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Chapter 4
Functions of the Fed
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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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
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Organization of the Fed

The Fed has five major components:

Federal Reserve district banks

Member banks

Board of Governors



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
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Organization of the Fed (cont’d)

Board of Governors

The Board of Governors consists of seven members

Each member is appointed by the President of the
U.S. and confirmed by the Senate

Members serve 14-year terms

Reduces political pressure

Terms are staggered so that one term expires in every even-
numbered year

Main roles:

Regulate commercial banks

Control monetary policy

The Consumer Advisory Council consists of up to 30 members

Represents the financial institutions industry and its consumers

The Thrift Institutions Advisory Council consists of
representatives of savings banks, S&Ls, and credit unions

Offers views on issues specifically related to thrift institutions
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Integration of Federal Reserve
Components
Advisory
Committee
Board of Governors
•
Regulates member
banks and BHCs
•
Sets reserve
requirements
Supervision
Federal Open
Market Committee
•
Conducts open
market operations
Federal Reserve
District Banks
•
Clear checks

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Monetary Policy Tools (cont’d)

Open market operations (cont’d)

Communication to the Trading Desk

The FOMC’s 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 short-
term loans to each other
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Monetary Policy Tools (cont’d)

Open market operations (cont’d)

Role of the Trading Desk

The manager of the Trading Desk instructs traders on the amount of
government securities to buy or sell in the secondary market

This is called open market operations


Fed sale of securities

To decrease the money supply, traders sell government
securities to government securities dealers

Sold to the dealer submitting the highest bid

As dealers pay, their account balances are reduced and the
total amount of funds at commercial banks is reduced

A tightening of the money supply

To force an increase in the Fed funds rate, the Trading Desk
can also sell Treasury securities
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Monetary Policy Tools (cont’d)

Open market operations (cont’d)

Fed use of repurchase agreements

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


The yields on the alternative investments will decline as
more money is invested in them

The reduction in yields on debt securities lowers the cost of
borrowing for the issuers of debt securities

Can encourage potential expenditures
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Monetary Policy Tools (cont’d)

Open market operations (cont’d)

Dynamic vs. defensive open market operations

Dynamic operations are implemented to increase or decrease the
level of funds

Defensive operations offset the impact of other conditions that
affect the level of funds
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Monetary Policy Tools (cont’d)

Open market operations (cont’d)

Open market operations in response to the Crash

Stock prices declined by 22 percent on October 19, 1987

The Fed loosened the money supply to provide liquidity

Monetary Policy Tools (cont’d)

Adjusting the discount rate

To 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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Monetary Policy Tools (cont’d)

Adjusting the discount rate (cont’d)

In 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

Contains a risk premium above the discount rate
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Monetary Policy Tools (cont’d)

A reduction increases the proportion of bank deposits that can
be lent out
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Monetary Policy Tools (cont’d)

Adjusting the reserve requirement ratio
(cont’d)

How reserve requirement adjustments affect money
growth

An initial increase in demand deposits as a result of loosening the
money supply multiplies into (1/reserve requirement ratio)

A higher ratio causes an initial injection to multiply by a smaller
amount