Federal reserve system (Fed)

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Intros
Lessons
  1. Federal Reserve System's Balance Sheet
    • U.S. Government Securities
    • Depository Institution Loans and Deposits
    • Federal Reserve Notes
    • Monetary Base
  2. Federal Reserve System's Policy Tools
    • Last Resort Loans
    • Required Reserve Ratio
    • Open Market Operation
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Examples
Topic Notes
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Federal Reserve System’ Structure

The Federal Reserve System is basically the central bank of the United States. There are three components of the Federal Reserve System’s (Fed):

  1. Board of Governors: President of the United States nominates 7 members in the board in which the Senate must approve, in order for them to govern the Federal Reserve System. The President also assigns one of the members as a chairman for a 4-year renewable term.

  2. Regional Federal Reserve Banks: The nation is divided into 12 Federal Reserve districts, where each district has a Federal Reserve Bank that issues bank notes and gives check-clearing services to commercial banks.

    Note: Of the 12 districts, the New York Federal Reserve Bank is special because it implements Fed’s policy decisions in the financial markets.

  3. Federal Open Market Committee (FOMC): is the main policymaking body of the Federal Reserve System. The FOMC has a total of 12 members, which are
    1. The 7 members of the Board of Governors including the chairman
    2. The president of the Federal Reserve Bank of New York
    3. The presidents of other Regional Federal Reserve Banks (fills 4 of the remaining voting positions in a rotating basis)

    The FOMC meets 8 times per year (or every 6 weeks) to look at the condition of the economy, and see what actions are needed to be taken by the New York Federal Reserve System.


Federal Reserve System’s Balance Sheet

In this section, we are going to look at the main assets and liabilities that the Federal Reserve System has in their balance sheet:

Fed’s Assets: The two main assets that the Federal Reserve System have are

  1. U.S. Government Securities: these securities are treasury bills, and treasury bonds, which are bought in the bond market (loanable funds market).

  2. Depository Institution Loans: When institutions are short on reserves, they can borrow from the Federal Reserve System. The loans are usually very small.


Fed’s Liabilities: the two main liabilities of the Federal Reserve System have are

  1. Federal Reserve Notes: are dollar bills we use in daily transactions. Households, businesses, depository institutions, and vaults of banks all have these notes.

  2. Depository institution deposits: these deposits at the Fed are part of the institution’s reserves.


Monetary Base: is the sum of the Federal Reserve System’s liabilities (Reserve notes & depository institution deposits) and the coins issued by the Treasury.

When the Fed changes the monetary base, it will change the quantity of money and the interest rate, which we will see in the next part.


Federal Reserve System’s Policy Tools

The Federal Reserve System plays a role in the quantity of money and interest rates by changing the availability of reserves to banks, and also changing the quantity of reserves that banks holds. This can be done by controlling 3 policy tools

  1. Last Resort Loans: We say that the Federal Reserve is the lender of last resort. This means that if a bank is short of reserves, they can borrow from the Fed with a specific interest rate. We call this interest rate the discount rate.

  2. Required Reserve Ratios: is the minimum percentage of deposits that depository institution must keep to hold as reserves.

    Example: If the bank has $100 million dollars of deposits and the required reserve ratio is 3%, then the minimum amount the bank needs to hold as reserves is $3 million.

  3. Open Market Operations: is the act of Fed buying and selling securities in the loanable funds market.

    1. If the Fed buys $100 thousand dollars’ worth of securities from a bank, then
      1. The Fed has $100 thousand more securities, and the bank has $100 thousand less.
      2. The Fed loses $100 thousand, and the bank has $100 thousand in their reserve deposits. (more reserves)

    2. If the Fed sells $100 thousand dollars’ worth of securities from a bank, then
      1. The Fed has $100 thousand less securities, and the bank has $100 thousand more.
      2. The Fed gains $100 thousand, and the bank loses $100 thousand in their reserve deposits. (less reserves)