Federal Reserve and Monetary Policy

What does the Money Supply consist of? M1 = cash, checking account deposits, and traveler’s checks M2 = M1 + savings accounts & money market accounts M3 = M2 +large deposits and other large, long-term deposits.

Examples 1.$100 in wallet = M1 2.$800 in checking account = M1 3.$1,000 in savings account = M2 4.A $20 traveler’s check from last business trip to China = M1 5.A $300 outstanding credit card bill = Neither 6.$3,000 in a small certificate of deposit = M2 7.A car worth $5,000 = Neither

What is the Money Supply (M1)? 1. Currency (cash and coins) 2. Checkable account balances Money in checking accounts 3. Traveler’s Checks The Federal Reserve can make the money supply increase (expand) or decrease (contract)

Bank Reserves Banks are required to keep a certain amount of funds in reserves to meet unexpected outflows. Banks may hold their reserves either as cash in their vaults or as deposits at the Fed.

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 (10%) x Ck Acct ($50 m) = Required R ($5 m) Excess Reserves = Total reserves – Required reserves TR ($15 m) – Required R ($5 m) = ER ($10 m)

The Fed Funds Market Banks that have less than required reserves can borrow from other banks (Federal Funds Market) The interest charged on the borrowed funds is the Federal Funds Rate (Currently %) The Federal Reserve can control the supply of federal funds by using Monetary Policy By comparison, in May 2006 the rate was 5%

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

Federal Reserve Act of 1913 Created the Federal Reserve System Originally 12 independent regional banks that could lend to one another Didn’t prevent Great Depression because they didn’t act together Reform brought about a new structure

Structure of the Federal Reserve

Who Conducts Monetary Policy? 1. Board of Governors: 7 members 2. Federal Open Market Committee (FOMC): (Board of Governors + 5 District Bank Presidents) Regional Banks = 4,000 Member banks

1. Board of Governors Federal Reserve Board Federal government agency Seven members appointed by President for 14 year terms, staggered two years apart Guide the Federal Reserve’s policy actions General oversight of all 12 regional banks Chairman: Ben Bernake – appointed for four years – reports to Congress twice a year. Job is up January 31 st, and Janet Yellen has been nominated.

2. Federal Open Market Committee FOMC makes key decisions about interest rates: Discount rate: interest rate Fed charges banks for loans (.75%) Federal funds rate: interest rate banks charge each other for loans (0 -.25%) FOMC oversees U.S. money supply Meets every 6 weeks

3. 12 Federal Reserve Districts

Federal Reserve: The Banker’s Bank Operate independently Under general oversight of Bd. Of Gov. Serve three audiences: Bankers: Store commercial banks excess currency and coins U.S. Treasury: Sell U.S. securities Public: Process and settle their checks and electronic payments

Take out a Dollar Bill

Monetarists Economists who follow Monetary Policy as a way to control business cycles Believe competitive markets provide the market with a high degree of economic stability Less government intervention the better When the government intervenes, one way is through the Federal Reserve changing the money supply

What is the Purpose of Monetary Policy? Tries to keep our economy healthy by regulating the money supply Economy performs well if inflation is low Economy performs well when interest rates are low These two ideals foster low unemployment and a growing economy Three tools to achieve economic health

The Three Monetary Policy Tools Change discount rate: interest rate Reserve banks charge banks for short-term loans (Currently.75) Change Reserve Requirements: portions of deposits that banks must hold in reserve, either in their bank vault or in the Reserve bank (Currently 10%) Open Market Operations: The Federal Reserve buys and/or sells U.S. government securities (bills, bonds, notes) - most used

Open Market Operations: Increase The Fed buys government Treasuries Pays for the bonds with a check drawn on itself Seller deposits check in a bank Bank presents the check to the Fed Fed honors the check by increasing the reserve balance To decrease: sells bonds thus reversing the process

Money Creation Money creation is the process by which money enters into circulation. By using one of the three tools the money supply is either increased or decreased Increased if the Fed wants the economy to expand (loose monetary policy) Decreased if the Fed wants to contract the economy (tight monetary policy)

Money Multiplier Adding money to the money supply This process will continue until no new loans are made A $5,000 deposit into a checking account could change the money supply by as much as $50,000 Δ in MS = 1/RR% X Δ in bank reserves Δ in MS = 1/.10 (10%) X $5,000 = $50,000

Debt Our money supply is based on debt Yep – that’s right No gold, no silver, no collateral Just good ole’ American debt Think about that for awhile

Fiscal and Monetary Policy Tools Fiscal Policy Tools Monetary Policy Tools Expansionary Tools: 1.  Govt spending 2.  taxes 1. OMO: bond purchases 2.  Discount rate 3.  RR

Fiscal and Monetary Policy Tools Fiscal Policy Tools Monetary Policy Tools Contractionary Tools 1.  Govt spending 2.  taxes 1. OMO: bond sales 2.  Discount rate 3.  RR