Federal Reserve System
L E A R N I N G O B J E C T I V E S
After studying this chapter, you should be able to do the following: LO 4.1 Discuss how the Federal Reserve System (Fed) responded to the recent fi nancial
crisis and Great Recession.
LO 4.2 Identify three weaknesses of the national banking system that existed before the Federal Reserve System was created.
LO 4.3 Describe the Federal Reserve System and identify the fi ve major components into which it is organized.
LO 4.4 Identify and describe the policy instruments used by the Fed to carry out monetary policy.
LO 4.5 Discuss the Fed’s supervisory and regulatory functions. LO 4.6 Identify important Fed service functions. LO 4.7 Identify specifi c examples of foreign countries that use central banking systems to
regulate money supply and implement monetary policy.
W H E R E W E H A V E B E E N . . . In Chapter 3 we discussed the types and roles of fi nancial institutions that have evolved in
the United States to meet the needs of individuals and businesses and help the fi nancial sys-
tem operate effi ciently. We also described the traditional diff erences between commercial
banking and investment banking, followed by coverage of the functions of banks (all depos-
itory institutions) and the banking system. By now you also should have an understanding of
the structure and chartering of commercial banks, the availability of branch banking, and the
use of bank holding companies. You also should now have a basic understanding of the bank
balance sheet and how the bank management process is carried out in terms of liquidity and
capital management. Selected information also was provided on international banking and
several foreign banking systems.
W H E R E W E A R E G O I N G . . . The last two chapters in Part 1 address the role of policy makers in the fi nancial system and
how international trade and fi nance infl uence the U.S. fi nancial system. In Chapter 5 you will
have the opportunity to review economic objectives that direct policy-making activities. We
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4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 77
then briefl y review fi scal policy and how it is administered through taxation and expenditure
plans. This is followed by a discussion of the policy instruments employed by the U.S.
Treasury and how the Treasury carries out its debt management activities. You will then see
how the money supply is changed by the banking system, as well as develop an understand-
ing of the factors that aff ect bank reserves. The monetary base and the money multiplier also
will be described and discussed. Chapter 6 focuses on how currency exchange rates are
determined and how international trade is fi nanced.
H O W T H I S C H A P T E R A P P L I E S T O M E . . .
Actions taken by the Fed impact your ability to borrow money and the cost of, or interest
rate on, that money. When the Fed is taking an easy monetary stance, money becomes
more easily available, which in turn leads to a lower cost. Such an action, in turn, will
likely result in lower interest rates on your credit card, your new automobile loan, and
possibly your interest rate on a new mortgage loan. Actions by the Fed also infl uence eco-
nomic activity and the type and kind of job opportunities that may be available to you. For
example, a tightening of monetary policy in an eff ort to control infl ation may lead to an
While many individuals know that the Federal Reserve System is the central bank of the
United States, what the Fed does and how it operates are less clear. Stephen H. Axilrod
There must be almost as many images of the Fed as an institution and of the wellsprings of its actions as there are viewers. Mine, born of a particular experience, is a generally benign one. It is of an unbiased, honest, straightforward institution that quite seriously and carefully carries out its congressionally given mandates. . . . It is of course through the window of monetary policy that the public chiefl y sees and judges the Fed.1
This chapter focuses on understanding the structure and functions of the Fed. Chapter 5 describes
how the Fed administers monetary policy in cooperation with fi scal policy and Treasury
operations to carry out the nation’s economic objectives.
4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession CRISIS As previously noted, the 2007–2008 fi nancial crisis and the 2008–2009 Great Reces-
sion combined to create a “perfect fi nancial storm.” Many government offi cials, politicians,
fi nancial institution executives, and business professionals felt during the midst of the
fi nancial storm that both the U.S. and world fi nancial systems were on the verge of collapse
in 2008. The Federal Reserve System (Fed), the central bank of the United States, is responsible for setting monetary policy and regulating the banking system. Direct actions
and involvement by the Fed were critical in government and related institutional eff orts to
avoid fi nancial collapse.
The federal government has historically played an active role in encouraging home own-
ership by supporting liquid markets for home mortgages. If banks and other lenders originate
home mortgages and then “hold” the mortgages, new mortgage funds are not readily available.
However, when banks and other lenders are able to sell their mortgages in a secondary mortgage
market to other investors, the proceeds from the sales can be used to make new mortgage loans. In
Federal Reserve System (Fed) U.S. central bank that sets monetary
policy and regulates banking
1 Stephen H. Axilrod, Inside the Fed, (Cambridge: The MIT Press, 2009), p. 159.
Copyright © 2017 John Wiley & Sons, Inc.
78 C H A P T E R 4 Federal Reserve System
1938, the president and Congress created the Federal National Mortgage Association (Fannie Mae) to support the fi nancial markets by purchasing home mortgages from banks and, thus, freeing-up funds that could be lent to other borrowers. Fannie Mae was converted to a government-
sponsored enterprise (GSE), or “privatized,” in 1968 by making it a public, investor-owned com-
pany. The Government National Mortgage Association (Ginnie Mae) was created in 1968 as a government-owned corporation. Ginnie Mae issues its own debt securities to obtain funds that
are invested in mortgages made to low to moderate income home purchasers. The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970, also as a government-owned corporation to aid the mortgage markets by purchasing and holding mortgage loans. In 1989,
Freddie Mac also became a GSE when it became a public, investor-owned company.
Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage
purchases and holdings. Ginnie Mae purchases Federal Housing Administration (FHA)
and Department of Veterans Aff airs (VA) federally insured mortgages, packages them into
mortgage-backed securities that are sold to investors. Ginnie Mae guarantees the payment
of interest and principal on the mortgages held in the pool. Fannie Mae purchases individual
mortgages or mortgage pools from fi nancial institutions and packages or repackages them into
mortgage-backed securities as ways to aid development of the secondary mortgage markets.
Freddie Mac purchases and holds mortgage loans.
As housing prices continued to increase, these mortgage-support activities by Ginnie
Mae, Fannie Mae, and Freddie Mac aided the government’s goal of increased home own-
ership. However, after the housing price bubble burst in mid-2006 and housing-related jobs
declined sharply, mortgage borrowers found it more diffi cult to meet interest and principal
payments, causing the values of mortgage-backed securities to decline sharply. To make the
housing-related developments worse, Fannie Mae and Freddie Mac held large amounts of low
quality, subprime mortgages that had higher likelihoods of loan defaults. As default rates on
these mortgage loans increased, both Fannie and Freddie suff ered cash and liquidity crises.
To avoid a meltdown, the Federal Reserve provided rescue funds in July 2008, and the U.S.
government assumed control of both fi rms in September 2008.
The Federal Reserve, sometimes with the aid of the U.S. Treasury, helped a number of
fi nancial institutions on the verge of failing, due to the collapse in value of mortgage-backed
securities, to merge with other fi rms. Examples included the Fed’s eff orts in aiding the March
2008 acquisition of Bear Stearns by the JPMorgan Chase bank and the sale of Merrill Lynch
to Bank of America during the latter part of 2008. However, Lehman Brothers, a major invest-
ment bank, was allowed to fail in September 2008. Shortly after the Lehman bankruptcy and
the Merrill sale, American International Group (AIG), the largest insurance fi rm in the United
States, was “bailed out” by the Federal Reserve with the U.S. government receiving an own-
ership interest in the company. Like Merrill, Fannie, and Freddie, AIG was considered “too
large to fail,” due to the potential impact of this on the global fi nancial markets.
In addition to direct intervention, the Fed also engaged in quantitative easing actions to
help avoid a fi nancial system collapse in 2008, and to stimulate economic growth after the
2008–09 recession. We will discuss the Fed’s quantitative easing actions later in the chapter.
DISCUSSION QUESTION 1 Do you support the Fed’s decision to bail out selected fi nancial institutions that were suff ering fi nancial distress in 2008?
4.2 The U.S. Banking System Prior to the Fed In Chapter 1, when we discussed the characteristics of an eff ective fi nancial system, we
said that one basic requirement was a monetary system that effi ciently carried out the fi n-
ancial functions of creating and transferring money. While we have an effi cient monetary
system today, this was not always the case. To understand the importance of the Federal
Reserve System, it is useful to review briefl y the weaknesses of the banking system that gave
rise to the establishment of the Fed. The National Banking Acts passed in 1863 and 1864
provided for a national banking system. Banks could receive national charters, capital and
reserve requirements on deposits and banknotes were established, and banknotes could be
Federal National Mortgage Association (Fannie Mae) created to support the fi nancial markets by
purchasing home mortgages from
banks so that the proceeds could be
lent to other borrowers
Government National Mortgage Association (Ginnie Mae) created to issue its own debt securities to
obtain funds that are invested in
mortgages made to low to moderate
income home purchasers
Federal Home Loan Mortgage Corporation (Freddie Mac) formed to support mortgage
markets by purchasing and holding
Copyright © 2017 John Wiley & Sons, Inc.
4.2 The U.S. Banking System Prior to the Fed 79
issued only against U.S. government securities owned by the banks but held with the U.S.
Treasury Department. These banknotes, backed by government securities, were supposed to
provide citizens with a safe and stable national currency. Improved bank supervision also was
provided for with the establishment of the Offi ce of the Comptroller of the Currency under
the control of the U.S. Treasury.
Weaknesses of the National Banking System Although the national banking system overcame many of the weaknesses of the prior systems
involving state banks, it lacked the ability to carry out other central banking system activities
that are essential to a well-operating fi nancial system. Three essential requirements include
(1) an effi cient national payments system, (2) an elastic or fl exible money supply that can
respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help
alleviate liquidity problems when they arise. The fi rst two requirements relate directly to the
transferring and creating money functions. The third requirement relates to the need to main-
tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the
ability to meet depositor withdrawals and to pay other liabilities as they come due. All three
of these required elements were defi cient until the Federal Reserve System was established.
The payments system under the National Banking Acts was based on an extensive net-
work of banks with correspondent banking relationships. It was costly to transfer funds from
region to region, and the check clearing and collection process sometimes was quite long.
Checks written on little-known banks located in out-of-the-way places often were discoun-
ted or were redeemed at less than face value. For example, let’s assume that a check written
on an account at a little-known bank in the western region of the United States was sent to
pay a bill owed to a fi rm in the eastern region. When the fi rm presented the check to its local
bank, the bank might record an amount less than the check’s face value in the fi rm’s checking
account. The amount of the discount was to cover the cost of getting the check cleared and
presented for collection to the bank located in the western region. Today, checks are processed
or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3
that the current U.S. payments system allows checks to be processed either directly or indirectly.
The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3
or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.
A second weakness of the banking system under the National Banking Acts was that the
money supply could not be easily expanded or contracted to meet changing seasonal needs
and/or changes in economic activity. As noted, banknotes could be issued only to the extent
that they were backed by U.S. government securities. Note issues were limited to 90 percent
of the par value, as stated on the face of the bond, or the market value of the bonds, whichever
was lower. When bonds sold at prices considerably above their par value, the advantage of
purchasing bonds as a basis to issue notes was eliminated. 2
For example, if a $1,000 par value bond was available for purchase at a price of $1,100,
the banks would not be inclined to make such a purchase since a maximum of $900 in notes
could be issued against the bond, in this case 90 percent of par value. The interest that the
bank could earn from the use of the $900 in notes would not be great enough to off set the high
price of the bond. When government bonds sold at par or at a discount, on the other hand,
the potential earning power of the note issues would be quite attractive and banks would be
encouraged to purchase bonds for note issue purposes. The volume of national bank notes,
thus the money supply, therefore depended on the government bond market rather than on the
seasonal, or cyclical, needs of the nation for currency.
A third weakness of the national banking system involved the arrangement for holding
reserves and the lack of a central authority that could lend to banks experiencing temporary
liquidity problems. A large part of the reserve balances of banks was held as deposits with
large city banks, in particular with large New York City banks. Banks outside of the large
cities were permitted to keep part of their reserves with their correspondent large city banks.
Certain percentages of deposits had to be retained in their own vaults. These were the only
2 A bond’s price will diff er from its stated or face value if the interest rate required in the marketplace is diff erent from
the interest rate stated on the bond certifi cate. Bond valuation calculations are discussed in Chapter 10.
Copyright © 2017 John Wiley & Sons, Inc.
80 C H A P T E R 4 Federal Reserve System
alternatives for holding reserve balances. During periods of economic stress, the position of
these large city banks was precarious because they had to meet the demand for deposit with-
drawals by their own customers as well as by the smaller banks. The frequent inability of the
large banks to meet such deposit withdrawal demands resulted in extreme hardship for the
smaller banks whose reserves they held. A mechanism for providing loans to banks to help
them weather short-term liquidity problems is crucial to a well-functioning banking system.
The Movement to Central Banking A central bank is a government-established organization responsible for supervising and regulating the banking system and for creating and regulating the money supply. While central
bank activities may diff er somewhat from country to country, central banks typically play an
important role in a country’s payments system. It is also common for a central bank to lend
money to its member banks, hold its own reserves, and be responsible for creating money.
Even though the shortcomings of the national banking system in terms of the payments
system, infl exible money supply, and illiquidity were known, opposition to a strong central
banking system still existed in the United States during the late 1800s. The vast western fron-
tiers and the local independence of the southern areas during this period created distrust of
centralized fi nancial control. This distrust deepened when many of the predatory practices of
large corporate combinations were being made public by legislative commissions and invest-
igations around the turn of the century.
The United States was one of the last major industrial nations to adopt a permanent sys-
tem of central banking. However, many fi nancial and political leaders had long recognized the
advantages of such a system. These supporters of central banking were given a big boost by
the fi nancial panic of 1907. The central banking system adopted by the United States under the
Federal Reserve Act of 1913 was, in fact, a compromise between the system of independently
owned banks in this country and the single central bank systems of such countries as Canada,
Great Britain, and Germany. This compromise took the form of a series of central banks, each
representing a specifi c region of the United States. The assumption was that each central bank
would be more responsive to the particular fi nancial problems of its region.
4.3 Structure of the Federal Reserve System The Federal Reserve System is the central bank of the United States and is responsible for
setting monetary policy and regulating the banking system. It is important to understand that
the Fed did not replace the system that existed under the National Banking Acts of 1863 and
1864 but, rather, it was superimposed on the national banking system created by these acts.
Certain provisions of the National Banking Acts, however, were modifi ed to permit greater
fl exibility of operations.
The Fed system consists of fi ve components:
Federal Reserve District Banks
Board of Governors
Federal Open Market Committee
These fi ve components are depicted in Figure 4.1.
Member Banks The Federal Reserve Act provided that all national banks were to become members of the
Fed. In addition, state-chartered banks were permitted to join the system if they could show
central bank federal government agency that facilitates the operation
of the fi nancial system and
regulates the money supply
Copyright © 2017 John Wiley & Sons, Inc.
4.3 Structure of the Federal Reserve System 81
evidence of a satisfactory fi nancial condition. The Federal Reserve Act also required that all
member banks purchase capital stock of the Reserve Bank of their district up to a maximum
of 6 percent of their paid-in capital and surplus. In practice, however, member banks have had
to pay only 3 percent; the remainder is subject to call at the discretion of the Fed. Member
banks are limited to a maximum of 6 percent dividends on the stock of the Reserve Bank that
they hold. The Reserve Banks, therefore, are private institutions owned by the many member
banks of the Fed.
State-chartered banks are permitted to withdraw from membership with the Fed six
months after written notice has been submitted to the Reserve Bank of their district. In such
cases, the stock originally purchased by the withdrawing member is canceled and a refund is
made for all money paid in.
BOARD OF GOVERNORS
(7 Appointed Members)
approves discount rates as part
of monetary policy
FEDERAL RESERVE BANKS
depository institutions and lend
to them at the discount window
transfer funds for depository