CHAPTER 4

The Federal Reserve System

and Monetary Policy
 CHAPTER 15
SECTION 1
Organization and Functions of
the Federal Reserve System
 Organization
 The Fed is responsible for monetary policy.

 Monetary policy: involves the changing rate of

growth of the supply of money in circulation in
order to affect the amount of credit, which affects
business activity in the economy.

 The Board of Governors oversees 12 district Federal

Reserve banks and regulates activity of member
banks and all other depository institutions.
 Organization
 The Federal Advisory Council reports to the
board of governors on general business
conditions in the country.

 The Federal Open Market Committee decides

what the Fed should do to control money
supply.

 Twelve Federal Reserve banks are set up as

corporations owned by member banks.
 Organization
 Member Banks—all national banks, those
chartered by the federal government, must join
the Federal Reserve System.

 State chartered banks may join if they choose.

 All institutions that accept deposits from

customers must keep reserves in their district
Federal Reserve bank.
 Functions
 The fed has many functions, including check
clearing, supervising member banks, holding
reserves, and supplying paper currency.
 Clearing checks is the method by which money is
deposited from one bank to another.

 Supervising member banks means the Fed must

regulate federally chartered commercial banks.

 The Fed maintains the nation’s paper money.

 Functions
 Its most important function is to regulate the
money supply.
 The Fed determines the amount of money in
circulation.
 More money in circulation means lenders are more
likely to offer money for loans.

 The Fed sets standards for consumer

protection, mainly truth-in-lending legislation.
CHAPTER 15
SECTION 2
Money Supply and the
Economy
 Loose and Tight Money Policies
 Monetary policy involves changing the growth
rate of the money supply in order to change the
cost and availability of credit.

 Loose money means credit is plentiful and

inexpensive.

 Used to encourage economic growth.

 Loose and Tight Money Policies
 Tight money means credit is in short supply
and expensive.

 Used to control inflation.

 The goal of monetary policy is to strike a

balance between tight and loose money.
 Fractional Reserve Banking
 Many banks are required to keep a percentage of
their total deposits in cash reserves in their
vaults or with the Federal Reserve bank.
 This enables the bank to provide funds for customers
who might suddenly want to withdraw large amounts
of cash from their accounts.

 Currently most financial institutions are

required to reserve 10 percent of their checkable
deposits and none on their interest-paying
deposits.
 Money Expansion
 Banks can use non-reserved deposits to create
new money.

 Money banks lend and receive is usually spent

or deposited in another bank who can also use
the deposits to create new money.

 This process is known as the multiple

expansion of money.
CHAPTER 15
SECTION 3
Regulating the Money
Supply
 Changing Reserve Requirements
 The lower the percentage of deposits in
reserve, the more money available to loan out.

 When the Fed raises its reserve requirements,

banks can call in loans, sell off investments, or
borrow from another bank (or the Federal
Reserve).
 Changing Reserve Requirements
 Raising the reserve decreases the amount of
money in the economy and slows it down.

 Because of the extreme effect on money supply,

the Fed has not been raising the reserve
recently.
 Changing the Discount Rate
 Discount Rate: interest rate that the Fed charges
on loans to member banks

 Prime Rate: rate of interest that banks charge on

loans to their best business customers

 A higher discount rate means that member

banks charge their customers higher interest,
reducing the money supply.
 Changing the Discount Rate
 Federal Funds Rate: interest rate that banks
charge each other on loans (usually overnight)

 Used to help a bank to increase its reserves by

borrowing from another bank.

 If the Fed decreases the federal fund rate,

banks will borrow more and, thus, lend more.
 This increases business activity.
 Open-Market Operations
 The buying and selling of government
securities is called open-market operations.

 When the Fed buys securities, it makes a

deposit into the reserve account of the security
dealer’s bank, giving that bank more money to
lend out because its reserve account is higher
than necessary.
 Open-Market Operations
 When the Fed sells securities, the purchasing
bank buys them with money from its reserves,
leaving the purchasing bank with less reserve
funds.

 This shows the multiple expansion of money

working in reverse because more money is
taken out of circulation than just the initial
withdrawal.
 Difficulties of Monetary Policy
 It is difficult to gather and evaluate information
about the money supply.

 Some critics of the Fed want to stop the Fed

from engaging in any monetary policy at all.

 Taxing and spending by the government affect

the economy, and the Fed has to consider this
also in the changes they can make.