Basic Finance The Federal Reserve 5 An introduction to financial institutions, investments & Management Eleventh Edition

The Role of The Federal Reserve The U.S. central bank Purpose: to control the supply of money to achieve Stable prices Full employment Economic growth

Structure of the Federal Reserve Board of Governors Twelve district banks Federal Open Market Committee (FOMC)

Structure of the Federal Reserve

Expansion of Money and Credit Fractional reserve banking Expansion (and contraction) of the money supply Importance of excess reserves

Reserve Requirement Percentage banks must hold against deposit liabilities Changing commercial banks' reserves leads to: Multiple expansion or Multiple contraction

Multiple Expansion Reserves are either Process of loan credition Required or Excess Process of loan credition

Multiple Epansion of the Supply of Money

Multiple Expansion Change in the money supply = change in excess reserves / reserve requirement

Multiple Expansion Reserve requirement = 10% Reserves increase by $100 Possible increase in the money supply: $100/0.1 = $1,000

Impact of Cash Withdrawals Multiple expansion in reverse Money supply contracts

Importance of the Federal Funds Market Market for reserves Lending reserves between banks Federal funds rate

Discount Rate Rate the Federal Reserve charges banks to borrow reserves

Target Federal Funds Rate Fed establishes a target rate Fed uses open market operations to achieve target rate

Multiple Contraction in the Supply of Money

Open Market Operations Buying and selling Federal government securities By far the most important tool of monetary policy

Open Market Operations: Monetary Expansion To expand the money supply, the Fed buys government securities Paying for the securities puts reserves into the banking system Purchases reduce interest rates

Open Market Operations: Monetary Contraction To contract the money supply, the Fed sells government securities Receiving payment for the securities removes reserves from the banking system Sales increase interest rates

The federal government's Fiscal Policy The federal government's taxation spending debt management

The possible impact of deficit spending or a surplus on Fiscal Policy The possible impact of deficit spending or a surplus on the money supply reserves of the banking system securities prices

Fiscal Policy Deficit: Government spending exceeds revenues Surplus: Government revenues exceeds spending

Deficit Spending Sources of funds to finance the deficit commercial banks non-bank public Federal Reserve foreign credit markets

Inflation General increase in prices Consumer Price Index (CPI) measures the rate of inflation

Fight Inflation by Contracting the money supply Raising interest rates Raising taxes

Deflation A general decline in prices Opposite impact from inflation Unexpected deflation hurts debtors and helps creditors Associated with higher levels of unemployment

Recession Increase in unemployment Reduction in the nation’s level of output