An intermediary is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank.  All the funds deposited are mingled in one big pool, which is then loaned out. Figure 1 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out.

Figure 1. Banks As Financial Intermediaries.

For some concrete examples of what banks do, watch the following video from Paul Solman’s Making Sense of Financial News.

The Federal Reserve System

Figure 1. Marriner S. Eccles Federal Reserve Headquarters, Washington, DC. Some of the most influential decisions regarding monetary policy in the United States are made behind these doors.

Introduction

Money, loans, and banks are all tied together. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions in goods and labor markets happen smoothly, and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation.

The government of every country has public policies that support the system of money, loans, and banking. But these policies do not always work perfectly.  In this section we will explore how monetary policy works and what may prevent it from working perfectly.

The Federal Reserve Banking System and Central Banks

In making decisions about the money supply—that is, the total amount of monetary assets available in an economy at a specific time—a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation’s banking system to protect bank depositors and insure the health of the bank’s finances.

The organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly is called the central bank. Most nations have central banks or currency boards. Some prominent central banks around the world include the European Central Bank, the Bank of Japan, and the Bank of England. In the United States, the central bank is called the Federal Reserve—often abbreviated as “the Fed.” This section explains the organization of the U.S. Federal Reserve and identifies the major responsibilities of a central bank.

Structure/Organization of the Federal Reserve

Unlike most central banks, the Federal Reserve is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a board of governors, consisting of seven members appointed by the president of the United States and confirmed by the Senate. Appointments are for fourteen-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the board of governors as much as possible from political pressure so that policy decisions can be made based only on their economic merits. In addition, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. Policy decisions of the Fed do not require congressional approval, and the president cannot ask for the resignation of a Federal Reserve governor as the president can with cabinet positions.

One member of the board of governors is designated as the chair. For example, from 1987 until early 2006, the chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. The current chair, Janet Yellen, has made many headlines already. Why? See the following feature to find out.

WHO HAS THE MOST IMMEDIATE ECONOMIC POWER IN THE WORLD?

Figure 1. Chair of the Federal Reserve Board. Janet L. Yellen is the first woman to hold the position of chair of the Federal Reserve Board of Governors.

What individual can make the financial market crash or soar just by making a public statement? It’s not Bill Gates or Warren Buffett. It’s not even the president of the United States. The answer is the chair of the Federal Reserve Board of Governors. In early 2014, Janet L. Yellen, shown in Figure 1, became the first woman to hold this post. Yellen has been described in the media as “perhaps the most qualified Fed chair in history.” With a PhD in economics from Yale University, Yellen has taught macroeconomics at Harvard, the London School of Economics, and most recently at the University of California at Berkeley. From 2004–2010, Yellen was president of the Federal Reserve Bank of San Francisco. Not an ivory-tower economist, Yellen became one of the few economists who warned about a possible bubble in the housing market, more than two years before the financial crisis occurred. Yellen served on the board of governors of the Federal Reserve twice, most recently as vice chair. She also spent two years as chair of the President’s Council of Economic Advisors. If experience and credentials mean anything, Yellen is likely to be an effective Fed chair.

The Fed chair is first among equals on the board of governors. While he or she has only one vote, the chair controls the agenda, and is the public voice of the Fed, so he or she has more power and influence than one might expect.

The Federal Reserve is more than the board of governors. The Fed also includes twelve regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. The Federal Reserve districts and the cities where their regional headquarters are located are shown in Figure 2. The commercial banks in each district elect a board of directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders.

Figure 2. The Twelve Federal Reserve Districts. There are twelve regional Federal Reserve banks, each with its own district.

What Does a Central Bank Do?

The Federal Reserve, like most central banks, is designed to perform the following three important functions:

The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves, and they can obtain loans from the Fed through the “discount window,” which will be discussed in the next reading. The Fed is also responsible for check processing. When you write a check to buy groceries, for example, the grocery store deposits the check in its bank account. Then, the physical check (or an image of that actual check) is returned to your bank, after which funds are transferred from your bank account to the account of the grocery store. The Fed is responsible for how these transactions are handled once the check leaves the cash register and is deposited into the store’s bank account. Does that mean that your check to the grocery store goes all the way to Washington, DC.? No. Instead the regulations that govern how banks handle checks, deposits, withdrawals are regulated by The Federal Reserve Act. This act is the reason that a bank must start paying you interest on a savings deposit the day it is received. It’s also the reason that if you deposit a large check, your bank may tell you that the funds will not be available for three to five business days.

On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.

Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to publicly disclose information about the loans they make for buying houses and how those loans are distributed geographically, as well as by sex and race of the loan applicants.

How a Central Bank Executes Monetary Policy

The most important function of the Federal Reserve is to conduct the nation’s monetary policy. Article I, Section 8 of the U.S. Constitution gives Congress the power “to coin money” and “to regulate the value thereof.” As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influence the level of economic activity, as described in more detail below.

A central bank has the following three traditional tools to implement monetary policy in the economy:

1. Open market operations
2. Changing reserve requirements
3. Changing the discount rate

In discussing how these three tools work, it is useful to think of the central bank as a “bank for banks”—that is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below.

Open Market Operations

The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate charged by commercial banks making overnight loans to other banks. As such, it is a very short-term interest rate, but one that reflects credit conditions in financial markets very well.

The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC is made up of the seven members of the Federal Reserve’s board of governors. It also includes five voting members who are drawn, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent voting member of the FOMC and the other four spots are filled on a rotating, annual basis, from the other eleven districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the chairman of the Federal Reserve has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy. The following video explains how these operations work.

https://youtu.be/-KdSYnLuNZk

Is it a sale of bonds by the central bank that increases bank reserves and lowers interest rates, or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the supply of money in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.

Changing Reserve Requirements

A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out. The following video will explain how changing the reserve requirement alters the money supply.

https://youtu.be/kTVf-NF2v4Q

In early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. Small changes in the reserve requirements are made almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. In practice, large changes in reserve requirements are rarely used to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult to comply with, while loosening requirements too much would create a danger of banks being unable to meet the demand for withdrawals.

Changing the Discount Rate

The Federal Reserve was founded in the aftermath of the Financial Panic of 1907 when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, can withstand a bank run. As a result of the Panic, the Federal Reserve was founded to be the “lender of last resort.” In the event of a bank run, sound banks could borrow as much cash as they needed from the Fed’s discount “window” to cover the bank run. The interest rate banks pay for such loans is called the discount rate. They are so named because loans are made against the bank’s outstanding loans “at a discount” of their face value. Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.

So, the third traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.
The following video explains the impact of changes to the Fed’s discount rate.

In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More important, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.

Try It: Chair the Fed

Achieve Low Unemployment and Low Inflation Rates

We have now seen that the Fed has three primary goals and a set of tools at its disposal to help it achieve these goals. If you were the chairperson of the Federal Reserve, do you think that you could accomplish these goals? Let’s find out!

After reading the following information, click on the Chair the Fed link below, which will take you to the Federal Reserve Bank of San Francisco Web site, where YOU will act as the Chair of the Fed. By manipulating the fed funds rate, you will try to keep inflation and unemployment at target rates.

Instructions for Playing the Game

The game puts the player in the role of setting monetary policy as Chair of the Fed. The goals are as follows: inflation (2 percent) and unemployment (5 percent). Remember that the fed funds rate is the primary tool for monetary policy and is shown on the game screen (green line in the chart area is initially set at 4 percent rate).

Record the starting levels for inflation, unemployment, and the fed funds rate (2.11 percent, 4.68 percent, and 4.00 percent, respectively) in your notes by making a small table with four columns labeled: Quarters Remaining, Inflation, Unemployment, and Fed Funds Rate.

Review the “rules” and functions of the simulation by clicking on “YOUR JOB.” Once you have familiarized yourself with the way the simulation works, you are ready to “GO.”

Start the game by clicking on the “Go” button. Once the first quarter is completed (fifteen quarters remaining), record all three rates. Using  the “raise” and “cut” buttons, make adjustments to the fed funds rate. The information in the headline reflects changes in the levels of inflation and unemployment.

Work through the remaining fifteen quarters, pausing to review each headline and record the new values of inflation and unemployment.

The game ends on an announcement screen indicating “Congratulations” if the Chair has kept the economy on track (close to the goals for inflation and unemployment) or “Sorry” if the goals have not been met.

Good Luck!

Play the Chair the Fed Simulation

Check Your Understanding

Answer the question(s) below to see how well you understand the topics covered above. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.

Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.