The Federal Reserve System The Fed
Structure • The Federal Reserve System divides the country into 12 districts, each with its own Federal Reserve bank.
The Board of Governors, which is made up of seven members appointed by the President and confirmed by the Senate to 14-year terms, directs the nation’s monetary policy and the overall activities of the Federal Reserve. • The Federal Open Market Committee is the official policy-making body; it is made up of the members of the Board of Governors and five of the district bank presidents. • Each district bank is directed by its nine-person board of directors. • The Chairman of this board serves a four-year term (not term-limited).
Fed Functions • Oversee other banks • Check clearinghouse • Print money • Main function = monetary policy
Monetary Policy – defined • Changes in the supply of money and the availability of credit initiated by a nation’s central bank to promote price stability, full employment, and reasonable rates of economic growth.
A simpler definition … The actions the Federal Reserve (Central Bank) takes to influence the level of GDP and the rate of inflation in the economy.
How Do They Do It? Tools of the Fed: 1. Open Market Operations 2. Discount Rate (Fed to banks) 3. Federal Funds Rate (bank to bank) 4. Reserve Requirements
Monetary Policy Tools • Open Market Operations – the buying and selling of government bonds (securities) by the Federal Reserve to control the bank reserves and the money supply. • To increase the availability of money the Fed buys government bonds. • To tighten the availability of money the Fed sells bonds. • This tool is used daily.
Discount Rate – the interest rate the Fed charges commercial banks for loans. • A change in the discount rate can either inhibit or encourage financial institutions’ lending and investment activities by making it more or less expensive for them to obtain funds. • Federal Funds Rate – the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.
Reserve Requirements – the fraction of banks’ deposits that they are required by law to keep on hand or with the Fed. • Lower reserve requirements mean banks can loan out a higher percentage of deposits. • Higher reserve requirements mean banks must keep a higher percentage of deposits in the vault. • Reserve requirement does not change very often.
Tight-Money Policy (contractionary) • When inflation is a problem, the Fed can decrease the money supply by: • Raising the discount rate, • Raising the reserve requirement, or • Selling government bonds • With less money in circulation, interest rates will rise, borrowing will decrease, aggregate demand will fall, price level falls, and GDP decreases.
Easy-Money Policy (expansionary) • During times of high unemployment/ recession, the Fed can increase the money supply by: • Lowering the discount rate, • Lowering the reserve requirement, or • Buying government bonds • With more money in circulation, interest rates will fall, borrowing with increase, aggregate demand will increase, prices will rise and GDP will increase … more jobs will become available.
How/When/Why If the economy needs a “boost” the Federal Reserve might: _______________ bonds. _______________ interest rates. _______________ reserve requirements.
How/When/Why If the economy needs to be “cooled off” the Federal Reserve might: _______________ bonds. _______________ interest rates. _______________ reserve requirements.
Bonus • If the Fed wanted to institute the most contractionary monetary policy possible, which of the following combinations would it choose? Gov’t SecuritiesDiscount RateReserve Requirement • Sell Decrease Increase • Sell Increase Increase • Buy Increase Decrease • Buy Decrease Increase • Sell No Change No Change