Explorations in Economics Alan B. Krueger & David A. Anderson

Chapter 17: The Federal Reserve and Monetary Policy Module 50: The Federal Reserve System Module 51: The Federal Reserve and Traditional Monetary Policy Module 52: Extraordinary Times, Extraordinary Tools

Do Now – The Most Powerful Woman in America – Who is She? 5/27/2018 Chapter 17-Mods 50-52

MODULE 50: THE FEDERAL RESERVE SYSTEM KEY IDEA: As the nation’s central bank, the Federal Reserve acts to maintain the safety of the banking system and the stability of the economy. OBJECTIVES: To explain why the Federal Reserve System was created. To identify the structure of the Federal Reserve System. To describe the functions of the Federal Reserve System. To explain the role of the Federal Reserve System in formulating and executing monetary policy. The Federal Reserve plays a key role in setting the pace of overall economic activity in the country. The FED was created when Woodrow Wilson signed the Federal Reserve Act in to law in 1913.

THE CREATION OF THE FEDERAL RESERVE SYSTEM The Federal Reserve Act of 1913 Panic of 1907 convinced Americans that a central bank could provide stability. The “Fed” becomes the bankers’ bank. Owned by the U.S. Government But run by an independent board of governors. Discuss the reasons for the central banking system Debate the idea of privately owned or owned and regulated by the Federal government. You can also explain the banks can borrow from each other at an extremely low rate or borrow from the Fed at a slightly higher rate to encourage private sector banking.

Fed’s Role and Structure Fed In Plain English 5/27/2018 Chapter 17-Mods 50-52

THE PURPOSE OF THE FEDERAL RESERVE SYSTEM Sets monetary policy – full employment and price stability to promote economic growth. Maintains stable banking system by regulating banks, and by making loans to member banks. Provide financial services (check clearing house) for the federal government and banking for commercial banks. Discuss why these four points are important to an economy. The Federal Reserve system turned 100 in 2013. How are these functions different from commercial banks?

The Federal Reserve Bank Fed Organization Board of Governors The Federal Reserve Bank 12 Regional Banks Open Market Committee 5/27/2018 Chapter 17-Mods 50-52

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Board of Governors of the Federal Reserve is made up of seven members appointed by the president. Key idea: Fed is independent of politics. Manage the operations of the Federal Reserve System Serve 14-yr terms; appointed by President Oversees operations of the Federal Reserve Banks Chair and Vice Chair chosen by members Set Monetary Policy for the nation Show the students the Board of Governors and the education of the Governors.

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Federal Reserve Banks implement Federal Reserve policies and provide services to member banks and federal government agencies. 12 District and 24 branch banks; each has 9- member board of directors Hold cash reserves and make loans for depository institutions Act as agent for federal government Supervise and act as bank examiner of the Fed Ask students which district banks serves their area? Ask students if they could open an account in their district bank?They can buy and redeem government securities and Savings Bonds at FED banks

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM Member banks of the Federal Reserve System include all nationally chartered banks and many state- chartered banks. They are stockholders in their district bank and help elect the district’s board of directors. Students will usually ask about the varying geography. Remind them that it was 1913 and most people lived east of the Mississippi River. What services do the 12 District Banks provide? check clearing, electronic funds transfer, and distribution of currency

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Federal Open Market Committee is the group within the Federal Reserve that creates monetary policy. Use the “beige book” online to show the students the metrics the FOMC uses to measure the economy. Use the graphic to explain the Fed’s oranization.

What is Monetary Policy? Actions to smooth out the ups and downs of the business cycle by controlling the money supply and interest rates. In the USA, monetary policy is set by the Federal Open Market Committee (FOMC) of the Federal Reserve Bank. 5/27/2018 Chapter 17-Mods 50-52

What happens to consumer borrowing when interest rates rise? Fall? Pair - Share What happens to business investment when interest rates rise? When they fall? What happens to consumer borrowing when interest rates rise? Fall? Based on the above, what happens to the economy when interest rates rise / fall? 5/27/2018 Chapter 17-Mods 50-52

Money Supply and Interest Rates By increasing or decreasing the money supply, we can increase or decrease interest rates. Challenge the students to graph this money market model for themselves at the board or in notebooks. Explain how the money supply increases or decreases when the Fed buys and sells securities. *The price of money is an interest rate and the opportunity cost to hold money *Money suppy is fixed. *Changes in price levels or income levels affect the demand for money.

Monetary Policy Increase Money Supply (expansionary, easy money) Decrease Money Supply (contractionary, tight money) Decrease interest rates Increase interest rates Increase investment and consumer spending (aggregate demand) Decrease investment and consumer spending (aggregate demand) Increases GDP Decrease GDP Increases prices Decrease prices Decrease unemployment Increase unemployment 5/27/2018 Chapter 17-Mods 50-52

Monetary Policy Organizer With your desk partner, complete the contractionary vs. expansionary chart. 5/27/2018 Chapter 17-Mods 50-52

How does the Fed change the money supply? It uses the money creation ability of the fractional reserve system! By increasing or decreasing bank reserves, the Fed can increase or decrease the money supply. Changes in money supply increase or decrease interest rates. Reserves can be changed through “open market operations” 5/27/2018 Chapter 17-Mods 50-52

How the Fed increases the money supply (easy money) Buys treasury bonds from banks Banks Fed Payment to banks increases bank reserves and the money supply 5/27/2018 Chapter 17-Mods 50-52

How the Fed decreases the money supply (tight money) Sells treasury bonds from banks Banks Fed Banks pay the Fed decreasing bank reserves and the money supply 5/27/2018 Chapter 17-Mods 50-52

TRADITIONAL MONETARY POLICY TOOLS Other tools of monetary policy The discount rate is the interest rate that the Fed charges financial institutions for short- term loans. Reserve Requirements-the percentage of demand deposits that banks must keep. The Fed does not change this often but it is powerful when they do. Make sure they know the difference between the discount rate and the Fed funds rate. Discuss how an increase in the discount rate or a increase in the reserve requirment could raise speculation about the health of the economy. The use of the discount rate in 2009-2011 by the FED was one of the extraordinary tools employed in the Great Recession.

JPM lends excess reserves Fed Funds Rate Fed funds: bank deposits at the Fed. Fed funds rate: interest rate that banks charge other banks to borrow their deposits at the Fed. JPM lends excess reserves Citibank needs reserves JP Morgan has excess reserves Citi pays interest 5/27/2018 Chapter 17-Mods 50-52

The Fed is the banker’s bank. Summary The Fed is the banker’s bank. Major jobs – keep banking system stable, inflation low and unemployment low, provide financial services to member banks. Controls money supply through open market operations. Tight money leads to higher interest rates, lower spending and slows economy. Easy money leads to lower interest rates, higher spending and faster growing economy. 5/27/2018 Chapter 17-Mods 50-52

Deficit, balance, surplus, national debt Mandatory vs. discretionary Review – Big Ideas Federal Budget: Deficit, balance, surplus, national debt Mandatory vs. discretionary Entitlement vs. means tested Fiscal Policy: Expansionary – taxes & spending Contractionary – taxes & spending Limitations of fiscal policy Pros & Cons of national debt. 5/27/2018 Chapter 17-Mods 50-52

Excess vs. required reserves Fractional reserve system Money creation Review – Big Ideas Money & Banking: 3 uses 3 types Excess vs. required reserves Fractional reserve system Money creation 5/27/2018 Chapter 17-Mods 50-52

Federal Reserve & Monetary Policy: 3 roles of the Fed Review – Big Ideas Federal Reserve & Monetary Policy: 3 roles of the Fed 3 parts of the Fed Expansionary monetary policy Contractionary monetary policy Advantages of monetary policy 5/27/2018 Chapter 17-Mods 50-52