Chapter 15 – The Fed and Monetary Policy

Section One – The Federal Reserve SystemI. Structure of the Fed

i. Main organizational structure has not changed since the 1930’sa. Private Ownership

i. It’s privately owned by it’s member banksii. All national banks are required to be members and own shares

b. Board of Governorsi. A seven member board of governors was established in 1935, each serving 14 year terms Figure 15.1Figure 15.1

c. Federal Reserve District Banksi. 12 District Reserve Banks located throughout the countryii. Each has it’s own president and board of directors

d. Federal Reserve Open Market Committeei. Makes decisions about the growth of the money supplyii. There are 12 voting members on the committeeiii. The committee meets eight times a year to meet and make decisions about the monetary policy

e. Advisory Committeesi. Three advisory committees advise the board directly

- health of the economy- consumer credit laws- savings institutions

II. Regulatory Responsibilitiesa. State Member Banks

i. Bank reserves are monitored by the Fed- serves to clear checks- control the size of the money supply

b. Bank Holding Companies – Corporations that own one or more banksi. They do not accept deposits or make loansii. Originally created to sidestep regulations they now are subject to more regulations than before

c. International Operationsi. Foreign banks can operate in the U.S.ii. Some own stock in U.S. banksiii. The Fed can terminate foreign bank operations inside the U.S.iv. The Fed also supervises U.S. banks oversees.

d. Member Bank Mergersi. If a state member bank is merged with another the Fed must approve the merger

III. Other Federal Reserve Servicesi. Clearing checksii. Consumer legislation – Truth in Lendingiii. Maintaining currency and coinsiv. Provides financial services for the federal governmentv. Maintains accounts for the IRS

Section Two – Monetary PolicyI. Fractional Bank Reserves

i. One of the most important roles they have is in managing the money supplyii. Fractional reserve banking

- Banks only required to keep a fraction of their reserves on hand- Subject to a reserve requirement, where a certain percentage of each deposit has to be set aside in reserve (12%)

a. How Banks Operatei. Examine the banks balance sheet and net worth

b. Organizing a Banki. Bank is organized as a corporationii. Owners supply cash in return for stock in the bank

d. Accepting Depositsi. The bank must set aside what is required for it’s reserve requirementii. The rest is shown as an asset that can be loaned out.

e. Making Loansi. It’s free to loan out $90

f. Reaching Maturityi. liquidity is desirable for banks. It means they can convert assets to cash quickly.ii. Once banks diversify their assets they achieve a high degree of liquidityiii. Can offer more products like savings accounts

II. Fractional Reserves and Monetary Expansiona. Loans and Monetary Growth

i. Excess reserves can continually be lent out- If loaned money is deposited in the bank, the bank can loan the excess money out again to a new customer

b. Reserves and the Money Supplyi. The money supply will stop growing at some point because each deposit is smaller than the one before.ii. As deposits are withdrawn bank reserves will fall

III. Tools of Monetary Policyi. Easy money policy – Allows the money supply to grow and interest rates to fallii. Tight money policy – Allows the money supply to fall and interest rates will rise

a. Reserve Requirementi. The Fed can change what the reserve requirement for banks

b. Open Market Operationsi. Buying and selling of government securities in financial markets

- When it buys government securities it increases the money supply- When it sells government securities it decreases the money supply

c. Discount Ratei. The interest rate the Fed charges on loans to financial institutionsii. If the interest rate goes up, banks borrow less and vice versa

d. Margin Requirementsi. The total amount of money needed to buy stocks (Now 50%)

- decreases the amount of speculatione. Other Tools

i. Press releases that banks use as signals to what future policy will beii. Credit controls – ex. Minimum down payments

Section Three – Monetary Policy, Banking and the EconomyI. Short-Run Impact

i. Cost of credit goes down when the money supply is expandedii. Cost of credit goes up when the money supply is restrictediii. No matter the policy the Fed chooses, it does have enormous impact on the economy, especially the financial sector.

I. Long-Run Impacti. In the long run, changes in the supply of money affects the general price level.

a. Monetizing the Debti. Create enough extra money to offset deficit spending to keep interest rates from changingii. Inflation can become worse with this policy if used too much

b. Taming Inflationi. Inflation distorts our economic statisticsii. Real rate of interest can be used (interest rate – rate of inflation)

III. Other Monetary Policy Issuesa. Timing and Burden

i. Results of policy changes aren’t always realized right awayii. Each choice will affect different industries differently

b. Present vs. Future Allocationi. Decisions affect how people consume either now or in the futureii. The rate of inflation changes how people invest

c. Defining Money i. M1 – Component of money supply that match money’s role as a medium of exchange (coins, currency,)ii. M2 – Component of money supply that match money’s role as a store of value (time deposits, savings deposits, money market funds)

IV. The Policies of Interest Ratesi. Fed operates under political pressureii. Threaten changes in policy over the Fediii. Can appoint members of the Board with certain goalsiv. People often think the economy is healthy if interest rates are low

- Can make policy changes in election years difficult