2. The Federal Reserve System, Monetary Policy, and Interest Rates

2. The Federal Reserve System, Monetary Policy, and Interest Rates Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2. The Federal Reserve System, Monetary Policy, and Interest Rates   The Federal Reserve(the Fed): central bank of the U.S. To Provide the Nation with a Safer, More Flexible, and More Stable Monetary and Financial System. within the Framework of the Overall Objectives of Economic and Financial Policies.  Four Major Functions: 1) Conduct Monetary Policy  2) Supervise and Regulate Depository Institutions  3) Maintain the Stability of the Financial System Made by Ajarn. Parinya Maglin,  4) Provide Payment and Other Financial Services to the Government Department of Finance, Bangkok  Commericial Campus. 2.1. Structure of the Federal Reserve System  12 Federal Reserve Banks around the U.S. and a Seven-Member Board of Governor located in Washington D.C. 2.1.1. Functions Performed by Federal Reserve System 2.1.2. Organization of Federal Reserve Made by Ajarn. Parinya Maglin, Banks Department of Finance, Bangkok Commericial Campus.   2.1.1. Functions Performed by Federal Reserve Banks(FRBs)  Assistance in the Conduct of Monetary Policy  Set and change discount rate. Discount rate: interest rate on loans made by FRBs to depository institutions. Discount window: facility through which FRBs issue loans to depository institutions.  Supervision and Regulation     Supervise and regulate activities of banks located in their district. The conduct of examinations and inspections of member banks, bank holding companies, and foreign banks. The authority to issue warnings(unsafe / unsound) The authority to approve various bank and bank holding company Made by Ajarn. Parinya applications for expanded activities(M&A)Maglin, Department of Finance, Bangkok Commericial Campus. 2.1.1. Functions Performed by Federal Reserve System-1  Government Services   Serve as the commercial bank for the U.S. Treasury. Issue and redeem saving bonds and treasury securities, deliver government securities to investors, provide for a wire transfer system for these securities(theFedwire), and make payments of interest and principal on these securities. Collect and replace damaged currency from circulation. Distribute new currency to meet the public’s need for cash.  New Currency Issue    Check Clearing   Process, route, and transfer funds from one bank to another. Made by Ajarn. Parinya Maglin, Operate a central check-clearing system for U.S.banks. Department of Finance, Bangkok Commericial Campus. 2.1.1. Functions Performed by Federal Reserve System-2  Wire Transfer Services   Linked electronically through the Federal Reserve Communication. Transfer funds and securities nationwide in a matter of minutes.  Research Services  Gather, analyze, and interpret economic data and development in the banking sector as well as the overall economy by a staff of professional economists. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.1.2. Organization of Federal Reserve Banks     12 Federal Reserve districts = operating arms of the central banking system. Each district has one main FRB, some of which also have branches in other cities within the district. 3 largest FRBs(>50% TA) are the New York, Chicago, and San Francisco banks. FRBs= nonprofit: income from (1) Interest earned on government securities (2) interest earned on reserves deposited at the Fed (3) fees from the provision of payment and other services toParinya Maglin, depository Made by Ajarn. member Department of Finance, Bangkok institutions. Commericial Campus. The Board of Governors of the Federal Reserve  (also called the Federal Reserve Board): seven-member board headquartered in Washington D.C.   appointed by the president of the U.S., confirmed by the Senate. Nonrenewable 14-year term. Primary responsibilities: formulate and conduct monetary policy  supervise and regulate banks, all bank holding companies, state chartered banks, Act and agreement corporations. Made by Ajarn. Parinya Maglin,  Department of Finance, Bangkok Commericial Campus. Federal Open Market Committee  (also called FOMC): a major monetary policy making body of the Federal Reserve System.    Seven members of the Federal Reserve Board of Governors  the president of the Federal Reserve Bank of New York  the president of four other Federal Reserve Banks Formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. Set guidelines regarding open market operations(purchase and sale of Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok U.S. government and federal agency securities. Commericial Campus. Balance Sheet of the Federal Reserve  Liabilities:Currency in circulation and reserves(depository institution reserve balances plus cash on hand at commercial banks) = monetary base or money base. Currency Outside Banks: largest liabilities(85.3% of TL and Equity)  Reserve Deposits:commercial bank reserve 10.6 % of TL and Equity influencing the size of the money supply.   required reserves( Fed requires banks to hold by law) + excess reserve(additional reservesby Ajarn. Parinya Maglin, to hold themselves) that banks choose Made Department of Finance, Bangkok Commericial Campus. Balance Sheet of the Federal Reserve  ASSETS: Treasury securities: securities issued by the U.S. government.  Gold: redeemable at the U.S.Treasury  Foreign exchange and Treasury currency: assist in foreign currency transactions or currency swap agreements.  Loans to domestic banks:liquidity emergency  discourage borrowing unless a bank is in serious liquidity need.  Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2. Monetary Policy Tools  Influencing the market for bank reserves, either the demand for, or supply of, excess reserves at depository institutions and money supply and the level of interest rates.  Two basic approaches to affect the market for bank excess reserves:  1) Target the quantity of reserves in the market.  2) Target the interest rate on the reserve. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2. Monetary Policy Tools   2.2.1. Open Market Operation 2.2.2. The Discount Rate  2.2.3 Reserve Requirements Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2.1. Open Market Operation    Primary determinant of changes in bank excess reserves that directly impact the size of the money supply and the level of interest rate. Purchase securities: increase the bank’s excess reserve. Sell securities:decrease(increase) bank’s(reserve account)deposit at the Fed. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2.2. The Discount Rate      Control the level of bank reserve. Signal of the FOMC’s intentions regarding the tenor of monetary policy. Lower: enhance commercial bank borrowing Two reasons :rarely use the discount rate  difficult to predict changes in bank discount window.  Great signalling effect on the financial market. Used only when the Fed wants to send a strong message to financial markets (new monetary policy target) Drop(increase)in the discount rate signals the intention to increase money supply and ease credit availability. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2.2. The Discount Rate-1  Three types of discount window loans offered to depository institutions.  1) Adjustment Credit: Offered for short-term liquidity problems that may result from a temporary deposit outflow from a bank.(major)   expected to be repaid quickly by the end of the next business day. Basic discount rate set by the local Federal Reserve Bank.  2) Seasonal Credit: Offered to banks for seasonal liquidity squeezes.   Small bank and historical pattern of seasonality in its business. Interest rate is based on the federal funds and certificate of deposit rates. Made by Ajarn. Parinya Maglin, (a bit higher than adjustment credit loans) Department of Finance, Bangkok Commericial Campus. 2.2.2. The Discount Rate-1  Three types of discount window loans offered to depository institutions(continue)  3) Extended Credit: Offered to banks with severe liquidity problems due to deposit outflows that will not be resolved in the foreseeable future.   One-half a percentage point above the interest rate of seasonal credit loans. Must summit a proposal(why it is needed)and an acceptable plan for restoring the liquidity of the bank. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.2.3 Reserve Requirements(reserve ratios)   Determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities on the balance sheet. Decrease(increase) in the reserve ratios: Depository institution may hold fewer(more) reserves against the transaction accounts. Able to lend out a greater(smaller) percentage of their deposits, thus increasing(decreasing) credit availability. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. 2.3. The Money Supply, and Interest Rates  2.3.1.The Money Supply, and Interest Rates  Effects of Monetary Tools on Economic Variables Open markert Expansionary Activities:  Contractionary Acitivities:  discount rate reserve ratio decrease increase decrease increase purchase sales  2.3.2. Money Supply VS Interest Rate Targeting  Money supply definition:page 112 (compare with that of Thailand) Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. Money supply definition:   Money Base: currency in circulation and reserve(depository institution reserve balances in accounts at Fed reserve banks plus vault cash on hand of commercial banks). M1: (1)currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions,(2) traveler’s checks of nonbank issuers, (3)demand deposits at all commercial banks less cash items in the process of collection and Fed Reserve float, and (4)other checkable deposits(OCDs), consisting of negotiable order of withdrawal(NOW) and automatic transfer service(ATS) accounts at depository institutions, credit union share draft Made Parinya accounts, and demand deposits by Ajarn.Finance, Bangkok at Thrift. Maglin, Department of Commericial Campus. Money supply definition:-1   M2 : M1 plus (1) overnight repurchase agreements(RPs) and overnight Eurodollars issued to U.S.residents (2) savings(including MMDAs) and small time deposits(including retail RPs), and (3) balances in both taxable and taxexempt general-purpose and broker-dealer money market funds. Excludes individual retirement accounts(IRAs) and Keogh balances at depository institutions and money market funds. M3-M2 plus(1) large time deposits and term RP liabilities issued by all depository institutions, (2) term Eurodollars held by U.S.residents at foreign branches of U.S.banks worldwide and at all banking offices in the U.K. and Parinya Maglin, Canada, and (3) balances inMade by taxable and tax-exempt. both Ajarn.Finance, Bangkok Department of Commericial Campus. 2.4. International Monetary Policies and Strategies Foreign investors= major participants in the financial markets. (economic conditions of other countries.)  2.4.1. Impact of Monetary Policy on Foreign Exchange Rates  Allow exchange rates to fluctuate freely.  Buying and selling currencies(foreign exchange intervention).  Bank of Japan bought $5 billion U.S.dollars for yen in the currency markets, thus increasing the supply of yen.(yen’s exchange rate was appreciating(rising) too fast = deterrent to Japan exports and the Made economy out of recession. Parinya Maglin, movement of the Japaneseby Ajarn.Finance, Bangkok Department of Commericial Campus. 2.4.1. Impact of Monetary Policy on Foreign Exchange Rates  Federal Reserve sells domestic currency to buy foreign currency( e.g. yen) in the foreign exchange market.  Increase in the Fed’s gold and foreign exchange and deposits.  Increase the Money supply in the U.S.  Homework: page118, q1, 4, 8, 11-13, 16, 17, 20 Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus. Group Presentation (Powerpoint & Handouts) during 15th week 8 groups: 20 mins each         1. Financial Repression and Financial Development 2. Privatization and Financial Liberalization 3. Legal Foundations 4. Information and Control 5. Inflation and Currency Stability 6. The Trouble with Banks 7. Financial Crises 8. Building Financial Institutions. Made by Ajarn. Parinya Maglin, Department of Finance, Bangkok Commericial Campus.