The Federal Reserve

Origins of the Fed Two central banks were terminated in 1811 and 1836 Fears of a centralized power and of interests based on money After 1836, the U.S. had no “lender of last resort” An institution that will extend credit when no one else will (helps banks that are about to collapse) The Federal Reserve Act of 1913 created a decentralized system that was more politically acceptable

Federal Reserve Banks Four groups are empowered within the Federal Reserve system 12 Federal Reserve Banks Private commercial member banks The Board of Governors The Federal Open Market Committee 16% of state chartered banks and 1/3 of all private banks are part of the Federal Reserve System, but all banks are subject to Federal Reserve requirements and regulatory policy

Functions of the 12 Regional Federal Reserve Banks Manage check clearing Manage currency in circulation by withdrawing old notes and issue new ones as banks withdraw cash from excess reserves Make discount loans to banks in their districts

Supervise and regulate banks in their districts by examining member banks and evaluating proposed mergers Act as a liaisons between the business community and the Fed system Examine bank holding companies and state-chartered member banks Collect data on local business conditions Staff professional economists to research topics related to the conduct of monetary policy

Federal Reserve Independence The Fed operates largely independent of pressure from Congress, the President, and business groups The President does appoint directors, and the Senate confirms them, however Congress can change laws governing the Fed (not part of the Constitution) Although the Fed is independent, it collaborates closely with the U.S. Treasury in times of crisis (think 2008 financial crisis)

Fed Independence Advantages Free from political pressure to create more money (this would inevitably lead to inflation) Monetary policy is too important to leave to politicians Disadvantages Fed structure is not democratic Fed is not accountable to any agency Often difficult to coordinate fiscal and monetary policy Fed does not always make successful monetary policy (1970s Great Inflation)

Increasing or decreasing the money supply Monetary Policy Increasing or decreasing the money supply

Goals of Monetary Policy Price Stability The Fed should insure that the overall level of prices moves in a stable and predictable fashion (2-3% inflation per year) High employment The fed would like to maintain the unemployment at its natural rate (5-8%) Economic growth The Fed’s ultimate goal is maximum sustainable economic output in the long-run. This can be done by creating policies to foster growth in the short-run

Keep financial markets stable If the financial market is unstable, the Fed will be unable to achieve other goals Keep the interest rate stable Rapid fluctuations of interest rates can destroy the financial system

Tools of the Fed for Monetary Policy Open Market Operations The Fed can buy U.S. treasuries from commercial banks, which will increase the money supply (or sell and decrease) Discount Rate Changes in the discount rate affect how much commercial banks can borrow from the Fed (borrow more = more money in the money supply Change the Reserve Requirement The Fed can change the percentage of how much money banks must have on hand Lower reserve  money supply rises Higher reserve  money supply falls

Consequences! Whenever the Fed increases the money supply, inflation will eventually happen