FIN 433
Chapter 4
4. Functions of the Fed
Overview
The central bank
The central bank of a country
▪ acts as the government’s banker and the bankers’ bank
▪ implements monetary policies
▪ controls the country’s money supply
▪ determines interest rates
▪ manages the country’s foreign exchange reserves
▪ regulates and supervises the banking industry
List of central banks
The central bank
A list of countries and their central banks:
▪ USA: the Federal Reserve System (or the Fed)
▪ EU: European Central Bank
▪ UK: Bank of England
▪ Canada: Bank of Canada
▪ India: Reserve Bank of India
▪ Australia: Reserve Bank of Australia
▪ China: People’s Bank of China
Organizational structure of the Fed
The Fed
The Fed has five major components
▪ Federal Reserve district banks (map, page 72)
▪ Member banks
▪ Board of Governors
▪ Federal Open Market Committee (FOMC)
▪ Advisory Committees
Organizational structure of the Fed
Federal Reserve district banks
▪ Twelve district banks: Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago,
St. Louis, Minneapolis, Kansas City, Dallas and San
Francisco
▪ The most important bank: New York
▪ Commercial banks can become members of the Fed by
buying stock in their district bank.
▪ This stock cannot be traded in a secondary market.
▪ Maximum dividend = 6% annually
Organizational structure of the Fed
Federal Reserve district banks
▪ Each district bank has nine directors:
▪ three class A directors – representatives of banks
▪ three class B directors – public voted in by the banks
▪ three class C directors – appointed by the Board of Governors
▪ Class B and class C directors appoint the President of
the district banks.
▪ Fed district banks clear checks, replace old currency
and provide loans to depository institutions in need.
▪ Fed district banks collect data and conduct research
projects.
Organizational structure of the Fed
Member banks
▪ Commercial banks can become member banks of the
Fed by buying stock of the Fed district bank.
▪ Elect six of nine directors in the district bank.
▪ 38% of American banks are members of the Fed
Organizational structure of the Fed
Board of Governors
▪ Seven members appointed by the U.S. President for
14-year terms (non-renewable)
▪ One of the members chosen as the Chair of the Federal
Reserve for a four-year term (renewable)
▪ Sets credit controls (margin requirements).
▪ Has the power to revise reserve requirements
▪ Participates in the FOMC decisions to control money
supply.
Organizational structure of the Fed
Federal Open Market Committee
▪ Seven BoG members plus 5 Fed district bank
Presidents
▪ The Chair of the BoG is also the Chair of the FOMC
▪ Main goals include stable economic growth with low
inflation by controlling money supply.
Organizational structure of the Fed
Advisory Committees
▪ Federal Advisory Council
Makes recommendations about economic and banking issues
▪ Consumer Advisory Council
Offers views on economic circumstances and the financial services
needs of consumers and communities, especially low and moderate-income
people
▪Community Depository Institutions Advisory Council
Offers views on issues related to savings banks, savings and loans
associations, and credit unions.
How the Fed controls money supply
The Fed
The Fed controls money supply to affect interest rates.
▪ Open market operations
▪ Role of the Fed’s Trading Desk
▪ Adjusting the Reserve Requirement Ratio
▪ Adjusting the Fed’s Loan Rate
How the Fed controls money supply
Federal Open Market Committee
▪ Meets eight times a year.
▪ Targets for the money supply growth level and the
interest rate level determined
▪ Actions taken to implement monetary policy dictated
by the FOMC
How the Fed controls money supply
Pre-Meeting Economic Reports
▪ The Beige book sent to FOMC members two weeks
before the FOMC meeting
▪ A consolidated report of economic conditions in each
of the 12 districts
▪ Analyses of the economy and economic forecasts sent
to FOMC members one week before the meeting
How the Fed controls money supply
Economic Presentations
▪ Presentations by staff members (usually economists)
to the Board of Governors and districts bank presidents
▪ Include data and trends for wages, consumer prices,
unemployment, GDP, business inventories, forex rates,
interest rates and financial market conditions
▪ Assessment conducted to predict economic growth
and inflation
▪ Much attention paid to factors (such as oil prices) that
can affect inflation
How the Fed controls money supply
FOMC decisions
▪ FOMC members make recommendations about the
federal funds rate
▪ A weakening economy might lead to
recommendations to lower federal funds rate to
stimulate the economy
▪ In December 2008, federal funds rate lowered to 0.00 –
0.25%
How the Fed controls money supply
FOMC statement
▪ FOMC statement summarizing the recommendations
provided at the end of the FOMC meeting
▪ Clearly written statement with meaningful details
▪ Made publicly available on the Federal Reserve’s
website
How the Fed controls money supply
Role of the Fed’s trading desk
▪ FOMC decisions forwarded to the Trading Desk (or
Open Market Desk) in a policy directive
▪ Traders instructed to buy or sell government securities
(known as open market operations)
How the Fed controls money supply
Fed Purchase of Securities
▪ Traders at the Trading Desk purchase Treasury
securities to lower federal funds rate.
▪ Fed purchase of treasury securities through securities
dealers increases the bank account balances of the
dealers and the total deposit in the banking system.
▪ This increase in the supply of funds places downward
pressure on federal funds rate.
▪ Such activity represents a loosening of money supply
growth.
How the Fed controls money supply
Fed Sale of Securities
▪ Traders at the Trading Desk sell Treasury securities to
increase federal funds rate.
▪ Fed sale of treasury securities through securities
dealers decreases the bank account balances of the
dealers and the total deposit in the banking system.
▪ This decrease in the supply of funds places upward
pressure on federal funds rate.
▪ Such activity represents a tightening of money supply
growth.
How the Fed controls money supply
Fed Trading of Repos
▪ Traders at the Trading Desk buy repurchase
agreements to increase bank funds for a few days to
ensure liquidity in the banking system for those days.
▪ The level of funds rises initially for a few days as the
Fed buys Treasury securities and then falls as the Fed
sells the Treasury securities back after a few days.
▪ This is done during holidays to correct temporary
imbalances.
How the Fed controls money supply
How the Fed Operations Affect All Interest Rates
▪ The use of open market operations to increase bank
funds can affect all interest rates.
▪ The federal funds rate may decline because banks may
have a larger supply of excess funds to lend out in the
federal funds market.
▪ Banks with excess funds may offer new loans at a
lower interest rate to make use of these funds.
▪ These banks may lower interest rates on deposits
because they have excess liquidity.
How the Fed controls money supply
How the Fed Operations Affect All Interest Rates
▪ When the Fed buy Treasury bills, it places upward
pressure on the prices of T-bills.
▪ Higher prices translate to lower yields for T-bills.
▪ Bank rates are also lowered, as previously discussed.
▪ Investors search for alternative investments.
▪ As more funds are invested in alternative securities,
their yields decline.
▪ The reduction in yields lowers the cost of borrowing.
▪ This encourages potential borrowers to borrow and
spend.
How the Fed controls money supply
Adjusting the Reserve Requirement Ratio
▪ Depository institutions (e.g. banks) must keep a
portion of their reserves with the central bank.
▪ Also called cash reserve ratio (CRR)
▪ A monetary policy tool because money supply can be
affected by changing CRR
▪ A lower CRR increases the proportion of a bank’s
deposits that can be lent out.
▪ As the funds loaned out are spent, a portion of these
loans come back in the form of new deposits.
▪ The lower the CRR, the greater is the lending capacity
of depository institutions.
Bangladesh Bank
Structure
▪ The government owns 100% of the shares.
▪ Four-year appointment for the governor, renewable
until retirement age.
Click here to read the latest monetary policy statement from the
Bangladesh Bank.