Federal Reserve and Monetary Policy

Creation of “The Fed” The Bank Panic of 1907 convinced Congress to look hard at banking Consumers and businesses needed access to increased sources of funds to encourage expansion Banks needed a source of emergency cash to present depositors panics that result in bank runs Tah! Dah! – Federal Reserve Act of 1913

Federal Reserve Act of 1913 Created the Federal Reserve System Originally 12 independent regional banks that could lend to one another Didn’t prevent Great Depression because they didn’t act together Reform brought about a new structure

Structure of the Federal Reserve

Federal Reserve Today Board of Governors – 7 members Federal Open Market Committee = Board of Governors + 5 District Bank Presidents 12 Regional Banks = 4,000 Member banks

Board of Governors Federal Reserve Board Federal government agency Seven members appointed by President for 14 year terms, staggered two years apart Guide the Federal Reserve’s policy actions General oversight of all 12 regional banks President – Ben Bernake – appointed for four years – reports to Congress twice a year

Federal Open Market Committee FMOC makes key decisions about interest rates Discount rate – interest rate Fed charges banks for loans Federal funds rate – interest rate banks charge each other for loans FMOC oversees U.S. money supply Meets every 6 weeks

12 Federal Reserve Districts

Banker’s Banks Operate independently Under general oversight of Bd. Of Gov. Serve three audiences Bankers - Store commercial banks excess currency and coins U.S. Treasury – sell securities Public - Process and settle their checks and electronic payments

Take out a Dollar Bill

Monetary Policy Keeping our economy healthy Economy performs well if inflation is low Also when interest rates are low These two ideals foster low unemployment and a growing economy Three tools to achieve this

Monetarists Economists who follow Monetary Policy as a way to control the business cycles They believe competitive markets provide the market with a high degree of economic stability – less government intervention the better When the government intervenes, it is through the Federal Reserve changing the money supply

What is the Money Supply? Currency (cash and coins) Checkable account balances Money in checking accounts Traveler’s Checks Feds can make the money supply increase or decrease

Monetary Policy Tools Change discount rate – interest rate Reserve banks charge banks for short- term loans Change Reserve Requirements – portions of deposits that banks must hold in reserve, either in their bank vault or in the Reserve bank Open Market Operations – buying and selling of U.S. government securities – most important tool

Discount Rate Reducing the Discount Rate If the Fed wants to encourage banks to loan out more of their money, it may reduce the discount rate, making it easier or cheaper for banks to borrow money if their reserves fall too low. Reducing the discount rate causes banks to lend out more money, which leads to an increase in the money supply. Increasing the Discount Rate If the Fed wants to discourage banks from loaning out more of their money, it may make it more expensive to borrow money if their reserves fall too low. Increasing the discount rate causes banks to lend out less money, which leads to a decrease in the money supply.

Reserve Requirement Reducing Reserve Requirements A reduction of the RRR would free up reserves for banks, allowing them to make more loans. A RRR reduction would also increase the money multiplier. Both of these effects would lead to a substantial increase in the money supply. Increasing Reserve Requirements Even a slight increase in the RRR would require banks to hold more money in reserve, shrinking the money supply. This method is not used often because it would cause too much disruption in the banking system.

Open Market Operations Bond Purchases In order to increase the money supply, the Federal Reserve Bank of New York buys government securities on the open market. The bonds are purchased with money drawn from Fed funds. When this money is deposited in the bank of the bond seller, the money supply increases. Bond Sales When the Fed sells bonds, it takes money out of the money supply. When bond dealers buy bonds they write a check and give it to the Fed. The Fed processes the check, and the money is taken out of circulation.

Money Creation Money creation is the process by which money enters into circulation. By using one of the three tools the money supply is either increased or decreased Increased if the Fed wants the economy to grow (loose monetary policy) Decreased if the Fed wants to slow down the economy (tight monetary policy)

Money Multiplier Adding money to the money supply This process will continue until no new loans are made A $5,000 deposit into a checking account could change the money supply by as much as $50,000

Types of Bank Reserves Total reserves = Deposits at the Fed + vault cash Ex: Reserve Acct. ($10 m) + vault ($5 m) = TR ($15 m) Required reserves = Reserve requirement X checking account deposits Ex. RR (20%) x Ck Acct ($50 m) = Required R ($10 m) Excess Reserves = Total reserves – Required reserves TR ($15 m) – Required R ($10 m) = ER ($5 m)

Formula Δ in MS = 1/RR% X Δ in bank reserves Δ in MS = 1/.10 (10%) X $5,000 = $25,000

Debt Our money supply is based on debt Yep – that’s right No gold, no silver, no collateral Just good ole’ American debt Think about that for awhile

Fiscal and Monetary Policy Tools Fiscal Policy Tools Monetary Policy Tools Expansionary Tools 1.  Govt spending 2.  taxes 1. OMO: bond purchases 2.  Discount rate 3.  RR

Fiscal and Monetary Policy Tools Fiscal Policy Tools Monetary Policy Tools Contractionary Tools 1.  Govt spending 2.  taxes 1. OMO: bond sales 2.  Discount rate 3.  RR