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Unformatted text preview: The Federal Reserve and the Banking System
How the U.S. Central Bank influences interest rates and the ability of the banking system to extend credit and create money The Federal Reserve System is the central banking authority in the United States
s s s The Board of Governors of the "Fed" supervises the nations banking system and influences interest rates and the money supply The Federal Open Market Committee is the policy making arm of the Fed The 12 district Federal Reserve Banks serve as banks for depository institutions, issue currency, and provide financial services. All depository institutions are required to have accounts at regional Federal Reserve Banks Fractional Reserve Banking
Depository institutions are required to keep reserves of a specified fraction of their deposits to meet demands of their depositors for funds s Reserves are primarily deposits these institutions keep in accounts at regional Federal Reserve Banks although some reserves are kept in the form of vault cash.
s Banks can "create" money
Total reserves = required reserves + excess reserves s Banks "create" checkable deposits when the extend credit to their customers s Banks can make loans to customers or by purchasing interest bearing securities whenever they have excess reserves s The Fed affects the ability of the banking system to make extend credit by influencing excess and required reserves
s A given amount of bank reserves support a multiple of deposits:
Maximum = Banking System Deposits Bank Reserves Required Reserve Ratio For example ,if the required reserve ratio is 10%, then $1 billion in reserves can support as much as $10 Billion in deposits. A Bank Balance sheet: A bank fails when its net worth approaches zero. If assets fall below the value of liabilities the bank is insolvent Monetary policy influences interest rates and money supply
s s s Monetary policy seeks to stabilize the economy by influencing bank reserves and thereby affecting the ability of the banking system to extend credit By influencing the supply of money and credit, the Fed can also influence short-term interest rates The "Federal Funds" rate is the interest rate depository institutions charge for short term (usually overnight) loans to each other of deposits at regional Federal reserve banks. This rate is directly affected by the changes in availability of bank reserves. The Tools of Monetary Policy
Changes in Reserve Requirements: This is rarely used s Changes in the Discount Rate the Fed charges to depository institutions for loans s Direct Lending through Financial Markets s Open Market Operations: Sales and Purchases of government securities by the Fed that absorb or replenish bank reserves
s Open Market Operations:
Most transactions are with securities dealers in New York that are mainly branches of large banks s Open market purchases increase bank reserves as the Fed pays for the securities it buys by crediting the accounts of depository institutions at regional Fed banks s Open market sales decrease bank reserves as the Fed debits the accounts of depository institutions to charge them for securities they buy
s Open market purchases: When the Fed pumps $1 billion of new excess reserves into the banking system by buying securities, the federal funds rate will immediately fall. The money stock could increase by $10 billion in new deposits when the required reserve ratio is 10%. s Open Market sales: A decrease in bank reserves from open market sales causes the federal funds rate to rise. Each $1 of reserves take out of the banking system could reduce the money stock by as much as $10 when the required reserve ratio is 10%.
s The Federal Open Market Committee (FOMC) Sets Goals for Open Market Operations
It meets 8 times each year to set goals for monetary policy and to plan open market operations ...
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