The Federal The Federal Reserve and Reserve and

Monetary PolicyMonetary PolicyChapter 16Chapter 16

The Federal The Federal Reserve SystemReserve System

Chapter 16, Section 1Chapter 16, Section 1

Federal Reserve Act of Federal Reserve Act of 19131913

Created the Federal Reserve (FED)Created the Federal Reserve (FED) System of federal banksSystem of federal banks 12 districts12 districts Overseen by the Board of GovernorsOverseen by the Board of Governors

7 governors7 governors 14 year terms appointed by the President14 year terms appointed by the President Appoints a chair confirmed by the SenateAppoints a chair confirmed by the Senate

Chairs serve a four year term that can be Chairs serve a four year term that can be renewedrenewed

FED DistrictsFED Districts 12 districts12 districts District bank reports on economic activity in the District bank reports on economic activity in the

district to the central bankdistrict to the central bank Member banks... All nationally chartered banks are Member banks... All nationally chartered banks are

required to join the Fed. Member banks contribute required to join the Fed. Member banks contribute funds to join the system, and receive stock in and funds to join the system, and receive stock in and dividends from the system in return. This ownership dividends from the system in return. This ownership of the system by banks, not government, gives the Fed of the system by banks, not government, gives the Fed a high degree of political independence.a high degree of political independence.

The The FOMC (Federal Open Market Committee), FOMC (Federal Open Market Committee), which consists of The Board of Governors and 5 of the which consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about 12 district bank presidents, makes key decisions about interest rates and the growth of the United States interest rates and the growth of the United States money supply.money supply.

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Federal Reserve Federal Reserve FunctionsFunctions

Chapter 16, Section 2Chapter 16, Section 2

Functions of the FEDFunctions of the FED

Banking and fiscal services to the Banking and fiscal services to the governmentgovernment

Banking and fiscal services to Banking and fiscal services to member and nonmember banksmember and nonmember banks

Regulates the banking industryRegulates the banking industry Tracks and manages the money Tracks and manages the money

supplysupply

Serving the GovernmentServing the Government

Acts as the Government’s bankActs as the Government’s bank Maintains a checking account for the Maintains a checking account for the

treasurytreasury Sells securitiesSells securities Issues currencyIssues currency

Coins are created at the US MintCoins are created at the US Mint Currency is created by the Bureau of Currency is created by the Bureau of

Engraving and PrintingEngraving and Printing The FED issues the currencyThe FED issues the currency

Serving BanksServing Banks Check clearingCheck clearing Loans to member banksLoans to member banks Stock to member banksStock to member banks Supervise lending practicesSupervise lending practices Lender of last resortLender of last resort

Banks loan money to each other and charge Banks loan money to each other and charge interest known as the Federal Funds Rateinterest known as the Federal Funds Rate

The FED can lend funds to banks in times of The FED can lend funds to banks in times of need and charge interestneed and charge interest

This is called the This is called the discount ratediscount rate

Regulating the Banking Regulating the Banking SystemSystem

The FED requires banks to report on The FED requires banks to report on their reservestheir reserves

Examine banks to ensure they are Examine banks to ensure they are following regulationsfollowing regulations Examiners look at the banks Net Worth Examiners look at the banks Net Worth

to determine if they are in troubleto determine if they are in trouble Net Worth represents total assets minus Net Worth represents total assets minus

total liabilitiestotal liabilities

Regulating the Money Regulating the Money SupplySupply

FED is best known for regulating the FED is best known for regulating the money supplymoney supply

Factors that affect demand for moneyFactors that affect demand for money Cash needed on handCash needed on hand Interest ratesInterest rates Price levels in the economyPrice levels in the economy General level of incomeGeneral level of income

The laws of supply and demand work The laws of supply and demand work the same with the money supplythe same with the money supply

Monetary Policy Monetary Policy ToolsTools

Chapter 16, Section 3Chapter 16, Section 3

Monetary PolicyMonetary Policy

Monetary policy refers to the action Monetary policy refers to the action the FED takes to influence economic the FED takes to influence economic performanceperformance

The FED can use monetary policy in The FED can use monetary policy in a number of waysa number of ways Money creation...not making it but Money creation...not making it but

putting it into circulationputting it into circulation Changing reserve requirementsChanging reserve requirements Changing the discount (interest) ratesChanging the discount (interest) rates Purchasing bondsPurchasing bonds

Money CreationMoney Creation

Banks keep a certain amount of funds on handBanks keep a certain amount of funds on hand The required reserve ratio (RRR) is the amount The required reserve ratio (RRR) is the amount

that must be kept by banks...this is established by that must be kept by banks...this is established by the FEDthe FED

After the RRR is kept, banks can loan money. This After the RRR is kept, banks can loan money. This process, along with gained interest creates process, along with gained interest creates money...or adds it to the money supplymoney...or adds it to the money supply

The money multiplier formula tells us how much The money multiplier formula tells us how much money will be created through this processmoney will be created through this process

However, banks may keep excess reserves on However, banks may keep excess reserves on handhand More money than is required by the RRRMore money than is required by the RRR

Reserve RequirementsReserve Requirements

The FED can influence the economy The FED can influence the economy by changing the RRRby changing the RRR

Raising the RRR will reduce the Raising the RRR will reduce the money in circulationmoney in circulation

Lowering it will increase the money in Lowering it will increase the money in circulationcirculation

FED does not do this today as it can FED does not do this today as it can be very disruptive to the loan processbe very disruptive to the loan process Loans may have to be recalledLoans may have to be recalled

The Discount RateThe Discount Rate Banks borrow from the FED and the interest Banks borrow from the FED and the interest

charged is known as the discount rate.charged is known as the discount rate. In turn, these banks loan to customers (you In turn, these banks loan to customers (you

and me) and the interest rate charged is and me) and the interest rate charged is known as the known as the prime rateprime rate. .

By changing the discount rate, the prime rate By changing the discount rate, the prime rate changes and affects our spending behaviorschanges and affects our spending behaviors Raising the discount rate will slow borrowing, Raising the discount rate will slow borrowing,

spending and the economyspending and the economy Lowering the discount rate will increase Lowering the discount rate will increase

borrowing, spending, and increase the economyborrowing, spending, and increase the economy 22ndnd most used form of Monetary Policy most used form of Monetary Policy

Open Market OperationsOpen Market Operations

The most used monetary tool is open The most used monetary tool is open market operationsmarket operations

The FED can purchase bonds to put The FED can purchase bonds to put money into circulationmoney into circulation

They sell government bonds to take They sell government bonds to take money out of circulationmoney out of circulation

ReviewReview

1. The required reserve ratio is 1. The required reserve ratio is (a) (a) the ratio of deposits to reserves required of banks by the the ratio of deposits to reserves required of banks by the

Federal Reserve.Federal Reserve.(b) (b) the ratio of accounts to customers required of banks by the the ratio of accounts to customers required of banks by the

Federal Reserve .Federal Reserve .(c) (c) the ratio of reserves to deposits required of banks by the the ratio of reserves to deposits required of banks by the

Federal Reserve.Federal Reserve.(d) (d) the ratio of paper currency to coins required of banks by the the ratio of paper currency to coins required of banks by the

Federal Reserve.Federal Reserve.

2. All of the following will increase the money 2. All of the following will increase the money supply exceptsupply except(a) (a) increasing the required reserve ratio.increasing the required reserve ratio.(b) (b) bond purchases by the Fed.bond purchases by the Fed.(c) (c) reducing the required reserve ratio.reducing the required reserve ratio.(d) (d) reducing the discount rate.reducing the discount rate.

Monetary Policy Monetary Policy and and

Macroeconomic Macroeconomic StabilizationStabilizationChapter 16, Section 4Chapter 16, Section 4

Using Monetary PolicyUsing Monetary Policy

Monetarism...the belief that the money Monetarism...the belief that the money supply is the most important factor in supply is the most important factor in macroeconomic performancemacroeconomic performance

Money supply and interest ratesMoney supply and interest rates In basic terms, the interest rate is the cost of In basic terms, the interest rate is the cost of

moneymoney Works under the principles of supply and Works under the principles of supply and

demanddemand When money supply is high, interest rates are lowWhen money supply is high, interest rates are low When money supply is low, interest rates are highWhen money supply is low, interest rates are high

Easy Money vs. Tight Easy Money vs. Tight Money PolicyMoney Policy

When money is in low supply, the When money is in low supply, the FED may follow an FED may follow an easy money easy money policypolicy...or follow policy that will ...or follow policy that will increase the money supplyincrease the money supply

When money is in high supply, the When money is in high supply, the FED will try to lower the money FED will try to lower the money supply or use supply or use tight money policytight money policy

Timing of Monetary Timing of Monetary PolicyPolicy

Policies of Monetary Policy need to be carefully Policies of Monetary Policy need to be carefully enacted to have the desired effect...if they are enacted to have the desired effect...if they are not time accordingly, they may have a negative not time accordingly, they may have a negative effect on the business cycleeffect on the business cycle

Like with Fiscal Policy, Monetary Policy takes Like with Fiscal Policy, Monetary Policy takes time to put in place and take effect...lagstime to put in place and take effect...lags Inside lag... Delay in implementing monetary policyInside lag... Delay in implementing monetary policy

The government takes time to recognize the problem and The government takes time to recognize the problem and create a solutioncreate a solution

Outside lag...the time it takes for the policy to have Outside lag...the time it takes for the policy to have an effectan effect

Predictions of the business cycle is key in this Predictions of the business cycle is key in this processprocess

Fiscal and Monetary Policy Tools

Fiscal policy tools Monetary policy tools

Expansionary Tools

Contractionary Tools

1. Increase government spending

2. Cutting taxes

1. Decrease government spending

2. Raising taxes

Fiscal and Monetary Fiscal and Monetary Policy ToolsPolicy Tools

1. Open market operations: bond purchases

2. Decreasing the discount rate

3. Decreasing reserve requirements

1. Open market sales: bond sales

2. Increasing the discount rate

3. Increasing reserve requirements

RememberRemember

Fiscal Policy is how the government Fiscal Policy is how the government uses its taxing and spending to uses its taxing and spending to influence the economyinfluence the economy

Monetary Policy is how the FED uses Monetary Policy is how the FED uses its control of the money supply to its control of the money supply to influence the economyinfluence the economy

ReviewReview

1. Monetarism is 1. Monetarism is (a) (a) the time it takes to enact monetary policy.the time it takes to enact monetary policy.(b) (b) the belief that the money supply means little to the belief that the money supply means little to

macroeconomic performance.macroeconomic performance.(c) (c) the time it takes for monetary policy to take affect.the time it takes for monetary policy to take affect.(d) (d) the belief that the money supply is the most important the belief that the money supply is the most important

factor in macroeconomic performance.factor in macroeconomic performance.

2. Tight money policies aim to 2. Tight money policies aim to (a) (a) increase the money supply and expand the economy.increase the money supply and expand the economy.(b) (b) decrease the money supply and expand the economy.decrease the money supply and expand the economy.(c) (c) decrease the money supply and slow the economy.decrease the money supply and slow the economy.(d) (d) increase the money supply and slow the economy.increase the money supply and slow the economy.