The Federal Reserve and Monetary Policy

1. The Federal Reserve and Monetary Policy Chapter 16

2. The Federal Reserve System Chapter 16, Section 1

3. Federal Reserve Act of 1913 • Created the Federal Reserve (FED) • System of federal banks • 12 districts • Overseen by the Board of Governors • 7 governors • 14 year terms appointed by the President • Appoints a chair confirmed by the Senate • Chairs serve a four year term that can be renewed

4. FED Districts • 12 districts • District bank reports on economic activity in the district to the Central Bank (FED) • Member banks... All nationally chartered banks are required to join the FED. The ownership of the system by banks, not the government, gives the FED a high degree of political independence. • The FOMC (Federal Open Market Committee), which consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about interest rates and the growth of the United States money supply.

5. Federal Reserve Functions Chapter 16, Section 2

6. Functions of the FED • Banking and fiscal services to the government • Banking and fiscal services to member and nonmember banks • Regulates the banking industry • Tracks and manages the money supply

7. Serving the Government • Acts as the Government’s bank • Maintains a checking account for the Treasury • Sells securities (bonds) • Issues currency • Coins are created at the US Mint • Currency is created by the Bureau of Engraving and Printing • The FED issues the currency

8. Serving Banks • Check clearing • Loans to member banks • Supervise lending practices • Lender of last resort • Banks loan money to each other and charge interest known as the Federal Funds Rate • The FED can lend funds to banks in times of need and charge interest • This is called the Discount Rate

9. Regulating the Banking System • The FED requires banks to report on their reserves • Liquid assets on hand • Examine banks to ensure they are following regulations • Examiners look at the bank’s Net Worth to determine if they are in trouble • Net Worth represents their total assets minus their total liabilities

10. Regulating the Money Supply • FED is best known for regulating the money supply • Factors that affect demand for money • Cash needed on hand • Interest rates • Price levels in the economy • General level of income • The laws of supply and demand work the same with the money supply

11. Monetary Policy Tools Chapter 16, Section 3

12. Monetary Policy • Monetary policy refers to the action the FED takes to influence economic performance • The FED can use monetary policy in a number of ways • Money creation...not making it but putting it into circulation • Changing reserve requirements • Changing the interest rates • Purchasing bonds (open market operations)

13. Money Creation • Banks keep a certain amount of funds on hand • The required reserve ratio (RRR) is the amount that must be kept by banks...this is established by the FED • After the RRR is kept, banks can loan money. This process, along with gained interest creates money...or adds it to the money supply • Banks may keep excess reserves on hand • More money than is required by the RRR

14. Reserve Requirements • The FED can influence the economy by changing the RRR • Raising the RRR will reduce the money in circulation • Lowering it will increase the money in circulation • Banks have more money to loan out • FED does not change the RRR very often

15. The Discount Rate • Banks borrow from the FED and the interest charged is known as the discount rate. • In turn, these banks loan to customers and establish interest rates known as the prime rate. • By changing the discount rate, the prime rate changes and affects spending behaviors • Raising the discount rate will slow borrowing, spending and the economy • Lowering the discount rate will increase borrowing and spending, and stimulate the economy • 2nd most used form of Monetary Policy

16. Open Market Operations • The most used monetary tool is open market operations • This involves buying and selling bonds on open markts • The FED will purchase bonds to put money into circulation • They sell government bonds to take money out of circulation

17. Review 1. The required reserve ratio is (a) the required amount of gas that must be left in reserve when your care is on empty (b) the amount of reserves that banks must keep in their vaults (c) the ratio of taxes the government must collect to cover Monetary Policy (d) the ratio of paper currency to coins required of banks by the Federal Reserve. 2. All of the following will increase the money supply except (a) increasing the required reserve ratio. (b) bond purchases by the Fed. (c) reducing the required reserve ratio. (d) reducing the discount rate.

18. Monetary Policy and Macroeconomic Stabilization Chapter 16, Section 4

19. Using Monetary Policy • Monetarism...the belief that the money supply is the most important factor in macroeconomic performance • Money supply and interest rates • In basic terms, the interest rate is the cost of money • Works under the principles of supply and demand • When money supply is high, interest rates are low • When money supply is low, interest rates are high

20. Easy Money vs. Tight Money Policy • When money is in low supply, the FED may follow an easy money policy...or follow policy that will increase the money supply • When money is in high supply, the FED will try to lower the money supply or use tight money policy

21. Timing of Monetary Policy • Policies of Monetary Policy need to be carefully enacted to have the desired effect...if they are not time accordingly, they may have a negative effect on the business cycle • Like with Fiscal Policy, Monetary Policy takes time to put in place and take effect...lags • Inside lag... Delay in implementing monetary policy • The government takes time to recognize the problem and create a solution • Outside lag...the time it takes for the policy to have an effect • Predictions of the business cycle is key in this process

22. Fiscal and Monetary Policy Tools Fiscal policy tools Monetary policy tools Fiscal and Monetary Policy Tools • Open market operations: bond purchases • Decreasing the discount rate • Decreasing reserve requirements • Increase government spending • Cutting taxes Expansionary Tools • Open market sales: bond sales • Increasing the discount rate • Increasing reserve requirements • Decrease government spending • Raising taxes Contractionary Tools

23. Remember • Fiscal Policy is how the government uses its taxing and spending to influence the economy • Monetary Policy is how the FED uses its control of the money supply to influence the economy

24. Review 1. Monetarism is (a) the time it takes to enact monetary policy. (b) the belief that the money supply means little to macroeconomic performance. (c) the time it takes for monetary policy to take affect. (d) the belief that the money supply is the most important factor in macroeconomic performance. 2. Tight money policies aim to (a) increase the money supply and expand the economy. (b) decrease the money supply and expand the economy. (c) decrease the money supply and slow the economy. (d) increase the money supply and slow the economy.