The Federal Reserve and Monetary Policy

What is the Federal Reserve (The Fed)? The Fed: the central bank of the US The gov’ts bank Why was it created? To provide financial stability and continuity to the US economy. The US had seen a series of recessions and bank collapses (1873, 1893, 1907).

What Does the Fed Do? Acts as gov’ts bank Promotes a healthy economy: full employment, stable prices, long-term interest rates through setting monetary policy. Monetary Policy: influencing the economy through changing the money supply and interest rates Supervises/regulates banks Clears checks Monitors reserves/loans Lends $ to banks in emergencies Buys/sells gov’t securities (bonds) Prints $

What is money? Fiat Money: issued by a gov’t; backed by faith Functions of Money: Medium of Exchange Facilitates transactions; accepted as payment Store of Value Can save and still purchase the same amount of goods and services at a later date Unit of Account/Standard of Value Can compare the value of different products (prices)

What does the Fed look like? Structure: 12 District Banks (headed by A president) Controlled by the Board of Governors in DC 7 members Appointed by THE president and confirmed by the Senate Federal Open Market Committee (FMOC) Conducts monetary policy Consists of The Board of Governors and 5 of the 12 district bank presidents Sets interest rates for the country Buys/sells gov’t securities (bonds) to increase/decrease money supply Current Interest Rate (Fed): 1.25%

Tools of the Fed How does the Fed control credit and the money supply? 1. Reserve Requirement: The amount of money banks must save at the Fed (can’t loan out) 2. Interest on Reserves: The money the Fed will PAY banks to keep required and excess reserves (incentive: loan out more/less depending on rate) Banks have to have money ON HAND for daily operations. They can’t buy a bunch of bonds or give out all their money in loans. If I want to withdraw $500 from my bank account, I need to know the bank will have the cash on hand when I go to get my money.

The Reserve Requirement If the Fed increases the reserve requirement, banks have to keep more money on reserve. This leaves less money to be loaned out. The money supply decreases. This could happen during an expansionary period with high inflation. If the Fed decreases the reserve requirement, banks don’t have to keep as much money on reserve. This leaves more funds to be loaned out. The money supply increases. This could happen during a contractionary period to increase spending and decrease the unemployment rate. *This tool is not used often because it causes too much of a disruption to the banking system*

Interest on Reserves The Fed will PAY banks to for required and excess reserves. If the Fed increases the interest on reserves, banks will loan out less money and instead keep more on reserve with the fed to earn the interest. This will decrease the money supply. This could happen during an expansionary period with high inflation. If the Fed decreases the interest on reserves, banks will keep less funds on reserve at the Fed because they won’t earn as much money in interest by doing so. They’ll make more loans and the money supply increases. This could happen during a contractionary period to increase spending and decrease the unemployment rate.

Tools of the Fed How does the Fed control credit and the money supply? 3. Discount Rate: The interest rate charged by the Federal Reserve to banks that borrow money (will borrow money when don’t have required reserves) *Just like when you borrow money, you have to pay back WITH interest, when banks borrow money from the Fed, they ALSO have to pay back WITH INTEREST*

The Discount Rate The interest rate CHARGED by the Fed when BANKS borrow money. If the discount rate increases, it will cost banks MORE to borrow money. They will borrow LESS and the money supply will decrease. This could happen during an expansionary period with high inflation. If the Fed decreases the discount rate, it’s cheaper for BANKS to borrow money, and they will increase the number of loans they give. This will increase the money supply. This could happen during a contractionary period to increase spending and decrease the unemployment rate.

Tools of the Fed How does the Fed control credit and the money supply? 4. Open Market Operations Buying and selling Treasury securities between the Fed and selected financial institutions in the open market If the Fed: BUYS bonds, the money supply gets BIGGER SELLS bonds, the money supply gets SMALLER

Open Market Operations If the Fed sells bonds on the open market, the money supply will decrease (Sell = Smaller). People exchange their money and receive bonds in return. Bonds cannot be used as currency. Spending decreases. This could happen during an expansionary period with high inflation. If the Fed buys bonds on the open market, the money supply will increase (Buy = Bigger). People sell their bonds and in return get more money to spend in the economy. This could happen during an expansionary period with high inflation.

Easy Money Policy: Goal: ____ $ supply; make credit more available (cheaper) How? ____ reserve requirement Less $ to hold on “reserve,” means more $ to loan ____ the interest on reserves Lower IR, not worth it to save money at the Fed; will make more loans ____ discount rate Cheaper to borrow; banks borrow more $ from Fed & give more loans $ supply ____) Buy Bonds (open market operations) Fed buys bonds, give $ to banks; more $ to loan out Goal: Increase Decrease

What Does this Accomplish? With an easy money policy, there is MORE money flowing into the economy. It’s EASY to get. Results: Interest rates decrease (cheaper to borrow) More borrowing = more spending More spending = growth

Tight Money Policy: Goal: ____ $ supply; make credit less available (more expensive) How? ____ reserve requirement More $ to hold on “reserve,” means less $ to loan ____ interest on reserves High IR means more of a profit to save money (loan out less) ____ discount rate More expensive to borrow; banks borrow less $ from Fed & give less loans, $ supply ____; less spending Sell Bonds (open market operations) Fed sells bonds, give bonds to banks; take $ out of economy Goal: Decrease Increase

What Does this Accomplish? With a tight money policy, there is LESS money flowing into the economy. It’s HARDER to get. Results: Interest rates increase (more expensive to borrowing) Less borrowing = less spending Less spending = controlling inflation Downside: unemployment rises