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- Banks as Creators of Money: The most important part of the money supply is the deposit liabilities of financial institutions. Such deposits are created by the banking institutions themselves.
Good business behavior will place restraints on the amount of money creation that the bank will do. For example, it needs to maintain adequate reserves in the form cash in the vault or deposits at other banks or at the central bank.
First, a bank will want to hold reserves that are sufficient to meet the requests of depositors to withdraw their funds. Thus, the bank needs reserves so that any depositor’s request for cash can be readily met. Second, deposit-issuing institutions are often required by regulatory authorities to hold reserves that are at least as great as a certain fraction of their deposits.
- Fractional Reserve Banking: The banks keep a certain part of deposits as reserves either as a legal requirement or by choice in order to be prepared for possible withdrawals. For simplest possible framework, we may assume that the banking system always maintains exactly that ratio of reserves to deposits.
- The Money Multiplier: If an amount of excess reserves is made available to the banking system, the banking system as a whole can increase the money supply by a multiple of the amount of excess reserves. This multiple depends on the size of the reserve ratio, which is the ratio of reserves held (because of legal requirements or as consequence of prudent banking business), to deposits.
The securities on the Fed’s balance sheet are U.S. government notes, bills, and bonds. By buying and selling securities, the Fed is able to exercise considerable control over the quantity of bank reserves.
- Structure of the Federal Reserve: The Federal Reserve System consists of twelve regional banks and the seven-member Board of Governors which is located in Washington, D.C. Nineteenth-century wariness of central government power led to great emphasis on a decentralized structure. The Federal Reserve Bank of New York has considerably more influence than the other regional banks because some of the important policy operations of the system (open market operations, the buying and selling of securities, and the foreign exchange market interventions) are conducted by the New York bank, and most of the nation’s largest banks are located in the New York district. However, the center of power in the entire system has tended over the years to shift away from the regional banks and the New York Fed in particular and toward the Board of Governors and the board chairman in particular.
- The functions of the Federal Reserve banks can be separated into “chore” functions and policy functions. The chore functions are to
- Examine the member banks
- Review merger applications
- Provide check-clearing services and electronic funds transfers
- Act as an agent for the distribution of new currency and for the sale of Treasury securities.
- The policy functions of the Federal Reserve banks are to:
- Set the discount rate,
- Administer the discount window.
- Participate on the Federal Open Market Committee (FOMC).
- The Open Market Desk where transactions in government securities are conducted is located in the New York Fed.
- The New York Fed holds the deposits and securities of foreign central banks,
- The New York Fed holds and manages the country’s gold stock.
The Board of Governors consists of seven members who hold 14-year terms and are appointed by the President. The chairman is the center of power for the whole Federal Reserve System. He or she is a board member appointed to a 4-year term as chairman by the President
- The formal functions of the Board include the following:
- Approve bank mergers.
- Set the regulations that determine what activities commercial banks are allowed to engage in.
- Set reserve requirements and approve changes in the discount rate.
- Direct open market operations through the FOMC
The Federal Open Market Committee (FOMC) consists of the Board’s governors and the presidents of the regional banks. Five of the twelve Federal Reserve Bank presidents are voting members of the FOMC at any one time. The committee meets in Washington about 8 times a year and reviews economic conditions and the behavior of the financial system. The purpose of the meeting is to formulate a directive on monetary policy. This directive provides instructions to the managers of the Open Market Desk (at the New York Fed) about how to conduct open market operations. If changes in economic and financial conditions warrant, the committee holds a telephone consultation between its regular meetings and changes the directive
- Tools of Monetary Policy:
- Open Market Operations: The Federal Reserve can increase its holdings of government securities, Q, by making open market purchases. The money supply function clearly implies that M increases when Q goes up. However, we need to understand why this is the case—how does an open market purchase of securities by the Fed lead to an increase in the stock of money.
- Discount Rate: Discount borrowing was once the major tool of monetary policy used by the Fed. With the development of the Federal Funds—interbank market for reserves—market in the post-war period, discount borrowing became less important. A bank that finds itself short of reserves can borrow the reserves from other banks or sell assets, such as the banks own holding of securities, in order to increase its reserves position.
- Reserve Requirements: Reserve requirements were extended and made largely uniform by a major banking reform bill in 1980, the Depository Institutions Deregulatory and Monetary Control Act (DIDMCA). Reserve requirements were extended to all depository institutions, and the structure of reserve requirements for various deposit types was vastly simplified. The changes were made to improve the Fed’s control over the money stock, which includes the liabilities of depository institutions other than commercial banks. However, since reserve balances at the Fed are not interest earning, the banks view them as an unfair burden that other financial institutions do not have. As a consequence, the fed has, over time, reduced the level of reserve requirements.
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