The Federal Reserve and Monetary Policy National Banks needed to address the following 1. Consumer an businesses needed access to increased sources of funds to encourage business expansion 2. Banks needed emergency cash to prevent panics.

Federal Reserve Act of 1913: Created Federal Reserve System, “the Fed” – group of 12 regional, independent banks. These banks could lend to other banks in times of need. Initially, Fed System didn’t work well b/c actions of one regional bank counteracted the actions of another.

12 Fed Districts In 1935, Congress adjusted the Federal Reserve structure so that the system could respond more effectively to crises. Today’s Fed has more centralized powers so that regional banks can work together while still representing their own concerns.

Structure of The Fed: Board of Governors: 7-members, serves 14 yr terms to create monetary policy. Member Banks: All nationally chartered banks are required to join the Fed. High level of political independence. Federal Open Market Committee: Board of Gov. & 5 of 12 district bank presidents key decisions on interest rates & growth of US money supply.

Structure of the Federal Reserve System 12 District Reserve Banks Federal Open Market Committee 4,000 member banks and 25,000 other depository institutions Board of Governors

Functions of the Federal Reserve: Provides banking & fiscal services to federal govt. Provides banking services to member & nonmember banks Regulates the banking industry Tracks & manages national money supply to meet current demand & to stabilize the economy

What does the Fed do? Monetary policy: the actions the Federal Reserve takes to influence the level of real GDP and the rate of inflation in the economy Theoretically independent from the executive branch

The Fed Serves the Govt. Federal Govt’s Banker: Maintains checking account for Treasury Dept. Processes payments such as social security checks & IRS refunds. Government Securities Actions: Financial agent for Treasury Dept. & other govt. agencies. HOW?... Sells, transfers, & redeems govt. securities. When buying securities, Fed gets the paper & seller gets the money. A lot of that money finds it way to banks, thereby helping their solvency & (theoretically) their ability to lend Issuing Currency: District Fed Banks are responsible for issuing paper currency, while Treasury Dept. issues coins.

The Fed Serves Banks: Check Clearing: Banks record whose account gives up money & whose receives money when a customer writes a check. Supervising Lending Practices: Monitors bank reserves throughout banking system Each of 12 Reserve Banks sends out examiners to check up on lending/financial activities of member banks. Lender of Last Resort: In economic emergencies, commercial (private)banks can borrow funds from the Fed https://www.youtube.com/watch?v=gTS4kuWT9lE&utm_content=bufferdcb33&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer Bank Examinations The Federal Reserve examines banks periodically to ensure that each institution is obeying laws and regulations. Examiners may also force banks to sell risky investments if their net worth, or total assets minus total liabilities, falls too low.

I’m just a check… After you write a check, recipient presents it at his or her bank. Check is then sent to a Federal Reserve Bank. Reserve bank collects the necessary funds from your bank & transfers them to recipient’s bank Your processed check is returned to you by your bank. Almost all done electronically now – even check writing.

The Fed Regulates Reserves: Financial institutions that hold deposits for customers must report daily to Fed about its reserves & activities. Fed uses these reserves to control how much money is in circulation at any one time.

The Fed Keeps Economy Stable (or tries to) The Fed monitors the supply of & demand for money in an effort to keep inflation rates stable.

Money Creation- process by which money enters into circulation You deposit $1,000 in your checking account, the bank doesn’t ignore the money you put in, but lends out some of it to other people (& businesses). Portion of original $1,000 that bank needs to keep on hand (not loan out) is called the Required Reserve Ratio (RRR). When bank lends a portion of your $$ to others, they too may deposit some of it. Banks then continue to lend out portions of that $$, although you still have $1,000 in your account. Hence, more money enters circulation. https://www.youtube.com/watch?v=RqWYmQQzXxs START @3:44!

If the RRR is 10% how much money will be available on your $1,000 deposit to loan out?

Money Creation To determine how much money is actually created by a deposit, we use the money multiplier formula. The money multiplier formula is calculated as 1/RRR. Money Creation You deposit $1,000 into your checking account. Your $1,000 deposit minus $100 in reserves is loaned to Elaine, who gives it to Joshua. $100 held in reserve $900 available for loans Joshua’s $900 deposit minus $90 in reserves is loaned to another customer. At this point, the money supply has increased by $2,710. $90 held in reserve $810 available for loans

The money multiplier equals 1/RRR Money Multiplier- amount of $ generated by each dollar of bank reserves The money multiplier equals 1/RRR Let’s say that the bank has to keep $100 of $1000 in reserves: The RRR is 10% SO.... The money multiplier is 1/10%=1/.10=10 Take the original amount of reserves and multiply by the multiplier (10) $100 X 10 =$1000

Money Multiplier Effect Original Amount: $1,000 Original Amount: $1,000 MM = 1/RRR MM = 1/.1 MM = 10 Economic Impact = $10,000 MM = 1/RRR MM = 1/.05 MM = 20 Economic Impact = $20,000 Lowering the RRR will increase the money supply

Money Multiplier Money Multiplier Equation: 1/RRR 1/10% 1/.1= 10 Let’s say the RRR is 10%. If the Fed injects $10 Billion in news reserves into the banking system how much can the money grow? Money Multiplier Equation: 1/RRR 1/10% 1/.1= 10 10 x $10 billion = $100 Billion

Tools for the Fed Activity: The Fed has 3 main tools to adjust the money supply: Reserve Requirement Discount Rate Open Market Opportunities

Reserve Requirements Reducing Reserve Requirements A 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.

Discount Rate Reducing the Discount Rate Increasing 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. http://video.cnbc.com/gallery/?video=3000467470 (What is a fed rate hike?)

Open Market (the most important) Bond Purchases In order to increase the money supply, the Federal Reserve Banks 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.

Types of Government Borrowing Treasury Bills – aka “T-Bills” Repaid within a year or less 13, 26, 39, 52 week coupon books Treasury notes 2-10 years Treasury Bonds Up to 30 years Very small (think holiday gifts) Very large (other countries buy them) Generally, longer time higher interest to account for risk and opportunity costs Government will raise the rate it pays to attract more people Right now rates are low because loaning money to the government is seen as safer than other markets Overall, the government borrowing is a complicated financial interaction – if interested, take a finance course in college

Controlling Money Supply Increase Money Supply Decrease Money Supply Reserve Requirements Decrease RRR Increase RRR Discount Rate Decrease Rate Increase Rate Open Market Buy Bonds Sell Bonds

Predicting the Cycle: The Fed must not only react to current trends, but also anticipate changes in the economy. Monetary Policy & Inflation: Expansionary policies enacted at wrong time can push inflation even higher. If current phase of business cycle is anticipated to be short, policymakers may choose to let cycle fix itself. If a recession is expected to last for years, most economists favor a more active monetary policy. How Quickly Does the Economy Self-Correct? Economists disagree about how quickly an economy can self-correct. Estimates range from two to six years. Since the economy may take quite a long time to recover on its own, there is time for policymakers to guide the economy back to stable levels of output and prices.

Business Cycles and Stabilization Policy Real GDP Time Business cycle Business cycle with properly timed stabilization policy Time Real GDP Business cycle Business cycle with poorly timed stabilization policy Good Timing Properly timed economic policy will minimize inflation at the peak of the business cycle and the effects of recessions in the troughs. Bad Timing If stabilization policy is not timed properly, it can actually make the business cycle worse. Inside Lags An inside lag is a delay in implementing monetary policy. Inside lags are caused by the time it actually takes to identify a shift in the business cycle. Outside Lags Outside lags are the time it takes for monetary policy to take affect once enacted.

Interest Rates and Spending Easy money policy: increase the money supply lowering interest rates to increase spending economy will expand Tight money policy: decrease the money supply increasing interest rates to decrease spending economy will contract

Combining Monetary and Fiscal Policy Monetary Policy Expansionary Tools use when the economy is in a recession Increase Government spending Decrease Taxes Buy Bonds Reduce RRR Decrease Discount Rate Contractionary Tools Use when the economy is expanding too fast Decrease Government spending Increase Taxes Sell Bonds Increase RRR Increase Discount Rate

Fed rate hike explained w/ Rube Goldberg Machine https://www.nytimes.com/interactive/2015/12/16/upshot/fed-interest-rates-rube-goldberg-machine.html?smid=pl-share&_r=0 https://www.youtube.com/watch?v=RaeIBeJT5hY