The Federal Reserve & Monetary Policy

Essential Standards The student will explain the role and functions of the Federal Reserve System. The student will describe the organization of the Federal Reserve System. The student will define monetary policy. The student will describe how the Federal Reserve uses the tools of monetary policy to promote price stability, full employment and economic growth. The student will explain how changes in monetary policy can impact an individual’s spending and savings choices.

The Federal Reserve Act of 1913 Created the Federal Reserve System… Usually referred to as “the Fed”. It is composed of 12 regional banks… Overseen by a board of governors… That lend money to private banks— “The Lender of Last Resort”. All private national banks are required to join the Federal Reserve System.

The Role of the Fed The Fed is the bank of the United States… It processes all government payments (social security, IRS refunds, etc.)… It also makes interest payments on government bonds… And is responsible for issuing currency.

The Banking System The Fed provides “check clearing” services for member banks… The process by which banks record whose account gives up money… And whose account receives it. It also supervises all lending practices… And makes sure that customers receive accurate information from lenders—terms, conditions, interest, etc.

Reserves Banks hold only a fraction of their funds in reserve… The rest has been lent to its customers. The Fed ensures that each bank keeps the required amount in reserve. The amount the bank must keep on hand is called the… Required Reserve Ratio (RRR).

Monetary Policy and the Money Supply The most important role of the Federal Reserve is in controlling the money supply— The total amount of currency held by individuals, plus money in bank accounts. By controlling the money supply, the Fed influences… The growth of the GDP. The rate of inflation.

Influencing the Money Supply The Fed controls the amount of money in the economy by three methods: 1. Altering the Reserve requirement: —Reducing the RRR… Increases the money supply (bank loans are allowed to lend more money) —Increasing the RRR… Reduces the money supply (bank loans are limited).

Influencing the Money Supply Open Market Operations… When the Fed buys government bonds/securities, bond sellers receive money that enters the economy… …and the money supply… —Increases. …When the Fed sells bonds/securities, the money supply… —Decreases.

Influencing the Money Supply Setting interest rates. The discount rate—the interest rate the Fed charges on loans to other banks. Lowering the discount rate makes loans cheaper… Banks respond by lowering the Prime Rate— The interest rate that banks charge their customers. When the discount rate is lowered, the money supply… INCREASES.

Money Supply Philosophy: Tight Money Tight Money Policy—usually introduced in periods of expansion and inflation. The Fed will DECREASE the money supply, which will slow down the economy. There are three methods: 1. The RRR… increase it! 2. Government securities… sell ‘em! 3. The discount rate…

Money Supply Philosophy: Easy Money Easy money policy—is usually introduced during times of contraction or recession… Is it designed to pump money into the economy to get it moving again. There are three methods: 1. The RRR… lower it! 2. Government securities… buy ‘em! 3. The discount rate…