2. The Fed plays a number of important roles in the U.S. economy. Among the thin

Question

2. The Fed plays a number of important roles in the U.S. economy. Among the things it does is conduct research on the nation's economy and regulate banks.

A. The Fed also acts as a bank for banks. What are the three activities the Fed undertakes when it acts as a bank for banks? Hint: What are the activities the Fed does for banks that are similar to the activities a bank does for its customers? (3 points)

B. The Fed also controls the money supply. List and explain the three tools the Fed uses to control the money supply. (6 points)

Explanation / Answer

Solution1:

The Reserve Banks serve banks, the U.S. Treasury, and, indirectly, the public. A Reserve Bank is often called a "banker's bank," storing currency and coin, and processing checks and electronic payments. Reserve Banks also supervise commercial banks in their regions. As the bank for the U.S. government, Reserve Banks handle the Treasury's payments, sell government securities and assist with the Treasury's cash management and investment activities. Reserve Banks conduct research on regional, national and international economic issues. Research plays a critical role in bringing broad economic perspectives to the national policymaking arena and supports Reserve Bank presidents who all attend meetings of the Federal Open Market Committee (FOMC).

The New York Fed and the other Reserve Banks provide several important services to the Federal government and to depository institutions. Depository institutions are charged a fee for these services.

As the banker for the Federal government, the Fed clears checks drawn on the Treasury's account. Acting as fiscal agents for the government, the Reserve Banks sell, service and redeem Treasury securities. Further, currency and coin are placed into or are withdrawn from circulation in response to seasonal and cyclical shifts in the public's need for cash. Almost all U.S. currency now consists of Federal Reserve notes, which were first issued in 1914.

The New York Fed operates two types of electronic funds transfer (EFT) systems, which permit the rapid nationwide clearing and settling of electronically originated credits and debits among financial institutions. One system, Fedwire, developed and maintained by the Fed and overseen by the Fed's Wholesale Product Office, transfers large-dollar payments among Federal Reserve offices, depository institutions and federal government agencies. The New York Fed serves as the Wholesale Product Office for the Federal Reserve System. In this capacity, it is responsible for strategic planning and oversight of the Fed's large-dollar funds and securities transfer businesses, as well as its net settlement services. The majority of U.S. Fedwire transactions originate from Second District financial institutions.

The other EFT system, which makes relatively small payments, consists of national and local automated clearing house (ACH) networks operated by or with the support of Reserve Banks. The ACH system was designed to reduce the use of paper checks for routine payments. In addition, a large number of payments are cleared privately through clearing houses, such as the Clearing House Interbank System, also known as CHIPS.

In the past, the New York Fed’s East Rutherford Operations Center in New Jersey handled check processing for New Jersey and the New York Metropolitan area. However, as part of the Federal Reserve’s check restructuring process, East Rutherford check processing operations were moved to the Federal Reserve Bank of Philadelphia. These changes were made in response to the changing market, including the decline of check volumes industry wide as consumers and businesses continue to move toward electronic payments.

Solution 2:

The function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves:

The Tools:

1. A change in reserve ratio is seldom used but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits.A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect. (Read more on this subject in Breaking Down The Fed Model.)

2. The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa). As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate that it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

3. Open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. Note that the terms "purchase" and "sell" refer to actions of the Fed, not the public. For example, an open-market purchase means the Fed is buying but the public is selling. Actually, the Fed carries out open-market operations only with the nation's largest securities dealers and banks, and not with the general public. In the case of an open-market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself. When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

The process does not end there. The monetary expansion following an open-market operation involves adjustments by banks and the public. (To find out more, see Formulating Monetary Policy.) The bank in which the original check from the Fed is deposited now has a reserve ratio that may be too high. In other words, its reserves and deposits have gone up by the same amount; therefore, its ratio of reserves to deposits has risen. To reduce this ratio of reserves to deposits, it chooses to expand loans.

When the bank makes an additional loan, the person receiving the loan gets a bank deposit. At this stage, when the bank makes a loan, the money supply rises by more than the amount of the open-market operation. This multiple expansion of the money supply is called the money multiplier. Bank loans and purchases of securities are described as bank credit. It is the existence of bank credit that makes the money stock larger than the monetary base, also known as "high-powered money". High-powered money consists of currency and bank deposits at the Fed.

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