Download o Why was the Federal Reserve created

o Why was the Federal Reserve created? What are its essential functions?
o Who are the decision makers of the Federal Reserve? How do these people obtain these
positions?
o How does the Federal Reserve control the monetary system?
o How do banks increase the money supply?
o How is inflation measured?
o What are the causes of inflation?
Slide 1:
The Federal Reserve (Fed) - Definition
The Fed is an example of a central bank:
“An institution designed to oversee the banking system and regulate the quantity of
money in the economy.” (Reference: Mankiw, G., Principles of Economics, 3rd, P.634)
Speaker’s Notes:

Whenever an economy relies on a system of fiat money, as the U.S. economy
does, some agency must be responsible for regulating the system.

Fiat money: money without intrinsic value that is used as money because of
government decree
Slide 2:
Creation and functions of the Fed
After a number of bank failures in 1907, the Congress was convinced that the U.S.
needed a central bank to ensure the health of the nation’s banking system. The Fed,
therefore has two (2) main functions:
1) To regulate banks and ensure the health of the banking system
2) To control the money supply
Speaker’s Notes:
Regulating banks is the responsibility of the regional Federal Reserve Banks. In this, the
Fed monitors each bank’s financial condition and facilitates bank transactions by clearing
checks.
The Fed also acts as the banks bank: it makes loans to commercial banks when banks
need to borrow
Controlling the Money Supply is what is known as the Monetary Policy. The monetary
policy is made by the Federal Open Market Committee (FOMC)
Slide 3:
The Fed – Decision Makers


7 Governors – Chairman included
12 members of the FOMC
Speaker’s Notes:
The Fed is run by its Board of Governors (serve for 14 year terms) , which has seven members appointed
by the president and confirmed by the Senate. Among the seven members of the Board of Governors, the
most important is the chairman . The chairman directs the Fed staff, presides over board meetings, and
testifies regularly about Fed policy in front of congressional committees. The president appoints the
chairman to a four-year term.
The Federal Open Market Committee is made up of the seven members of the Board of Governors and five
of the 12 regional bank presidents. All 12 regional presidents attend each FOMC meeting, but only five get
to vote. The five with voting rights rotate among the 12 regional presidents over time. The president of the
New York Fed always gets a vote, however, because New York is the traditional financial center of the
U.S. economy and because all Fed purchases and sales of government
bonds are conducted at the New York Fed’s trading desk.
Slide 4:
The Money Supply
As stated earlier, the Fed controls the money supply – amount of money injected into the
economy. The Fed controls the money supply through three (3) different tools:
1) Open-Market Operations
2) Reserve Requirements
3) Discount Rate
Speaker’s Notes:
Open-Market Operations: the Fed conducts open market operations when it buys or sells
government bonds. To increase the money supply, the Fed instructs its bond traders at the
New York Fed to buy bonds from the public in the nation’s bond markets.
Reserve Requirements: The Fed also influences the money supply with reserve
requirements, which are regulations on the minimum amount of reserves that banks must
hold against deposits. Reserve requirements influence how much money the banking
system can create with each dollar of reserves. An increase in reserve requirements
means that banks must hold more reserves and, therefore, can loan out less of each dollar
that is deposited; as a result, it raises the reserve ratio, lowers the money multiplier, and
decreases the money supply. Conversely, a decrease in reserve requirements lowers the
reserve ratio, raises the money multiplier, and increases the money supply.
The Discount Rate The third tool in the Fed’s toolbox is the discount rate, the
interest rate on the loans that the Fed makes to banks. The Fed can alter the money
supply by changing the discount rate. A higher discount rate discourages banks from
borrowing reserves from the Fed. Thus, an increase in the discount rate reduces the
quantity of reserves in the banking system, which in turn reduces the money supply.
Conversely, a lower discount rate encourages banks to borrow from the Fed, increases the
quantity of reserves, and increases the money supply.
Slide 5:
How do banks increase the money supply?
Banks create money through the Money Multiplier - The amount of money the banking
system generates with each dollar of reserves
Example, if the Required Reserve Ratio (RRR) is 0.2, the money multiplier would be
calculated as follows:
M=
1
1

5
RRR 0.2
Therefore if we assume that the initial deposited amount is $100, and the RRR = 0.2,
The amount of money that would be created = $100 × M = $100 × 5 = $500
Slide 6:
Inflation
Inflation is defined as an increase in the overall prices in the economy.
Three Types of Inflation:
a) Demand-pull Inflation
b) Cost-push inflation
c) Hyper inflation – most feared
Speaker’s Notes:
Demand-pull Inflation: Typically, changes in the price levels are attributed to an excess
of total spending beyond the economy’s capacity to produce. Because resources are fully
employed, the business sector cannot respond to this excess in demand by expanding
output, so the excess demand bids up the prices of the limited real output, causing
demand-pull inflation. The essence of this type of inflation is “too much money chasing
too few goods.”
Cost-push Inflation: Inflation might also arise on the supply or cost side of the market.
During several periods in our economic history the price level has risen even though
aggregate demand was not excessive. These were the periods when output and
employment were both declining (evidence of a deficiency of total demand) while the
general price level was increasing. The theory of cost-push inflation explains rising
prices in terms of factors which raise per-unit production costs.
Rising per unit costs squeeze profits and reduce the amount of output firms are willing to
supply at the existing price level. As a result, the economy’s supply of goods and
services declines. This decline in supply drives up the price level.
Since natural disasters causes breaks in production ( a factory might be destroyed for
example), causing supply to decline which would also lead to inflation.
This is confirmed in the article Are Inflation Expectations Rising from the Ashes?
Which states “The University of Michigan’s Survey of Consumers reported a drastic
decline in consumer confidence following the devastating effects of Hurricane
Katrina……Less well publicized was the large increase in expectations of future inflation
that was also recorded in this survey. For example, at the end of August, just before
Hurricane Katrina, respondents in the Michigan survey were expecting the inflation rate
over the subsequent 12 months to be 3.1 percent. However, by the end of September, the
same measure of inflation expectations was 4.3 percent.”i
Slide 7:
How is inflation measured?
Inflation is measured as a percentage change in the consumer price index (CPI). The
Consumer Price Index measures the prices of a market basket of some 300 consumer
goods and services purchased by a typical urban consumer. The CPI is a historical,
fixed-weight price index, if the base year is 1980 and 20% of consumer spending was on
housing during 1980, the assumption is that 20% of spending is still on housing in 2007.
The base period is changed roughly every 10 years. The idea behind the historical, fixedweight approach is to measure changes in the cost of a constant standard of living.
Changes in the Consumer Price Index thus allegedly measure the rate of inflation facing
the consumers.
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http://research.stlouisfed.org/publications/mt/20051101/cover.pdf