Federal Reserve and

Monetary Policy

Creation of “The Fed”The Bank Panic of 1907 convinced Congress to look hard at bankingConsumers and businesses needed access to increased sources of funds to encourage expansionBanks needed a source of emergency cash to present depositors panics that result in bank runsTah! Dah! – Federal Reserve Act of 1913

Federal Reserve Act of 1913

Created the Federal Reserve SystemOriginally 12 independent regional banks that could lend to one anotherDidn’t prevent Great Depression because they didn’t act togetherReform brought about a new structure

Structure of the Federal Reserve

Federal Reserve Today

Board of Governors – 7 membersFederal Open Market Committee = Board of Governors + 5 District Bank Presidents12 Regional Banks = 4,000 Member banks

Board of GovernorsFederal Reserve BoardFederal government agencySeven members appointed by President for 14 year terms, staggered two years apartGuide the Federal Reserve’s policy actionsGeneral oversight of all 12 regional banksPresident – Ben Bernake – appointed for four years – reports to Congress twice a year

Federal Open Market Committee

FMOC makes key decisions about interest rates

Discount rate – interest rate Fed charges banks for loansFederal funds rate – interest rate banks charge each other for loans

FMOC oversees U.S. money supplyMeets every 6 weeks

12 Federal Reserve Districts

Banker’s BanksOperate independently Under general oversight of Bd. Of Gov.Serve three audiences

Bankers - Store commercial banks excess currency and coinsU.S. Treasury – sell securities Public - Process and settle their checks and electronic payments

Take out a Dollar Bill

Monetary Policy

Keeping our economy healthyEconomy performs well if inflation is lowAlso when interest rates are lowThese two ideals foster low unemployment and a growing economyThree tools to achieve this

MonetaristsEconomists who follow Monetary Policy as a way to control the business cyclesThey believe competitive markets provide the market with a high degree of economic stability – less government intervention the betterWhen the government intervenes, it is through the Federal Reserve changing the money supply

What is the Money Supply?

Currency (cash and coins)Checkable account balances

Money in checking accounts

Traveler’s Checks

Feds can make the money supply increase or decrease

Monetary Policy ToolsChange discount rate – interest rate Reserve banks charge banks for short-term loansChange Reserve Requirements – portions of deposits that banks must hold in reserve, either in their bank vault or in the Reserve bank Open Market Operations – buying and selling of U.S. government securities – most important tool

Discount RateReducing the

Discount Rate

If the Fed wants to encourage banks to loan out more of their money, it may reduce the discount rate, making it easier or cheaper for banks to borrow money if their reserves fall too low.

Reducing the discount rate causes banks to lend out more money, which leads to an increase in the money supply.

Increasing the Discount Rate

If the Fed wants to discourage banks from loaning out more of their money, it may make it more expensive to borrow money if their reserves fall too low.

Increasing the discount rate causes banks to lend out less money, which leads to a decrease in the money supply.

Reserve Requirement Reducing Reserve

RequirementsA reduction of the RRR would free up reserves for banks, allowing them to make more loans.A RRR reduction would also increase the money multiplier. Both of these effects would lead to a substantial increase in the money supply.

Increasing Reserve Requirements

Even a slight increase in the RRR would require banks to hold more money in reserve, shrinking the money supply.This method is not used often because it would cause too much disruption in the banking system.

Open Market OperationsBond Purchases

In order to increase the money supply, the Federal Reserve Bank of New York buys government securities on the open market.The bonds are purchased with money drawn from Fed funds. When this money is deposited in the bank of the bond seller, the money supply increases.

Bond Sales

When the Fed sells bonds, it takes money out of the money supply.

When bond dealers buy bonds they write a check and give it to the Fed. The Fed processes the check, and the money is taken out of circulation.

Money CreationMoney creation is the process by which money enters into circulation.By using one of the three tools the money supply is either increased or decreasedIncreased if the Fed wants the economy to grow (loose monetary policy)Decreased if the Fed wants to slow down the economy (tight monetary policy)

Money Multiplier

Adding money to the money supplyThis process will continue until no new loans are madeA $5,000 deposit into a checking account could change the money supply by as much as $50,000

Types of Bank Reserves

Total reserves = Deposits at the Fed + vault cash

Ex: Reserve Acct. ($10 m) + vault ($5 m) = TR ($15 m)

Required reserves = Reserve requirement X checking account deposits

Ex. RR (20%) x Ck Acct ($50 m) = Required R ($10 m)

Excess Reserves = Total reserves – Required reserves

TR ($15 m) – Required R ($10 m) = ER ($5 m)

Formula

Δ in MS = 1/RR% X Δ in bank reserves

Δ in MS = 1/.10 (10%) X $5,000 = $25,000

DebtOur money supply is based on debtYep – that’s right No gold, no silver, no collateralJust good ole’ American debtThink about that for awhile

Fiscal and Monetary Policy Tools

Fiscal PolicyTools

Monetary Policy Tools

ExpansionaryTools

1. Govt spending

2. taxes

1. OMO: bond purchases

2. Discount rate

3. RR

Fiscal and Monetary Policy Tools

Fiscal PolicyTools

Monetary Policy Tools

Contractionary

Tools

1. Govt spending2. taxes

1. OMO: bond sales2. Discount rate3. RR