THE FEDERAL RESERVE SYSTEM AND MONETARY

POLICYChapter 15

Prior to the Fed Over 30,000 different currency

Anyone could create currency Some currencies worth more than others Some banks didn’t keep enough reserve to do

everyday banking of customers Banks constantly going BANKRUPT

Congress creates The Federal Reserve Bank (THE FED) in 1913

Organization of the Fed Board of Governors

Directs the operations 7 full time members

Appointed by Pres – approved by Senate 14 year term – new member every 2 years

Decisions not approved by anyone Federal Advisory Council

12 members chosen by directors of each bank Meets 4 times a year – reports directly to BoG

Federal Open Market Committee Meet 8 times a year Controls Money Supply Made up of 7 BoG, head of NY Fed Bank, 4 other bank heads rotate

12 District Banks 25 Branch Banks Most other banks and lending institutions

The Banks U.S. divided into 12 Federal Reserve Districts

Each district has one Fed Reserve Bank Set up as corporation with member banks as

owners 25 Branch banks assist in carrying out duties All national banks must join State banks have choice

Advantages: Stockholders of district bank

Receive Dividends Vote for 6 of district banks 9 board members

Functions of the Fed Check Clearing Government’s Fiscal Agent Supervising Banks Holding Reserves and Setting Reserve

Requirement Supplying Paper Currency Regulating the Money Supply

Main function Affects interest rates for borrowers Affects availability of credit Affects business activity

Loose and Tight Money Policies Monetary Policy

Changing the rate of growth of the money supply in order to affect the cost and availability of credit

Cost of Credit – Interest paid As cost goes up??? As cost goes down??? Loose Money Policy (AKA Expansionary)

Lots of credit Credit is cheap Consumers buy more Businesses expand More employment

Tight Money Policy (AKA Contractionary) Difficult to get credit Cost more to borrow Businesses postpone expansion Unemployment increases Reduction in production

Fractional Reserve Banking Fed sets Reserve Requirement

Amount of checkable deposits that must be in “reserve” at all times Held in case customers want to withdraw funds Currently 10%

Rest of money is used to create “New Money”

Regulating the Money Supply

Board of Governors can do 3 things to control money supply Changing Reserve Requirement Changing Discount Rate Open Market Operations

Changing Reserve Requirement(Rarely Used)

Raising the Reserve??? Less money (deposits) available to loan out

Used to slow economy if too much spendingLowering the Reserve???

More money (deposits) available to loan out More loans means more in supply Consumers can spend more

Changing Discount Rate Banks may have to borrow from the Fed

If goes below Reserve Requirement Customers borrowing Customers withdraw

Fed charges Discount Rate (Interest) to banks If Discount Rate High???

Banks charge higher interest to customers Customers/Businesses likely won’t borrow

Lowering the Discount Rate??? Banks charge lower interest to customers

Customers/Businesses will borrow at this times Can also alter the Federal Funds Rate

Rate that banks charge when lending to each other When do banks borrow from each other???

Open Market Operations(Most used tool to control Money Supply)

Buying/Selling Treasury Bonds, Notes, Bills How does this alter Money Supply?

Government buys securities Deposits money into dealer’s bank Bank then keeps RR and loans rest out

Increases Money Supply Government sells securities

Dealer’s banks must use deposits to purchase Banks have less money above reserve so less

loans Decreases Money Supply

Time and Criticism of The Fed No matter what tool used

Takes about 12 months before fully felt Criticisms of Fed Policies

Have caused higher than necessary inflation because improperly increasing money supply

Has made recessions worse by causing tight money policy when economy already contracting

Some people call for The Fed to increase money supply by same amount each year (steady inflation)

Tax policies of Federal Government can also affect The Fed policy Sometimes work against each other