The Federal The Federal Reserve SystemReserve System

Powers of a Central BankPowers of a Central Bank Acts as a banker Acts as a banker

to the central to the central governmentgovernment

Acts as a banker Acts as a banker to banksto banks

Acts as a Acts as a regulator of banksregulator of banks

Sets monetary Sets monetary policy (policies policy (policies that influence that influence interest rates and interest rates and money supply)money supply)

Federal Reserve Act of 1913Federal Reserve Act of 1913 Federal Bank is Federal Bank is

created by act of created by act of Congress, and can be Congress, and can be changed by Congresschanged by Congress

Not “part” of the Not “part” of the national government, national government, but authorized by but authorized by CongressCongress

12 Federal Reserve 12 Federal Reserve Districts (Colorado is Districts (Colorado is in the Kansas City in the Kansas City district)district)

Each district is made Each district is made up of the region’s up of the region’s member banks that member banks that choose to joinchoose to join

Structure of the FedStructure of the Fed Member banks elect Member banks elect

a board of directors, a board of directors, which elects a which elects a district bank district bank presidentpresident

National “Board of National “Board of Governors” Governors” appointed by appointed by president, confirmed president, confirmed by Senateby Senate

Governors serve 14-Governors serve 14-year terms; chairman year terms; chairman serves 4-year termserves 4-year term

Federal Open Market CommitteeFederal Open Market Committee ““FOMC” (Federal Open FOMC” (Federal Open

Market Committee) decides Market Committee) decides interest rate policyinterest rate policy

Tasked with two key Tasked with two key directives:directives:

– Keep inflation lowKeep inflation low– Keep employment highKeep employment high

Meet 8 times per year, and Meet 8 times per year, and immediately publish policy immediately publish policy decisionsdecisions

Fed can only control short-Fed can only control short-term interest rates: term interest rates: mortgage rates and long-mortgage rates and long-term government bonds are term government bonds are affected by affected by

– supply & demand in non-supply & demand in non-governmental “loanable governmental “loanable funds” marketfunds” market

– expectations of inflation expectations of inflation over long termover long term

Fed Power #1: Reserve RatioFed Power #1: Reserve Ratio

Controls power of Controls power of banks to “create banks to “create money” through money” through loansloans

Monetary Control Act Monetary Control Act of 1980 required all of 1980 required all banks to obey banks to obey reserve lawsreserve laws

Fed last changed Fed last changed reserve requirement reserve requirement in 1992, lowering it in 1992, lowering it from 12% to 10%from 12% to 10%

Fed Power #2: Discount WindowFed Power #2: Discount Window

Short-term loans to Short-term loans to member banks as member banks as “lender of last “lender of last resort”resort”

Rarely used by Rarely used by banks, because they banks, because they use federal funds use federal funds market insteadmarket instead

(Instead, banks now (Instead, banks now borrow money from borrow money from each other overnight each other overnight -- the “Federal funds -- the “Federal funds rate”)rate”)

Fed Power #3: Federal Funds RateFed Power #3: Federal Funds Rate

This is hugely important!This is hugely important! Primary monetary policy Primary monetary policy to affect economyto affect economy

Key: interest rates affect Key: interest rates affect the I component of ADthe I component of AD

Federal Funds Rate is Federal Funds Rate is the interest rate banks the interest rate banks charge each other on charge each other on overnight loansovernight loans

Banks need overnight Banks need overnight loans to adjust their loans to adjust their reserves so that they reserves so that they can meet the reserve can meet the reserve ratio requirementratio requirement

Banks with excess Banks with excess reserves lend to banks reserves lend to banks with insufficient reserveswith insufficient reserves

How Does it Work?How Does it Work? Federal Funds interest Federal Funds interest

rates determined by rates determined by money supplymoney supply

– If money is scarce, If money is scarce, interest rates are highinterest rates are high

– If money is abundant, If money is abundant, interest rates are lowinterest rates are low

Fed increases the money Fed increases the money supply (“expansionary supply (“expansionary policy”) bypolicy”) by

– buyingbuying treasury bonds on treasury bonds on open marketopen market

– Money leaves Fed; goes Money leaves Fed; goes into money supplyinto money supply

Fed decreases money Fed decreases money supply (“contractionary supply (“contractionary policy”) bypolicy”) by

– SellingSelling treasury bonds on treasury bonds on open marketopen market

– Money leaves money Money leaves money supply and is absorbed by supply and is absorbed by FedFed

Money Market GraphMoney Market Graph Basically, the Federal Basically, the Federal

Funds Rate (very short Funds Rate (very short term), controlled by Fedterm), controlled by Fed

Shows nominal interest Shows nominal interest rates (actual “street” rates rates (actual “street” rates as seen in newspaper)as seen in newspaper)

Money supply is a constant Money supply is a constant (for the present time), so is (for the present time), so is verticalvertical

MS can shift with Fed MS can shift with Fed FOMC policy (Fed buys and FOMC policy (Fed buys and sells bonds)sells bonds)

MD can shift with MD can shift with – Price LevelPrice Level– GDPGDP– Psychology of marketPsychology of market– Society’s need for Society’s need for cashcash

Quantity of Money

Interest Rate (i)

MD

MS

Quantity of Money

Interest Rate

MD

MS2MS1

i1

i2