Chapter 15Chapter 15The Federal Reserve System &The Federal Reserve System &

Monetary PolicyMonetary Policy Section 1Section 1 Organization & Function Organization & Function

of the Federal Reserve of the Federal Reserve SystemSystem

Section 2Section 2 Money Supply & the Money Supply & the EconomyEconomy

Section 3Section 3 Regulating the Money Regulating the Money SupplySupply

Organization & Functions of the Organization & Functions of the FedFed

Created in 1913 as a central banking Created in 1913 as a central banking organization to end panics and recessions.organization to end panics and recessions.

Fed – Federal Reserve SystemFed – Federal Reserve System

Fed is responsible for monetary policyFed is responsible for monetary policy

Monetary Policy – policy that involves Monetary Policy – policy that involves changing the rate of growth of the supply changing the rate of growth of the supply of money in circulation in order to affect of money in circulation in order to affect the cost and availability of creditthe cost and availability of credit

Organization & Functions of the Organization & Functions of the FedFed

Board of Governors – directs the operation Board of Governors – directs the operation of the Fedof the Fed

7 members appointed by the President 7 members appointed by the President with Senate approval for 14 yearswith Senate approval for 14 years

Alan Greenspan & Ben Bernanke – Alan Greenspan & Ben Bernanke – serve(d) as chairperson serve(d) as chairperson

12 District Banks 12 District Banks 25 Branch Banks25 Branch Banks Member BanksMember Banks

Organization & Functions of the Organization & Functions of the FedFed

Federal Advisory Council – reports to Federal Advisory Council – reports to the board of governors on general the board of governors on general business conditions in the countrybusiness conditions in the country

Federal Open Market Committee – Federal Open Market Committee – determines whether or not to change determines whether or not to change interest rates which impacts the interest rates which impacts the financial worldfinancial world

Organization & Functions of the Organization & Functions of the FedFed

12 Federal Reserve districts with a bank 12 Federal Reserve districts with a bank (page 402)(page 402)

Set up as a corporation owned by member Set up as a corporation owned by member banks with a 9 member board of directorsbanks with a 9 member board of directors

Services are available to all banksServices are available to all banks Decides truth-in-lending rules to protect Decides truth-in-lending rules to protect

consumersconsumers

Functions of the Federal ReserveFunctions of the Federal Reserve

Clearing ChecksClearing Checks – see figure 15.3 – see figure 15.3

Government’s Fiscal AgentGovernment’s Fiscal Agent – – tracks govt. deposits, checking tracks govt. deposits, checking account for the Treasury, & advises account for the Treasury, & advises federal governmentfederal government

Supervises Member BanksSupervises Member Banks – – regulates state banksregulates state banks

Functions of the Federal ReserveFunctions of the Federal Reserve

Holding Reserves & Setting Reserve Holding Reserves & Setting Reserve RequirementsRequirements – controls money in circulation by – controls money in circulation by setting % required for setting % required for reservesreserves

Supplying Paper CurrencySupplying Paper Currency – all paper money – all paper money printed in D.C. by Bureau of Engraving & Printing printed in D.C. by Bureau of Engraving & Printing to replace old money & meet demandto replace old money & meet demand

Regulating the Money SupplyRegulating the Money Supply – primary – primary responsibility which affects the amount of credit responsibility which affects the amount of credit & business activity& business activity

Money Supply & the EconomyMoney Supply & the Economy Fed’s most important function involves Fed’s most important function involves

controlling the rate of growth of the controlling the rate of growth of the money supplymoney supply

Loose money policy – monetary policy that Loose money policy – monetary policy that makes credit inexpensive and abundant, makes credit inexpensive and abundant, possibly leading to inflationpossibly leading to inflation

Tight money policy – monetary policy that Tight money policy – monetary policy that makes credit expensive and in short makes credit expensive and in short supply in an effort to slow the economysupply in an effort to slow the economy

Money Supply & the EconomyMoney Supply & the Economy

Loose Money SupplyLoose Money Supply– Borrowing is easyBorrowing is easy– Consumers buy moreConsumers buy more– Businesses expandBusinesses expand– More people are employedMore people are employed– People spend morePeople spend more

Inflation resultsInflation results

Money Supply & the EconomyMoney Supply & the Economy

Tight Money SupplyTight Money Supply– Borrowing is difficultBorrowing is difficult– Consumers buy lessConsumers buy less– Businesses postpone expansionBusinesses postpone expansion– Unemployment increasesUnemployment increases– Production is reducedProduction is reduced

Money Supply & the EconomyMoney Supply & the Economy

Fractional reserve banking – system in Fractional reserve banking – system in which only a fraction of the deposits in a which only a fraction of the deposits in a bank is kept on hand, or in reserve; the bank is kept on hand, or in reserve; the remainder is available to lendremainder is available to lend

Reserve requirements – regulations set by Reserve requirements – regulations set by the Fed requiring banks to keep a certain the Fed requiring banks to keep a certain percentage of their deposits as cash in percentage of their deposits as cash in their own vaults or as deposits in their their own vaults or as deposits in their Federal Reserve district bankFederal Reserve district bank

Money Supply & the EconomyMoney Supply & the Economy

Expanding the money supply – Expanding the money supply – see15.6 on page 409see15.6 on page 409

Regulating the Money SupplyRegulating the Money Supply

The main goal of the Federal reserve The main goal of the Federal reserve is to keep the money supply growing is to keep the money supply growing steadily and the economy running steadily and the economy running smoothly without inflation.smoothly without inflation.

Changing Reserve RequirementsChanging Reserve Requirements

Control money supply through reserve Control money supply through reserve requirements.requirements.

Lower the % of deposits kept in reserve, Lower the % of deposits kept in reserve, the more $s available to loanthe more $s available to loan

Higher the % of deposits, the more $s Higher the % of deposits, the more $s available to loanavailable to loan

Raising reserve requirements slows down Raising reserve requirements slows down the economy.the economy.

Changing the reserve requirement is Changing the reserve requirement is rarely used.rarely used.

Changing the Discount RateChanging the Discount Rate

Banks my need to borrow money to meet Banks my need to borrow money to meet their reserve requirements.their reserve requirements.

Discount rate is the interest rate the Fed Discount rate is the interest rate the Fed charges for loans to banks.charges for loans to banks.

Prime rate is the interest rate banks Prime rate is the interest rate banks charge their best customers.charge their best customers.

Increase in these rates lowers the money Increase in these rates lowers the money supply and vice versa.supply and vice versa.

Typically the Fed does not use the Typically the Fed does not use the discount rate to regulate the economy.discount rate to regulate the economy.

Federal Funds RateFederal Funds Rate

Federal funds rate is the interest rate that Federal funds rate is the interest rate that banks charge each other on loans (usually banks charge each other on loans (usually overnight).overnight).

The federal funds market is active with The federal funds market is active with billions of dollars exchanged each day.billions of dollars exchanged each day.

The lower the rate the more banks will The lower the rate the more banks will borrow and business activity increases.borrow and business activity increases.

The higher the rate the less will be The higher the rate the less will be borrowed and business activity decreases.borrowed and business activity decreases.

Open-Market OperationsOpen-Market Operations

Open-market operations – buying Open-market operations – buying and selling U.S. securities by the Fed and selling U.S. securities by the Fed to affect the money supply.to affect the money supply.

When the Fed buys securities, money When the Fed buys securities, money supply increases.supply increases.

Selling securities lowers reserves and Selling securities lowers reserves and money supply decreases.money supply decreases.

Difficulties of Monetary SupplyDifficulties of Monetary Supply

Keeping track of the money supply is Keeping track of the money supply is difficult in trying to gauge the economy.difficult in trying to gauge the economy.

Credit cards and electronic banking make Credit cards and electronic banking make tracking money supply difficult.tracking money supply difficult.

Fed is criticized for decisions that may Fed is criticized for decisions that may lead to inflation or recession.lead to inflation or recession.

Fed receives conflicting advice from many Fed receives conflicting advice from many directions.directions.

Other factors, such as federal taxing & Other factors, such as federal taxing & spending also greatly affect the economy.spending also greatly affect the economy.