2 Role of the Federal Reserve Est. by President Wilson in 1913Supervises member banksHolds Cash Reservesfunds available for short-term borrowing by commercial banks or governmentguarantees that money is available in the economy when neededMoves money into and out of circulation
3 Characteristics of the Federal Reserve (independent of elected officials) Lack of a Single Central Bankmost countries have single central bankFed relies on district banks to carry out national policiesOwnership and Control by the Member Banksin countries with a central bank gov’t owns all shares of stock, allowing tight controlmember banks own stock in Fed; resulting in political independenceOptional membership in the Fed for some banksnationally chartered banks must be members; state chartered banks are optionalless than 40% of banks nationally are Fed members; 5800 Member Banks
4 Organization of the Fed Board of Governors (another mechanism for independence)highest policy making body in Fed regulating money supply7 member board appointed by President; serve 14 years; new appointment every 2 years; each serves 4 year terms7 members and Chairman (Ben Bernanke) are permanent members of the Federal Open Market CommissionFederal Open Market Commission—12 member committee; decides whether to buy or sell gov’t securitiesBoard of Governors plus 4 district bank presidents that rotateFederal Reserve Banks—1913,12 F.R. district banks that deal only with government and financial institutions that serve a designated geographic region25 branch officesMember Banks2750 national member banks1000 state member banks
8 Services to Banks: 12 district banks don’t have checking, savings accounts; they service member banksClearing ChecksAmericans write 40 billions checks a yearFed tracks this by crediting and debiting reserve accountsLoans to Bankswe get loans from banks; banks get loans from Fedbanks need loans to cover increased withdrawals or loansmost are short-term to cover immediate problemfarm loans, natural disasters, financial emergenciesparticipating banks face strict monitoring and scrutiny
9 Services to Government Dept. of Treasury is Gov’t banker; collect taxes through IRS and Customs; produces money with U.S. Mint; Fed is gov’t bankServing as the Government’s Bankserves as depository for federal revenues; deposited by Treasurerholds a Treasury checking accountrecords the deposits and withdrawals of federal fundsadvises Congress and President on economic policySupervising member banks “banking systems watchdog”monitors loans and investments and reviews bank records of reservesregulates bank mergersRegulating the Money Supply—amount of money circulating in the economyDollars—printed by Bureau of Engraving and PrintingCoins—printed by U.S. MintFed distributes currencyCurrency is put into distribution for 2 reasons:replace old and worn out notesincrease amount of money in circulation by buying or selling government securities (T-bills and bonds)
10 Money Supply: Economists way to measure the nation’s money supply M1—easiest way to measure only easily accessiblecounts all currency in circulation + travelers checks + checking account depositschecking accounts are 63% of M1M2—a broader measure used by those who feel M1 doesn’t measure all accessible moneyCounts M1 + mutual funds + savings deposits + time deposits < $100, 000M3 and L—both are broader measures than M2M3 counts M2 + large time depositsL counts M3 + savings bonds + short term T-Bills + any other Near money
11 Questions Who is the current Chairman of the Federal Reserve? What are the three roles of the Federal Reserve?The Federal Reserve is broken into 4 levels of organization. What are the four levels, and what is the role of each?What services does the Fed offer to member banks?What services does the Fed provide the federal government?What events led to the creation of the Federal Reserve System?How is the Federal Reserve System designed to be largely independent of the federal government? Why would this separation from elected representatives be desirable?How would Fed policy change if Mr. Bernanke were an elected official instead of appointed?What services does the Fed provide to banks?How does the Fed serve the government?What are the four different measurements of the U.S. money supply? Which funds are included in each measurement?
12 Monetary PolicyMonetary Policy—plan to expand or contract the money supply in order to influence the cost and availability of creditdone by regulating money supply and interest rates;Policy is based on the Federal Reserve measures of the money supply and Aggregate DemandPolicy is enacted by the Federal Reserve
13 Monetary Policy: Strategies Easy-Money Policy—designed to expand money supply, increase aggregate demand, reduce unemployment, and promote economic growth during recessionsCharges banks lower interest rates, encourages borrowing (spending)Fed can expand money supply by buying securitiesTight-Money Policy—Slows business activity and helps stabilize prices to reduce aggregate demandResults from inflation when too much money is circulating and credit is too easily accessibleFed can raise interest rates to make credit less accessibleFed can decrease the money supply by selling securities
14 Monetary Policy: Tools—ways to affect aggregate demand Open-Market Operations—buying and selling of securitiesTo contract money supply Fed sells government securities. Cash paid for securities is withdrawn from bank reserves, shrinking money supply and decreasing aggregate demandTo expand money supply Fed buys government securities. Money makes it way into individual and business accounts increasing cash reserves and loan pools. This increases aggregate demand which leads to an increase in productionDiscount Rate—interest rate that the Fed charges member banks for the use of its reserves.a lower interest rate encourages banks to borrow more for their reserves. They then loan this to businesses and consumers to spend, increasing aggregate demandincreasing interest rates discourages banks from borrowing. Banks will pass this increased interest onto businesses and consumers by raising the prime rate, ultimately decreasing the amount of loans that are made, decreasing aggregate demand.prime rate—interest rates banks charge on loans to their most reliable business customerslaw of demand—as price to borrow money increases (prime rate) demand decreases; as price decreases demand increases
15 Monetary Policy: Tools—ways to affect aggregate demand Reserve requirements—changes affect lending capacity of banksincrease reserve requirement—less money available for loansdecrease reserve requirement—more money available for loans“Moral Suasion”—attempts by the Federal Reserve to put pressure on the member banks either to increase or decrease all or certain kinds of loans. Takes form of news releases, letters of appeal, Congressional testimony and conferences.
16 Summary of Monetary Policy Tools Formal ToolFed ActionEffects on EconomyMoney SupplyOpen Market SecuritiesBuys gov’t securitiesBank reserves increase; aggregate demand & production increasesExpandsSells gov’t securitiesBank reserves shrink; aggregate demand decreasesContractsDiscount RateLowers discount rateEncourages banks to borrow from the Fed; bank reserves increaseRaises discount rateDiscourages banks to borrow from Fed; bank reserves decreaseReserve RequirementLowers the reserve requirement %Banks hold fewer reserves & extend more loans; interest rates fall; Aggregate demand increasesRaises the reserve requirement %Banks hold more reserves & extend fewer loans; interest rates rise; Aggregate demand decreasescontracts
17 Challenges to Monetary Policy Economic ForecastingU.S. economy has millions of economic actors buying, selling, producingForecast can be difficult, and if incorrect could harm economyTime Lagscollection and analysis of economic datadiscussion and debate to reach consensus on dataconsumers/ producers need time to adjust their economic activityPriorities and Trade-offseasy-money policy fights recession, but increases inflationtight-money policy fights inflation, but contributes to recessionLack of Coordinationsometimes Monetary Policy will conflict with Fiscal PolicyConflicting Opinionseconomics is not an exact science and can be influenced by personal economic philosophies of conservative v. liberal
18 Questions!How does Monetary Policy affect investment spending in factories and equipment? The housing market? Consumer spending?Who enacts Monetary Policy? Why is Monetary Policy easier to enact than Fiscal Policy during periods of inflation?What are the tools of Monetary Policy?What Monetary Policy should be enacted during a recession? Inflation?What are some challenges to enacting Monetary Policy?Considering our current economic situation, would you expect the Fed to enact easy money or tight money policies?