The Federal Reserve and Monetary Policy Introduction to Economics Johnstown High School Mr. Cox

The Federal Reserve The “Fed” Central bank of the United States, 12 Reserve Banks Established in 1913 Fed and FDIC (Federal Deposit Insurance Corporation) were formed to reduce economic panics, and to lessen severity of economic cycle Ensure a stable economy Money Supply No longer based on gold standard, just confidence of American people Controlling money supply helps to control inflation

Board of Governors Seven members Work includes: Appointed by the president Confirmed by the Senate Serve staggered 14-year terms Run by Chairwoman Janet Yellen Work includes: Analyzing economic developments Supervising and regulating the operations of Federal Reserve Banks Exercising responsibility in the nation’s payments system Administering consumer credit protection laws Authorizing changes in banks’ reserve requirements Supervising Fed member banks and other financial entities Authorizing changes in the Fed’s discount rate Seven members (governors) of the Federal Reserve Board are appointed by the President and subject to approval by the Senate. Structure provides for public accountability in the System, but because these governors serve staggered 14-year terms, the Board is insulated somewhat from short-term political pressure. Not one president can load the Board with candidates who will further a political agenda. The work of the Board includes: coordinating the activities of the regional Reserve Banks, analyzing domestic and international economic issues, exercising broad responsibility in the nation’s payments system, and administering laws regarding consumer credit protection.

Sustainable Economic Growth Stable Prices Sustainable Economic Growth Full Employment Monetary Policy Monetary policy: the Federal Reserve’s power to regulate the money supply and interest rates The Federal Reserve uses monetary policy by managing the money supply and interest rates Easy-money policy Expansionary policy that speeds the growth of the money supply to prevent recession (decline in the GDP) Tight-money policy Contractionary policy that slows the growth of the money supply to prevent inflation *Most common tool of Federal Reserve is open-market operations (buying and selling of government securities).

Fed Tools Open Market Tools – most used Buying and selling of government “securities” in the bond market Treasury bonds, notes, bills, or other government bonds (guaranteed by US gov. and tax exempt) Recommendation by FOMC (Federal Open Market Committee), component of the Fed Final interest rate decisions

Other Tools of the Fed The Reserve Requirement The Prime Rate: Reserve requirement for banks to keep at the Fed –”required reserve ratio” Minimum percent of deposit keep in reserve at all times Lowering the ratio allows for more loans and thus more money in circulation vs. raising, which tightens money supply Average reserve requirement, 3-10% The Prime Rate: Interest rate that banks charge their most credit-worthy customers The prime rate is also important for retail customers, as the prime rate directly affects the lending rates which are available for mortgage, small business and personal loans.

Effects of Low Interest Rates Generally, low interest rates stimulate the economy because there is more money available to lend. Consumers buy cars and houses. Businesses expand, buy equipment, etc. Why does the Fed lower interest rates? If inflation is in check, lower rates stimulate economic activity, thus boosting economic growth.

Effects of High Interest Rates The Fed raises interest rates as an effective way to fight inflation. Inflation—a sustained rise in the general price level; that is, all prices are rising together. (Dollar is worth less) Impacts Consumers pay more to borrow money, dampening spending. Businesses have difficulty borrowing; unemployment rises. The Fed generally raises rates as an effective way to quell inflation (a sustained rise in the general price level). Inflation means that your money is worth less Impact of Raising Rates: Businesses have difficulty in obtaining loans for expansion; unemployment rises Consumers will pay higher interest rates on credit cards and mortgages, which can cool spending.

Largest Concern: The National Debt John Maynard Keynes = Deficit Spending Emergencies only Fear of Government Bankruptcy Increase taxes, refinance debt Sell new bonds to pay off old bonds Burden on Future Generations Individuals and Institutions pay interest Holders of government bonds benefit Foreign-owned Debt Japan and China Interest paid to foreign countries but they buy US goods with it Offset by Americans buying foreign bonds Crowding-out Effect Crowding private borrowers out of the lending market Interest rate so high, no one can afford a loan Government borrowing raises interest rates but spend the money on creating jobs