The Federal Reserve System“the Fed”

12 Federal Reserve DistrictsCommercial banks’ banker

Board of Governors

Fed Reserve Building

Board of Governors• Purpose: To oversee all

Fed Reserve operations• 7 members

– appointed by president– approved by Senate– 14 yr. term– Former chairmen

• Ben Bernanke • Alan Greenspan

Federal Open Market Committee (FOMC)

• 12 members– 7 from Board of Governors (all

7 members)– 5 Chairpersons from regional

Fed banks.– Chairperson of NY Fed

ALWAYS sits on the FOMC. The other four spots are rotated among the other regional Fed banks.

– PURPOSE OF FOMC: To control the money supply (ie. to set monetary policy)

Janet Yellen, current Fed chairperson

6 Major Jobs of the Fed

• Control the money supply (set monetary policy)• Serve as “lender of last resort,” for example

during financial crises.• Supervise member banks (check reserve

requirements, capital requirements, audit for bad loans and investments, etc.)

• Hold bank reserves.• Provide check-clearing services• Supply the economy with paper money and coins

(The U.S. Mint creates/prints physical money! However the Federal Reserve transfers coins and bills to banks, and destroys old dollar bills).

1.Supply the economy with paper money and coins.

“U.S. Mint”Bureau of Engraving and Printing

2. Hold bank reserves

reserves at the Fed + vault cash =total reserves

3.Provide check-clearing services

• Facilitates check-cashing between commercial banks.– for example, Wells-Fargo and Bank of America

Between banks, cities

• EXAMPLE:• Pete pays Sue for a used car. He gives her a

check for $2,000. • Sue deposits the check in her bank and is

credited with $2,000 in her account.• Sue’s bank sends the check to FRB who

increases the bank’s reserve account by $2,000.• FRB decreases Pete’s bank’s reserve by

$2,000• FRB notifies Pete’s bank to reduce Pete’s

account by $2,000.

4. Supervise member banks5. Serve as lender of last resort

• Fed may “audit” a bank– check that the loans it made are good– be sure it has followed banking rules– verify the accuracy of its accounting.

• Fed can lend funds to struggling banks.– Glass-Steagall Act (1933) establishes FDIC

6. Control the money supply.I kept the most important for last!

• Tools for changing the money supply– Reserve Requirement– Discount Rate– Open Market Operations

Why is changing the money supply important?

TO CONTROL INFLATION and/or UNEMPLOYMENT

Monetary Policy

Section Review Answers

11.1 page 292

1. Federal Open Market committee: major decision maker in the FRB.

2. Federal Reserve System : US Central Bank

3. Board of Governor’s : controls and coordinates fed activities (7 members)

4. Reserve account: funds required to be held in the FRB

Review

Describe the structure of the Federal Reserve System.

7 member Board of Governors appointed by president, ratified by Senate 14 year term, chairman has 4-year term12 districts

In what year was it founded?

1913

Review

1. 6 major jobs?• Supply the economy with paper money

and coins (U.S. Mint prints them)• Hold bank reserves.• Provide check-clearing services• Supervise member banks• Serve as lender of last resort.• Control the money supply

Review

• Why would a bank choose to join the Federal Reserve System?

• The Fed helps maintain bank stability• Consumers want their accounts to be

covered by FDIC

Review

• Describe the check-clearing process.

• Pete pays Sue for a used car. He gives her a check for $2,000.

• Sue deposits the check in her bank and is credited with $2,000 in her account.

• Sue’s bank sends the check to FRB who increases the bank’s reserve account by $2,000.

• FRB decreases Pete’s bank’s reserve by $2,000• FRB notifies Pete’s bank to reduce Pete’s account by

$2,000.

11.3

“Fed” Tools for Changing the Money Supply

These tools are used to implement

MONETARY POLICY

Monetary policy has two basic goals: to promote "maximum" sustainable output and employment

to promote "stable" prices

Why would the Fed want to change the money supply?

• Slow INFLATION • (too much money chasing too few goods)

• Lower UNEMPLOYMENT• (too many people out of work)

• Promote Growth in the Economy• Slow down an “over-heated” economy

– Adjusting for the normal business cycle

Typical Business Cycle

Long Term Growth

Monetary Policy• Fed is responsible for maintaining price stability

and employment• “Expansionary Monetary Policy”

– goal is to increase money supply• to reduce unemployment• to avoid deflation

• “Contractionary Monetary Policy”– goal is to decrease the money supply

• to reduce inflation• To prevent “bubbles”

3 Important Tools

1. Changing the Reserve Requirement

2. Changing the Discount Rate

3. Conducting “Open Market Operations”

The three tools are interactive

1. Reserve Requirementcurrently: 10%

• Raise the reserve requirement = Less money in circulation– slows the economy

• eventually brings price stability (lowers inflation)

• Lower the reserve requirement = More money in circulation– More money to buy goods and services

• requiring more jobs to produce them

(lowers unemployment)

2. Changing the discount rate

• discount rate = interest rate on fed to bank loans (set by Fed)

• federal funds rate = interest rate on bank to bank loans (set by fed funds market)Raising the interest rate influences how much banks will decide to borrow from the fed (who will lend them money “out of thin air”, increasing money supply)

Keeping the discount rate low encourages borrowing

federal funds rate=interest rate on bank to bank loansdiscount rate=interest rate on fed to bank loans

When the federal funds rate is lower than the discount rate, who would you borrow from?

When the discount rate is lower than the federal funds rate, who would you borrow from?

• The Fed can encourage borrowing by keeping rates low

Another bank

The Fed

currently: discount rate: .75%federal funds rate: .25%

2006 discount rate - 6.25% federal funds rate - 5.25%

What is the Fed trying to do?

Federal Open Market Committee (FOMC)

• controls Open Market Operations– Open Market Purchases buys government

securities = increases money supply– Open Market Sales sells government

securities = reduces the money supply

1

Important Background Information

• U.S. Department of the Treasury– the agency of government responsible for

paying for government and its actions• collects taxes• borrows money if needed

– It borrows from the public by offering securities» securities: promises to repay with interest at some

future time

Open Market Purchases

• Fed offers to buy your government security. – “Thin air” money is

given to you.– Money supply

increases

Open Market Sales

• Fed offers to sell government securities it holds. – You pay for it.– Your money

“disappears” into the Fed

– Decreases the money supply.

Review

• What are three ways the Fed can control the money supply?

Reserve RequirementDiscount RateOpen Market Operations

Review

• Why does the Fed want to control the money supply?

• Monetary Policy: maintain employment control inflation

Review

• What is the “reserve requirement”?– If the Fed wants to reduce the money supply,

what does it do to the reserve requirement?• What is the discount rate?

– What is the federal funds rate?– If the Fed wants to increase the money

supply, what does it do to the discount rate?

Review

• What is the difference between an Open Market Sale and an Open Market Purchase?

• action?• goal?