NEXT The Federal Reserve and Monetary Policy

NEXT Chapter 16: The Federal Reserve and Monetary Policy KEY CONCEPTS Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession. WHY THE CONCEPT MATTERS Monetary policy is one of the most important tools for addressing extremes in the business cycle.

NEXT Creating the Fed KEY CONCEPTS Government struggled to stabilize economy until Federal Reserve Act Central bank—a nation’s monetary authority – monetary means “relating to money” Federal Reserve System—central bank of the U.S., called the Fed –independent organization within government; established 1913 The Federal Reserve System

NEXT Creating the Fed The Duties of a Central Bank Most countries have central bank—government controlled or independent Hold private banks’ reserves; control loanable funds and money supply Assure stability: control how money issued, circulated –regulate, supervise banks—make sure they serve depositors, the economy Lend money to private banks and government

NEXT Creating the Fed The Duties of the Fed Fed uses regulation, oversight to protect bank customers, borrowers Banking services for private banks and government include –holding deposits, transferring funds, making loans Helps finance wars, stabilize economy in national emergencies Regulates money supply; distributes currency—coins and paper money

NEXT The Structure of the Fed KEY CONCEPTS Fed not a single national bank; has national and regional structure –has some independence from political influence; accountable to Congress Represents compromise to divide power between regions and nation –many citizens reluctant to give much power to a national bank –also U.S. is large, economically diverse, has complex banking system

NEXT The Structure of the Fed Elements of the Fed Board of Governors—sets policy; supervises operations of the Fed –chairman is most influential member and spokesperson 12 district banks carry out policy; serve as central bank for regions Member banks: all nationally-chartered banks; state banks may apply –must buy district bank stock; cannot sell in open market

NEXT The Structure of the Fed Elements of the Fed Federal Open Market Committee—supervises government security sales Federal Advisory Council—represents commercial banking industry Consumer Advisory Council—advises on consumer protection laws on borrowing Thrift Institutions Advisory Council—needs of savings institutions –thrifts not regulated by Fed; must meet reserve requirements; may borrow

NEXT Reviewing Key Concepts Explain the relationship between the terms in each of these pairs: central bank and Federal Reserve System monetary and currency Board of Governors and Federal Open Market Committee

NEXT Serving the Banking System KEY CONCEPTS Fed helps banks do their jobs –provides check clearing, other services to transfer funds –lends money –regulates, supervises banking activity Functions of the Federal Reserve

NEXT Serving the Banking System Service 1: Check Clearing Check clearing—process for recording bank clients’ receipts, payments –most checks clear in two days or less Electronic payments often replace checks Private companies also involved in check-clearing process

NEXT Serving the Banking System Service 2: Lending Money Banks often lend to each other on short-term basis In natural disaster, all banks in region lack cash flow –Fed lends to banks with enough assets and capital to qualify Small banks with seasonal cash flow needs may borrow from Fed Fed serves as lender of last resort to prevent banking crisis

NEXT Serving the Banking System Service 3: Regulating and Supervising Banks Fed banks supervise state-chartered members, bank holding companies – bank holding company owns, has controlling interest in several banks Fed banks enforce truth-in-lending laws Conduct bank exams—audit financial practices of banks in district Monitor bank mergers to ensure competition

NEXT Serving the Federal Government KEY CONCEPTS Fed serves as federal government’s banker –helps carry out taxation and spending activities

NEXT Serving the Federal Government Service 1: Paying Government Bills Tax revenues are deposited with the Fed Fed issues checks, makes electronic payments via U.S. Treasury –for transfer payments, employee wages, direct spending, tax refunds –deducts amounts from government’s account Processes postal money orders, food stamps

NEXT Serving the Federal Government Service 2: Selling Government Securities Fed processes U.S. savings bonds, auctions other securities –provides information, collects payment, credits funds, delivers bonds Pays interest on bonds Federal Open Market Committee (FOMC) supervises sales of securities –purpose is to stabilize the economy

NEXT Serving the Federal Government Service 3: Distributing Currency Federal Reserve notes are official paper currency of U.S.: fiat money Treasury Department prints notes that go to Fed district banks Fed banks distribute notes to depository institutions in amounts needed –currency then goes to people and businesses Fed also distributes coins produced by U.S. Mint

NEXT Creating Money KEY CONCEPTS Creating money—how money enters circulation through deposits, loans Fed establishes required reserve ratio (RRR) for banks –fraction of bank’s deposits that it must keep in reserve Reserve may be stored as cash in bank’s vault or deposited with Fed

NEXT Creating Money Example: Money Creation Banking system creates money whenever banks get deposit and make loan Level of the RRR determines how much money may be loaned Money supply increases by total loans made after initial cash deposit – deposit multiplier formula tells how much money supply will increase

NEXT Factors Affecting Demand for Money KEY CONCEPTS Fed monitors amount of M1 and M2 to manage supply of money –M1 is cash and checkable deposits –M2 is M1 plus savings deposits and certain time deposits Four factors affect how much money individuals and businesses demand

NEXT Factors Affecting Demand for Money Factor 1: Cash on Hand People, businesses need cash for everyday financial transactions –use cash, checks, debit cards Fed increases cash to banks at special times or to special places –holiday season; tourist areas during summer; disaster areas

NEXT Factors Affecting Demand for Money Factor 2: Interest Rates If interest rates high, people put excess cash in savings instruments –money pulled from circulation, exists as part of M2 High interest rates lessen incentive to spend, increase incentive to save –low interest rates have opposite effect

NEXT Factors Affecting Demand for Money Factor 3: Cost of Consumer Goods and Services If cost of consumer products increase, people need more money Businesses may need more money to cover higher production costs –if pass costs to consumers, consumers may need more money in turn

NEXT Factors Affecting Demand for Money Factor 4: Level of Income As income increases, people and businesses hold on to more cash –keep more because able to spend more on goods and services Several actions Fed can take in response to changes in demand for money

NEXT Reviewing Key Concepts Use each of the terms in a sentence that illustrates the meaning of the term: check clearing bank holding company required reserve ratio

NEXT The Fed’s Monetary Tools KEY CONCEPTS Monetary policy—actions the Fed takes to change money supply –purpose is to influence the economy Fed has three courses of action to take individually or in combination Monetary Policy

NEXT The Fed’s Monetary Tools Action 1: Open Market Operations Open market operations—sales and purchase of government securities –Fed buys securities to expand money supply; sells to contract supply Federal funds rate (FFR)—interest rate banks charge one another Fed signals intent to buy or sell by announcing a target for the FFR –if lowers target, Fed buys bonds; if raises target, it sells bonds

NEXT The Fed’s Monetary Tools Action 2: Adjusting the Reserve Requirement Fed changes required reserve ratio to change the money supply –increase in RRR reduces money supply; decrease expands it RRR averages 10–12% for transaction deposits, 0–3% for time deposits

NEXT The Fed’s Monetary Tools Action 3: Adjusting the Discount Rate Discount rate—interest rate Fed charges on loans to other banks –affects money supply because it determines reserves banks have to lend Prime rate—interest rate banks charge their best customers –other borrowers pay 2-3 percentage points above prime If discount rate rises, so do prime, business and consumer rates

NEXT Approaches to Monetary Policy KEY CONCEPTS Monetary policy used to promote growth and stability Expansionary monetary policy—plan to increase the money supply Contractionary monetary policy—plan to reduce the money supply

NEXT Approaches to Monetary Policy Policy 1: Expansionary Policy Expansionary monetary policy also called easy-money policy In recession, Fed increases money supply to increase aggregate demand Fed can buy bonds on open market, decrease RRR or discount rate –most common practice is to buy bonds to make interest rates fall

NEXT Approaches to Monetary Policy Policy 2: Contractionary Policy Tight-money policy is another name for contractionary monetary policy Fed decreases money supply to check aggregate demand, inflation Fed can sell bonds on open market, increase RRR or discount rate –most common action is to sell bonds to raise interest rates

NEXT Alan Greenspan: Fighting Inflation Managing Monetary Policy Greenspan served as chair of Fed’s Board of Governors over 18 years –his insight and persuasiveness made him extremely influential Was very successful at growing economy without inflation –great knowledge of tools of monetary policy and economic indicators –sense of timing: knew just when to expand or contract money supply

NEXT Impacts and Limitation of Monetary Policy KEY CONCEPTS Purposes of monetary policy—curb inflation and halt recessions Changes in monetary policy have both short-term and long-term effects

NEXT Impacts and Limitation of Monetary Policy Impact 1: Short-Term Effects The short-term effect is a change in the price of credit Open market operations influence FFR fairly quickly –change loanable reserves banks have Easy-money policy lowers interest rates; tight-money raises them

NEXT Impacts and Limitation of Monetary Policy Impact 2: Policy Lags Delays in getting information to identify problems delays Fed action Policy adjustments may take a long time to take effect in the economy –example: businesses may delay expansion until interest rates drop

NEXT Impacts and Limitation of Monetary Policy Impact 3: Timing Issues Monetary policy must be coordinated with business cycle for stability –bad timing may exaggerate a phase of the business cycle Monetarism holds that rapid changes in money supply cause instability –Milton Friedman found inflation goes with rapid growth in money supply –little or no inflation when money supply growth slow and steady

NEXT Impacts and Limitation of Monetary Policy Other Issues Monetary policy more effective if coordinated with fiscal policy Goals of Fed may clash with those of Congress or President –governors serve 14 years; have less political pressure than politicians

NEXT Reviewing Key Concepts Explain the differences between the terms in each of these pairs: monetary policy and monetarism easy-money policy and tight-money policy discount rate and prime rate

NEXT Policies to Expand the Economy KEY CONCEPTS Fiscal and monetary policies impact each other Both have limitations: policy lags, political constraints, timing issues –timing also affected by people’s actions based on rational expectations Opponents of discretionary policy favor a stable monetary policy –thus people, businesses will not make decisions ahead of policies Applying Monetary and Fiscal Policy

NEXT Policies to Expand the Economy Example: Expansionary Monetary and Fiscal Policy Expansionary policy meant to reduce unemployment, increase investment Expansionary fiscal policy raises interest rates; monetary lowers them –actual change in rates depends on relative strength of the two policies –amount of investment spending depends on rates

NEXT Policies to Control Inflation KEY CONCEPTS Goal of contractionary monetary policy is to stabilize economy –decrease inflation and increase interest rates

NEXT Policies to Control Inflation Example: Contractionary Monetary and Fiscal Policy Contractionary policies decrease aggregate demand, control inflation Fiscal policy lowers interest rates; monetary policy raises them –actual change in rates depends on relative strength of the two policies –amount of investment spending depends on rates

NEXT Policies to Control Inflation Example: Wage and Price Controls Government may establish non-mandatory wage and price guidelines Wage and price controls—limits on increases in wages and prices –mandatory and enforced by government –WWII: President Roosevelt used to control inflation due to shortages 1970s: President Nixon used to try to combat stagflation

NEXT Policies in Conflict KEY CONCEPTS Coordinated policies usually produce desired effect on economy If uncoordinated, one policy can counter effects of the other –creates economic instability

NEXT Policies in Conflict Example: Conflicting Monetary and Fiscal Policies Example: CPI is 6% and rising; unemployment is 7% –Fed tries to fix inflation by selling bonds, raising discount rate –government tries to lower unemployment by cutting taxes, more spending Only clear result of conflicting policies is higher interest rates

NEXT Reviewing Key Concepts Use the terms below in a sentence that illustrates the meaning of the terms: wage and price controls

NEXT Interpreting Signals from the Fed Background Economists and financial observers scrutinize everything the Fed chairman says in an attempt to predict how his statements will affect the economy. A hint that the Fed might change interest rates can lead to a great deal of activity in the stock market. What’s the Issue How much does the market rely on signals from the Fed to make economic decisions? Thinking Economically How do articles A and C illustrate the rational expectations theory? Based on these three sources and your own knowledge, how would you describe the differences and similarities between Greenspan and Bernanke and their impact on the market?