Monetary Policy & The Federal Reserve

Key Questions

Monetary Policy Monetary Policy The actions of the Federal Reserve to influence the money supply, which affects interest rates Modifying interest rates Buying or selling government bonds Changing the amount of money banks are required to keep on hand In the short run, monetary policy affects the real variables of GDP and unemployment (In the long run, monetary policy affects only the price level)

What is the federal reserve system? The Federal Reserve is the central bank of the United States A central bank is the government agency that oversees the banking system and is responsible for the amount of money and credit in the economy

What does the fed do? Regulates bank holding companies and state chartered banks Supply money and credit to the economy to maintain stable prices and full employment Ensure smooth functioning of the payments system Act as the government’s bank Fed (a CB) created to ensure the safety of the banking system through regulation. National banks required to join the Fed system. Enormous bank failures led to the creation of the FDIC in 1933. Glass-Steagall prevents banks from underwriting or dealing in corporate securities. G-S prohibited investment banks from engaging in commercial banking. Banks had to sell off their investment banking divisions. What is the relationship between the Fed, the Treasury, the FDIC, etc.? Regulatory agencies are a crazy quilt of overlapping jurisdictions. OCC does national, Fed does state chartered and holding companies, FDIC, state regulators have sole authority over state banks with no FDIC insurance.

characteristics Created by Congress, meant to be quasi- independent Board members have long terms Financially independent of U.S. government Decentralized organization Authority vested in 12 regional reserve banks

Each of the 12 districts has one main branch, other branches Each of the 12 districts has one main branch, other branches. Allocation of regional banks reflects conditions around 1913. NY, Chicago, and SF are the 3 largest district banks in terms of assets. (50%) FRBs are quasi-public, technically owned by member banks. (just technically). 9 directors (6 elected by Banks, 3 by BOG); 3 A directors are professional bankers; 3 B directors are leaders from industry, labor agriculture; 3 C directors are appointed by BOG as public reps. What is the function of the regional reserve banks? Functions: Payments: clear checks, issue new currency, withdraw damaged currency, BS&R: evaluate bank consolidation, make discount loans, BS&R, Monetary Policy: collect data on local business conditions, conduct economic research. Monetary Policy: decide who gets discount loans, select banker for Federal Advisory Council, serve on the FOMC, votes on policy rotate through 4/11 banks and NY. Special role of FRB NY: 1) Contains the largest banks for BS&R; 2) Conducts OMO and FX operations, (ensures smooth functioning of financial markets); 3) Only FRB to be a member of BIS. (close contact with foreign central bankers); 4) NY President is only permanent member of the FOMC. Political genius to stress regional representation over HQ in NY or DC. National banks are required to be members of the Federal Reserve System. State banks are not required to be members. 1/3 of banks are members, down from 1/2 in 1947. Banks used to leave Fed system b/c they were required to keep deposits there. This hurt the conduct of monetary policy. Depository Institutions Deregulation and Monetary Control Act of 1980 required all banks to keep same required reserves with the Fed. All banks given discount window privileges.

The fed’s objectives Stable prices “Maximum” employment Moderate long-term interest rates 1. What's the number one monetary policy of the FED? And how does the FED meet it? Generally, fostering an atmosphere of price stability is the best way to meet all our goals. How did the FED keep balance between monetary and fiscal policies within past years? There is no such thing as fiscal policy, per se. U.S. tax and spending policies don’t change (exogenously) very often. Mostly, the US deficit reacts to economic conditions, not the other way round. 2. How can we reach the goal of both stable price and full employment? In reality, government can reach one of them at the sacrifice of another one, is it true? In the short run, there may be a tradeoff between inflation and full employment. There is no such tradeoff in the long run. 3. What are the current issues for Federal Reserve Bank? What do you think about the economic condition in U.S.? Is it substantial or bubble? Is productivity growth permanently higher and by how much? Should the Fed be concerned with asset prices? If so, what, if anything should we do about them? How do they figure into our reaction function? What is happening to velocity?

Monetary Policy Tools The federal funds rate The discount rate Interest rate banks charge each other for overnight loans to meet reserve requirements Most influential interest rate in U.S. economy The discount rate Interest rate at which a bank borrows funds from a federal reserve bank Allows Fed to control the supply of money Loan of last resort Reserve requirements Amount of cash a bank must hold in reserve against deposits made by customers Fed Funds Rate The Federal reserve influences it by buying and selling government securities--T-Bills. When we buy T-Bills, we inject more money into the economy and make short-term interest rates lower. When we sell T-Bills, we take money of the economy and raise short-term interest rates. Buying and selling government securities to the public is called OMO. Where does the Fed get the money to buy bonds? The government has the power to create base money. The Fed creates its own money. Discount Rate

Changing interest rates Lower interest rates/more money leads to more spending and investment, higher prices in the long run. Higher interest rates/less money leads to less spending and investment, lower prices in the long run Volatile monetary policy leads to uncertainty about future economic conditions and discourages economic activity.

Output and INflation What is the relationship between inflation and employment? Expansive monetary policy can cause both temporarily higher employment and permanently higher prices Low unemployment does not cause inflation An environment of stable prices is the best way to promote employment in the long run

Monetary policy can be expansionary or contractionary Monetary policy can be expansionary or contractionary. This occurs by taking action that increases or decreases the money supply, respectively

Expansionary Policy Occurs when the central bank acts to increase the money supply Done through open market purchases: central bank buys bonds Increased supply of funds lowers the interest rate, and firms take more loans out

Expansionary Policy In the short run, expansionary monetary policy increases real GDP and reduces unemployment Overall price level rises as flexible prices increase Real employment and real output expand as a result of simply increasing the money supply

Contractionary policy Occurs when a central bank takes action to reduce the money supply Often done during times of rapid expansion in order to curb potential inflation Performed through open market operations when the central bank sells bonds This takes money out of the loanable funds market and raises the interest rate