Introduction to Finance

• Financial Management 
Financial management activities are directly 
aff ected by Fed monetary policy actions. A tightening of monetary 
policy makes it more diffi
cult and costly for businesses to borrow 
funds. To the extent that economic activity also declines, it is more 
diffi
cult for fi nancial managers to sell new stocks and bonds in the 
primary securities markets. Of course, an easing of monetary policy 
will make it easier for fi nancial managers to raise fi nancial capital and 
they will be able to do so at lower interest rates.

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Review Questions
99
Summary
LO 4.1 
The Federal Reserve System (Fed) responded to the recent fi n-
ancial crisis and Great Recession by providing rescue funds to some 
fi nancial institutions and by helping other fi nancially weak institu-
tions merge with stronger institutions. These actions were necessary 
to keep many fi nancial institutions from failing due to liquidity crises 
caused by precipitous declines in the values of the home mortgage 
loans and mortgage-backed securities that they held because of mort-
gage loan defaults.
LO 4.2 
The national banking system that existed before the Federal 
Reserve System was created lacked an effi
cient national payments 
system for transferring money, a fl exible money supply that can 
respond to changes in the demand for money, and a lending/
borrowing mechanism to help alleviate liquidity problems when 
they arise.
LO 4.3 
The Federal Reserve System is the central bank of the United 
States and is responsible for setting monetary policy and regulating 
the banking system. The Fed is organized into fi ve major components: 
(1) member banks, (2) Federal Reserve District Banks, (3) Board 
of Governors, (4) Federal Open Market Committee, and (5) advisory 
committees.
LO 4.4 
The policy instruments used by the Fed to carry out monetary 
policy are changing reserve requirements, changing the discount rate, 
and conducting open-market operations. In recent years, the Fed has 
also engaged in a nontraditional monetary policy called quantitative 
easing. Banks are required by the Fed to hold reserves equal to a 
specifi ed percentage of their deposits. An increase in the required 
reserves ratio reduces bank reserves, and vice versa. The Fed dis-
count rate is the interest rate that a bank must pay to borrow from its 
regional Reserve Bank. Higher discount rates will discourage money 
supply expansion, and vice versa. Open-market operations involves 
the buying and selling of securities in the open market by the Fed 
through its FOMC to alter bank reserves. The purchasing of securities 
increases bank reserves, and vice versa. Quantitative easing involves 
the purchasing of securities from banks and other fi nancial institu-
tions to increase the money supply and liquidity.
LO 4.5 
The Fed is authorized to supervise and examine member bank 
assets, operations, fi nancial conditions, and compliance with banking 
laws and regulations. In practice, the Fed focuses on examination of 
state-chartered member banks and all bank holding companies. Nation-
ally chartered banks are examined by the Offi
ce of the Comptroller of 
the Currency. The Fed has legal responsibility for administering several 
banking laws and is responsible for enforcing laws, such as the Con-
sumer Credit Protection Act of 1968, that help consumers understand 
the costs of alternative forms of credit.
LO 4.6 
Reserve Banks provide a range of services to depository insti-
tutions and to the U.S. government. The most important service is the 
payments mechanism for transferring money throughout the banking 
system. Other services include electronic funds transfers, safekeep-
ing and transfer of securities, and serving as fi scal agent for the U.S. 
government.
LO 4.7 
Foreign countries that use central banking systems, like the 
Fed in the United States, to regulate money supply and set monetary 
policy include the United Kingdom (Bank of England), Japan (Bank 
of Japan), and euro-member countries (European Central Bank). 
There is some similarity between the Fed operating with 12 Federal 
Reserve Banks that represent diff erent districts in the United States 
and the European Central Bank operating with central banks from 
each eurozone member.
Key Terms
accommodative function
bank reserves
central bank
Consumer Credit Protection 
Act
defensive activities
dynamic actions
European Central Bank (ECB)
excess reserves
Fed Board of Governors
Fed discount rate
federal funds rate
Federal Home Loan Mortgage 
Corporation (Freddie Mac)
Federal National Mortgage 
Association (Fannie Mae)
Federal Reserve System (Fed)
fractional reserve system
Government National Mortgage 
Association (Ginnie Mae) 
monetary policy
open-market operations
primary credit rate 
quantitative easing (QE) 
Regulation Z
required reserves
required reserves ratio
Review Questions