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 PolicyInflation Tight Money Policy

1. Borrowing is easy2. Consumers buy more3. Businesses expand4. More people are

employed5. People spend more

Loose Money Policy

1. Borrowing is difficult2. Consumers buy less3. Businesses postpone

expansion4. Unemployment

increases5. 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

Round Deposit Amount of Deposit

Required Reserve (10%)

Excess Reserve

1 Student A 1,000

2 Student B

3 Student C

4 Student 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