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Module
36(72)
The Federal Reserve and
Monetary Policy
Module Objectives
What students will learn:
• The functions of the Federal Reserve System
• The major tools the Federal Reserve uses to serve its functions
Module Outline
Opening Example: Ben Bernanke, the chairman of the Federal Reserve from 2006–
2014, had more influence over the fluctuations in the economy than the president of the
United States, which explains why he was Time magazine’s person of the year in 2009.
This example raises the question of how much power the chairman actually has.
I. The Functions of the Federal Reserve System
A.Provide financial services: The Fed provides various banking services for commercial banks, including holding reserves and clearing checks.
B.Supervise and regulate the banking institutions: The Fed must regulate the
operations of commercial banks.
C. Maintain stability: The Fed often provides liquidity to member banks in order
to maintain the stability of the financial system.
D.Conduct monetary policy: The Fed uses monetary policy to address fluctuations
in the macroeconomy.
II.How the Fed Conducts Policy
A.Reserve requirements
1.Definition: The federal funds market allows banks that fall short of the
reserve requirement to borrow funds from banks with excess reserves.
2.Definition: The federal funds rate is the interest rate determined in the
federal funds market.
B. Discount rate
1.Definition: The discount rate is the rate of interest the Fed charges on
loans to banks.
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module 36(72)
the federal reserve and monetary policy
C. Open-market operations
1. Definition: An open-market operation is a purchase or sale of government debt by the Fed.
2. The Federal Reserve’s assets include government debt, mainly in the form
of U.S. Treasury bills.
3. The Federal Reserve’s liabilities include the currency in circulation plus
bank reserves, which together constitute the monetary base.
4. Monetary policy is most often conducted using open-market operations.
5. An open-market purchase of Treasury bills increases the monetary base
and the money supply, while an open-market sale of Treasury bills
decreases the monetary base and the money supply.
Teaching Tips
The Federal Reserve System: Functions and Policy Tools
Creating Student Interest
Students are likely to have limited knowledge of the Federal Reserve and its functions.
To stimulate interest, ask them if they ever wondered how funds get transferred from a
person’s bank account to the store where he or she just made a purchase with a debit
card. Also ask them if they ever worry that their bank will go out of business. Then ask
them how the Federal Reserve actually increases the money supply. It surely does not
just print money and pass it out. The answers to these questions will be revealed as you
present the functions and policy tools of the Federal Reserve.
Presenting the Material
Explain what exactly the Federal Reserve does in terms of the four functions. Next introduce the tools of monetary policy and present a few numerical examples of open market
operations. Students are sure to have an idea that the Federal Reserve sets interest rates.
Explain that it actually has direct control only over the monetary base, although this
control does allow it to influence interest rates. If you have played the money creation
game suggested in the previous section, refer to that game. Have students imagine that
the Federal Reserve has just purchased government bonds from bank 1, and now bank
1 has more reserves to lend. How can the bank encourage its customers to borrow more
funds? By lowering the interest rate.
Case Studies in the Text
Economics in Action
Who Gets the Interest on the Fed’s Assets?—This EIA explains that some of the interest on
assets held by the Fed is used to finance the Fed’s operations and the rest is turned over
to the U.S. Treasury.
Ask students the following questions:
1. How much profit did the Federal Reserve make in 2012, and how much
of this profit did it give to the Treasury? (Answer: $91 billion and $88.9
billion)
2. In what way do taxpayers bear the real cost of counterfeiting? (If there
are more fake $100 bills in circulation, the Fed will issue fewer real $100
bills, and this will reduce interest payments made to the Fed and the U.S.
Treasury.)
module 36(72)
the federal reserve and monetary policy
Activities
Which of the Fed’s Policy Tools…? (15 minutes)
Pair students and ask them to identify an appropriate tool at the Fed’s disposal, as well
as the appropriate action to be taken by the Fed, to deal with the following economic
situations.
1. Significant decreases in real GDP for three straight quarters
2. Increases in the unemployment rate over the past six months
3. Monthly increases in the producer price index for the past four months
4. A severe depression
5. Significant increases in the CPI over the past six months
Possible
answers:
1. decrease in the required reserve ratio
2. purchases of U.S. Treasury bills by the Fed
3. sales of U.S. Treasury bills by the Fed
4. decrease in the discount rate
5. increase in the federal funds rate by sale of U.S Treasury bills
Web Resources
The following website provides information from the Federal Reserve System: http://
www.federalreserve.gov/
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