The Fed and Monetary Policy CHAPTER 15 The Fed and Monetary Policy

Section 1: The Federal Reserve System Main Idea: The Federal Reserve works to strengthen and stabilize the nation’s monetary system. Objectives: Describe the structure of the Federal Reserve System. Explain the major regulatory responsibilities of the Fed.

Section 1 Introduction On December 23, 1913, Congress created the Federal Reserve System, or “Fed,” as the central bank of the United States. Today, the Fed provides financial services to the government, regulates financial institutions, maintains the payments system, enforces consumer protection laws, and conducts monetary policy. Because everyone uses money, and because interest rates affect the overall level of economic activity, the Fed’s activities affect us all.

Structure of the Fed The Federal Reserve System is owned by its member banks The Board of Governors establishes policies for the Federal Reserve and member banks to follow, regulates certain operations, and controls the money supply. The 12 Federal Reserve district banks and 25 branch banks are located near the commercial banks they serve.

Structure of the Fed (cont.) The Federal Open Market Committee (FOMC) makes decisions about the growth of the money supply. The Federal Advisory Council, the Consumer Advisory Council, and the Thrift Institutions Advisory Council advise the Board of Governors.

Structure of the Fed (cont.)

Regulatory Responsibilities The Fed monitors member banks’ reserves. The Fed oversees bank holding companies. The Fed oversees foreign banks operating in the United States as well as the international operations of U.S. member banks and holding companies operating abroad. The Fed approves bank mergers.

Other Federal Reserve Services The Federal Reserve is responsible for check clearing. The Federal Reserve is responsible for extending truth-in-lending disclosures to millions of individuals who purchase or borrow from corporations, retail stores, automobile dealers, and lending institutions. The Federal Reserve is responsible for issuing paper currency. The Federal Reserve is responsible for providing financial services to the federal government.

Other Federal Reserve Services (cont.) Figure 15.2

Section 2: Monetary Policy Main Idea: Federal Reserve actions intended to stabilize the economy make up what is called monetary policy. Objectives: Describe the use of fractional reserves. Understand the tools used to conduct monetary policy.

Section 2 Introduction One of the Federal Reserve System’s most important responsibilities is that of monetary policy. Monetary policy is the expansion or contraction of the money supply in order to influence the cost and availability of credit. The Fed does not hesitate to change interest rates whenever the economy’s health is threatened. Monetary policy is a structured process. In order to understand it better, it helps to understand the fractional reserve system that our banking system is based on.

Fractional Bank Reserves The Federal Reserve requires that member banks keep a certain percentage of their deposits in the form of legal reserves. A bank’s balance sheet shows its assets, liabilities, and net worth. Balance sheets are sometimes referred to as T-accounts, because the accounts form a T when written. Every time a bank customer makes a deposit, the bank must set aside a portion of the deposit as reserves.

Fractional Bank Reserves (cont.) Banks earn money by lending out that portion of their deposits that need not be held as reserves. To earn its profits, a bank usually needs to charge 2-3 percent more for its loans than the rate of interest it pays for its saving accounts and time deposits, interest bearing deposits that cannot be withdrawn by check.

Fractional Bank Reserves (cont.) Figure 15.3a Figure 15.3b Figure 15.3c

Fractional Reserves and Monetary Expansion A system of fractional reserve banking allows banks to make a large volume of loans. A change in the money supply is equal to the change in reserves divided by the reserve requirement. Figure 15.4

Tools of Monetary Policy The Fed can affect the money supply by changing the reserve requirement. The Fed can affect the money supply by buying and selling government securities (open market operations). The Fed can affect the money supply by changing the discount rate, the interest rate the Fed charges on loans to financial institutions. The Fed can affect the money supply by changing margin requirements. The Fed can affect the money through moral suasion and selective credit controls.

Tools of Monetary Policy (cont.) Figure 15.6

Section 3: Monetary Policy, Banking, and the Economy Main Idea: Changes in the money supply affect the interest rate, the availability of credit, and the price level. Objectives: Explain how monetary policy affects interest rates in the short run. Relate monetary expansion to inflation in the long run. Identify the two major definitions of money. Describe how interest rates are affected by political pressure.

Section 3 Introduction The impact of monetary policy on the economy is complex. In the short run, monetary policy affects interest rates and the availability of credit. In the long run, it affects inflation and economic growth, which is one of the Fed’s major concerns. In addition, no one can be sure how long it will take for the effects of monetary policy to impact the economy.

Short-Run Impact Changes in the money supply affect interest rates. Sometimes the Fed’s long-term objectives force it to keep interest rates above or below the desired level in the short run.

Short-Run Impact (cont.) Figure 15.7a

Short-Run Impact (cont.)

Long-Run Impact Changes in the money supply affect the general level of prices. Monetizing the government’s debt means creating enough extra money to offset deficit spending in order to prevent interest rates from changing.

Long-Run Impact In 1980 the Fed decided to control inflation by restricting the growth of the money supply. The real rate of inflation is the market rate of interest minus the rate of inflation.

Other Monetary Policy Issues A tight monetary policy can hurt some industries, like homebuilding and automobiles, more than other industries. High interest rates encourage people to forgo consumption today and increase their savings; low interest rates encourage people to borrow money today, which will reduce their ability to consume in the future.

Other Monetary Policy Issues (cont.) M1 includes traveler’s checks, coins, currency, demand deposits, and other checkable accounts; M2 includes M1 plus small denomination time deposits, savings deposits, and money market funds. Figure 15.9

The Politics of Interest Rates The Fed is an independent monetary authority, but it comes under political pressure to raise or lower interest rates. The president and Congress can affect the Board of Governors by appointing new members when governors’ terms expire.