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Understanding the Federal Reserve: Embracing Monetary Policy Tools for Economic Stability

The Federal Reserve operates as the central bank of the United States, using monetary policy tools to manage the money supply and influence the economy. Key functions include Open Market Operations, adjusting Reserve Requirements, and setting the Discount Rate. The Fed's decisions directly impact inflation and unemployment, emphasizing the delicate balance between these two factors. By understanding how banks function within this system and the role of the money multiplier and fractional reserve banking, we can better comprehend the Fed's profound influence on the economy.

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Understanding the Federal Reserve: Embracing Monetary Policy Tools for Economic Stability

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  1. The Federal Reserve Or, How I learned to stop worrying and embrace MONETARY POLICY.

  2. The Fed • Operates as a Central Bank • Uses the tools of monetary policy to influence the quantity of reserves (money) in the banking system • Powerful influence over the money supply and general price level

  3. FOMC • Federal Open Market Committee: makes decisions to increase or decrease the # of dollars in the economy

  4. The Fed and the Economy • Central Banks (like the Fed) are very important b/c they can profoundly affect the economy • Prices rise when the government prints too much money (inflation) • Short run trade off of inflation and lower unemployment

  5. Three Monetary Tools • 1. Open Market Operations: buying and selling bonds • 2. Reserve Requirements: changing the reserve ratio at banks • 3. The discount rate

  6. OMO • Buying or selling of government bonds • To increase the money supply, the Fed will buy bonds from the public • Each new dollar held as currency increases the money supply by $1.00 • Each new dollar deposited into a bank increases the money supply to a greater extent • To decrease the money supply, the Fed sells gov’t bonds to the public • Used most often by the Fed

  7. Reserve Requirements • Regulations in the minimum amount of reserves that banks must hold against deposits • They rarely change this b/c it would disrupt business of banking

  8. How do Banks Work? • Banks hold your demand deposits and manage them for you • The behavior of banks can greatly influence the money supply • Reserves: deposits that banks have received but have not loaned out

  9. T-Accounts • An accounting statement • If banks hold all money in reserves, they don’t influence the money supply • Assets: the reserves the bank holds in its vaults • Liabilities: the amount it owes it’s depositors or customers

  10. Money Multiplier • the amount o money the banking system generates with each dollar of reserve • It is the reciprocal of your reserve ratio: • If your reserve ratio is 10% or 1/10 then your multiplier is 10 • The amount of money that banks creates depends on the reserve ratio • The higher the reserve ratio, the less of each deposit banks loan out and the smaller the multiplier

  11. Fractional Reserve Ratio • A banking system in which banks hold only a fraction of deposits as reserves • They want to loan out some of the money deposited in their bank and charge interest so that they can make money • Reserve ratio: the % of deposits that banks hold onto • Reserve Requirement: the minimum the Fed requires • Excess Reserve: if a bank if being conservative

  12. Discount Rate • The interest rate on loans the Fed makes to banks • If a bank has too few reserves to meet the requirement, they have to borrow from the Fed • A high discount rate discourages borrowing and lending

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