chapter 12 roles and services of the federal reserve & other central banks around the world

Chapter 12

Roles and Services of The Federal Reserve & Other Central

Banks Around The World

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McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

• To explore the many roles and functions of the central banks around the world.

• To see how and why the Federal Reserve System came to be established as the U.S. central bank.

• To examine how the Federal Reserve System is organized to carry out the many tasks it must perform.

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Learning Objectives

• To discover how important central bank independence from the dictates of governments is in carrying out effective money and credit policy.

• To understand the concept of legal reserves and how the Federal Reserve System influences the level and growth of legal reserves and, ultimately, deposits and loans.

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Introduction

• A central bank is a government agency that monitors the operation of its financial system and controls the growth of the nation’s money supply.

• Central banks are “bankers’ banks.” They communicate with commercial banks and securities dealers in carrying out their essential public policy functions.

• The U.S. central bank is the Federal Reserve System.

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The World’s Leading Central Banks

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The Roles of Central Banks

Control of the money supply, which is closely linked to economic activity and price inflation

Stabilizing the money and capital markets, by fostering their development and ensuring a stable flow of funds through them

Lender of last resort for financial institutions squeezed by severe liquidity pressures

Supervisor of the banking system

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The Roles of Central Banks

Maintaining and improving the payments mechanism - a smoothly functioning and efficient payments mechanism is vital for business and commerce

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The Goals of Central Banking

• Central banking in the U.S. and in most other nations is directed toward the goals of:

Achieving maximum sustainable output and employment; and

Promoting stable prices.• The recent emphasis has been on long-run price stability and a

growing list of nations have set inflation-rate targets or target ranges.

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The Goals of Central Banking

• Through its influence over interest rates and the growth of the money supply, the central bank is able to influence the economy’s progress toward each of the goals.

• However, the goals often conflict and trade-offs have to be accepted.

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The Channels Through Which Central Banks Work

Policy toolsof the

central bank

Volume & growthof borrowing &

spendingby the public on

domestic & foreign consumer & capital

goods & services

Economic goals:•A stable price level and low inflation

•Sustainable economic growth

•Maximum employment

Cost & availability of credit

Size & growthof the money supply

Market valueof the public’s

security holdings

Currency exchange rates

Public expectations regarding security

prices, interest rates, currency prices, money supply &

credit availability

Market interest

rates

Level & growth

of reserves

in the banking system

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History of the Federal Reserve System

• The U.S. was one of the last major nations in the Western hemisphere to permanently charter a central bank.

• U.S. public officials were hesitant to do so for fear that a central bank with great financial power will restrict the availability of credit.

• However, a series of crises plagued the U.S. financial system in the late 19th and early 20th centuries.

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Problems in the Early U.S. Banking System

• Prior to the Civil War, the states controlled the banking system and many did a poor job.

• The high failure rate among poorly capitalized and ill-managed banks resulted in substantial losses for unlucky depositors.

• The 1863 National Banking Act created a dual banking system, but competition between federal and state bank regulatory agencies sometimes led to actions detrimental to public interest.

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Problems in the Early U.S. Banking System

• The new national bank notes proved to be unresponsive to the nation’s growing need for a money or cash medium.

• The process of clearing and collecting checks was also too slow and expensive, and many banks charged a check redemption fee.

• There were recurring liquidity crises too, when the massive sell-offs of bank-held securities led to panic selling by other investors.

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Creation of the Federal Reserve System

• The Federal Reserve Act was signed in 1913. Twelve Federal Reserve banks were chartered and they opened for business as World War I began in Europe.

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The Early Structure of the Federal Reserve

• The first Federal Reserve System was quite different from the Fed of today.

• The chief policy tool was the discount rate charged on loans of reserves to eligible banks, and each Reserve bank had the authority to set its own discount rate.

• The Federal Reserve banks were also given authority to issue their own paper notes to serve as a circulating currency.

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The Early Structure of the Federal Reserve

• Hence, although a supervisory board of seven members had been set up in Washington, D.C., the regional Reserve banks possessed the essential monetary tools and made the key policy decisions during the Fed’s early years.

• Then slowly, economic, financial, and political forces combined to amend the original Federal Reserve Act and remake the character and methods of the central bank.

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Goals and Policy Tools of the Fed

• The Great Depression brought about a concentration of power within the Fed.

• The seven-member Board of Governors in Washington, D.C., became the central administrative and policymaking group.

• In addition, the Federal Open Market Committee was created to oversee the conduct of open market operations, which rapidly became the Fed’s main policy tool.

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How the Fed is Organized Today

Board of Governors(7 members appointed

by the president)

3,200 member banksof the system

Supervise

Manager of the System Open Market Account

Supervise

12 Federal Reserve banks & 25 branch banks

(reserve bank presidents appointed by Board of

Governors)

Supervise

Federal Open Market Committee

(12 voting members)

Serve

Serve

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• In principle, the Board of Governors is independent of both legislative and executive branches of the federal government.

• This independence is supported by terms of office much longer than the president’s (up to 14 years), and by the fact that the Fed is self-supporting.

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• When the Federal Open Market Committee (FOMC) has reached a consensus on the appropriate future course for monetary policy, a directive is given to the manager of the System Open Market Account (SOMA)

• The SOMA manager is a vice president of the Federal Reserve Bank of New York.

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There is a Federal Reserve bank in each of the twelve districts.

Source: Board of Governors of the Federal Reserve System

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• Each Reserve bank houses a research division that studies regional economic and financial developments, and reports its findings to the Board of Governors and to the FOMC.

• The Reserve banks also provide the securities needed for open market sales, and take their pro rata share of security purchases made by the Federal Reserve System.

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Source: Board of Governors of the Federal Reserve System

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• The member banks of the Federal Reserve System consist of national banks, which are required to join the system, and state-chartered banks that agree to conform to the Fed’s rules.

• At year-end 2000, there are 2,230 national banks and just under 1,000 state-chartered banks registered as members of the Federal Reserve System, compared to more than 5,000 nonmember banks.

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Roles of the Federal Reserve System Today

• Collecting and clearing checks and other means of payment (through an electronic network known as the FEDWIRE)

• Issuing currency and coin• Maintaining a sound banking and financial system, by serving

as a lender of last resort (through the discount window of each Reserve bank) and by supervising member banks

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Roles of the Federal Reserve System Today

• Serving as the Federal government’s fiscal agent, by holding the Treasury’s checking account and by maintaining reasonable stability in the government securities market

• Providing information to the public, through statistical releases and research reports

• Carrying out monetary policy, through the use of various tools

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The Key Focus ofCentral Bank Monetary Policy

• In regulating money and credit conditions to strengthen the economy, most central banks target market interest rates.

• To impact market rates, central banks usually make use of their control over the volume of reserves available to the banking system.

• These reserves are the raw material out of which depository institutions create credit and cause the money supply to grow.

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The Key Focus ofCentral Bank Monetary Policy

• The total supply of reserves can be changed

- through open market operations,- by making loans to depository institutions through the

central bank’s discount window, and- by changing the legal reserve requirements applicable

to deposits held by depository institutions.

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Reserve Composition

• Legal reserves in the U.S. consist of the amount of deposits each institution keeps with the Federal Reserve bank in its district plus the amount of currency and coin held in its vault.

• Total legal reserves = Required reserves + Excess reserves

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The Deposit Multiplier

• As a whole, the banking system can create more deposit money by using its excess reserves to make loans and purchase securities.

• The deposit multiplier indicates how many dollars of deposits can result from an injection of new excess reserves into the system.

• Transaction deposit multiplier = 1 .

Reserve requirement on transaction deposits

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• Maximum volume of new deposits and loans = Deposit multiplier Excess reserves

• In the real world however, leakages of funds from the banking system greatly reduce the size of the deposit multiplier.

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RRD = the required legal reserve ratio for transaction (demand) accounts

LA = the amount of additional currency and other liquid assets the public wishes to hold for each dollar of new transaction deposits they receive

EXR = the quantity of excess reserves depository institutions desire to hold for precautionary purposes out of each dollar of new transaction deposits.

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The Money Multiplier

• Central bankers are usually more interested in a related concept known as the money multiplier, which defines the relationship between a measure of the money supply and the size of the total reserve base available to depository institutions.

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The Money Multiplier

• Recognizing the important link between currency and bank reserves, economists have developed the concept of the monetary base, which is simply the sum of legal reserves plus the amount of currency and coin held by the public.

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Markets on the Net

• Bank of England at www.bankofengland.gov• Bank of Japan at www.boj.ur.jp• Board of Governors of the Federal Reserve System at

www.federalreserve.gov• Center for the Study of Central Banks at

www.law.nyu.edu/centralbankscenter• European Central Bank www.ecb.int• Federal Open Market Committee at

www.federalreserve.gov/fomc

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Markets on the Net

• Federal Reserve Services at www.frbservices.org• Federal Reserve Bank of New York at www.ny.frb.org• Federal Reserve Releases at www.federalreserve.gov/releases• Reserve Bank of New Zealand at www.rbnz.govt.nz

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Chapter Review

• Introduction to Central Banking• The Roles of Central Banks in the Economy and Financial

System- Control of the Money Supply to Avoid Damaging Inflation- Stabilizing the Money and Capital Markets- Lender of Last Resort- Supervisor of the Banking System - Maintaining and Improving the Payments Mechanism

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Chapter Review

• The Goals and Channels of Central Banking- Central Banks’ Goals- Challenges in Achieving Central Bank Goals- The Channels through which Central Banks Work

• History of the Federal Reserve System- Problems in the Early U.S. Banking System- Creation of the Federal Reserve System- The Early Structure of the Fed- Goals and Policy Tools of the Fed

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Chapter Review

• How the Fed is Organized Today- The Board of Governors- The Federal Open Market Committee- The Federal Reserve Banks- The Member Banks of the Federal Reserve System

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Chapter Review

• Roles of the Federal Reserve System Today- The Clearing and Collection of Checks and Other Payments

Media- Issuing Currency & Coin and Related Services- Maintaining a Sound Banking and Financial System- Serving as the Federal Government’s Fiscal Agent- Providing Information to the Public- Carrying Out Monetary Policy

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Chapter Review

• The Key Focus of Central Bank Monetary Policy: Interest Rates, Reserves and Money

• Reserve Composition and the Deposit & Money Multipliers- The Deposit Multiplier- The Money Multiplier

chapter 12 roles and services of the federal reserve & other central banks around the world

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