
subject to an additional step in being cleared through the Fed. The Chicago distributor, like
the San Francisco distributor, deposits the check with the bank of its choice and, in turn, re-
ceives an increase in its account. The Chicago bank deposits the check for collection with the
Reserve Bank of Chicago, which forwards the check to the Reserve Bank of San Francisco.
The Reserve Bank of San Francisco, of course, then presents the check for payment to the
bank on which it was drawn. Thus, there are two routes of check clearance: the intradistrict settlement, in which the transaction takes place entirely within a single Federal Reserve dis- trict, and the interdistrict settlement, in which there are relationships between banks of two Federal Reserve districts.
As described, Reserve Banks are able to minimize the actual fl ow of funds by increas-
ing or decreasing reserves of the participating depository institutions. In the same way, the
Interdistrict Settlement Fund eliminates the fl ow of funds between the Reserve Banks needed
to make interdistrict settlements. The Interdistrict Settlement Fund in Washington, D.C., has
a substantial deposit from each of the Reserve Banks. These deposit credits are alternately
increased or decreased, depending on the clearance balance of the day’s activities on the part
of each Reserve Bank. At a certain hour each day, each Reserve Bank informs the Interdistrict
Settlement Fund by direct wire of the amount of checks it received the previous day that were
drawn upon depository institutions in other Federal Reserve districts. The deposit of each
Reserve Bank with the Interdistrict Settlement Fund is increased or decreased according to the
balance of the day’s check-clearance activities.
Check Clearance Through Federal Reserve Branch Banks Branch banks of the Reserve Banks enter into the clearance process in a very important way. If a check is
deposited with a depository located closer to a Reserve Branch Bank than to a Reserve Bank,
the branch bank, in eff ect, takes the place of the Reserve Bank. The Federal Reserve facilitates
the check-clearing services of the Reserve Banks and their branches by maintaining a small
group of regional check-processing centers.
Check Routing In the past, a many employees at the 12 Reserve Banks were engaged in check clearing. Fundamental to the clearance process was the need to read the system of
symbols and numerals shown in Figure 4.5. Although these symbols are slightly diff erent from conventional numbers, they are easily read and are referred to as the magnetic ink
character recognition (MICR) line. Information about the clearance process is printed on
the lower part of the check. In addition to the clearance symbol, banks include a symbol for
each customer’s account. Banks also continue to include the older check routing symbol in
Copyright © 2017 John Wiley & Sons, Inc.
4.6 Fed Service Functions 97
the upper right-hand corner of their checks. Today, banks can keep an image of a check and
process payment electronically through automated clearing houses (ACHs). Banks now also
have several ways to clear checks.
Transfer of Credit The Fed provides for the transfer of hundreds of millions of dollars in depository balances
around the country daily. The communication system called Fedwire may be used by depos-
itory institutions to transfer funds for their own accounts, to move balances at correspondent
banks, and to send funds to another institution on behalf of customers.
Other Service Activities A large portion of Fed employees hold jobs directly related to the Fed’s role as fi scal agent for the U.S. government. The services include holding the Treasury’s checking accounts; assist-
ing in the collection of taxes; transferring money from one region to another; and selling,
redeeming, and paying interest on federal securities. The federal government makes most of
its payments to the public from funds on deposit at the Reserve Banks. The Fed also acts as
fi scal agent for foreign central banks and international organizations such as the International
J. C. MORRISON 1765 SHERIDAN DRIVE
YOUR CITY, U.S.A. 12345
PAY TO THE
ORDER OF $
One Wall Street New York, New York 10015
SAMPLE – VOID DOLLARS
(Irving Trust Company)
1 2 9
State or City
(New York City)
Customer’s Account Number
Federal Reserve District
Federal Reserve Bank
of New York
Immediate Credit Availability
in New York
Routing Number Check Digit (8)
ABA Bank Number (0067)
Routing Symbol (0210)
FIGURE 4.5 Traditional Use of Check Routing Symbols
Copyright © 2017 John Wiley & Sons, Inc.
98 C H A P T E R 4 Federal Reserve System
4.7 Central Banks in Other Countries GLOBAL Central banks in other developed countries, like the U.S. Fed, are responsible for regu-
lating the country’s money supply, safeguarding the country’s currency, and carrying out the
country’s monetary policy. Most other countries have a single central bank with branches that
diff er from the Fed’s 12 Reserve Banks. Of course, the Fed BOG has eff ectively centralized
control of U.S. monetary policy.
Empirical evidence shows a link between central bank independence from government inter-
vention and infl ation and economic growth rates. In countries where central banks are relatively
independent from their governments, there have generally been lower infl ation rates and higher
economic growth rates than in countries where central banks are closely tied to their governments.
Three economically important foreign central banks are those of the United Kingdom,
Japan, and the European Monetary Union. The central bank in the United Kingdom is the Bank of England (BOE). It was created well before the formation of the Federal Reserve System in 1913. The BOE is managed by a governor and fi ve additional offi cers, all of whom are appointed
for fi ve-year terms. The BOE governor reports to the chancellor, who has fi nal responsibility for
setting monetary policy. In contrast with the United States, commercial banks in Great Britain
are not required to hold reserves at the Bank of England. Also, recall from Chapter 3 that Great
Britain does not legally separate commercial banking and investment banking activities.
The central bank of Japan, called the Bank of Japan (BOJ), was created in 1947. The top offi cial of the BOJ is the governor, who heads the Policy Board, which is the central decision-
making authority. The governor and some members of the board are appointed by the Japanese
equivalent of the U.S. Congress, and other board members are appointed by the fi nance minister.
Japanese commercial banks, like their U.S. counterparts, are required to hold reserves on deposit
with the BOJ, and banks can borrow at an offi cial discount rate from the BOJ.
The European Central Bank (ECB) conducts monetary policy for the European coun- tries that belong to the European Monetary Union and also have adopted the euro as their com-
mon currency. Eleven European countries joined in 1999 and Greece was admitted in 2001.
Euro notes and coins were offi cially introduced at the beginning of 2002, and all 12 individual
national currencies were withdrawn as legal tender by July 1, 2002. The number of “eurozone”
members has recently increased to 19 countries. The ECB, which is headquartered in Frank-
furt, Germany, is responsible for controlling infl ation and for managing the value of the euro
relative to other currencies. The ECB structure is somewhat similar to the U.S. Fed’s in that
the national central banks of the euro countries operate much like the 12 Federal Reserve
District Banks. Like the Fed BOG, the governing council of the ECB includes governors from
some of the national central banks. Each national central bank is responsible for managing
payment systems and furnishing currency and credit in its home country.
LEARNING ACTIVITY Go to the European Central Bank’s website, http://www.ecb.int, and fi nd information on how that bank is structured and how it operates.
European Central Bank (ECB) conducts monetary policy for the
European countries that adopted the
euro as their common currency
Applying Finance To… • Institutions and Markets Depository institutions, commercial banks, S&Ls, savings banks, and credit unions comprise the banking sys-
tem. The Fed is the U.S. central bank, which supervises and regulates
the banking system. The Fed, along with depository institutions, cre-
ates and transfers money. Monetary policy actions of the Fed aff ect the
primary fi nancial markets for debt obligations, infl uencing the availabil-
ity of bank loans and the interest rates that must be paid on those loans.
• Investments Securities markets, both primary and secondary, are also aff ected by Fed actions. An increase in reserve requirements will
restrict the amount of individual savings that would be available to make
loans. Other Fed actions may cause banks to raise loan interest rates, and
cause the economy to slow down and security prices to decline. When
the Fed raises the discount rate, banks react to protect their profi t mar-
gins by raising their lending rates to individuals and businesses.
• Financial Management Financial management activities are directly aff ected by Fed monetary policy actions. A tightening of monetary
policy makes it more diffi cult and costly for businesses to borrow
funds. To the extent that economic activity also declines, it is more
diffi cult for fi nancial managers to sell new stocks and bonds in the
primary securities markets. Of course, an easing of monetary policy
will make it easier for fi nancial managers to raise fi nancial capital and
they will be able to do so at lower interest rates.
Copyright © 2017 John Wiley & Sons, Inc.
Review Questions 99
Summary LO 4.1 The Federal Reserve System (Fed) responded to the recent fi n- ancial crisis and Great Recession by providing rescue funds to some
fi nancial institutions and by helping other fi nancially weak institu-
tions merge with stronger institutions. These actions were necessary
to keep many fi nancial institutions from failing due to liquidity crises
caused by precipitous declines in the values of the home mortgage
loans and mortgage-backed securities that they held because of mort-
gage loan defaults.
LO 4.2 The national banking system that existed before the Federal Reserve System was created lacked an effi cient national payments
system for transferring money, a fl exible money supply that can
respond to changes in the demand for money, and a lending/
borrowing mechanism to help alleviate liquidity problems when
LO 4.3 The Federal Reserve System is the central bank of the United States and is responsible for setting monetary policy and regulating
the banking system. The Fed is organized into fi ve major components:
(1) member banks, (2) Federal Reserve District Banks, (3) Board
of Governors, (4) Federal Open Market Committee, and (5) advisory
LO 4.4 The policy instruments used by the Fed to carry out monetary policy are changing reserve requirements, changing the discount rate,
and conducting open-market operations. In recent years, the Fed has
also engaged in a nontraditional monetary policy called quantitative
easing. Banks are required by the Fed to hold reserves equal to a
specifi ed percentage of their deposits. An increase in the required
reserves ratio reduces bank reserves, and vice versa. The Fed dis-
count rate is the interest rate that a bank must pay to borrow from its
regional Reserve Bank. Higher discount rates will discourage money
supply expansion, and vice versa. Open-market operations involves
the buying and selling of securities in the open market by the Fed
through its FOMC to alter bank reserves. The purchasing of securities
increases bank reserves, and vice versa. Quantitative easing involves
the purchasing of securities from banks and other fi nancial institu-
tions to increase the money supply and liquidity.
LO 4.5 The Fed is authorized to supervise and examine member bank assets, operations, fi nancial conditions, and compliance with banking
laws and regulations. In practice, the Fed focuses on examination of
state-chartered member banks and all bank holding companies. Nation-
ally chartered banks are examined by the Offi ce of the Comptroller of
the Currency. The Fed has legal responsibility for administering several
banking laws and is responsible for enforcing laws, such as the Con-
sumer Credit Protection Act of 1968, that help consumers understand
the costs of alternative forms of credit.
LO 4.6 Reserve Banks provide a range of services to depository insti- tutions and to the U.S. government. The most important service is the
payments mechanism for transferring money throughout the banking
system. Other services include electronic funds transfers, safekeep-
ing and transfer of securities, and serving as fi scal agent for the U.S.
LO 4.7 Foreign countries that use central banking systems, like the Fed in the United States, to regulate money supply and set monetary
policy include the United Kingdom (Bank of England), Japan (Bank
of Japan), and euro-member countries (European Central Bank).
There is some similarity between the Fed operating with 12 Federal
Reserve Banks that represent diff erent districts in the United States
and the European Central Bank operating with central banks from
each eurozone member.
Key Terms accommodative function
Consumer Credit Protection
European Central Bank (ECB)
Fed Board of Governors
Fed discount rate
federal funds rate
Federal Home Loan Mortgage
Corporation (Freddie Mac)
Federal National Mortgage
Association (Fannie Mae)
Federal Reserve System (Fed)
fractional reserve system
Government National Mortgage
Association (Ginnie Mae)
primary credit rate
quantitative easing (QE)
required reserves ratio
Review Questions 1. (LO 4.1) Identify some of the institutional participants in the mortgage markets.
2. (LO 4.1) What actions did the Fed take to help avoid a fi nancial system collapse in 2008–09?
3. (LO 4.2) Describe the weaknesses of the national banking system that was in place prior to passage of the Federal Reserve
Act of 1913.
4. (LO 4.2) What functions and activities do central banks usually perform?
5. (LO 4.3) Describe the organizational structure of the Federal Reserve System in terms of its fi ve major components.
6. (LO 4.3) Explain how the banking interests of large, medium, and small businesses are represented on the board of directors of each
Copyright © 2017 John Wiley & Sons, Inc.
100 C H A P T E R 4 Federal Reserve System
Exercises 1. You are a resident of Seattle, Washington, and maintain a check- ing account with a bank in that city. You have just written a check
on that bank to pay your tuition. Describe the process by which the
banking system enables your college to collect the funds from your
2. As the executive of a bank or thrift institution you are faced with an intense seasonal demand for loans. Assuming that your loanable
funds are inadequate to take care of the demand, how might your
Reserve Bank help you with this problem?
3. The Federal Reserve Board of Governors has decided to ease mon- etary conditions to counter early signs of an economic downturn.
Because price infl ation has been a burden in recent years, the Board is
eager to avoid any action that the public might interpret as a return to
infl ationary conditions. How might the Board use its various powers
to accomplish the objective of monetary ease without drawing unfa-
vorable publicity to its actions?
4. An economic contraction (recession) is now well under way, and the Fed plans to use all facilities at its command to halt the decline.
Describe the measures that it may take.
5. You have recently retired and are intent on extensive travel to many of the exotic lands you have only read about. You will be receiving
not only a pension check and Social Security check but also dividends
and interest from several corporations. You are concerned about the
deposit of these checks during your several months of absence, and
you have asked your banker if there is an arrangement available to
solve this problem. What alternative might the banker suggest?
6. The prime rate, and other interest rates, off ered by banks often change in the same direction as a change in the Fed’s target for the
federal funds rate. As an employee of a Federal Reserve District Bank
you have been told that your district bank will be increasing its dis-
count rate early next week. Expectations are that an increase in the
discount rate will lead to an increase in the federal funds rate, which
will lead to an increase in the prime rate and other bank lending rates.
You have been thinking about buying a new automobile for the past
couple of months. Given this information of a planned discount rate
increase, you are considering buying your new automobile before the
end of the week. What are the ethical issues, if any, involved in this
scenario? What would you do?
Problems 1. A new bank has vault cash of $1 million and $5 million in deposits held at its Federal Reserve District Bank.
a. If the required reserves ratio is 8 percent, what dollar amount of deposits can the bank have?
b. If the bank holds $65 million in deposits and currently holds bank reserves such that excess reserves are zero, what required re-
serves ratio is implied?
2. Assume a bank has $5 million in deposits and $1 million in vault cash. If the bank holds $1 million in excess reserves and the required
reserves ratio is 8 percent, what level of deposits are being held?
3. A bank has $110 million in deposits and holds $10 million in vault cash.
a. If the required reserves ratio is 10 percent, what dollar amount of reserves must be held at the Federal Reserve Bank?
7. (LO 4.3) What is a Reserve Branch Bank? How many such branches exist, and where are most of them located?
8. (LO 4.3) How are members of the Board of Governors of the Federal Reserve System appointed? To what extent are they subject
to political pressures?
9. (LO 4.3) Discuss the structure, functions, and importance of the Federal Open Market Committee.
10. (LO 4.3) Identify the seven individuals who served as chairs of the Fed Board of Governors since the early 1950s. Indicate each indi-
vidual’s approximate time and length of service as chair.
11. (LO 4.4) Distinguish among the dynamic, defensive, and accom- modative responsibilities of the Fed.
12. (LO 4.4) Identify and briefl y describe the three traditional instru- ments that may be used by the Fed to set monetary policy.
13. (LO 4.4) Describe what is meant by quantitative easing by the Fed. 14. (LO 4.4) Reserve Banks have at times been described as bankers’ banks because of their lending powers. What is meant by this statement?
15. (LO 4.4) Describe the two “targets” that the Fed can use when establishing monetary policy. Which target has the Fed focused on in
16. (LO 4.5) Explain the usual procedures for examining national banks. How does this process diff er from the examination of member
banks of the Federal Reserve System holding state charters?
17. (LO 4.5) What federal agencies are responsible for supervising and regulating depository institutions that are not commercial banks?
18. (LO 4.5) Describe the objectives of the Consumer Credit Pro- tection Act of 1968. What is the Truth in Lending section of the act?
What is Regulation Z?
19. (LO 4.6) Explain the process by which the Federal Reserve Banks provide the economy with currency and coin.
20. (LO 4.6) Describe how a check drawn on a commercial bank but deposited for collection in another bank in a distant city might be
cleared through the facilities of the Federal Reserve System.
21. (LO 4.6) What is the special role of the Federal Reserve Inter- district Settlement Fund in the check-clearance process?
22. (LO 4.6) In what way do the Reserve Banks serve as fi scal agents for the U.S. government?
23. (LO 4.7) Briefl y describe and compare the central banks in the United Kingdom, Japan, and Economic Monetary Union.
Copyright © 2017 John Wiley & Sons, Inc.
b. How would your answer in Part (a) change if the required reserves ratio was increased to 12 percent?
4. A bank has $10 million in vault cash and $110 million in deposits. If total bank reserves were $15 million with $2 million considered to
be excess reserves, what required reserves ratio is implied?
5. The Friendly National Bank holds $50 million in reserves at its Federal Reserve District Bank. The required reserves ratio is
a. If the bank has $600 million in deposits, what amount of vault cash would be needed for the bank to be in compliance with the
required reserves ratio?
b. If the bank holds $10 million in vault cash, determine the re- quired reserves ratio that would be needed for the bank to avoid a
reserves defi cit.
c. If the Friendly National Bank experiences a required reserves defi cit, what actions can it take to be in compliance with the exist-
ing required reserves ratio?
6. Assume that banks must hold a 2 percent reserve percentage against transaction account balances up to and including $40 mil-
lion. For transaction accounts above $40 million, the required reserve
percentage is 8 percent. Also assume that Dell National Bank has
transaction account balances of $200 million.
a. Calculate the dollar amount of required reserves that Dell National Bank must hold.
b. What percentage of Dell’s total transaction account balance must be held in the form of required reserves?
7. Assume that the Fed decides to increase the required reserve per- centage on transaction accounts above $40 million from 8 percent
to 10 percent. All other information remains the same as given in
Problem 6, including the transaction account balances held by Dell
a. What would be the dollar amount of required reserves? b. What percentage of total transaction account balances held by Dell would be held as required reserves?
8. Show how your answers in Problem 6 would change if the Fed lowered the cut-off between the 2 percent rate and the 8 percent rate
from $40 million in transaction account balances down to $20 million.
9. Challenge Problem You have been asked to assess the impact of possible changes in reserve requirement components on the dollar
amount of reserves required. Assume the reserve percentages are set
at 2 percent on the fi rst $50 million of transaction account amounts,
4 percent on the second $50 million, and 10 percent on transaction
amounts over $100 million. First National Bank has transaction
account balances of $100 million, while Second National Bank’s
transaction balances are $150 million and Third National Bank’s
transaction balances are $250 million.
a. Determine the dollar amounts of required reserves for each of the three banks.
b. Calculate the percentage of reserves to total transactions accounts for each of the three banks.
c. The central bank wants to slow the economy by raising the re- serve requirements for member banks. To do so, the reserve per-
centages will be increased to 12 percent on transaction balances
above $100 million. Simultaneously, the 2 percent rate will apply
on the fi rst $25 million. Calculate the reserve requirement amount
for each of the three banks after these changes have taken place.
d. Show the dollar amount of changes in reserve requirement amounts for each bank. Calculate the percentage of reserve require-
ment amounts to transaction account balances for each bank.
e. Which of the two reserve requirement changes discussed in (c) causes the greatest impact on the dollar amount of reserves for
all three of the banks?
f. Now assume that you could either (1) lower the transactions account amount for the lowest category from $50 million down
to $25 million or (2) increase the reserve percentage from
10 percent to 12 percent on transactions account amounts over
$200 million. Which choice would you recommend if you were
trying to achieve a moderate slowing of economic activity?
Copyright © 2017 John Wiley & Sons, Inc.