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Economics Dr.

Katie Sauer

Chapter 10 Reading Guide: The Federal Reserve I. Introduction The USs Federal Reserve (aka the Fed) has tools with more direct impact on the global economy than any other institution in the world. The Chairman of the Fed is named _______________________________. The Federal Reserve controls the USs money supply. By controlling the money supply, the Fed is controlling the economys credit tap. When the tap is open wide, interest rates ___________ and consumers and firms spend more freely. This would be done to:

When the Fed tightens the tap, it __________ interest rates so consumers and firms spend more slowly.

There are ________ Fed banks spread out across the country. The Board of Governors has 7 members and is located in _______________________________. - Ben Bernanke is the chairman Some of the duties of the Federal Reserve System are The other main responsibility of the Fed is to make __________________________________.

II. Monetary Policy A. Introduction Explain how economists view the Fed:

What did Nobel Prize winner Robert Mundell have to say about the importance of monetary policy?

There are limits to how fast an economy can grow. PT Cruiser example:

The pace at which the economy can grow without causing _________________________ might reasonably be considered the economys speed limit. There are only so many ways to increase production: Each of the above is scarce and or unpredictable. The speed limit for the US economy is probably somewhere near ______% growth per year. Its the Feds job to stimulate the economy if it is sluggish. However the Feds job is also to take away the punch bowl just as the party gets going. Explain what this analogy means.

When inflation gets out of control, the Fed might need to engineer a recession to get it under control. Inflation in 1972 was ______%. Inflation in 1980 was ______%. To slow the party down, the Fed raised interest rates to _____%. During the 1981-1982 recession, GDP __________________________________ and unemployment _________________________________________. By 1983, inflation was _______%. B. Interest Rates The Fed cant tell commercial banks what interest rate to charge nor can it tell people to borrow money to buy things. The Feds control over interest rates is indirect. When banks have a lot of money, interest rates will be __________to attract borrowers. When capital is scarce, interest rates will be _____________ to reflect the scarcity. It is simple supply and demand and the Fed controls the supply of money. 2

The decision to raise or lower the money supply (and therefore interest rates) is made by the ___________________________________________________________________. Its membership is comprised of: The chair is _____________________________. The FOMC has 2 primary tools. 1. The discount rate is the rate the Fed charges to _________ for loans. When the Fed lowers the discount rate:

2. The federal funds rate is the rate ____________ charge to banks for loans. The Fed targets this rate by: When the Fed lowers the federal funds rate target:

C. Where does the Feds money come from? In the US, the power to create new money rests with the Fed. The Fed, however, doesnt give money to the banking system, instead it trades the new money for _______________________________________________. The reason that banks hold government bonds is:

When banks are holding bonds instead of cash, funds are not being __________________________. When banks are holding cash instead of bonds, funds are available to lend out. Explain the cascading effect of a monetary injection:

D. The difficulty of the Feds job The Feds mandate is to facilitate a sustainable pace of economic growth. This is difficult because 1. 2. 3. Speed limit analogy recap: The Fed must facilitate an economic growth rate that is neither too fast nor too slow. This is difficult because: Some people give credit to former Fed chairman Alan Greenspan, some criticize him. Explain.

III. The Nature of Money Money is not the same as wealth. Explain.

A. What is Money? In most societies, some kind of money has evolved to make it easier to trade with one another. In order to be money, the item must fulfill 3 functions. Means of Exchange:

Unit of Account:

Relatively Scarce:

Examples of money used in prisons: 4

B. History Prior to the 20th century, banks: In 1913, the US government: In 1917, the US: Even though modern currency is not backed by gold, it has value because it has purchasing power. In order for money to have purchasing power, individuals must be willing to accept and use it. India example:

C. Inflation Inflation means that:

The inflation rate is measured as:

The way to think about inflation is NOT that prices are going up, but that the purchasing power of the dollar is going down. A paper currency has value only because _________________________________. The ____________________________ controls that scarcity. An incompetent or corrupt central bank can destroy the value of its money. Germany example:

Latin America example:

Belarus example:

The Costs of Inflation: 1. Ways that high inflation distorts the economy: 2. Low to moderate inflation leads to ___________________________________ comparisons. Example:

3. Moderate inflation eats away at wealth.

4. Inflation arbitrarily redistributes wealth.

Side note on Real & Nominal Interest rates:

5. Inflation distorts taxes

6. Inflation creates uncertainty When moderate inflation is constant or predictable, it has very little effect. In reality, inflation is not constant or predictable. Salary negotiations: Lenders: D. Governments and Inflation While it seems obvious that governments and central banks would want to fight inflation, in reality, we often see the opposite. Why? 1. +2. +3. =

Explain the inflation tax:

Explain how inflation can factor in to re-election strategy.

In order to do their jobs properly, central banks need to be independent of politics. Countries that have independent central banks end up with _____________ inflation rates. Explain some of the ways that the Fed is structured to be more independent and how it is not perfectly isolated from politics.

E. Deflation Deflation is: Explain how deflation can kick off a dangerous economic cycle.

Monetary policy may be unable to break a deflationary spiral. Japan example:

US example:

F. The Financial Crisis Explain the actions that the Fed took during the recent financial crisis.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.