THE FEDERAL RESERVE SYSTEM

THE PROBLEM Up until the early 1900s, many banks lacked adequate reserves to meet the needs of the public Banks operated on the gold standard, in which paper money and coins had the value of a certain amount of gold When a lot of people wanted to exchange paper money for gold at the same time, these banks ran out of gold and failed

THE SOLUTION The Federal Reserve System was created in 1913 as the nation’s first true central bank The Fed could lend to other banks in times of need

ORGANIZATION OF THE FED The U.S. is divided into 12 districts Each district has a Federal Reserve Bank Federal Reserve Board made up of people appointed by President has responsibility of supervising Fed banks Fed banks allows other banks to borrow money to meet short-term demands. This helps prevent bank failures. Primary objective is to manage the economy by controlling the money supply.

Board of Governors: 7 people 12 District Reserve Banks Thousands of member banks and depository institutions

MONETARY POLICY The process by which the Federal Reserve controls the supply of money. Expansionary policy quickly expands the amount of money in the economy and is used to combat unemployment by lowering interest rates Contractionary policy expands the money supply slowly or even decreases it. It’s used to slow inflation There are three tools the Fed uses to enact its monetary policy…

TOOLS OF THE FED Reserve requirements : the Fed can adjust the amount of reserves in the banking system by requiring banks to keep more or less money in reserve If the reserve requirement is decreased, the money supply expands because banks increase lending If the reserve requirement is increased, the money supply contracts because banks decrease lending

An increase in reserve requirements causes banks to increase reserves. Reserve Requirement Money Supply A reduction in reserve requirements causes banks to decrease reserves. Banks reduce lending, causing the money supply to contract. Banks increase lending, causing the money supply to expand. Reserve Requirement

TOOLS OF THE FED Discount Rate : the interest rate that the Fed charges on loans to financial institutions If the Fed raises the discount rate, banks will raise the interest rate for loans they give to the public If the Fed lowers the discount rate, banks will lower the interest rate for loans they give to the public

TOOLS OF THE FED Open market operations : the buying and selling of government securities in order to alter the supply of money When the Fed wants to increase the money supply, it buys securities/bonds (debt obligations) from banks using Federal Reserve funds. Banks then have extra money that they can lend out. When the Fed wants to decrease the money supply, it sells securities/bonds and receives money from banks. Banks have decreased reserves so they decrease loans.

Through bond sales, the Fed removes reserves from the banking system. Bonds Circulating Money Supply The Fed’s purchase of bonds increases reserves in the banking system. Banks reduce lending, causing the money supply to contract. Banks increase lending, causing the money supply to expand.