The Federal Reserve

and Monetary Policy

Part I – The Federal Reserve

System

Banking History: A Central Bank?

• Debated since 1790

• Following the Panic of 1907, Congress decided that a central bank was needed.

The Federal Reserve Act of 1913

• The Federal Reserve System “the Fed,” is

a group of 12 regional, independent

banks.

• Initially did not work well because one

regional bank would counteract another.

• In 1935, Congress restructured the Federal

Reserve so that regional banks can work

together while still representing their own

concerns.

Structure of the Federal Reserve

The Board of Governors

– Seven-member board.

– Actions taken by the Federal Reserve are

called monetary policy.

Federal Reserve Districts

– The Federal Reserve Regional Banks

monitor and report on economic activity

in their districts.

Structure of the Federal Reserve

Member Banks

– All nationally chartered banks are required to join the Fed.

– Member banks contribute funds to join the system

– This ownership of the system by banks, not government, gives the Fed a high degree of political independence.

The Federal Open Market Committee (FOMC)

– Consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about interest rates and the growth of the United States money supply.

The Pyramid Structure of the Federal Reserve Structure of the Federal Reserve System

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Comprehension Check 1. How many Federal Reserve Districts are there?

2. How many members are on the Board of

Governors?

3. What does FOMC stand for?

4. What year was the Federal Reserve created?

5. What year did Congress restructure the Federal

Reserve?

Part II – Federal

Reserve Functions

1. Federal Government’s Banker

–maintains a checking account for the

Treasury Department

–Processes payments: social security

checks, IRS refunds.

Serving Government

2. Government Securities Auctions

–financial agent for the Treasury

Department

–Sells, transfers, and redeems

government securities.

–Handles funds raised from selling T-

bills, T-notes, and Treasury bonds.

3. Issuing Currency

–Responsible for issuing paper

currency (Department of the

Treasury issues coins.)

Serving Banks

Check Clearing

1. Process by which banks record

whose account gives up money,

and whose account receives

money

The Journey of a Check

- After you write a check, the recipient presents it at his or her bank.

The Path of a Check

Check writer

Recipient

- The check is then sent to a

Federal Reserve Bank.

Federal

Reserve Bank

- The reserve bank collects the

necessary funds from your

bank and transfers them to

the recipient’s bank. Check

writer’s bank • Your processed check used

to be returned to you by your

bank. Now due to digital age

a record is kept only online.

2. Supervising Lending Practices

–Ensures reserves are met

–Enforces truth-in-lending laws.

3. Lender of Last Resort

–In case of economic emergency,

commercial banks can borrow

funds from the Federal Reserve.

–The interest rate at which banks

can borrow money is called the

discount rate.

Regulating the Banking System

Reserves

• Financial Institutions

MUST repost its reserves

and activities daily.

Bank Examinations

• Ensures banks follow

laws and regulations.

Regulating the Money Supply

•Best known for its role in

regulating the money supply.

•monitors the levels of M1 and M2

and compares these measures of

the money supply with the current

demand for money.

Factors That Affect Demand for Money

1. Cash needed on hand (Cash makes transactions easier.)

2. Interest rates (Higher interest rates lead to a decrease in the demand for cash.)

3. Price levels in the economy (As prices rise, so does the demand for cash.)

4. General level of income (As income rises, so does the demand for cash.)

Stabilizing the Economy

• Monitors the supply of and the demand for money in an effort to keep inflation rates stable.

Part II – Comprehension Check

1. What is M1 ?

2. What are Truth in Lending Laws?

3. Check clearing is done by what institution?

4. Who issues paper currency?

5. What MUST financial institutions do EVERY day?

Part III – Monetary Policy Tools

The Money Creation Process

• Money Multiplier Formula. The money multiplier

formula is calculated as 1/RRR.

Money Creation

You deposit $1,000

into your checking

account.

Your $1,000 deposit

minus $100 in reserves

is loaned to Elaine, who

gives it to Joshua.

$100 held in reserve

$900 available for loans

Joshua’s $900 deposit

minus $90 in reserves is

loaned to another

customer.

At this point, the money

supply has increased by

$2,710.

$90 held in reserve

$810 available for loans

Federal Reserve

Monetary Tools

1. Reserve Requirements

Reducing Reserve Requirements

Increasing Reserve Requirements

2. Discount Rate

•The discount rate is the interest

rate that banks pay to borrow

money from the Fed.

•Reducing the Discount Rate vs.

Increasing the Discount Rate

3. Open Market

Operations

•The most important monetary tool

is open market operations. Open

market operations are the buying

and selling of government securities

to alter the money supply.

Part IV – Monetary Policy and

Macroeconomic Stabilization

How Monetary Policy Works

Interest Rates and Spending

• Easy money policy, it will increase the

money supply.

• Tight money policy, it will decrease the

money supply.

•Monetarism is the belief that the money supply

is the most important factor in macroeconomic

performance.

The Problem of Timing Good Timing

• Properly timed economic policy will minimize inflation at the peak of the business cycle and the effects of recessions in the troughs.

Bad Timing

• If stabilization policy is not

timed properly, it can actually

make the business cycle worse.

Business Cycles and Stabilization Policy

Rea

l G

DP

Time

Business cycle Business cycle with

properly timed

stabilization policy

Time

Re

al G

DP

Business

cycle

Business cycle with

poorly timed

stabilization policy

•Policy lags are problems experienced in the timing of macroeconomic policy. There are two types:

Policy Lags

Inside Lags • An inside lag is a delay

in implementing monetary policy.

• Inside lags are caused by the time it actually takes to identify a shift in the business cycle.

Outside Lags

• Outside lags are the time it takes for monetary policy to take affect once enacted.

Anticipating the Business Cycle

How Quickly Does the Economy Self-Correct?

• Estimates range from two to six years.

• Since the economy may take quite a long time to

recover on its own, there is time for policymakers to

guide the economy back to stable levels of output

and prices.

•The Federal Reserve must anticipate

changes in the economy.

Fiscal and Monetary Policy Tools • The federal government and the Federal

Reserve both have tools to influence the nation’s economy.

Fiscal and Monetary Policy Tools

Fiscal policy tools Monetary policy tools

1. increasing government

spending

2. cutting taxes

Expansionary

tools

1. open market operations:

bond purchases

2. decreasing the discount

rate

3. decreasing reserve

requirements

Contractionary

tools

1. decreasing government

spending

2. raising taxes

1. open market operations:

bond sales

2. increasing the discount

rate

3. increasing reserve

requirements