Monetary Policy

Role of the Federal Reserve

Est. by President Wilson in 1913• Supervises member banks• Holds Cash Reserves

• funds available for short-term borrowing by commercial banks or government

• guarantees that money is available in the economy when needed

• Moves money into and out of circulation

Characteristics of the Federal Reserve (independent of elected officials)

• Lack of a Single Central Bank• most countries have single central bank• Fed relies on district banks to carry out

national policies• Ownership and Control by the Member

Banks• in countries with a central bank gov’t

owns all shares of stock, allowing tight control

• member banks own stock in Fed; resulting in political independence

• Optional membership in the Fed for some banks• nationally chartered banks must be

members; state chartered banks are optional

• less than 40% of banks nationally are Fed members; 5800 Member Banks

Organization of the Fed • Board of Governors (another mechanism for independence)

• highest policy making body in Fed regulating money supply• 7 member board appointed by President; serve 14 years; new

appointment every 2 years; each serves 4 year terms• 7 members and Chairman (Ben Bernanke) are permanent

members of the Federal Open Market Commission • Federal Open Market Commission—12 member committee; decides

whether to buy or sell gov’t securities• Board of Governors plus 4 district bank presidents that rotate

• Federal Reserve Banks—1913, • 12 F.R. district banks that deal only with government and

financial institutions that serve a designated geographic region• 25 branch offices

• Member Banks• 2750 national member banks• 1000 state member banks

Organization of the Federal Reserve

Federal Reserve District Banks

Services to Banks:12 district banks don’t have checking, savings

accounts; they service member banks

• Clearing Checks• Americans write 40 billions checks a year• Fed tracks this by crediting and debiting reserve accounts

• Loans to Banks• we get loans from banks; banks get loans from Fed• banks need loans to cover increased withdrawals or loans• most are short-term to cover immediate problem

• farm loans, natural disasters, financial emergencies• participating banks face strict monitoring and scrutiny

Services to Government

Dept. of Treasury is Gov’t banker; collect taxes through IRS and Customs; produces money with U.S. Mint; Fed is gov’t bank

• Serving as the Government’s Bank• serves as depository for federal revenues; deposited by Treasurer • holds a Treasury checking account• records the deposits and withdrawals of federal funds• advises Congress and President on economic policy

• Supervising member banks “banking systems watchdog”• monitors loans and investments and reviews bank records of reserves• regulates bank mergers

• Regulating the Money Supply—amount of money circulating in the economy• Dollars—printed by Bureau of Engraving and Printing• Coins—printed by U.S. Mint• Fed distributes currency• Currency is put into distribution for 2 reasons:

• replace old and worn out notes• increase amount of money in circulation by buying or selling government

securities (T-bills and bonds)

Money Supply:Economists way to measure the nation’s money

supply

• M1—easiest way to measure only easily accessible • counts all currency in circulation + travelers checks + checking

account deposits• checking accounts are 63% of M1

• M2—a broader measure used by those who feel M1 doesn’t measure all accessible money• Counts M1 + mutual funds + savings deposits + time deposits <

$100, 000• M3 and L—both are broader measures than M2

• M3 counts M2 + large time deposits• L counts M3 + savings bonds + short term T-Bills + any other

Near money

Questions• Who is the current Chairman of the Federal Reserve?• What are the three roles of the Federal Reserve?• The Federal Reserve is broken into 4 levels of organization. What are the four

levels, and what is the role of each?• What services does the Fed offer to member banks?• What services does the Fed provide the federal government?• What events led to the creation of the Federal Reserve System?• How is the Federal Reserve System designed to be largely independent of the

federal government? Why would this separation from elected representatives be desirable?

• How would Fed policy change if Mr. Bernanke were an elected official instead of appointed?

• What services does the Fed provide to banks?• How does the Fed serve the government?• What are the four different measurements of the U.S. money supply? Which

funds are included in each measurement?

Monetary Policy• Monetary Policy—plan to expand or contract the money

supply in order to influence the cost and availability of credit• done by regulating money supply and interest rates; • Policy is based on the Federal Reserve measures of

the money supply and Aggregate Demand• Policy is enacted by the Federal Reserve

Monetary Policy: Strategies• Easy-Money Policy—designed to expand money supply, increase

aggregate demand, reduce unemployment, and promote economic growth during recessions• Charges banks lower interest rates, encourages borrowing

(spending)• Fed can expand money supply by buying securities

• Tight-Money Policy—Slows business activity and helps stabilize prices to reduce aggregate demand• Results from inflation when too much money is circulating and

credit is too easily accessible• Fed can raise interest rates to make credit less accessible• Fed can decrease the money supply by selling securities

Monetary Policy: Tools—ways to affect aggregate demand• Open-Market Operations—buying and selling of securities

• To contract money supply Fed sells government securities. Cash paid for securities is withdrawn from bank reserves, shrinking money supply and decreasing aggregate demand

• To expand money supply Fed buys government securities. Money makes it way into individual and business accounts increasing cash reserves and loan pools. This increases aggregate demand which leads to an increase in production

• Discount Rate—interest rate that the Fed charges member banks for the use of its reserves.

• a lower interest rate encourages banks to borrow more for their reserves. They then loan this to businesses and consumers to spend, increasing aggregate demand

• increasing interest rates discourages banks from borrowing. Banks will pass this increased interest onto businesses and consumers by raising the prime rate, ultimately decreasing the amount of loans that are made, decreasing aggregate demand.

• prime rate—interest rates banks charge on loans to their most reliable business customers

• law of demand—as price to borrow money increases (prime rate) demand decreases; as price decreases demand increases

Monetary Policy: Tools—ways to affect aggregate demand

• Reserve requirements—changes affect lending capacity of banks• increase reserve requirement—less money available

for loans• decrease reserve requirement—more money

available for loans• “Moral Suasion”—attempts by the Federal Reserve to

put pressure on the member banks either to increase or decrease all or certain kinds of loans. Takes form of news releases, letters of appeal, Congressional testimony and conferences.

Summary of Monetary Policy ToolsFormal Tool Fed Action Effects on Economy Money

Supply

Open Market Securities

Buys gov’t securities

Bank reserves increase; aggregate demand & production increases

Expands

Sells gov’t securities

Bank reserves shrink; aggregate demand decreases

Contracts

Discount Rate Lowers discount rate

Encourages banks to borrow from the Fed; bank reserves increase

Expands

Raises discount rate

Discourages banks to borrow from Fed; bank reserves decrease

Contracts

Reserve Requirement

Lowers the reserve requirement %

Banks hold fewer reserves & extend more loans; interest rates fall; Aggregate demand increases

Expands

Raises the reserve requirement %

Banks hold more reserves & extend fewer loans; interest rates rise; Aggregate demand decreases

contracts

Challenges to Monetary Policy• Economic Forecasting

• U.S. economy has millions of economic actors buying, selling, producing• Forecast can be difficult, and if incorrect could harm economy

• Time Lags• collection and analysis of economic data• discussion and debate to reach consensus on data• consumers/ producers need time to adjust their economic activity

• Priorities and Trade-offs• easy-money policy fights recession, but increases inflation• tight-money policy fights inflation, but contributes to recession

• Lack of Coordination• sometimes Monetary Policy will conflict with Fiscal Policy

• Conflicting Opinions• economics is not an exact science and can be influenced by personal

economic philosophies of conservative v. liberal

Questions!

• How does Monetary Policy affect investment spending in factories and equipment? The housing market? Consumer spending?

• Who enacts Monetary Policy? Why is Monetary Policy easier to enact than Fiscal Policy during periods of inflation?

• What are the tools of Monetary Policy?• What Monetary Policy should be enacted during a

recession? Inflation?• What are some challenges to enacting Monetary Policy?• Considering our current economic situation, would you

expect the Fed to enact easy money or tight money policies?