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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. i http://research.stlouisfed.org/publications/mt/20051101/cover.pdf