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CHAPTER 2 THE FEDERAL RESERVE AND ITS POWERS CHAPTER OBJECTIVES 1. This chapter describes the background and structure of the Federal Reserve System, perhaps the most powerful component of the financial system. The Fed has broad responsibilities for regulating the financial system, controlling the money supply, and influencing interest rates. Its design was influenced by inadequacies of the 19 th -century banking system, which remain useful lessons about the consequences of neglecting or mismanaging systems of money and banking. 2. The chapter explains the components of the Fed’s balance sheet and relates them to the money supply and financial system, thus introducing the concept of the “monetary base”. Understanding the main components of the monetary base is crucial before moving on to Chapter 3. 3. The chapter introduces the “tools of monetary policy”—open market operations, the discount rate, and reserve requirements. The tools differ concretely and significantly from each other, and have changed in relative importance as the financial system has evolved. The ability to compare and contrast them—and to understand why open market operations are the only fully viable tool of monetary policy—is also crucial before moving on to Chapter 3. CHANGES FROM THE LAST EDITION 1. Tables, exhibits, and data have been updated. 2. Anecdotal material and illustrations have been updated. CHAPTER KEY POINTS 1. The Fed has centralized as the U.S. has evolved from a confederation of regional economies to a truly national economy. The 12 Federal Reserve Banks, once largely autonomous in their respective regional districts, remain operationally important but have lost their authority to set monetary policy. They are a minority (5 votes out of 12) on the FOMC, which sets U.S. monetary policy under ultimate control of the Board of Governors. Students should have this in mind as they compare the Fed’s formal organizational structure (Exhibit 2.3) to its actual power structure (Exhibit 2.4). 2. The Fed's powers have expanded substantially since its creation. In addition to its original central bank functions, the Fed has gained many regulatory powers, summarized in Exhibit 2.5. Today the Fed directly influences the behavior of practically every U.S. financial institution. The Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA”) empowered the Fed to impose uniform reserve requirements on all depository institutions. Throughout its existence, the Fed’s power and credibility have been based in large part on its considerable independence within the federal government. Students should understand how and why this independence endures, and grasp the ultimate limits on it. 3.
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This note was uploaded on 03/24/2011 for the course FINA 409 taught by Professor John during the Spring '11 term at Ohio State.

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