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Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Organization of the Fed Monetary policy tools Impact of technical factors on funds Fed control of the money supply Monetary Control Act of 1980 Global monetary policy
Reserve district banks Member banks Board of Governors Federal Open Market Committee (FOMC) Advisory committees
Commercial banks that become members of the Fed must purchase stock in their district banks
Pays a maximum dividend of 6% annually Six elected by member banks; three appointed by the Board of Governors The nine directors appoint the president of the district bank
District banks clear checks, replace old currency, provide loans to depository institutions, and conduct research
Member banks
All
national banks are required to be members of the Fed State-chartered banks are not required to be members About 35% of all banks are members
Board of Governors
The Board of Governors consists of seven Each member is appointed by the President
members of the
Reduces political pressure Terms are staggered so that one term expires in every evennumbered year
FOMC consists of the seven members of the Board of Governors plus the presidents of five Fed district banks
Goals:
Decisions
on changes in monetary policy are forwarded to the Trading Desk (Open Market Desk) at the NY Fed district bank
Advisory committees
The Federal Advisory Council consists of one member from each district
Makes recommendations to the Fed about economic and banking issues Represents the financial institutions industry and its consumers
The Thrift Institutions Advisory Council consists of representatives of savings banks, S&Ls, and credit unions
Board of Governors Regulates member banks and BHCs Sets reserve requirements Federal Open Market Committee Conducts open market operations
Supervision Federal Reserve District Banks Clear checks Replace old currency Provide loans to depository institutions
The FOMC meets 8 times a year At each meeting, the target money supply growth level and interest rate level are determined FOMC meeting agenda
Members receive the Beige Book two weeks prior to the meeting Meeting is attended by the Board of Governors, the 12 presidents of the district banks, and staff members Staff members begin with presentations about current economic conditions and recent economic trends Next, each FOMC member can offer recommendations about whether monetary growth and interest rate target levels should be changed Last, voting members vote on monetary policy and interest rates
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The FOMCs decision on target money supply levels is forwarded to the Trading Desk at the NY district bank through a policy directive FOMC objectives are specified in a target range for the money supply growth The FOMC also specifies a desired target for the federal funds rate
The federal funds rate is the rate charged by banks on shortterm loans to each other
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The manager of the Trading Desk instructs traders on the amount of government securities to buy or sell in the secondary market
The Trading Desk continuously conducts open market operations in response to ongoing changes in bank deposit levels
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Dealers provide a list of securities for sale Traders purchase those that are most attractive
The total funds of commercial banks increase by the dollar amount of securities purchased by the Fed
To force a decline in the Fed funds rate, the Trading Desk can also purchase Treasury securities
The Fed funds rate will decline along with other interest rates
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sale of securities
To decrease the money supply, traders sell government securities to government securities dealers
As dealers pay, their account balances are reduced and the total amount of funds at commercial banks is reduced
To force an increase in the Fed funds rate, the Trading Desk can also sell Treasury securities
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Used to increase the aggregate level of bank funds for only a few days The Trading Desk trades repurchase agreements rather than government securities
Purchases Treasury securities with an agreement to sell back the securities at a specified date in the near future
When the Fed uses open market operations to increase bank funds, interest rates are affected because:
The fed funds rate may decline Banks with excess funds may offer new loans at a lower interest rate Banks may lower interest rates on deposits The yield on Treasury securities may decline
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The Fed loosened the money supply to provide liquidity The Fed monitored bank deposits to ensure there was no run on deposits The Fed monitored credit relationships between commercial banks and securities firms
Open
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increase the money supply, the Fed can authorize a reduction in the discount rate
Encourages depository institutions to borrow from the Fed
To
decrease the money supply, the Fed can increase the discount rate
Discouraged borrowing from the Fed
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January 2003 the Fed classified its loans as primary or secondary credit
Primary credit can be used for any purpose but it available only to financially sound institutions Secondary credit is provided to banks that do not qualify for secondary credit
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the Fed has often adjusted the discount rate to keep it in line with changes in the targeted federal funds rate In January 2003, the Fed set the discount rate at a level above the federal funds rate
Loans from the Fed serve as a backup source of funds The discount rate no longer serves as a signal about the Feds monetary policy
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reserve requirement ratio is the proportion of bank deposits that must be held as reserves
Set by the Board of Governors Historically set between 8 and 12 percent
Currently 10 percent of transaction accounts A reduction increases the proportion of bank deposits that can be lent out
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The volume of funds can change without the Feds intervention because of:
Federal
Reserve float
The amount of checks credited to banks funds that have not yet been collected
Currency
in circulation
Staff at the NY Fed and the Board of Governors provide daily forecasts of how technical factors will affect the level of funds
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M2 includes everything in M1 plus savings accounts and small time deposits, money market deposit accounts (MMDAs), and other items M3 includes everything in M2 plus large time deposits and other items
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may be difficult for the Fed to simultaneously control money supply growth and the federal funds rate
In October 1979 it focused primarily on the money supply In the last several years, the Fed focused on maintaining the federal funds rate within a narrow target range In 2000, the Fed reduced its focus on the use of specific money supply target ranges
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The Depository Institutions Deregulations and Monetary Control Act (DIDMCA) of 1980 had two objectives:
To
deregulate some aspects of the depository institutions industry To enhance the Feds ability to control the money supply
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DIDMCA mandates that all depository institutions be subject to the same reserve requirements imposed by the Fed
All depository institutions must report their deposit levels promptly to the Fed
Improves the Feds knowledge of the current level of deposits in the banking system
DIDMCA allowed all depository institutions that offer transaction accounts to have access to the discount window
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Central banks of other countries use open market operations, reserve requirement adjustment, and adjustments in the interest rate they charge on loans The Fed must consider economic conditions in other major countries when assessing the U.S. economy
Coordinating
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On June 1, 2002, the euro replaced the currencies of 12 European countries The European Central Bank (ECB) sets monetary policy for all participating countries
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Sometimes central banks of various countries coordinate efforts for a common cause
After September 11, 2001, central banks of various countries injected money into the banking system to provide more liquidity On September 17, 2001, several central banks reduced their interest rates If two countries attempt to weaken their currencies simultaneously, the exchange rate is subject to conflicting forces
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