Chapter 14 The Federal Reserve System & Monetary Policy Section 1 The Federal Reserve System

I. The Panic of 1907 Two causes: 1.No way to expand the amount of money in circulation Consumers and businesses competed for a fixed supply of loanable funds Consumers and businesses competed for a fixed supply of loanable funds People withdrew their savings People withdrew their savings “Run” on the banks “Run” on the banks

2.System of pyramid reserves failed In NY, SF, and Chicago In NY, SF, and Chicago Some people lost their savings Some people lost their savings Panic of 1907 Panic of 1907 Federal Reserve Act Federal Reserve Act

________________________________ Small Local Banks _____________________ Larger City Banks Largest Commercial Banks Cash reserves Deposit Cash reserves Deposit Loans

II. Role of The Fed Goals were “to furnish an elastic currency, and…to establish a more effective supervision of banking in the U.S.” Goals were “to furnish an elastic currency, and…to establish a more effective supervision of banking in the U.S.”

3 main purposes: 1.Supervises member banks 2.Holds cash reserves Guarantees money is available when needed Guarantees money is available when needed 3.Moves money in & out of circulation Stabilizes the national banking systems Stabilizes the national banking systems

III. Characteristics of the Fed 1.Lack of a Single Central Bank Federal Reserve System relies on 12 district banks to carry out the banking policies developed at the national level Federal Reserve System relies on 12 district banks to carry out the banking policies developed at the national level

2.Owned and controlled by member banks Government does not own stock in the FED Government does not own stock in the FED Member banks own the stock Member banks own the stock FED does report to Congress FED does report to Congress

3.Optional membership for some banks Nationally chartered banks must join the FED Nationally chartered banks must join the FED State-chartered banks membership is optional State-chartered banks membership is optional Less than 40% of commercial banks in the U.S are members of the FED Less than 40% of commercial banks in the U.S are members of the FED

IV. Organization of the FED A.National Level Main decision makers: Board of Governors & The Federal Open Market Committee (FOMC) Main decision makers: Board of Governors & The Federal Open Market Committee (FOMC) Board has 7 members appointed by President, approved by Senate Board has 7 members appointed by President, approved by Senate Serve 14 year terms Serve 14 year terms Chairperson serves 4 year term Chairperson serves 4 year term The 7 board members and 4 Federal Reserve bank Presidents make up the FOMC The 7 board members and 4 Federal Reserve bank Presidents make up the FOMC

B.District Level 12 separate Federal Reserve Banks 12 separate Federal Reserve Banks Designated geographic regions Designated geographic regions 25 branch offices 25 branch offices Member banks elect 6 directors Member banks elect 6 directors Board of Governors selects 3 others Board of Governors selects 3 others

Chapter 14 The Federal Reserve System & Monetary Policy Section 2 The Federal Reserve at Work

I. Services to Banks The Fed oversees the flow of money between member banks and its district banks The Fed oversees the flow of money between member banks and its district banks Mainly by clearing checks and lending reserves to commercial banks Mainly by clearing checks and lending reserves to commercial banks

A.Clearing Checks Americans write about Americans write about 40 billion checks every year 40 billion checks every year Check clearing is a method of crediting and debiting banks’ reserve accounts Check clearing is a method of crediting and debiting banks’ reserve accounts B.Loans to banks Depositors make large, unexpected withdrawals Depositors make large, unexpected withdrawals Banks need short-term loans to replenish their cash reserves Banks need short-term loans to replenish their cash reserves

II. Services to the Government Each year the U.S. Government raises and spends more than Each year the U.S. Government raises and spends more than $1 Trillion $1 Trillion The Treasury Department works closely with the Fed The Treasury Department works closely with the Fed The secretary of the treasury is the chief financial officer The secretary of the treasury is the chief financial officer Pay’s bills, IRS, U.S. Mint, etc. Pay’s bills, IRS, U.S. Mint, etc.

A.Serving as the Government’s Bank Government funds are deposited in Federal Reserve Banks by the Treasury Government funds are deposited in Federal Reserve Banks by the Treasury Treasury writes checks for tax refunds, social security, etc. Treasury writes checks for tax refunds, social security, etc. B.Supervising member Banks Each Federal Reserve bank has a staff of bank examiners that supervises the financial activities of member banks Each Federal Reserve bank has a staff of bank examiners that supervises the financial activities of member banks The Fed provides the following services to the Government:

C.Regulating the Money Supply Money supply is the amount of money circulating in the U.S. economy Money supply is the amount of money circulating in the U.S. economy Federal Reserve notes (dollars) printed by the Treasury Department’s Bureau of Engraving and Printing Federal Reserve notes (dollars) printed by the Treasury Department’s Bureau of Engraving and Printing Coins are generated by U.S. Mint Coins are generated by U.S. Mint

1.Replace old money 2.Expand pool of cash that Federal Reserve Banks can loan Two reasons new currency is put into circulation:

III. Money Supply  To regulate the money supply, the Fed must determine how much money is circulating in the economy A.M1  The narrowest and simplest measure of the money supply  All of the currency in circulation  Travelers checks, checking accounts More than $1 trillion in 1995 More than $1 trillion in 1995

B.M2 (Broader measure) More accurate More accurate Counts M1 plus money market accounts, mutual fund, and other savings deposits under $100,000 (CD’s) Counts M1 plus money market accounts, mutual fund, and other savings deposits under $100,000 (CD’s) In 1995 = $3.6 trillion In 1995 = $3.6 trillion

C.M3 Includes M2 as well as large time deposits over $100,000 Includes M2 as well as large time deposits over $100,000 $4.5 trillion $4.5 trillion D.L Includes M3, savings bonds, short-term treasury securities and other near money Includes M3, savings bonds, short-term treasury securities and other near money $5.6 trillion $5.6 trillion

Chapter 14 The Federal Reserve System & Monetary Policy Section 3 Monetary Strategies Part 1

I.Monetary Policy & Aggregate Demand Monetary policy is the plan to expand or contract the money supply in order to influence the cost and availability of credit Monetary policy is the plan to expand or contract the money supply in order to influence the cost and availability of credit Influences aggregate demand Influences aggregate demand Money supply and aggregate demand are used to develop a monetary policy Money supply and aggregate demand are used to develop a monetary policy

A.Easy-Money Policy Designed to expand the money supply, increase aggregate demand, create jobs, reduce unemployment and stimulate growth Designed to expand the money supply, increase aggregate demand, create jobs, reduce unemployment and stimulate growth During recessions the Fed offers a lower interest rate to banks During recessions the Fed offers a lower interest rate to banks

B.Tight-Money Policy Slows business activity and helps stabilize prices by restricting the money supply and thus limiting credit Slows business activity and helps stabilize prices by restricting the money supply and thus limiting credit Aggregate demand decreases as a result of higher interest rates Aggregate demand decreases as a result of higher interest rates There are several ways the Fed can put monetary policy to work

II. Components of Monetary Policy A.Open Market Operations Main tool ~ buying or selling of government securities Main tool ~ buying or selling of government securities If Fed wants to shrink the money supply, it will sell government securities>>>cash paid for securities shrinks bank reserves>>>shrinking money supply>>>decreasing aggregate demand If Fed wants to shrink the money supply, it will sell government securities>>>cash paid for securities shrinks bank reserves>>>shrinking money supply>>>decreasing aggregate demand

If Fed wants to add money into the economy, it buys back securities>>> cash paid will increase reserves and loan pools>>>more loans>>>more spending If Fed wants to add money into the economy, it buys back securities>>> cash paid will increase reserves and loan pools>>>more loans>>>more spending

B.Discount Rate The rate charged to member banks for the use of its reserves The rate charged to member banks for the use of its reserves Lower rates = increased borrowing = more spending Lower rates = increased borrowing = more spending The prime rate ~ the rate commercial banks charge to their customers ~ also increases or decreases The prime rate ~ the rate commercial banks charge to their customers ~ also increases or decreases

C.Reserve requirement Money that must be held by banks in their vault or in the Fed Money that must be held by banks in their vault or in the Fed Requirements change annually based on a formula specified by the Monetary Control Act of 1980 Requirements change annually based on a formula specified by the Monetary Control Act of 1980 Less required in reserve = more money to loan + more spending Less required in reserve = more money to loan + more spending More required in reserve = less money to loan = less spending More required in reserve = less money to loan = less spending

D.Margin Requirement The Securities Exchange Act of 1934 authorizes the Board of Governors to set margin requirements ~ the percentage of cash an investor must have to buy stocks, options and other investments The Securities Exchange Act of 1934 authorizes the Board of Governors to set margin requirements ~ the percentage of cash an investor must have to buy stocks, options and other investments High margin = more cash, less credit purchases High margin = more cash, less credit purchases

E.Credit Regulation Times of national emergency Times of national emergency F.Moral Suasion Unofficial pressure that Fed exerts on banking system Unofficial pressure that Fed exerts on banking system Can be direct appeal to individual commercial banks through letters, conferences, public releases, and testimony before Congressional committees Can be direct appeal to individual commercial banks through letters, conferences, public releases, and testimony before Congressional committees

Chapter 14 The Federal Reserve System & Monetary Policy Section 3 Monetary Strategies Part 2

I. Policy Limitations The Feds main challenges: Economic forecasts Economic forecasts Time lags in developing and carrying out monetary policy Time lags in developing and carrying out monetary policy Priorities and trade-offs Priorities and trade-offs Lack of coordination among government agencies in formulating economic policies Lack of coordination among government agencies in formulating economic policies Conflicting opinions about monetary policy Conflicting opinions about monetary policy

A. Economic Forecasting A prediction of future business activity and consumer spending A prediction of future business activity and consumer spending Incorrect forecasts can lead to inappropriate policies Incorrect forecasts can lead to inappropriate policies

B. Time Lags Three types of time lags: 1.Collection and analysis of data can take months 2.Time-consuming debates before an agreement on policy is reached 3.Additional months may pass before the impact of the policy is felt

C. Priorities and Trade-offs Monetary policy can only do what it is designed for>>>fight for inflation or recession Monetary policy can only do what it is designed for>>>fight for inflation or recession

D. Lack of Coordination Other government agencies sometimes target different economic priorities than those identified by the Fed Other government agencies sometimes target different economic priorities than those identified by the Fed Ex. 1980’s ~ Fed’s tight money policy ~ Congress approved massive tax reductions Ex. 1980’s ~ Fed’s tight money policy ~ Congress approved massive tax reductions

E. Conflicting Opinions Some believe the Fed does more harm than good by manipulating the money supply Some believe the Fed does more harm than good by manipulating the money supply