Ch16 Federal Reserve and Monetary Policy

Federal Reserve Bank History The Federal Reserve Bank is the central bank of the U.S., created by the Federal Reserve Act of 1913 as a compromise between those who believed that a central bank was necessary to create stability in the banking system, and those who feared too much control over the economy held by the federal government.

What is the Fed? The Federal Reserve (known as the Fed) is composed of 12 district reserve banks (by geographical area), and some 4000 private banks and 25,000 other depository institutions under some government control. The control comes from a board of governors appointed by the president with advise and consent of the senate. Members of the board serve for 14 years, and the chairman of the board is selected from among them to serve for 4 years.

What the Fed Does The Federal Reserve can be considered a regulatory agency, in that it polices its member’s banks, and the Fed makes decisions regarding key banking operations. These decisions are referred to as Monetary Policy, (or you might want to think of it as the policies of money.) Among these decisions are key interest rates, and the money supply.

Bank of the U.S. The Fed is the bank of the U.S. government, and holds the money collected in taxes for the government, as well as make payments for the government, sells government securities (Treasury Bills, Notes, and Bonds), and reclaims them.

Regulation The Fed regulates the banking industry in several ways. It serves the banks by clearing checks, supervising lending practices, and being a lender of last resort. As a lender to other banks, the Fed sets the rates at which banks lend to each other (federal funds rate), and the rates at which the Fed will lend to commercial banks (discount rate), and the Prime Rate for best customers.

Demand for money One of the principal jobs of the Fed is to control the money supply. Because the economy is almost always growing, the Fed needs to create more cash for people to use. The Fed balances the amount of money demanded by the public against inflationary pressures. If too much money is made, inflation rises. Too little money, and the economy can stall or go into recession.

How Rates Work Rates (or Interest Rates) determine how much interest will be paid on a loan. When interest rates go higher, the demand for loans decreases, lowering the availability of cash in the economy. When rates go down, this increases the money supply.

Reserve Ratio As part of their operations, the Fed also sets the required reserve ratio that banks need to comply with. The reserve ratio is the amount of money each bank needs to hold in its vault compared to the amount it loans out to others. If a bank finds that it has loaned out too much, it can usually go to the Fed to borrow money to cover its reserve requirement. When the reserve ratio is low, banks can lend more money, increasing the money supply. By loaning money, banks actually multiply the amount of money available in the economy using the simple formula deposit x 1/RRR (Required Reserve Ratio). The current ratio is 10% Money Multiplier

Monetary Policies Putting all of this together, the Fed has enormous power over the economy. By using the tools of interest rates, printing money, and setting reserve rates, the Fed can institute tight money policies, or easy money policies that will determine the amount of economic activity taking place. These policies take time to have effect though, and the Fed needs to watch the market carefully and predict if either recessionary or inflationary pressures are going to be affecting the economy months and years ahead of time to smooth out the economy.