The Federal Reserve System and Monetary Policy

Money Final payment for goods and services Purposes of money: – Medium of Exchange: It can be used to purchase goods and services – Unit of account: It can be used to compare the value of different goods and services – Store of value: It can be held to buy something in the future Too much money in the economy can cause inflation Too little money in the economy can lead to falling prices and falling production

The Federal Reserve Created in 1913 Central banking system in the U.S. Board of Governors directs the operations of the Fed The Fed… – Clear checks – Acts as the federal gov’ts fiscal agent – Supervises member banks – Holds and sets reserve requirements – Supplies paper currency – Sets standards for the type of credit information to be supplied to consumers – ***Regulates the money supply through monetary policy

Monetary Policy Changing the rate of growth of the supply of money Encourages and discourages banks from making loans Money supply is set by the B.O.G Supply/demand for money determine interest rates that must be paid for the use of borrowed money If the Fed increases the money supply… – interest rates will fall (less expensive to borrow) – Increase in borrowing/spending If the Fed reduces the money supply… – Interest rates will increase – Less will be borrowed/spent

Balancing Monetary Policy InflationTight Money Policy 1.Borrowing is easy 2.Consumers buy more 3.Businesses expand 4.More people are employed 5.People spend more Loose Money Policy 1.Borrowing is difficult 2.Consumers buy less 3.Businesses postpone expansion 4.Unemployment increases 5.Production cutbacks Recession

Inflation/Recession If the Fed is fighting inflation, it wants to decrease the money supply If the Fed is fighting unemployment and declining GDP, it wants to increase the money supply

Fractional Reserve Banking Minimum percentage of deposits that banks must keep on reserve to back up checking- type accounts Most keep 10% in reserves

RoundDepositAmount of Deposit Required Reserve (10%) Excess Reserve 1Student A1,000 2Student B 3Student C 4Student D Total deposits

3 Tools of Monetary Policy (1)*Open Market Operations – Buys or sells U.S. government securities to influence the money supply – *during a recession, bonds are purchased, interest rates are lowered, increase in loans (2) Changes in the Discount Rate – Interest rate that the Fed charges on loans to banks – *during a recession, interest rates are lowered, increase in loans

(3) Changes in the Reserve Requirement – When the Fed lowers the reserve requirement, banks have more money to lend and the money supply increases – When the Fed raises the reserve requirement, banks have less money to lend and the money supply decreases – *during a recession, reduce reserve requirement, make loans, reduced interest – *during inflation, reduce money supply, raise interest rates