The Federal Reserve and Monetary Policy Chapter 16

The Federal Reserve System Chapter 16, Section 1

Federal Reserve Act of 1913 Created the Federal Reserve (FED) Created the Federal Reserve (FED) System of federal banks (loan $ to other banks) System of federal banks (loan $ to other banks) 12 districts (each has a regional bank) 12 districts (each has a regional bank) Overseen by the Board of Governors Overseen by the Board of Governors 7 governors 7 governors 14 year terms appointed by the President 14 year terms appointed by the President Appoints a chair confirmed by the Senate Appoints a chair confirmed by the Senate Chairs serve a four year term that can be renewed Chairs serve a four year term that can be renewed

FED Districts 12 districts 12 districts District bank reports on economic activity in the district to the central bank District bank reports on economic activity in the district to the central bank Member banks... All nationally chartered banks are required to join the Fed. Member banks contribute funds to join the system Member banks... All nationally chartered banks are required to join the Fed. Member banks contribute funds to join the system Banks receive stock in and dividends from the system in return. This ownership of the system by banks, not government, gives the Fed a high degree of political independence (not worried about political parties) Banks receive stock in and dividends from the system in return. This ownership of the system by banks, not government, gives the Fed a high degree of political independence (not worried about political parties) The FOMC (Federal Open Market Committee), which consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about interest rates and the growth of the United States money supply. The FOMC (Federal Open Market Committee), which consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about interest rates and the growth of the United States money supply.

Structure of the Federal Reserve System 12 District Reserve Banks Federal Open Market Committee 4,000 member banks and 25,000 other depository institutions Board of Governors 7 Governors 12 District Banks

Federal Reserve Functions Chapter 16, Section 2

Functions of the FED Banking and fiscal services to the government Banking and fiscal services to the government Carries out all functions to help control the economy Carries out all functions to help control the economy Banking and fiscal services to member and nonmember banks Banking and fiscal services to member and nonmember banks Regulates the banking industry Regulates the banking industry Tracks and manages the money supply Tracks and manages the money supply This helps meet current demand and stabilize the economy This helps meet current demand and stabilize the economy

Serving the Government Acts as the Government’s bank Acts as the Government’s bank Maintains a checking account for the treasury Maintains a checking account for the treasury Sells securities, gov’t bonds, notes, etc. Sells securities, gov’t bonds, notes, etc. Issues currency Issues currency Coins are created at the US Mint (issued by FED) Coins are created at the US Mint (issued by FED) Currency is created by the Bureau of Engraving and Printing Currency is created by the Bureau of Engraving and Printing Coins & bills can be taken out of circulation Coins & bills can be taken out of circulation

Serving Banks Check clearing Check clearing Loans to member banks Loans to member banks Loans to other banks will be examined by the FED Loans to other banks will be examined by the FED Stock to member banks Stock to member banks Supervise lending practices Supervise lending practices Lender of last resort for commercial banks Lender of last resort for commercial banks Banks loan money to each other and charge interest known as the Federal Funds Rate Banks loan money to each other and charge interest known as the Federal Funds Rate The FED can lend funds to banks in times of need and charge interest The FED can lend funds to banks in times of need and charge interest This is called the discount rate This is called the discount rate

Regulating the Banking System The FED requires banks to report on their reserves daily about banking activities The FED requires banks to report on their reserves daily about banking activities Examine banks to ensure they are following regulations Examine banks to ensure they are following regulations Examiners look at the banks Net Worth to determine if they are in trouble Examiners look at the banks Net Worth to determine if they are in trouble Net Worth represents total assets minus total liabilities Net Worth represents total assets minus total liabilities If Net Worth is low bank may be in trouble If Net Worth is low bank may be in trouble Visits will be unexpected to ensure sound practices Visits will be unexpected to ensure sound practices

Regulating the Money Supply FED is best known for regulating the money supply FED is best known for regulating the money supply Factors that affect demand for money Factors that affect demand for money Cash needed on hand (high demand for this) Cash needed on hand (high demand for this) Interest rates (if rates are high, people will hold $$) Interest rates (if rates are high, people will hold $$) Price levels in the economy affect money supply Price levels in the economy affect money supply General level of income for families General level of income for families The laws of supply and demand work the same with the money supply The laws of supply and demand work the same with the money supply

Monetary Policy Tools Chapter 16, Section 3

Monetary Policy Monetary policy refers to the action the FED takes to influence economic performance Monetary policy refers to the action the FED takes to influence economic performance The FED can use monetary policy in a number of ways The FED can use monetary policy in a number of ways Money creation...not making it but putting it into circulation by normal banking business Money creation...not making it but putting it into circulation by normal banking business Changing reserve requirements Changing reserve requirements Changing the discount (interest) rates Changing the discount (interest) rates Purchasing bonds Purchasing bonds

Money Creation Banks keep a certain amount of funds on hand Banks keep a certain amount of funds on hand The required reserve ratio (RRR) is the amount that must be kept by banks...this is established by the FED The required reserve ratio (RRR) is the amount that must be kept by banks...this is established by the FED After the RRR is kept, banks can loan money. This process, along with gained interest creates money...or adds it to the money supply After the RRR is kept, banks can loan money. This process, along with gained interest creates money...or adds it to the money supply The money multiplier formula tells us how much money will be created through this process (1/RRR…very small) The money multiplier formula tells us how much money will be created through this process (1/RRR…very small) However, banks may keep excess reserves on hand However, banks may keep excess reserves on hand More money than is required by the RRR to ensure the bank is meeting customer needs More money than is required by the RRR to ensure the bank is meeting customer needs

Reserve Requirements The FED can influence the economy by changing the RRR The FED can influence the economy by changing the RRR Raising the RRR will reduce the money in circulation because banks will hold more $$ Raising the RRR will reduce the money in circulation because banks will hold more $$ Lowering it will increase the money in circulation (banks can make more loans) Lowering it will increase the money in circulation (banks can make more loans) FED does not use these tactics a lot as it can be very disruptive to the loan process FED does not use these tactics a lot as it can be very disruptive to the loan process Loans may have to be recalled Loans may have to be recalled

The Discount Rate Banks borrow from the FED and the interest charged is known as the discount rate. Banks borrow from the FED and the interest charged is known as the discount rate. In turn, these banks loan to customers(you and me) and the interest rate charged is known as the prime rate. In turn, these banks loan to customers(you and me) and the interest rate charged is known as the prime rate. By changing the discount rate, the prime rate changes and affects our spending behaviors By changing the discount rate, the prime rate changes and affects our spending behaviors Raising the discount rate will slow borrowing, spending and the economy…banks won’t want to borrow from FED Raising the discount rate will slow borrowing, spending and the economy…banks won’t want to borrow from FED Lowering the discount rate will increase borrowing, spending, and increase the economy…banks will be more likely to borrow from the FED Lowering the discount rate will increase borrowing, spending, and increase the economy…banks will be more likely to borrow from the FED 2 nd most used form of Monetary Policy 2 nd most used form of Monetary Policy

Open Market Operations The most used monetary tool is open market operations  buying & selling of gov’t securities to alter money supply The most used monetary tool is open market operations  buying & selling of gov’t securities to alter money supply The FED can purchase bonds to put money into circulation The FED can purchase bonds to put money into circulation They sell government bonds to take money out of circulation They sell government bonds to take money out of circulation

Review 1. The required reserve ratio is (a) the ratio of deposits to reserves required of banks by the Federal Reserve. (b) the ratio of accounts to customers required of banks by the Federal Reserve. (c) the ratio of reserves to deposits required of banks by the Federal Reserve. (d) the ratio of paper currency to coins required of banks by the Federal Reserve. 2. All of the following will increase the money supply except (a) increasing the required reserve ratio. (b) bond purchases by the Fed. (c) reducing the required reserve ratio. (d) reducing the discount rate.

Monetary Policy and Macroeconomic Stabilization Chapter 16, Section 4

Using Monetary Policy Monetarism...the belief that the money supply is the most important factor in macroeconomic performance Monetarism...the belief that the money supply is the most important factor in macroeconomic performance Money supply and interest rates Money supply and interest rates In basic terms, the interest rate is the cost of money In basic terms, the interest rate is the cost of money This is the price you (borrower) pay for getting money This is the price you (borrower) pay for getting money Works under the principles of supply and demand Works under the principles of supply and demand When money supply is high, interest rates are low When money supply is high, interest rates are low When money supply is low, interest rates are high When money supply is low, interest rates are high

Easy Money vs. Tight Money Policy When money is in low supply, the FED may follow an easy money policy When money is in low supply, the FED may follow an easy money policy Policies will increase the money supply in order to lower interest rates & promote investment spending Policies will increase the money supply in order to lower interest rates & promote investment spending When money is in high supply, the FED will try to lower the money supply or use tight money policy When money is in high supply, the FED will try to lower the money supply or use tight money policy Reduce $$ supply to push interest rates up which will cause investment spending to decline Reduce $$ supply to push interest rates up which will cause investment spending to decline

Timing of Monetary Policy Policies of Monetary Policy need to be carefully enacted to have the desired effect...if they are not timed accordingly, they may have a negative effect on the business cycle Policies of Monetary Policy need to be carefully enacted to have the desired effect...if they are not timed accordingly, they may have a negative effect on the business cycle Like with Fiscal Policy, Monetary Policy takes time to put in place and take effect...lags are created Like with Fiscal Policy, Monetary Policy takes time to put in place and take effect...lags are created Inside lag... Delay in implementing monetary policy Inside lag... Delay in implementing monetary policy The government takes time to recognize the problem and create a solution The government takes time to recognize the problem and create a solution Outside lag...the time it takes for the policy to have an effect Outside lag...the time it takes for the policy to have an effect Predictions of the business cycle is key in this process Predictions of the business cycle is key in this process Timing could have a positive or negative effect on cycles Timing could have a positive or negative effect on cycles

Fiscal and Monetary Policy Tools Fiscal policy toolsMonetary policy tools Expansionary Tools -These will help the economy expand and grow Contractionary Tools -These will slow the economy 1.Increase government spending 2.Cutting taxes 1.Decrease government spending 2.Raising taxes Fiscal and Monetary Policy Tools 1.Open market operations: bond purchases 2.Decreasing the discount rate 3.Decreasing reserve requirements 1.Open market sales: bond sales 2.Increasing the discount rate 3.Increasing reserve requirements

Remember Fiscal Policy is how the government uses its taxing and spending to influence the economy Fiscal Policy is how the government uses its taxing and spending to influence the economy Monetary Policy is how the FED uses its control of the money supply to influence the economy Monetary Policy is how the FED uses its control of the money supply to influence the economy Whatever policy is used, the economy will either contract or expand Whatever policy is used, the economy will either contract or expand

Review 1. Monetarism is (a) the time it takes to enact monetary policy. (b) the belief that the money supply means little to macroeconomic performance. (c) the time it takes for monetary policy to take affect. (d) the belief that the money supply is the most important factor in macroeconomic performance. 2. Tight money policies aim to (a) increase the money supply and expand the economy. (b) decrease the money supply and expand the economy. (c) decrease the money supply and slow the economy. (d) increase the money supply and slow the economy.