The Federal Reserve

and Monetary Policy

Chapter 16
The Federal Reserve
System
Chapter 16, Section 1
Federal Reserve Act of 1913
• Created the Federal Reserve (FED)
• System of federal banks
• 12 districts
• Overseen by the Board of Governors
• 7 governors
• 14 year terms appointed by the President
• Appoints a chair confirmed by the Senate
• Chairs serve a four year term that can be renewed
FED Districts
• 12 districts
• District bank reports on economic activity in the district
to the Central Bank (FED)
• Member banks... All nationally chartered banks are
required to join the FED. The ownership of the system by
banks, not the government, gives the FED a high degree
of political independence.
• The FOMC (Federal Open Market Committee), which
consists of The Board of Governors and 5 of the 12
district bank presidents, makes key decisions about
interest rates and the growth of the United States
money supply.
Federal Reserve
Functions
Chapter 16, Section 2
Functions of the FED
• Banking and fiscal services to the government
• Banking and fiscal services to member and nonmember banks
• Regulates the banking industry
• Tracks and manages the money supply
Serving the Government
• Acts as the Government’s bank
• Maintains a checking account for the Treasury
• Sells securities (bonds)
• Issues currency
• Coins are created at the US Mint
• Currency is created by the Bureau of Engraving and Printing
• The FED issues the currency
Serving Banks
• Check clearing
• Loans to member banks
• Supervise lending practices
• Lender of last resort
• Banks loan money to each other and charge interest
known as the Federal Funds Rate
• The FED can lend funds to banks in times of need and
charge interest
• This is called the Discount Rate
Regulating the Banking
System
• The FED requires banks to report on their reserves
• Liquid assets on hand
• Examine banks to ensure they are following regulations
• Examiners look at the bank’s Net Worth to determine if they are
in trouble
• Net Worth represents their total assets minus their total liabilities
Regulating the Money Supply
• FED is best known for regulating the money supply
• Factors that affect demand for money
• Cash needed on hand
• Interest rates
• Price levels in the economy
• General level of income
• The laws of supply and demand work the same with the
money supply
Monetary Policy
Tools
Chapter 16, Section 3
Monetary Policy
• Monetary policy refers to the action the FED takes to
influence economic performance
• The FED can use monetary policy in a number of ways
• Money creation...not making it but putting it into circulation
• Changing reserve requirements
• Changing the interest rates
• Purchasing bonds (open market operations)
Money Creation
• Banks keep a certain amount of funds on hand
• The required reserve ratio (RRR) is the amount that
must be kept by banks...this is established by the FED
• After the RRR is kept, banks can loan money. This
process, along with gained interest creates money...or
adds it to the money supply
• Banks may keep excess reserves on hand
• More money than is required by the RRR
Reserve Requirements
• The FED can influence the economy by changing the RRR
• Raising the RRR will reduce the money in circulation
• Lowering it will increase the money in circulation
• Banks have more money to loan out
• FED does not change the RRR very often
The Discount Rate
• Banks borrow from the FED and the interest
charged is known as the discount rate.
• In turn, these banks loan to customers and
establish interest rates known as the prime rate.
• By changing the discount rate, the prime rate
changes and affects spending behaviors
• Raising the discount rate will slow borrowing,
spending and the economy
• Lowering the discount rate will increase borrowing
and spending, and stimulate the economy
• 2nd most used form of Monetary Policy
Open Market Operations
• The most used monetary tool is open market operations
• This involves buying and selling bonds on open markts
• The FED will purchase bonds to put money into circulation
• They sell government bonds to take money out of circulation
Review
1. The required reserve ratio is
(a) the required amount of gas that must be left in reserve when your care
is on empty
(b) the amount of reserves that banks must keep in their vaults
(c) the ratio of taxes the government must collect to cover Monetary Policy
(d) the ratio of paper currency to coins required of banks by the Federal
Reserve.

2. All of the following will increase the money supply

except
(a) increasing the required reserve ratio.
(b) bond purchases by the Fed.
(c) reducing the required reserve ratio.
(d) reducing the discount rate.
Monetary Policy and
Macroeconomic
Stabilization
Chapter 16, Section 4
Using Monetary Policy
• Monetarism...the belief that the money supply is the most
important factor in macroeconomic performance
• Money supply and interest rates
• In basic terms, the interest rate is the cost of money
• Works under the principles of supply and demand
• When money supply is high, interest rates are low
• When money supply is low, interest rates are high
Easy Money vs. Tight Money
Policy
• When money is in low supply, the FED may follow an easy
money policy...or follow policy that will increase the money
supply
• When money is in high supply, the FED will try to lower the
money supply or use tight money policy
Timing of Monetary Policy
• Policies of Monetary Policy need to be carefully
enacted to have the desired effect...if they are not
time accordingly, they may have a negative effect
on the business cycle
• Like with Fiscal Policy, Monetary Policy takes time
to put in place and take effect...lags
• Inside lag... Delay in implementing monetary policy
• The government takes time to recognize the problem and create a
solution
• Outside lag...the time it takes for the policy to have an
effect
• Predictions of the business cycle is key in this
process
Fiscal and Monetary Policy
Tools
Fiscal and Monetary Policy Tools

Fiscal policy tools Monetary policy tools

1. Open market operations:

Expansionary Tools 1. Increase government bond purchases
spending
2. Decreasing the discount
2. Cutting taxes rate
3. Decreasing reserve
requirements

1. Open market sales: bond

1. Decrease government sales
Contractionary Tools
spending
2. Increasing the discount
2. Raising taxes rate
3. Increasing reserve
requirements
Remember
• Fiscal Policy is how the government uses its taxing and
spending to influence the economy
• Monetary Policy is how the FED uses its control of the money
supply to influence the economy
Review
1. Monetarism is
(a) the time it takes to enact monetary policy.
(b) the belief that the money supply means little to macroeconomic
performance.
(c) the time it takes for monetary policy to take affect.
(d) the belief that the money supply is the most important factor in
macroeconomic performance.

2. Tight money policies aim to

(a) increase the money supply and expand the economy.
(b) decrease the money supply and expand the economy.
(c) decrease the money supply and slow the economy.
(d) increase the money supply and slow the economy.