The Federal Reserve and Monetary Policy Chapters 15

Federal Reserve System Federal Reserve is the Central Bank of the US It was founded in 1913 The Federal Reserve is independent of the three branches of government 7 Board of Governors serve for 14 years, appointed by President

Tasks of the Fed Fed supplies the economy with currency Provides a system of check clearing Hold reserves of banks Acts as the government fiscal agency for government Supervises member banks Lender of last resort Regulates the money supply

Fractional Reserve Banking System Since the 1930’s the Fed requires member banks to hold a fraction of their checking deposits in reserve This is so there is always cash available to customers and the bank remains solvent. Currently the Fed requires 10% of all deposits to be held in reserve E.g. if a bank receives $100 deposit it must keep $10 in reserve but it can loan $90

Reserve Requirements Required reserves - this is the ratio established by the Fed (currently 10%) Excess reserves are all monies that meet the legal reserve requirements, over and above the required reserves. Excess reserves may be loaned by bank

Assets and Liabilities Each bank has liabilities, primarily money owed to depositors in transaction accounts (checking accounts) In addition, banks have assets, primarily The reserves and loans they control

Expanding or Contracting the Supply of Money The FED however, can increase or decrease the total money supply. In a recession, the FED seeks to expand the money supply through a “loose money policy” In an expansion, the Fed seeks to lower the money supply through a “tight money” policy.

Three Fed Tools The Fed has three tools for changing the money supply including: 1. Changing the reserve requirements of banks. 2. Buying and Selling bonds 3. Changing the Discount rate.

Expansionary Monetary Policy The Federal Reserve can raise the money supply three ways: Buys bonds on the open market - infuses cash into money supply (most common method) Lower the discount rate - the interest rate that the Fed charges member banks Lower reserve rate - (the amount banks must keep and not loan out (least common method)

Open Market Operations The FED can increase or decrease the money supply quickly through the buying and selling T-Bills (Treasury Bills) with its FED Open Market Committee (FOMC) If the Fed buys bonds from T-Bill investors , they receive FED money. T-Bill investors deposit funds in banks, increasing bank reserves, therefore lowering interest rates. If the Fed sells bonds, investors pay fed for T-Bills. They take money out of bank reserves, therefore raising interest rates.

Contractionary Monetary Policy The Federal Reserve can lower the money supply three ways: Sell bonds on the open market - takes cash out of the money supply Raise the discount rate Raise reserve rate

Money Supply Graph

The discount and federal funds rates Discount rate - the interest rate at which the Fed charges member banks to borrow money Banks may also borrow each other’s reserves for short term purposes. The interest rate at which banks borrow each other’s reserves is called the Federal Funds Rate In recent years the FED has changed the Federal Funds Rate more often than the discount rate.

Discount and FED funds rates continued If the government lowers the discount or federal funds rates, then banks borrow more and have more reserves to lend --> expansionary monetary policy If the government raises the discount or federal fund rates, then banks borrow less, and have less reserves to lend -->contractionary monetary policy