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Chapter 4 Functions of the Fed Outline Organization of the Fed Federal Reserve District Banks Member Banks Board of Governors Federal Open Market Committee (FOMC) Advisory Committees Integration of Federal Reserve Components How the Fed Controls Money Supply Open Market Operations Role of the Fed’s Trading Desk How Fed Operations Affect All Interest Rates Adjusting the Reserve Requirement Ratio Adjusting the Fed’s Loan Rate The Fed’s Intervention During the Credit Crisis Fed Loans to Facilitate Rescue of Bear Stearns Fed Purchases of Mortgage-Backed Securities Fed’s Purchase of Commercial Paper Fed’s Purchase of Long-Term Treasury Securities Perception of Fed Intervention During the Crisis Global Monetary Policy A Single Eurozone Monetary Policy Global Central Bank Coordination Key Concepts 1. Describe the role and the organization of the Fed. 2. Explain how monetary policy tools are used by the Fed to control economic conditions. 3. Explain why the Fed’s monetary policy can not ignore international conditions. POINT/COUNTER-POINT: Should There Be One Global Central Bank? POINT: Yes. One global central bank could serve all countries in the manner that the European Central Bank now serves several European countries. If there was a single central bank, there could be a single monetary policy across all countries. COUNTER-POINT: No. A global central bank could create a global monetary policy only if there was a single currency used throughout the world. Moreover, all countries would not agree on the monetary policy that is appropriate. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: While there may be some benefits if the monetary policy was consistent among countries, it would be impossible to get agreement among all countries about the policy to be used. Countries would not want to give up their power to control their own money supply. Questions 1. The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks. ANSWER: Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and early 1900s, several bank panics occurred, which encouraged another attempt. In 1913, the Federal Reserve Act was passed and specified 12 districts across the United States, as well as a city in each district where a Federal Reserve district bank was to be established. The Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans to depository institutions in need of funds. 2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to achieve these goals? ANSWER: The main goals of the FOMC are to promote high employment, economic growth, and price stability. 3. Open Market Operations. Explain how the Fed increases the money supply through open market operations. ANSWER: The Fed can increase money supply by purchasing securities in the secondary market. 4. Policy Directive. What is the policy directive, and who carries it out? ANSWER: A policy directive is established by the Fed and submitted to the Trading Desk. The manager of the Trading Desk must ensure that the directive is achieved. 5. The Beige Book. What is the Beige book and why is it important to the FOMC? ANSWER: The Beige book is a consolidated report of regional economic conditions in each of the 12 districts. This book is sent to FOMC members before their meeting so that they are updated on regional conditions before they decide on monetary policy. 6. Reserve Requirements. How is money supply growth affected by an increase in the reserve requirement ratio? ANSWER: An increase in the reserve requirement ratio reduces the proportion of deposited funds that a financial institution can lend out. Consequently, it reduces the rate by which money can multiply. 7. Control of Money Supply. Describe the characteristics that a measure of money should have if it is to be manipulated by the Fed. ANSWER: A desirable measure of money is one that can be precisely controlled by the Fed and has a predictable impact on economic variables. 8. FOMC Economic Presentations. What is the purpose of economic presentations during a POMC meeting? ANSWER: Economic presentations offer the FOMC information about the prevailing economic conditions, so that the FOMC can decide whether it should attempt to revise money supply growth in order to improve the economy. 9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money supply. ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions. 10. Open Market Operations. Why do the Fed’s open market operations have a different effect on money supply than do transactions between two depository institutions? ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution, money is transferred to the depository institution without any offset at another institution. However, a similar transaction between depository institutions would increase the account balance at one institution and decrease the account balance at the other institution. 11. Discount Window Lending During Credit Crisis. Explain how and why the Fed extended its discount window lending to nonbank financial institutions during the credit crisis. ANSWER: In 2008, the Fed expanded its role by lending to other types of institutions. In March 2008, the Fed’s discount window provided funding to rescue Bear Stearns, a large securities firm that was about to go bankrupt. On March 16, 2008, the Fed’s discount window provided a loan to J.P. Morgan Chase that was passed through to Bear Stearns. This ensured that the clearing operations would continue and avoided liquidity problems. On the following day, the Fed expanded its role further by announcing that it would provide emergency loans to the about 20 primary dealers that serve as key financial intermediaries for the large Treasury securities transactions in the secondary market. It also committed to loans of up to $200 billion of Treasury securities to primary dealers for a term of 28 days (rather than overnight). These provisions were intended to calm the financial markets. 12. The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions that are near bankruptcy? ANSWER: The Fed might argue that the credit crisis is a threat to the financial system and that it needed to intervene to prevent a bigger crisis. Some critics might argue that the Fed has too much power and that Congress should be involved in decisions regarding the use of taxpayer funds to rescue financial institutions. 13. Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the Fed during the credit crisis? ANSWER: Some supporters of a government rescue would argue that the credit crisis would be worse if the large financial institutions were not rescued. However, others might argue that the government rescue encourages financial institutions to take risk, with the hope of being bailed out if the strategies backfire. 14. The Fed's Impact on Unemployment. Explain how the Fed's monetary policy affects the unemployment level. ANSWER: The Fed's monetary policy affects interest rates, which affect the cost of borrowing by households and businesses, and therefore affect their level of spending for products and services. The aggregate demand for products and services affects the number of people employed by businesses and therefore affects the unemployment level. 15. The Fed's Impact on Home Purchases. Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers? ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on mortgages. When the Fed reduces interest rates, it reduces the monthly payment to be made on new mortgages. Thus, it may increase the demand for homes by consumers. If it increases interest rates, it may reduce the demand for homes. 16. The Fed's Impact on Security Prices. Explain how the Fed's monetary policy may indirectly affect the prices of equity securities. ANSWER: The Fed's monetary policy influences the aggregate demand for products and services, and therefore affects the cash flows generated by publicly-traded businesses. The value of the stock of a business is influenced by expectations of its future cash flows. 17. Impact of FOMC Statement. How might the FOMC statement (following the committee's meeting) stabilize financial markets more than if no statement were provided? ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the FOMC meeting, and there would be more uncertainty regarding the Fed's future monetary policy. The statement makes the Fed's plans more transparent. 18. Fed Facility Programs During the Credit Crisis. Explain how the Fed's facility programs improved liquidity in some debt markets. ANSWER: The Fed established facilities that provided loans to financial institutions that were willing to invest in some types of debt securities, such as bonds that were backed by consumer loans. In this way, the Fed increased the liquidity of these markets, which allowed easier access for consumers who wanted to borrow funds. The Fed also used some of its own funds to purchase commercial paper, which restored the liquidity of the commercial paper market. 19. Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established, and housed within the Federal Reserve. Explain the role of this bureau. ANSWER: The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. The existence of a bureau can act more quickly to protect consumers from deceptive practices than waiting for Congress to pass new laws. 20. Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its independent monetary policy and control over its domestic interest rates. ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the European Central Bank (ECB), which controls the supply of euros in the banking system. The ECB influences the interest rate on euros regardless of the country. If the interest rate on euros was higher in one eurozone country, funds would flow to that country until the supply and demand conditions caused the interest rate there to be the same as in other euro countries. The Fed’s Power. What should be the Fed’s role? Should it be focused only on monetary policy? Or should it be allowed to engage in the trading of various types of securities in order to stabilize the financial system when securities markets are suffering from investor fears and the potential for high default risk? ANSWER: The Federal Reserve's role encompasses both monetary policy and the regulation of the financial system, and its activities are guided by its dual mandate: to promote maximum employment and stable prices. While the primary focus of the Fed is indeed on monetary policy, which involves setting interest rates, managing the money supply, and influencing economic conditions, it also plays a crucial role in maintaining financial stability. Here are some considerations regarding the Fed's role in stabilizing the financial system: 1. Monetary Policy : Monetary policy is the traditional tool used by the Fed to achieve its mandate of price stability and maximum employment. By adjusting interest rates and managing the money supply, the Fed aims to influence economic activity and inflation levels. This involves setting short-term interest rates (through the federal funds rate) and conducting open market operations to buy or sell government securities, thereby affecting longer-term interest rates. 2. Financial Stability : In addition to monetary policy, the Fed has a responsibility to maintain financial stability and mitigate systemic risks within the financial system. During periods of financial distress, such as market crises or liquidity shortages, the Fed may employ a range of tools to stabilize financial markets and prevent disruptions that could threaten the broader economy. This may include providing liquidity to financial institutions through lending facilities, conducting emergency asset purchases, or implementing regulatory measures to address vulnerabilities in the financial system. 3. Emergency Powers : The Fed's ability to engage in the trading of various types of securities, including corporate bonds, mortgage-backed securities, and other assets, can be seen as part of its toolkit for addressing financial crises and systemic risks. These activities, often referred to as unconventional monetary policy or crisis management measures, are typically deployed in exceptional circumstances when traditional monetary policy tools are insufficient to stabilize markets or support economic recovery. 4. Accountability and Oversight : While the Fed's interventions in financial markets can be effective in restoring confidence and preventing systemic collapse during crises, they also raise questions about accountability, transparency, and potential moral hazard. It is essential for the Fed to operate within a clear framework of accountability and oversight to ensure that its actions are consistent with its mandate and do not unduly distort market mechanisms or create long-term risks. In summary, the Fed's role should encompass both monetary policy and the stabilization of the financial system. While monetary policy remains the primary tool for achieving its mandate of price stability and maximum employment, the Fed should be equipped with the necessary authority and tools to address financial instability and systemic risks when necessary. However, the exercise of these emergency powers should be subject to appropriate oversight and accountability to ensure their effectiveness and legitimacy. 22. The Fed and Mortgage-Backed Securities How has the Fed used mortgage-backed securities in recent years, and what has it been trying to accomplish? ANSWER: The Fed purchased large amounts of mortgage-backed securities during 2008 and 2009 in an attempt to calm investors’ fears that the value of these securities would decline due to the high default rate on mortgages. The Fed has continued to purchase mortgage-backed securities in an effort to stimulate the housing market by creating a demand for mortgages and mortgage-backed securities. 23. The Fed and Commercial Paper. Why and how did the Fed intervene in the commercial paper market during the credit crisis? ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial paper it had issued, investors feared that other financial institutions with large holdings of mortgage-backed securities might default on their commercial paper. Therefore, investors stopped buying commercial paper in the secondary market, causing it to become illiquid and making credit increasingly hard to obtain. The Fed purchased large amounts of commercial paper to boost investor confidence and restore liquidity to the market. 24. The Fed and Long-Term Treasury Securities. Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed’s usual operations? ANSWER: The Fed’s purchases of long-term Treasury securities differed from its normal open market operations, which focus on short-term Treasury securities. By purchasing long-term securities, the Fed hoped to reduce long-term Treasury bond yields, which would ultimately result in lower long-term borrowing rates. These lower borrowing rates would in turn stimulate the economy by encouraging more long-term borrowing by firms for capital expenditures and by individuals to purchase homes. 25. The Fed and TALF. What was TALF, and why did the Fed create it? ANSWER: TALF was the term asset–backed facility that the Fed created in 2008 to provide financing to financial institutions purchasing high-quality bonds backed by consumer, credit card, or automobile loans. The secondary market for these loans had become inactive during the credit crisis, thereby discouraging lenders from making these loans because they could not readily sell the loans in the market. By providing financing to institutions that purchased these loans, TALF increased the market’s liquidity and thus indirectly encouraged lenders to make more consumer loans. Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “The Fed’s future monetary policy will be dependent on the economic indicators to be reported this week.” The Fed makes policy decisions based on expectations about economic conditions, and its expectations are influenced by the economic indicators. b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.” The Fed attempts to prevent the economy from becoming too strong by slowing the economy down during periods of excessive growth; in this way, it reduces the upward pressure on prices (inflation). c. “Inflation will likely increase because real short-term interest rates currently are negative.” Negative real short-term interest rates imply that the inflation rate exceeds the existing nominal interest rate. Under these conditions, savers may not perceive saving to be worthwhile because interest rates are too low, and borrowers may borrow even more because of relatively low interest rates. Therefore, inflation could increase in response to the high degree of spending. Managing in Financial Markets As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve implements monetary policy—and that the federal government implements spending and tax policies, or fiscal policy—to affect economic growth and inflation. However, it is difficult to achieve high economic growth without igniting inflation. Although the Federal Reserve is often said to be independent of the administration in office, there is much interaction between monetary and fiscal policies. Assume that the economy is currently stagnant and that some economists are concerned about the possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this year than in the previous five years. Assume that the Federal Reserve chairman’s term will expire in four months and that the president of the United States will have to appoint a new chairman (or reappoint the existing chairman). It is widely known that the existing chairman would like to be reappointed. Also assume that next year is an election year for the administration. a. Given the circumstances, do you expect that the administration will be more concerned about increasing economic growth or reducing inflation? Given the circumstances described, the administration is likely to be more concerned about increasing economic growth rather than reducing inflation. Here's why: 1. Stagnant Economy and Concerns about Recession : With the economy currently stagnant and concerns about the possibility of a recession, policymakers, including the administration, would prioritize stimulating economic growth to prevent or mitigate the effects of a downturn. Economic growth is essential for creating jobs, boosting consumer spending, and fostering business investment, which are crucial for overall economic health. 2. High Growth in Some Industries : The fact that some industries are experiencing high growth indicates that there are pockets of strength within the economy. The administration would likely seek to capitalize on these areas of growth and leverage them to stimulate broader economic expansion. 3. Federal Reserve Chairman's Reappointment : The looming expiration of the Federal Reserve chairman's term, coupled with the chairman's desire for reappointment, introduces a political dimension to monetary policy decisions. The administration may be inclined to support policies that align with the chairman's goals and objectives, including measures aimed at promoting economic growth. 4. Upcoming Election Year : Next year being an election year for the administration further underscores the importance of demonstrating strong economic performance and delivering tangible benefits to voters. A focus on increasing economic growth can help bolster the administration's electoral prospects and enhance its chances of reelection. Given these considerations, while inflation is a concern, the administration is likely to prioritize policies aimed at stimulating economic growth to address the current stagnation and mitigate the risk of recession. However, the administration may also seek to strike a balance between promoting growth and managing inflationary pressures to maintain overall economic stability. b. Given the circumstances, do you expect that the Fed will be more concerned about increasing economic growth or reducing inflation? The Fed tends to focus on maintaining a low level of inflation, because of the possibility that sustained high inflation can cause high interest rates, which may result in a sluggish economy in the long run. It is not unusual for the Fed to focus on fighting inflation while the administration is more concerned about economic growth. However, given that the chairman of the Fed wants to be reappointed, he may be more willing to endorse a monetary policy that is desired by the administration (assuming that he is politically motivated). c. Your firm is relying on you for some insight on how the government will influence economic conditions and therefore the demand for your firm’s products. Given the circumstances, what is your forecast of how the government will affect economic conditions? Based on the circumstances described, my forecast is that the government will likely pursue expansionary fiscal policies to stimulate economic growth and mitigate the risk of recession. Here's why: 1. Stagnant Economy and Concerns about Recession : With the economy currently stagnant and concerns about the possibility of a recession, the government is likely to prioritize policies aimed at boosting economic activity and restoring confidence. Expansionary fiscal policies, such as increased government spending on infrastructure projects, healthcare, or education, can stimulate demand, create jobs, and spur investment, thereby helping to revitalize economic growth. 2. High Growth in Some Industries : Despite the overall stagnation, the fact that some industries are experiencing high growth indicates potential areas for economic expansion. The government may seek to support and capitalize on these growth sectors by providing targeted incentives, grants, or tax breaks to encourage further investment and innovation. 3. Federal Reserve Chairman's Reappointment : The impending expiration of the Federal Reserve chairman's term and the chairman's desire for reappointment introduce a political dimension to monetary policy decisions. The government may seek to influence monetary policy decisions to complement its fiscal initiatives and support its broader economic objectives, such as promoting growth and maintaining price stability. 4. Upcoming Election Year : As next year is an election year for the administration, there will likely be pressure to demonstrate strong economic performance and deliver tangible benefits to voters. Expansionary fiscal policies can help generate positive economic outcomes, such as job creation and income growth, which are crucial for bolstering the administration's electoral prospects and enhancing its chances of reelection. In summary, given the current economic conditions and political dynamics, I forecast that the government will likely implement expansionary fiscal policies to stimulate economic growth, support key industries, and address concerns about recessionary risks. These policies are expected to have a positive impact on overall economic conditions and contribute to increased demand for your firm's products. Flow of Funds Exercise Monitoring the Fed Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making acquisitions. The company expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The Carson Company is also considering the issuance of stock to raise funds in the next year. Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets. It recently received an alert from the service that suggested the Fed has been selling large holdings of its Treasury securities in the secondary Treasury securities market. How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on the price of Treasury securities? Explain. The actions will place downward pressure on Treasury securities prices, because of an increase in supply of securities for sale in the secondary market. Will these actions place upward or downward pressure on Treasury yields? Explain. The actions will place upward pressure on Treasury yields, because a lower price is paid for the securities. Will these actions place upward or downward pressure on interest rates? Explain. The actions will place upward pressure on interest rates because there would be a reduction in bank balances as investors use funds to buy the Treasury securities. The payments to the Fed are maintained outside of the banking system. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
