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CHAPTER 14 THE FEDERAL RESERVE AND MONETARY POLICY

GOAL:  “Furnish an elastic currency”  “Establish a more effective supervision of banking in the US.  How does it do this? 1.Supervises member banks 2.Holds cash reserves  Used for short-term borrowing by commerical banks and the gov’t 3.Moves money in and out of circulation  Stabilizes monetary and banking systems GOAL OF FEDERAL RESERVE

1.District banks carry our banking policies developed at national level 2.Gov’t does not own or fully control the central bank  Member banks own stock in the Federal Reserve (Fed) banks in their district.  Fed is extremely independent of government pressure 3.Nationally chartered banks are required to join Fed, but not state chartered banks. CHARACTERISTICS OF THE FED

 Designed to oversee banking practices across US  Operates on national and district level  National Level:  Board of Governors makes decisions  Regulates the supply of money in the economy  Governors are appointed, serving 14 year terms  Chairperson (Ben Bernanke) – 4 year term  District Level:  Worry of minority controlling banks led to districts  12 separate districts, each with their own bank  All commercial banks chartered by federal government are members ORGANIZATION OF THE FED

 Fed provides services to us indirectly  Services to Banks  Loans to Banks  If you need a loan, you go to a bank  If a bank needs a loan, it goes to the district Federal Reserve bank  Banks will take out short-term loans to replenish their cash supply  “Lender of Last Resort”  Fed may give loans to corporations and individuals if they are unable to obtain funding elsewhere. WHAT THE FED DOES

 Services to the Gov’t  Helps manage the governments finances  Government’s Bank  Hold’s gov’t money  Supervising Member Banks – “Watchdog”  Reviews loans and investments banks make  Monitors bank’s reserves, make sure they have enough cash  Regulating Money Supply  Money Supply – Amount of money in circulation  Why is new currency put in circulation? 1.Get rid of old currency 2.Increase Money Supply by expanding how much Federal Reserve banks can loan. WHAT THE FED DOES

Imagine I gave each of you $1000 How would this impact: Demand Supply Prices Employment 10,000? 100?

 Monetary Policy (MP) – The plan to expand or contract the money supply in order to influence the cost and availability of credit.  This influences “aggregate demand”  Aggregate Demand (AG) – The total demand for all products in the economy  Fed will adopt either “easy-money” policy or “tight-money” policy MONETARY POLICY

 Expands money supply  Increases Aggregate Demand (AG)  Create Jobs  Reduce Unemployment  Promote Economic Growth  Does this during a recession EASY-MONEY POLICY

 The Fed lowers interests rate for banks to borrow money  Banks lower their own interest rates they charge to customers  Say a Car Loan drops from 8% to 6.5%  People start getting car loans and buy cars  Demand for cars increases  Car producers hire more workers to build more cars  These new workers now have income to contribute to the economy EASY-MONEY POLICY - EXAMPLE

 Slows business activity  High interest rates  Stabilizes prices  Reduce Money Supply  Both of these reduce Aggregate Demand  Fed may determine that inflation is going to happen because too much money is circulation and credit is too accessible. TIGHT-MONEY POLICY

 Example from “DuckTales”  WHY IS STOPPING INFLATION IMPORTANT?

 Discount Rate (DR) – The interest rate the Fed charges member banks for the use of reserves.  Fed adjusts DR to encourage/discourage borrowing  Lowering DR  Banks will borrow more and turn the cash into loans for people and businesses  Banks pass on savings to members  Raising DR  Banks are discouraged from borrowing  Banks will raise their interest rates, discouraging people from borrowing COMPONENTS OF MONETARY POLICY

 Reserve Requirement (RR) – The money that must be held by banks either in their own vaults or in their accounts at the district Federal Reserve Bank  How much cash banks should have on hand at a given time  Decrease RR  Banks don’t need to hold as much cash  They can give out more loans  Increases demand  Increase RR  Banks hold onto cash  Banks cut back on lending  Interest Rates increase, demand decreases COMPONENTS OF MONETARY POLICY

 Credit Regulation  Can regulate consumer credit in times of national emergency  Example: Higher down payments and shorter repayments on loans  If credit is more expensive, fewer people will buy consumer goods. COMPONENTS OF MONETARY POLICY

 The Fed’s Main Challenges  Economic Forecasting  Time Lags  Priorities and Trade-Offs  Lack of Coordination  Conflicting Opinions POLICY LIMITATIONS

 Economic Forecasting  Fed must predict future business activity and consumer spending  US economy includes millions of factors making it difficult  Time Lags  It takes time for policies to go into effect  It takes months for the Fed to analyze large amounts of data  Must discuss the appropriate action  Months may pass before the impact of policy changes are felt POLICY LIMITATIONS

 Priorities and Trade-Offs  Monetary Policy is used primarily to fight either inflation or recession  Sometimes, fixing one problem creates another  Example: Easy-Money policy to fight recession causes inflation  Lack of Coordination  Sometimes other gov’t agencies target different economic issues  Can hinder economic stability and send mixed signals to market  Conflicting Opinions  Policy makers disagree how Monetary Policy should be used  Economics is NOT an exact science POLICY LIMITATIONS