Federal Reserve Economics 71a Spring 2007 Mayo, Chapter 5 (skim) Lecture notes 2.5

Federal Reserve  Goals Stable prices Full employment Growth  Tools Monetary policy Bank regulation

Money Growth and Inflation “Why monetary policy is tricky”  (Money growth) > (Economic growth) Inflation  (Money growth) < (Economic growth) Deflation  Getting this right is tricky

The Federal Reserve and the Money Supply  The Fed does not set the money supply  Indirect tools Reserve requirements Discount rate Open market operations  All are only indirect

Reserve Requirements  Deposit $100 in bank Bank must keep % (reserve) in vault Loans out rest Example 10%: Keep $10 (reserve), loan $90  This $90 ends up at another bank Keep $9, loan $81  Money multiplier  Reducing the reserve requirement has big positive impact on the money supply  Rarely done

Discount Rates  Banks can borrow reserves from the Fed  Interest rate Fed charges banks is called the discount rate  Reducing this increases reserves and also the money supply  Federal funds rate Related interest rate Interest banks charge eachother (bank to bank)  Only discount rate is set by Federal Reserve

Open Market Operations  Federal reserve buys and sells government securities  Purchasing government bonds Increases money supply Reduces interest rates  Selling government bonds Decreases money supply Increase interest rates

How Does this Market Work?  Treasury bill (Tbill) Treasury bill pays $102 in 90 days Price today is $100 Interest = 2%  Federal reserve starts buying Price goes up to $101 Interest ( )/101 = approx 1%

Monetary Targets  Money supply  Interest rates  Inflation rates

The Federal Reserve and Financial Markets  Not really in its jurisdiction  Clearly linked to banking and monetary system  Should the Federal Reserve care about what is going on in other financial markets?  Can movements in other markets impact the “money supply”? (Stock market, Real estate)  Federal Reserve does worry about systemic risk

Summary  Monetary policy is difficult  Tools are not precise Don’t get to set the money supply  Interactions with financial markets (both local and globally) are important