The Federal Reserve System and Monetary Policy Chapter 15 The Federal Reserve System and Monetary Policy

Organization and Functions of the Federal Reserve System Chapter 15 Section 1 Organization and Functions of the Federal Reserve System

Organization The Fed is responsible for monetary policy. Monetary policy: involves the changing rate of growth of the supply of money in circulation in order to affect the amount of credit, which affects business activity in the economy. The Board of Governors oversees 12 district Federal Reserve banks and regulates activity of member banks and all other depository institutions.

Organization The Federal Advisory Council reports to the board of governors on general business conditions in the country. The Federal Open Market Committee decides what the Fed should do to control money supply. Twelve Federal Reserve banks are set up as corporations owned by member banks.

Organization Member Banks—all national banks, those chartered by the federal government, must join the Federal Reserve System. State chartered banks may join if they choose. All institutions that accept deposits from customers must keep reserves in their district Federal Reserve bank.

Functions The fed has many functions, including check clearing, supervising member banks, holding reserves, and supplying paper currency. Clearing checks is the method by which money is deposited from one bank to another. Supervising member banks means the Fed must regulate federally chartered commercial banks. The Fed maintains the nation’s paper money.

Functions Its most important function is to regulate the money supply. The Fed determines the amount of money in circulation. More money in circulation means lenders are more likely to offer money for loans. The Fed sets standards for consumer protection, mainly truth-in-lending legislation.

Money Supply and the Economy Chapter 15 Section 2 Money Supply and the Economy

Loose and Tight Money Policies Monetary policy involves changing the growth rate of the money supply in order to change the cost and availability of credit. Loose money means credit is plentiful and inexpensive. Used to encourage economic growth.

Loose and Tight Money Policies Tight money means credit is in short supply and expensive. Used to control inflation. The goal of monetary policy is to strike a balance between tight and loose money.

Fractional Reserve Banking Many banks are required to keep a percentage of their total deposits in cash reserves in their vaults or with the Federal Reserve bank. This enables the bank to provide funds for customers who might suddenly want to withdraw large amounts of cash from their accounts. Currently most financial institutions are required to reserve 10 percent of their checkable deposits and none on their interest-paying deposits.

Money Expansion Banks can use non-reserved deposits to create new money. Money banks lend and receive is usually spent or deposited in another bank who can also use the deposits to create new money. This process is known as the multiple expansion of money.

Regulating the Money Supply Chapter 15 Section 3 Regulating the Money Supply

Changing Reserve Requirements The lower the percentage of deposits in reserve, the more money available to loan out. When the Fed raises its reserve requirements, banks can call in loans, sell off investments, or borrow from another bank (or the Federal Reserve).

Changing Reserve Requirements Raising the reserve decreases the amount of money in the economy and slows it down. Because of the extreme effect on money supply, the Fed has not been raising the reserve recently.

Changing the Discount Rate Discount Rate: interest rate that the Fed charges on loans to member banks Prime Rate: rate of interest that banks charge on loans to their best business customers A higher discount rate means that member banks charge their customers higher interest, reducing the money supply.

Changing the Discount Rate Federal Funds Rate: interest rate that banks charge each other on loans (usually overnight) Used to help a bank to increase its reserves by borrowing from another bank. If the Fed decreases the federal fund rate, banks will borrow more and, thus, lend more. This increases business activity.

Open-Market Operations The buying and selling of government securities is called open-market operations. When the Fed buys securities, it makes a deposit into the reserve account of the security dealer’s bank, giving that bank more money to lend out because its reserve account is higher than necessary.

Open-Market Operations When the Fed sells securities, the purchasing bank buys them with money from its reserves, leaving the purchasing bank with less reserve funds. This shows the multiple expansion of money working in reverse because more money is taken out of circulation than just the initial withdrawal.

Difficulties of Monetary Policy It is difficult to gather and evaluate information about the money supply. Some critics of the Fed want to stop the Fed from engaging in any monetary policy at all. Taxing and spending by the government affect the economy, and the Fed has to consider this also in the changes they can make.