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A primary function of Federal Reserve Banks is to influence the monetary (and financial) conditions of the U.S. financial markets, and thus, the economy. Describe two ways in which Federal Reserve Banks fulfill this function.
Five of the twelve Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC), which determines monetary policy regarding the open market sale and purchase of government securities, and therefore, interest rates.
The Boards of Directors of the Federal Reserve Bank set and change the discount rate (the interest rate on "lender of last resort" loans made by the Federal Reserve Banks to depository institutions).
Federal Reserve Boards have discretion in deciding which banks qualify for discount window loans because such loans are viewed as available only under emergency or special liquidity situations.
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The Federal Reserve System has supervisory and regulatory responsibility over the activities of state-chartered member banks and bank holding companies located in their districts. Describe two ways in which the Fed fulfills this responsibility.
Using teams of bank examiners to conduct examinations and inspections of member banks, bank holding companies, and foreign bank offices.
Issuing orders (e.g., cease and desist orders show some banking activity be viewed as unsafe or unsound).
Approving various bank and bank holding company applications for expanded activities (e.g., mergers and acquisitions).
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One of the Federal Reserve System's primary functions is to provide payment and other financial services to the U.S. government. Describe two such payments and other financial services
Federal Reserve Banks are responsible for operating the U.S. savings bonds scheme and for issuing Treasury securities as well as other government-sponsored securities (e.g., Fannie Mae and Freddie Mac).
New currency issue
Federal Reserve Banks are responsible for collecting and replacing currency (paper and coin) from circulation.
Check clearing
The Federal Reserve System operates a central check-clearing system for U.S. banks.
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The Federal Reserve System routes interbank checks to depository institutions on which they are written and transfers appropriate funds from one bank to another.
Wire transfer services - The Federal Reserve operates two electronic (wire) transfer systems.
- Fedwire, which allows depository institutions to transfer funds on their own behalf or for their customers.
- Automated Clearinghouse (ACH), which is a nationwide method to electronically process credit and debit transfers of funds.
- Research services
- Each Federal Reserve Bank has a staff of professional economists. These economists gather, analyze, and interpret economic data and developments in the banking sectors as well as the overall economy
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Define or describe the following two monetary terms:
(a) Discount rate
(b) Fed funds rate
(a) Discount rate—the interest rate on loans made by Federal Reserve Banks to depository institutions
(b) Fed funds rate—the interest rate on short-term funds transferred between financial institutions, usually for a period of one day
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Describe the structure of the Board of Governors of the Federal Reserve System.
The Board of Governors (also called the Federal Reserve Board) is a seven-member board headquartered in Washington, D.C.
Each board member is appointed by the president of the U.S. and must be confirmed by the Senate.
Each board member also sits on the Federal Open Market Committee (FOMC).
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In addition to its supervisory and regulatory responsibilities, the Board of Governors of the Federal Reserve System has several other responsibilities. Describe two other responsibilities.
The Board is responsible for formulating and conducting monetary policy.
The Board, through the FOMC, sets money supply and interest rate targets.
The Board approves member bank mergers and acquisitions and specifies permissible nonbank activities of bank holding companies.
Board members confer with officials of other government agencies, representatives of banking industry groups, officials of the central banks of other countries, and members of Congress.
The Board's president often advises the U.S. president on economic policy and serves as the spokesperson for the Federal Reserve System in Congress and to the public.
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Describe three responsibilities of the Federal Open Market Committee (FOMC).
The FOMC is the major monetary policy-making body of the Federal Reserve System, formulating policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade.
The FOMC sets guidelines for open market operations, which is the sale and purchase of U.S. government and federal agency securities.
The FOMC sets ranges for the growth of monetary aggregates.
The FOMC directs operations of the Federal Reserve in foreign exchange markets.- The FOMC monitors and guides the reserve requirements and discount rates (although these are not specifically set by the FOMC).
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Explain why the Federal Reserve rarely uses the discount rate as a monetary tool.
It is hard for the Federal Reserve to predict changes in bank discount window borrowing when the discount rate changes. So, the exact effect of the discount rate change on the money supply is often uncertain.
Because of its "signaling" importance, a discount rate change often has great effects on the financial markets
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Explain the effect on depository institutions when the Federal Reserve decreases reserve requirements.
A decrease in the reserve requirement means that depository institutions may hold fewer reserves (vault cash plus reserve deposits at the Fed) against their transaction accounts (deposits).
Consequently, depository institutions are able to lend out a greater percentage of their deposits, thus increasing credit availability in the economy.
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The Federal Reserve offers different types of discount window loans (credit). Describe two of these loans (credit).
Adjustment credit is offered for short-term liquidity problems that may have been caused by a temporary deposit outflow from a bank.
Seasonal credit is offered to banks to offset seasonal liquidity squeezes, for example, for banks in rural areas that experience seasonal deposit flow patterns reflecting the agricultural crop cycle.
Extended credit is offered to more severely liquidity-constrained banks due to deposit outflows that will not be resolved in the foreseeable future (although banks must still be seen as solvent).
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Explain what is meant by open market operations.
Open market operations are the sales or purchases by the Federal Reserve of securities in the U.S. securities market.
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Describe the effect on bank reserves, and also on the operation of banks, when the Federal Reserve sells Treasury securities.
When the Fed sells Treasury securities, it decreases the total supply of bank reserves in the financial system.
This in turn decreases the ability of banks to make new loans and to create new deposits.
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All else held constant, identify three effects that occur when the Federal Reserve purchases securities in the open market.
The reserve accounts of banks increase.
An increase in the reserve accounts of banks results in an increase in bank deposits and in the money supply.
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All else held constant, identify three effects that occur when the Federal Reserve lowers the discount rate.
This generally results in lower interest rates.
Lower interest rates encourage borrowing from banks.
Economic agents spend more when they get cheaper funds.
Households, businesses, and government are more likely to invest in fixed assets (e.g., housing, plant, and equipment).
Households increase their purchase of durable goods (e.g., automobiles, appliances).
State and local government spending increases (e.g., new road construction, school improvements).
Lower domestic interest rates relative to foreign rates can result in a decrease in the (foreign) exchange value of the dollar relative to other currencies.
As the dollar's exchange rate decreases, U.S. goods become relatively inexpensive. Eventually U.S. exports increase.
Increase in spending from all these markets participants results in economic expansion, stimulates additional real production, and may cause the inflation rate to rise.
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Explain foreign exchange intervention.
Foreign exchange intervention is when central banks influence their country's exchange rates by buying and selling currencies, especially when the banks perceive the market to be unstable.
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The Federal Open Market Committee (FOMC) instructs the Federal Reserve Bank of New York (FRBNY) Trading Desk to purchase $300 million in U.S. Treasury securities. If the reserve requirement is set at 15 percent, what is the effect on the money supply resulting from this purchase of Treasury securities? Show your calculations.
1 ÷ Reserve requirement) x Open market purchases = Increase in money supply.
(1 ÷ 0.15) x $300 million = $2 billion. Score 1 point for (1/0.15).
Score 1 point for "Increases money supply." Score 3 point for $2 billion increase in money supply. Maximum 3 points.
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