Download Chapter 15

The Federal Reserve
System and Monetary
Policy
Chapter 15
S
Organization and
Functions of the Fed
Chapter 15, Section 1
S
Organization of the Fed
The Federal Reserve
System
“The Fed”
Board of Governors
(7 members)
Federal Reserve Banks
(12 District banks)
(25 Branch banks)
Federal Advisory
Council
(12 members)
Federal Open Market
Committee
(12 members)
The Fed and Monetary Policy
S “The Fed” was created in 1913 to end the periodic financial panics
(recessions and depressions) occurring during the 1800s and early
1900s.
S “The Fed” is responsible for monetary policy in the United States.
S Monetary policy: policy that involves changing the rate of growth
of the supply of money in circulation in order to affect the cost
and availability of credit
S The goal of monetary policy is to keep the economy growing
while keeping inflation and unemployment low.
Board of Governors
S
The 7 members are appointed by the president and approved by the Senate.
S
The president selects one member as “chairperson”. The current chairperson
of the Fed is Janet Yellen.
S
They serve one term of 14 years.
S
The board of governors does not report to the president thus reducing
exposure to political pressures.
S
These members also serve on the Federal Open Market Committee.
S
Supervises the 12 district banks and regulates member banks.
Federal Advisory Council
S Made up of 12 members elected by each of the 12 district
banks.
S The council advises the Board of Governors.
Federal Open Market Committee
S FOMC: a 12 member committee of the Fed that meets 8
times each year to decide the course of action that the Fed
should take to control the money supply (monetary policy)
S One of they ways they do this is by raising or lowering interest
rates.
12 District Banks
S The U.S. is divided, geographically, into 12 districts with one
district bank in each of the 12 districts.
S Michigan’s district bank is in Chicago.
Functions of the Fed
S The primary function of the Fed is to control the money supply
through monetary policy.
S Check clearing (transferring funds from one bank to another)
S Acting as the federal government’s fiscal agent (maintain the
government’s checking account)
S Supervising and regulating banks
S Holding reserves and setting reserve requirements
S Supplying paper currency
Money Supply and the
Economy
Chapter 15, Section 2
S
Monetary Policy
S Monetary policy: changing the rate of growth of the money
supply in order to affect interest rates and the availability of credit
S Goal: keep the economy growing while keeping inflation and
unemployment low.
S It can take months for the effects of monetary policy to be felt in
the economy.
S There are two types of monetary policy:
S Tight money policy
S Loose money policy
Loose Money Policy
S “Expansionary”
S Characteristics:
monetary policy that makes
S Interest rates are low
credit inexpensive and
S Borrowing is easy
abundant, but possibly
S Consumers buy more
leading to inflation.
S Businesses expand
S Pro: encourages economic
S More people are employed
growth
S Con: may lead to inflation
S Loose money policy:
Tight Money Policy
S “Contractionary”
S Characteristics:
S Interest rates are higher
S Tight money policy:
S Borrowing is more difficult
monetary policy that makes
credit expensive and in short S Consumers buy less
S Businesses postpone
supply in an effort to slow
expansion
the economy.
S Unemployment increases
S Pro: controls inflation
S Production is reduced
S Con: leads to economic
slowdown “recession”
Fractional Reserve Banking
S Fractional reserve banking: system in which only a fraction
of the deposits in a bank is kept on hand, or in reserve; the
remainder is available to lend
S Reserve requirements: regulations set by the Fed requiring
banks to keep a certain percentage of their checkable
deposits as cash their own vaults or as deposits in their
Federal Reserve District Bank
S The current reserve requirement is about 10%
Multiple Expansion of the Money
Supply
Round
Deposited
by
Amt of
Deposit
20%
Reserves
80% to
Lend
Loaned
to
Paid to
$1,000
$200
$800 Mr.
Jones
Computer
World
1
Bank A
2
Computer
World
$800
$160
$640 Ms.
Wang
Mr. Diaz
3
Mr. Diaz
$640
$128
$512 Mrs.
Fontana
Mrs.
Powers
4
Mrs.
Powers
$512
$102
$410
5
All others
$5,000
$1,000
Total (eventually)
Regulating the Money
Supply
Chapter 15, Section 3
S
How the Fed Affects the Money
Supply
Changing the
Reserve
Requirement
Changing the
Discount Rate
Open Market
Operations
• This is the primary
method the Fed uses.
Changing the Reserve Requirement
S Expansionary (loose money policy) – Decreasing the
reserve rate increases the amount of money banks have
available to loan. This is an increase of the money supply.
S Contractionary (tight money policy) – Increasing the
reserve rate decreases the amount of money banks have
available to loan. This is a decrease of the money supply.
S A small change in the reserve requirement has a large effect
on the money supply. For this reason it is rarely used.
Changing the Discount Rate
S Discount rate: interest rate that the Fed charges on loans to
commercial banks and other depository institutions.
S These banks borrow money to cover their reserve
requirements.
S Prime rate: rate of interest that banks charge on loans to
their best business customers
S Federal funds rate: interest rates that banks charge each
other on loans (usually overnight)
Changing the Discount Rate
S Expansionary (loose money policy) – If the Fed lowers the
discount rate, banks can charge a lower prime rate making credit
less expensive for businesses.
S Banks may also borrow more than what they need to meet the
reserve requirement just to loan. This increases the money supply.
S Contractionary (tight money policy) – If the Fed raises the
discount rate, banks will charge a higher prime rate making credit
more expensive for businesses.
S This method is rarely used by the Fed.
Open-Market Operations
S Open-market operations: buying and selling of United
States securities by the Fed to affect the money supply.
S This is the primary way that the Fed affects the money supply.
S Effects from this are not immediate; it may takes months for
this to be felt in the economy.
S The Fed’s monetary policy is not the only factor affecting
the economy. The government’s taxing and spending policy
affect the economy too. The Fed must consider this when
enacting monetary policy.
Open-Market Operations
Expansionary (Loose Money Policy)
The Fed buys T-bills, notes
and bonds from a securities
dealer
The dealer deposits the
proceeds from the sale in
the bank
The bank keeps the
required reserves and loans
the remainder increasing
the money supply through
“multiple expansion of the
money supply”
Open-Market Operations
Contractionary (Tight Money Policy)
The Fed sells T-bills, notes
and bonds to a securities
dealer
The dealer withdraws
money from the bank to
buy the securities from the
Fed
This means the bank has
less funds available to lend.
This decreases the money
supply because “multiple
expansion of the money
supply” works in reverse.
Criticism of Fed Policies
S The effects of Fed policy are not immediate. It can take
several months for the effects of Fed policies to be felt in the
economy.
S At times, the Fed has been criticized for making inflation or
a recession worse.
S The Fed is not the only force affecting the economy. The
spending and taxing policies of the government are also at
work.