The Federal Reserve System

Powers of a Central Bank  Acts as a banker to the central government  Acts as a banker to banks  Acts as a regulator of banks  Sets monetary policy (policies that influence interest rates and money supply)

Federal Reserve Act of 1913  Federal Bank is created by act of Congress, and can be changed by Congress  Not “part” of the national government, but authorized by Congress  12 Federal Reserve Districts (Colorado is in the Kansas City district)  Each district is made up of the region’s member banks that choose to join

Structure of the Fed  Member banks elect a board of directors, which elects a district bank president  National “Board of Governors” appointed by president, confirmed by Senate  Governors serve 14- year terms; chairman serves 4- year term

Federal Open Market Committee  “FOMC” (Federal Open Market Committee) decides interest rate policy  Tasked with two key directives: –Keep inflation low –Keep employment high  Meet 8 times per year, and immediately publish policy decisions  Fed can only control short- term interest rates: mortgage rates and long- term government bonds are affected by –supply & demand in non- governmental “loanable funds” market –expectations of inflation over long term

Fed Power #1: Reserve Ratio  Controls power of banks to “create money” through loans  Monetary Control Act of 1980 required all banks to obey reserve laws  Fed last changed reserve requirement in 1992, lowering it from 12% to 10%

Fed Power #2: Discount Window  Short-term loans to member banks as “lender of last resort”  Rarely used by banks, because they use federal funds market instead  (Instead, banks now borrow money from each other overnight -- the “Federal funds rate”)

Fed Power #3: Federal Funds Rate  This is hugely important! Primary monetary policy to affect economy  Key: interest rates affect the I component of AD  Federal Funds Rate is the interest rate banks charge each other on overnight loans  Banks need overnight loans to adjust their reserves so that they can meet the reserve ratio requirement  Banks with excess reserves lend to banks with insufficient reserves

How Does it Work?  Federal Funds interest rates determined by money supply –If money is scarce, interest rates are high –If money is abundant, interest rates are low  Fed increases the money supply (“expansionary policy”) by –buying treasury bonds on open market –Money leaves Fed; goes into money supply  Fed decreases money supply (“contractionary policy”) by –Selling treasury bonds on open market –Money leaves money supply and is absorbed by Fed

Money Market Graph  Basically, the Federal Funds Rate (very short term), controlled by Fed  Shows nominal interest rates (actual “street” rates as seen in newspaper)  Money supply is a constant (for the present time), so is vertical  MS can shift with Fed FOMC policy (Fed buys and sells bonds)  MD can shift with –Price Level –GDP –Psychology of market –Society’s need for cash