Federal Reserve and Central Banking

Mr. Clifford Mr. Clifford

The Federal Reserve The Federal Reserve is the central bank of the United States A central bank is an institution that oversees and regulates the banking system as well as control the money supply

The Federal Reserve The Reserve System is made up of 12 privately owned District Federal Reserve Banks and a government system that oversees it (the Board of Governors) The Treasury prints bills, the Federal Reserve puts the bills into circulation/takes them out

The Great Depression Out with the old ideas… …In with the new ideas Laissez-faire Inflation is the only problem Gold standard …In with the new ideas National Banking Act created deposit insurance with the FDIC (Federal Deposit Insurance Corporation) and created the FOMC (Federal Open Market Committee) to conduct monetary policy Glass-Steagall Act separated commercial and investment banks This was repealed in 1999 because it drastically limited the interactions between the banks and the diversification of assets is a good thing

Basic Functions 1) Provides financial service for commercial banks Holds reserves, provides cash, clears checks 2) Regulates banking institutions to ensure the soundness of the nation’s banking and financial system 3) Maintains the stability of the financial system Provides liquidity to financial institutions 4) Conducts monetary policy Prevents or addresses extreme fluctuations in the economy

Price Stabilization One of the main goals of the Federal Reserve is to stabilize prices to help promote economic growth or prevent economic collapses Their long-term effects on prices is strong, but in the short term they influence real output and real interest rates

Monetary Policy Expansionary monetary policy = lower interest rates promote spending and investment which leads to increased employment (easy money) It increases the supply of bank loans and makes them less expensive which increases aggregate demand, output and employment Contractionary monetary policy = higher interest rates prevent inflation and promote price stability It tightens the supply of money in order to reduce spending and control inflation (tight money)

Mr. Clifford Mr. Clifford

EMP 1) Buy securities to increase commercial bank reserves A tradable financial asset of any kind Debt securities = bonds, banknotes Equity securities = stocks 2) Lower the reserve ratio By lowering it, they change the required reserves into excess reserves 3) Lower the discount rate (also called the federal funds rate) They can entice commercial banks to borrow more reserves from the Federal Reserve

Discount Rate? The discount rate is the rate that commercial banks must pay to borrow from the Federal Reserve When it’s cheaper, the banks borrow more reserves When it’s more expensive, the banks borrow less

CMP 1) Sell securities 2) Increase the reserve ratio Reduces commercial bank reserves 2) Increase the reserve ratio Automatically removes excess reserves from banks 3) Raise the discount rate Discourages commercial banks from borrowing from the Reserve in order to build up their reserves

Open Market Operations OMOs = the Federal Reserve buys and sells U.S. Treasury bills Through a transaction with commercial banks that changes the banks’ reserves When the Fed buys Treasury bills, it increases banks’ reserves. When it sells Treasury bills, it decreases banks’ reserves Changes in the money supply changes the equilibrium interest rates

Expansion Multiplier Recap: the expansion multiplier = the excess reserves times the multiplier (the DEM)

Example Let’s say there’s a $5,000 deposit into a bank with a 10% required reserve The DEM is 1/0.1= 10 ASSETS__________________________LIABILITIES Loans $4,500 Deposits $5,000 Reserves $500 EMS = $4,500 x 10 = $45,000

Game Time! Federal Reserve Game