1. Banking & The Federal Reserve Modules 26-27

2. Banks 1) Banks 2) How Banks Create Money 3) The Money Multiplier Banks have several important functions 1.Store money Keep it safe 2.Save money We can earn interest on our deposits 3.Loan money Lending is how banks make money

3. Banks 1) Banks 2) How Banks Create Money 3) The Money Multiplier When people deposit money in a bank, the bank does not keep the full value of that deposit Instead, it keeps only a fraction and uses the rest for loans The portion of deposits that banks keep on hand makes up its reserves

4. Banks 1)Banks 2) How Banks Create Money 3) The Money Multiplier The Federal Reserve sets the reserve ratio – the percentage of deposits banks must keep readily available – Currently this is 10% As banks make loans, those funds are re-deposited, and a portion of them can be loaned out again…and again

5. Banks 1)Banks 2) How Banks Create Money 3) The Money Multiplier This cycle of depositing – loaning – depositing, etc increases the money supply – Remember, M1 includes checking accounts as well as currency! The value of the money multiplier is: M = 1/rr rr= reserve ratio

6. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems

7. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The nation’s decentralized central bank with two goals assigned by US Congress: 1.Maximize Employment – Stimulate economic growth 2.Influence the growth of the money supply – Control inflation

8. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The Federal Reserve is tasked with: 1.Providing financial services to the US government 2.Regulating financial institutions 3.Maintaining the payments system 4.Enforcing consumer protection laws 5.Monetary Policy

9. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The Fed is a blend of private sector and government: 1.Government and private banks both appoint board members 2.Regional structure 3.Funded by interest on holdings

10. Figure 26.1 The Federal Reserve System Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

11. Figure 27.1 The Federal Reserve’s Assets and Liabilities Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

12. Figure 25.4 The Monetary Base and the Money Supply Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

13. Monetary Policy 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The Federal Reserve uses monetary policy to affect the amount of the money supply, and thus influence economic growth and inflation Setting the Reserve Rate – If the Fed increases the reserve rate, the money supply will go down – If the Fed decreases the reserve rate, the money supply will go up

14. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The Discount Rate is the interest rate that the Fed charges bank to borrow funds – Normally set 1% above the federal funds rate, which is the rate at which member banks borrow from each other – By lowering the discount rate, the Fed can encourage more borrowing and thus increase the money supply

15. The Federal Reserve 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The primary way the Fed influences the money supply, is through open market transactions: The Fed buys or sells US Treasury Bonds If the Fed buys bonds, the money supply increases If the Fed sells bonds, the money supply decreases

16. Figure 27.2 Open-Market Operations by the Federal Reserve Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

17. Problems 1) The Federal Reserve - Purpose - Structure 2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions 3) Problems The Federal Reserve purchases $25 million in treasury bonds from the public. 1.If the reserve rate is 5%, theoretically, how much would the money supply increase? 2.What if the reserve rate were 20%?