Federal Reserve System Research Paper

//Federal Reserve System Research Paper

Federal Reserve System Research Paper

 

Introduction

The central banking system in the United States is known as the Federal Reserve System, commonly related to as the Fed. The Fed is the ultimate regulatory and banking authority in the United States, serving both financial institutions and the public at large.

The Fed was established in December 1913 by the Federal Reserve Act, mainly as a result of the continuous economic and monetary instability that the United States suffered during the nineteenth century. The Fed was headquartered in Washington DC. Today, the Fed continues to be the most powerful financial institution in the United States, with regulatory and policy making authorities that enable it to maintain control of the economy (FRS, p.1).

Our federal reserve system research paper covers the following:

Structure of the Federal Reserve System

The Board of Governors

The bureaucratic structure of the Fed is quite complicated, but at the same time, it is aimed at maintaining a specialized monetary policy and independence from politics. At the top of the hierarchy stands the Board of Governors, which has the final word in all policy issues concerning bank regulation and supervision and in most aspects of monetary control. This board controls both the banking and the monetary policies in the United States.

The Board consists of seven members who are appointed by the President and confirmed by the Senate for 14 years in office. On the other hand, the chairman and the vice  Chairman are appointed by the President and approved by the Senate for four years which may be renewable as long as they remain members of the board. The board of governors also issues an annual report on operations and semi-annual reports that explain the situation of the economy as well as the objectives of the Fed (Prager, p.1).

The Board also controls reserve requirements for depository institutions and approves discount rate changes that are proposed by the Reserve Bank directors. Furthermore, the Board manages financial safety and soundness, in addition to consumer protective regulations, as well as banking consolidation policies such as the approval of bank mergers and acquisitions. Finally, the Board is entitled to oversee the services of Reserve Banks’ services to depository institutions, bank supervision functions, and accounting procedures, in addition to approving Reserve Banks’ budgets (FRS, p.2).

Federal Reserve Banks

The Fed constitutes twelve Federal Reserve Banks that govern their respective districts, in addition to branches in 25 cities. Each Bank is a corporate entity of its own and has a board of nine directors. These directors are supervised by the Board of Governors. The functions of the directors are to oversee the operations of their banks, to appoint and recommend salaries for the bank’s president and the first vice president (FRS, p.3).

The Federal Reserve Banks also monitor national and international economic conditions and provide information to the system on the monetary needs of their districts. These banks also hold reserve balances for depository institutions such as commercial banks. Furthermore, these banks are considered the lenders of last resorts for these depository institutions. The directors of these Banks also set the discount rate charged on loans to depository institutions, although these rates re subject to the approval by the Board of Governors. Finally, the Banks serve, examine and supervise various depository institutions, and the US Treasury (FRS, p. 3).

Federal Open Market Committee (FOMC)

This committee is made up of twelve members who in reality are the seven members of the Board of Governors and five presidents of the Reserve Banks (including one who should be the president of the Federal Reserve Bank of New York). The function of the FOMC is to direct open market operations which is considered the most important tool of monetary policy (FRS, p.4).

Advisory Committees

These committees are specifically established in order to provide advice to the System and provide information on various groups affected by the System policies. One important committee is the Federal Advisory Council which meets with the Board of Governors four times a year to discuss economic and banking issues. Another is the Consumer Advisory Council which represents consumers and institutions that finance them. The Thrift Institutions Advisory Council is responsible for providing information and views on the special needs and problems of thrift institutions (Prager, p.3).

Member Banks

At the base of the Federal Reserve System are the member commercial banks. All national banks are required to join the system; membership of state-chartered institutions is voluntary. Members have to purchase capital stock in their district Reserve bank, for which they are entitled to a statutory 6 percent stock dividend and the right to vote for six directors of that district bank. Stock ownership does not convey control or the financial interest normally attached to stock in a corporation. The stock may not be sold or used as collateral and must be returned to the Reserve bank if the commercial bank terminates its membership (Prager, p.3).

Functions of the Federal Reserve System

The Monetary Control Act of 1980 imposed a reserve requirement on all depository institutions, but it also permits them to borrow from the Federal Reserve and to obtain payment-mechanism and other services from the Fed. Moreover, the act stipulates that the Federal Reserve charge a fee for services provided. By enabling banks to borrow reserves from the Reserve banks, the liquidity of the entire banking system is increased (Prager, p.4).

Monetary Control

The Fed is best known for the influence it has on interest rates by “loosening” or “tightening” the money supply. The term money supply has various technical definitions, but basically it is the amount of money available at any one time in the U.S. financial system. The money supply can be divided into three major parts. M1 represents the money held by the public in addition to checking deposits in depository institutions. M2 constitutes M1 in addition to saving accounts and small time deposits. M3 constitutes M1 and M2 in addition to large time deposits. Since 1979, the Federal Reserve System has been concerned with influencing monetary policy through controlling M2 and M3, rather than M1 which is too difficult and less efficient and effective to control (Prager, p.4).

Open Market Operations

The Federal Reserve’s open market operations are the most flexible and most frequently used instrument of controlling the money supply. When the FOMC decides that the money supply is growing too slowly, the bank may purchase U.S. government securities, thus injecting cash into the financial system and expanding the monetary base. This enables banks to create additional deposits, which constitute a major portion of the money supply. Similarly, if the money supply grow more rapidly than is desired, the FOMC will sell federal securities on the open market. Such sales reduce bank reserves and thus the ability of the banking system to create deposits (Prager, p.5).

Thus, open market operations conducted by the Fed maybe divided into two major operations. The first is the purchasing of securities by the Fed. This means that the total reserves of commercial banks that manage these securities will increase, thus enabling banks to make more loans and create new deposits. The objective of this policy is to increase money supply (Hakes, 118-119).

In contrast, if the Fed sells securities, this will lead to a decrease to money supply as reserves in depository institutions will be reduced and the demand on depository accounts will fall, hence declining the ability of banks to lend money (Hakes, p. 119). .

Another Open Market Operations tool is repurchase agreements whose objective is to impose temporary changes on the aggregate levels of bank reserves. There are two types of repurchase agreements. In the first type, the Federal Reserve System will purchase securities from dealers with an agreement to resell at a specified date in the future. Inversely, the Fed might sell securities to dealers with an agreement to purchase back at some time in the future. The objective of repurchase agreements is to correct temporary imbalances in the level of bank reserves, especially during holidays (Hakes, p.119).

The consequences of the open market operations of the Fed basically impact the supply of loanable funds available in depository institutions. If the deposit rates decrease, then Treasury Bill rates will also decrease, thus encouraging borrowers to borrow money from financial institutions. Open market operations may be classified into two types, dynamic or defensive. Dynamic operations are those through which the Fed tries to affect the status quo of the money supply the economy. Defensive operations, on the other hand, such as repurchase agreements, are those which are used for the correction of an anticipated problem or situation (Hakes, p. 120).

Adjustment of Discount Rate

Although the open-market operation is the most flexible and the most frequently used instrument of monetary policy, similar results can be achieved by changing the required reserve ratio, that is, the percentage of deposits that banks must maintain on reserve at the Federal Reserve banks. When the required reserve ratio is raised, banks are unable to create as much money as they previously were able to because a larger portion of their assets must be held in reserve; the converse is true when the reserve ratio is reduced (Prager, p.6).

The adjustment of discount rates might affect three types of credit. The first type is known as adjustment credit aimed at short-term liquidity problems. Seasonal credit aims at dealing with seasonal liquidity squeezes, while extended credit aims at dealing with problems that cannot be resolved in the foreseen future (Hakes, p.120).

To increase the money supply, the Fed will reduce the discount rate, hence encouraging depository institutions to borrow from the Fed. To decrease the money supply, the Fed will increase the discount rate, thus forcing depository institutions to borrow from other alternatives. Naturally, as depository institutions return their loans to the Fed and seek alternative resources, the money supply will eventually be reduced (Hakes, p. 121).

Adjustment of the discount rate might also have an “announcement effect,” signaling a change in the Federal Reserve’s underlying evaluation of economic conditions.

The Federal Reserve also has a narrow role in regulating operations of the stock market. It may selectively lower or raise the margin requirement, which is the percentage of a stock price that must be provided in cash by someone who buys the stock on credit. The margin requirement, a legacy of depression legislation, aims to control and curb speculation (Prager, p.6).

In addition to this, the Fed can adjust the reserve requirement ratio to control monetary supply and financial institutions. Traditionally, these institutions were required to maintain 8 to 12% of their transaction accounts and a smaller proportion of their saving accounts at the Fed. These reserves may not be used to earn interest. When the Fed reduces the Reserve Ratio, lending institutions have more money to lend to the public, and hence, the money supply consequently increases. In the 1990s, however, the Fed has been oriented towards reducing these reserve requirements. For example, in 1992, it reduced the ratio of transaction accounts from 12% to 10% (Hakes, p. 122).

Impact of the Fed Policies on the US Economy

Although the Fed has proven to be an indispensable regulator of the American economy, economics in general tend to believe that the policies of the Federal Reserve have had both positive and negative effects. To start with, the Federal Reserve policy decisions have occasionally increased rather than decreased economic instability. Secondly, economists argue that minute adjustments of monetary instruments are not productive and may even be destabilizing to the economy. Thirdly, Federal Reserve policies that slow down the growth rate of money supply tend to have a positive impact on controlling inflation. Finally, the Federal Reserve has proven to be ineffective in facing some national problems that are supply related, especially seen in the 1980s, such as an energy shortage (Prager, p.7).

The Federal Reserve is also held responsible for its inability to deal with the depression in the 1930s, especially as its weak monetary policies worsened the depression. The price stability period in the late 1950s and early 1960s is partly due to the Fed’s effective monetary policy. During the 1970s and early 1980s, the Fed attempted to combat inflation by raising interest rates to unusually high levels but it was seriously criticized for these policies. Today, the Fed enjoys a lot of praise and appreciation in the financial industry in the US as both inflation and interest rates steadily dropped through the mid- and late 1980s and into the early 1990s (Prager, p. 9).

 

Comparison to the Lebanese Central Bank

Like the Fed, the Central Bank of Lebanon (Banque du Liban) is responsible for the management of the monetary policy in the country. The monetary tools, capabilities and influence of the Lebanese Central Bank, however, differ substantially from those of the Fed, mainly because of a variety of reasons. To start with, the Fed has much more experience in the money markets, specifically with respect to the regulation and control of securities. The Central Bank only developed some experience in this domain very recently. Secondly, the Fed enjoys much more independence from political pressures than does the Central Bank of Lebanon. It is true that the governors of the Central Bank are political independent, but political pressures can be considerable because of the relatively short term of tenure.

Nonetheless, we may also argue that the Central Bank of Lebanon has been applying some monetary policies that are similar to those of the Fed. To start with, the Central Bank has been actively involved in regulating a number of financial industries in Lebanon, mostly during the 1990s as part of economic reconstruction. The most notable sectors in this respect are commercial banking and investment banking.

Secondly, unlike the Fed, the Central Bank of Lebanon was for most of the 1990s involved in currency speculation, that is, buying and selling Lebanese pounds and US dollars in order to stabilize the exchange rate. The Fed does not involve in such operations because the US currency is backed by a powerful economy. The Lebanese pound, on the other hand, suffered severely as a result of economic and political instability for more than two decades, and hence, the intervention of the Central Bank of Lebanon was indispensable. Indeed, much of the stability of the Lebanese pound today is owed to this intervention.

With respect to interest rates, the Central Bank of Lebanon shares some similarities and differences with the Fed. During the 1970s and early 1980s, the Fed raised interest rates to very high levels in order to curb inflation, bring the money supply under control and make sure that the economy remained stable. This was specifically to deal with the international debt crises that were affecting the US. The Central Bank of Lebanon adopted a similar policy in the early 1990s, increasing interest rates to very high levels. The objectives of this policy was to support the Lebanese pound, and at the same time, to attract investors to lend the Lebanese government. The Lebanese government started issuing treasury bills at high discount rates, and hence, since the discount rates were much higher than the interest rates offered in depository institutions, most money was used to purchase treasury bills. This effectively lead to the financing of the public sector through domestic debt, and at the same time, it limited the ability of speculators to play against the Lebanese pound as more of their money were frozen in treasury bills (Abu Ziki & Abu Ghanem, p. 17).

This policy also affected banks in a number of ways. First of all, banks were no longer able to attract sufficient deposits, particularly as most money went to treasury bills. This created many difficulties for smaller banks and forced them to adjust their policies, seeking sounder practices. At the same time, this forced a number of banks to merge together in order to consolidate deposits and face economic and competition challenges. Meanwhile, the policy of high interest rates was accompanied by an increase in the reserve requirements for banks. This meant that not only were banks forced to offer lower interest rates to the public and depositors, but they were also faced with limited capacity to lend, since more of the deposits that they kept were to be held at the Central Bank. Nonetheless, with higher interest rates, banks were lending at higher interest rates (Abu Ziki & Abu Ghanem, p. 18).

The Fed reduced the discount rates in the late 1980s and early 1990s, leading to growth in the American economy, a trend that continues until today. In Lebanon, the Central Bank initiated a similar change of policy in the mid-1990s, reducing interest rates on treasury bills. The major incentive behind this policy in Lebanon was to reduce the size of the domestic debt, as the Lebanese government turned to foreign lenders who lent the government money at several points below the discount rate in Lebanon. Eventually, interest rates in Lebanon began to drop, but at the same time, reserve requirements remained high. This meant that the money supply was still tight, and banks still had a limited capacity to lend to borrowers (Abu Ziki & Abu Ghanem, p. 18).

For Lebanese businesses, the price of money (discount rate) was still too high to borrow, and even if businesses were willing to take risks and borrow, banks did not have the capacity to lend due to the restrictions from the Central Bank. Eventually, this killed off the investment incentive in the economy, and led to a serious decline in the growth rate. Thus, while the Central Bank reduced the discount rate, it did so at a very slow rate that did not create the incentive for investment and economic growth (Abu Ziki & Abu Ghanem, p. 19).

The Central Bank of Lebanon might very well be blamed for the failure to create incentives for investment in the economy. However, the rationale for the Bank’s monetary policy is also important to consider. First of all, the Bank’s primary aim was to maintain the stability of the Lebanese pound. The only way to achieve this was through high discount rates that would keep the money supply under control, and that would at the same time, keep the money supply tight.

More importantly, a major concern of the Lebanese Central Bank was to keep the inflation rate low. Indeed, since the initiation of the high interest rates, inflation rates in the country have been reduced dramatically to the extent that the double-digit growth days of inflation are almost history now.

To evaluate the monetary policy of the Lebanese Central Bank, we can say that this policy has led to the stability of the Lebanese economy. At the same time, however, interest rates should still drop to less than 10% if the economy is to grow because the high cost of borrowing is killing off the incentive for investment and thus slowing the business cycle. Yet, the Central Bank’s policy to keep the reserve requirements of commercial banks high is still recommended because it is this policy that has stabilized the Lebanese banking sector and forced Lebanese banks to search for new business opportunities, away from the traditional line of lending to businesses and households.

It is difficult to compare the successes and limitations of the Fed and the Central Bank, because the two institutions adopted their monetary policies and tools under different circumstances. What is noticed, however, is that the monetary policy of the Fed faces less pressure than that of the Lebanese Central Bank, mainly because the economy in the US is managed through a balance of monetary and fiscal policies. In Lebanon, monetary policy is still used more frequently to influence the economy whereas fiscal policies remain underdeveloped and less influential.

 
Recommendations

After comparing the operations of the Fed and the Central Bank of Lebanon, we recommend a number of changes. First of all, we believe that the Central Bank of Lebanon should continue reducing the discount rate until it goes below 10% if investment and growth in the economy are to be encouraged. Secondly, we recommend that the Central Bank maintain high reserve requirements of banks for a few more years until Lebanese banks become stable and powerful enough; only then should reserve requirements be reduced to loosen the monetary policy and to increase the money supply without creating inflation.

Another recommendation that we believe is necessary is to reform the Lebanese economic practices such that monetary policies will play a less influential role in the management of the economy. We believe that fiscal instruments in Lebanon are still used in a primitive and inadequate manner. Monetary policies should only be reserved to deal with serious economic problems rather than to frequent influencing of the economy.

 

 

 

 

 

 

 

 

References

Business Outlook. “US: The betting now is for a rate cut.” Business Week,

September 28, 1998: pp. 72-74.

 

Abu Ziki, Faisal & Abu Ghanim, Bahij. “Interview with Governor of Central

Bank.” Al-Iktisad wal-Aamal, September 1999: pp. 12-19.

 

Federal Reserve System. “Structure & Functions.” FRS online,

www.frbatlanta.org/publica/struct/strucfn.htm, December 15, 1999.

 

Hakes, David. Monetary Policy. New York: Brown & Benchmark, 1995.

 

Prager, Jonas. “Federal Reserve System.” Encyclopedia Encarta, Microsoft

Inc., 1998.

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