The Federal Reserve and Monetary Policy Chapter 15 The Federal Reserve and Monetary Policy © OnlineTexts.com p. 1 Econweb.com

The Federal Reserve The Federal Reserve is the United States Central Bank. Founded in 1913 after four severe banking panics. Chartered by the federal government but is largely independent of the authority of the Congress and President. Primary role is to conduct monetary policy and to act as a lender of the last resort to banks to stabilize the financial system. © OnlineTexts.com p. 2 Econweb.com

Structure of the Fed The unique structure of the Federal Reserve is a consequence of history and politics. © OnlineTexts.com p. 3 Econweb.com

Structure of the Fed The Board of Governors is the highest governing body of the Federal Reserve. It consists of seven members including the chairperson--currently Alan Greenspan. The Twelve District Banks provide regional check clearing, bank supervision, payments processing, and economic analysis. © OnlineTexts.com p. 4 Econweb.com

Structure of the Fed The F.O.M.C. (Federal Open Market Committee) is responsible for directing monetary policy. consists of 12 members, the seven from the Board of Governors plus five Presidents of the District Banks who serve on a rotating basis, one of which is always from the New York Fed. meets about every six weeks to discuss monetary policy and decide what course of action to take. © OnlineTexts.com p. 5 Econweb.com

Tools of Monetary Policy The Federal Reserve's attempt at stabilization policy is referred to as monetary policy. Tool include: Open Market Operations (OMO), Change in the discount rate, and Change in the reserve requirement ratio. © OnlineTexts.com p. 6 Econweb.com

Tool #1: Open Market Operations An Open Market Operation is the Fed's purchase (open market purchase) or sale (open market sale) of government securities via transactions in the open market. by far the most important tool of the Fed and it is used daily to target the federal funds rate. An open market operation impacts the banking system by changing bank reserves initially and, ultimately, the money supply. © OnlineTexts.com p. 7 Econweb.com

Tool #1: Open Market Operations Example: the Fed purchases $100 million of government securities from commercial banks. © OnlineTexts.com p. 8 Econweb.com

Tool #2: Change in the Discount Rate The discount window is where depository institutions go to borrow funds from the Fed. The discount rate is the interest rate at which the Federal Reserve lends funds to banks. Borrowings from the discount window are short-term, usually lasting only a week or two. Changes to the system were implemented recently, establishing primary credit and secondary credit programs. © OnlineTexts.com p. 9 Econweb.com

Tool #2: Change in the Discount Rate Suppose the Fed decreases the discount rate by one percentage point, say, from six percent to five percent. This change induces banks to borrow $5 million more in reserves from the Fed to fund additional loan opportunities. © OnlineTexts.com p. 10 Econweb.com

Tool #3: Change in the Required Reserve Ratio The required reserve ratio is the minimum amount of reserves that a bank must hold relative to its deposit base. Reserves include vault cash and reserves held at the Federal Reserve. Currently in the U.S. banking system, the required reserve ratio is 10 percent. Lowering the ratio frees up reserves, while raising the ratio reduces reserves. © OnlineTexts.com p. 11 Econweb.com

Tool #3: Change in the Required Reserve Ratio Example: the Fed lowers the required reserve ratio from 12.5 percent to 10 percent, freeing up $2,500 in excess reserves. © OnlineTexts.com p. 12 Econweb.com

Summary of Monetary Policy Tools © OnlineTexts.com p. 13 Econweb.com

Impacts of Monetary Policy on the Economy How do Federal Reserve actions impact the behavior of output, inflation, and unemployment? Monetary policy ultimately works by changing interest rates in the loanable funds market, which change the level of demand for goods and services in the economy. © OnlineTexts.com p. 14 Econweb.com

The Loanable Funds Market Demand for loanable funds comes borrowers. The supply of loanable funds comes from savers. © OnlineTexts.com p. 15 Econweb.com

The Loanable Funds Market Expansionary monetary policy, by increasing bank the quantity of bank reserves, increases the supply of loanable funds, which lowers interest rates. © OnlineTexts.com p. 16 Econweb.com

The Impact of Monetary Policy on the Economy The final piece of the puzzle is that the lower interest rates increase investment, which shifts the Aggregate Demand curve to the right. Both the level of output and the price level increase. Contractionary policy reduces the price level and the level of output. Remember that monetary policy affects Aggregate Demand, not Aggregate Supply. © OnlineTexts.com p. 17 Econweb.com

Expansionary Monetary Policy © OnlineTexts.com p. 18 Econweb.com