Download Chapter 16 The Federal Reserve and Monetary Policy

Chapter 16 The Federal Reserve and
Monetary Policy
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The Federal Reserve System
Federal Reserve Functions
Monetary Policy Tools
Monetary Policy and Macroeconomics Stabilization
How effective is monetary policy
as an economic tool?
1. The Federal Reserve System
• Organized to provide money to banks that are in need of loans
Benjamin Bernanke,
Chairman of the Federal
Reserve
Received largest number
of votes than any other
previous chairman
Highly qualified expert in
the Great Depression and
Economics
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With his predecessor, Alan Greenspan, looking on, Chairman Ben Bernanke addresses President George W. Bush and
others after being sworn in to the Federal Reserve post. Also on stage with the President are Mrs. Anna Bernanke and
Roger W. Ferguson, Jr., Vice Chairman of the Federal Reserve.
Banking History
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1.
Monetary Policy - actions that the Federal Reserve System takes to
influence the level of real GDP and the rate of inflation in the economy
Reserves - deposits that a bank keeps readily available as opposed to
lending them out
Reserve Requirements - the amount of reserves that banks require to
keep hand on
The Fed can
encourage
money creation
by making it
cheaper for
banks to
borrow
2.
The Fed can
raise and lower
reserve
requirements
and raise and
lower the
discount rate
3.
Open market
operations,
the buying and
selling of
government
securities
Federal Reserve uses a variety of
tools to stabilize the U.S. Economy
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Federal Reserve Act
of 1913
• Congress, in 1913, passed the
Federal Reserve Act, which
allowed a group of 12 banks to
lend to other banks in time of
need
• Central Banking System of the
United States to lend legal
tender
• Signed into law by President
Woodrow Wilson
Structure of the Federal Reserve
The Federal Reserve System is privately owned by the member banks
themselves. However, it is publicly controlled by the Federal Government.
The Structure represents compromises between centralized power and
regional power.
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The Board of Governors – headquartered in Washington, D.C., seven
governors, appointed for staggered 14-year terms by the President and
approved by the Senate; also approves a chairman – serves 4-year term
and can be renewed
Twelve Federal Reserve banks – divides the U.S. into 12 districts with
one federal reserve in each region; each district has nine diverse
directors to represent many interests and one becomes chairman
Member Banks -4,000 member banks and 2,500 depository institutions
(all are required to join); banks must contribute a small amount of
money and therefore receive stock in the system (banks themselves,
rather than government, own federal reserve – gives more
independence)
The Federal Open Market Committee - ,makes key monetary policy
decisions about interest rates and the growth the of the United States
money supply; committee meets 8 times a year to discuss the cost and
availability of credit, for business and consumers; affects financial
markets and home mortgages
Most federal reserves districts contain a variety of agricultural,
manufacturing, and service industries, as well as rural and urban areas.
2. Federal Reserve Functions
• As the central bank of the United States, the 12 district banks
that make up the core of the federal reserve carry out several
important functions (Handles all the federal government’s
banking needs)
• Provides banking and fiscal services to the federal government
• Biggest function - issue money
• The U.S. government pays about 1.2 trillion dollars each year to
support such social insurance programs as Medicare, Social
Security, and veterans benefits
Serving Government
• The Federal Reserve serves as banker for the United States
government (WHATA HARD JOB, I STRUGGLE BALANCING
MY CHECKING ACCOUNT)!
– Banker and Agent -maintains a checking account for the
federal government
– Processes social security checks, income tax refunds, and
other government payments, unemployment, welfare
– The Fed sells, transfers, and redeems securities such as
government bonds, bills, and notes to finance all programs of
U.S. government.
• Issuing Currency - the Treasury Department – coins are minted
in the U.S. Treasury; the district Federal Reserve Banks issue
paper currency (Federal Reserve Notes)
Serving Banks
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The Fed provides services to banks as well; most visible function Check Clearing - banks record whose account gives up money and whose
account receives money when a customer writes a check; 18 billion a
year!!! Average waiting time 2 days
Bank holding Company - company that owns more than one bank; Fed
makes sure that it doesn’t influence banking compromises
FED protects consumers; all sellers must provide Truth-in-Lending laws
Lender of Last Resort
– Federal Funds Rate - interest rate that banks charge each other
for loans
– Discount Rate - interest rate that the Federal Reserve charges
commercial banks for loans
Regulating the Banking System
• Reserves –operates as a fractional reserve banking system;
Banks hold only a fraction of their funds-just enough to meet
customer daily needs. Banks then lend their remaining reserves,
charging interest rates to earn returns
• The Fed uses these reserves to control how much money is in
circulation at any one time
• Bank Examinations – Fed examines banks periodically to make
sure that each institution is obeying laws and regulations; may
classify banks as a risk and require more examinations
Regulating the Money Supply
• The Fed is best known for regulating the nation’s money supply
• The Demand for Money – people and firms need to have a
certain amount of money on hand to make economic transactions
• As interest rates rise, consumer demand will fall because it
becomes too expensive, as interest rates lower, consumer
demand rises because it is cheaper
• Stabilizing the Economy-the laws of supply and demand affect
money, just as they affect everything else in the economy.
– Too much money in the economy leads to a rise in prices, or
inflation
– Too little money in the economy leads to a decrease in prices,
causing deflation
3. Monetary Policy Tools
• The Federal Reserve has the power to make money and to put
money into circulation
• How does this money get into the economy?
Money Creation
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The process by which money enters into circulation
Banks make money by charging interest on loans
Required Reserve Ratio - the fraction of deposits that banks are
required to keep in reserve
The Money Multiplier - a formula used to determine how much new
money can be created with each demand deposit and added to the
money supply
Example:
– You deposit $1,000 into your checking account. Your $1000
deposit minus $100 in reserves is loaned to Elaine, who gives
it to Joshua. Joshua’s $900 deposit minus $90 in reserves is
loaned to another customer. At this point, the money supply
has increased by $2,710
– $1000 plus $900 plus $810 equals $2,710
– As of 2008, banks had no reserve requirements on the first
$9.3 million of demand deposit assets. They were required to
hold 3 percent reserves on demand deposit assets between
$9.3 million and $43.9 million, and 10 percent on all demand
deposit assets exceeding $43.9 million
Reserve Requirements
• Increase in reserve requirements causes banks to increase
reserves and the money supply in banking reduces, causing less
lending
• A reduction in reserve requirements causes banks to decrease
reserves and the money supply in banking increasing, causing
more lending
Money Supply
Reserve Requirements
An increase in
Reserve requirements
Causes banks to increase
reserves
Banks reduce
Lending, causing
the money supply
To contract
Reserve Requirements
A reduction in
Reserve requirements
Causes banks to
Decrease reserves
Money Supply
Banks increase
Lending, causing the
money supply
To expand
The Discount Rates
• In the past, the Fed lowered or raised the discount rate to
increase or decrease the money supply.
• Rates that the Federal Reserve charges on loans to financial
institutions
• Primarily used to ensure that sufficient funds are available in
the economy
• Changes in the federal funds rate and the discount rate affect
the cost of borrowing to banks or other financial institutions;
affects the Prime Rate!
• The Prime Rate - rate of interest that banks charge on shortterm loans to their best customers
Open Market Operations
• The buying and selling of government securities in order to alter
the money system - most often used monetary policy tool
– Bond Purchases –when Fed decides to increase money supply,
it orders the trading desk to purchase a certain amount of
government securities on the Open Market
– Bond Sales – chooses to decrease money, it must make a sale
– Targets-keeps an eye on M1 and M2 money
Bonds Circulating
Through bond sales,
The Fed removes
Reserves from the
Banking system
Money Supply
Banks reduce lending
Causing the money
Supply to contract
Bonds Circulating
The Fed’s purchase
Of bonds increases
Reserves in the
Banking system
Money Supply
Banks increase lending
Causing the money
Supply to expand
4. Monetary Policy and
Macroeconomic Stabilization
• Some economists have great faith in monetary policy.
• Monetarism - the belief that the money supply is the most
important factor in the macroeconomic performance
• Monetary policies alters the supply of money. The supply of
money affects interest rates.
How Monetary Policy Works
• The Money Supply and Interest Rates
– It is easy to see the cost of money when you are borrowing
it. This is known as the interest rate. If the market for
money is high, the interest rate is low, if the market for
money is low, the interest rate is high
• Interest Rates and Spending – most important factor of
spending in the economy
• Easy Money Policy - increases the money supply – case –
macroeconomy is experiencing contraction – declining incomethe Fed may want to expand or stimulate by increase
• Tight Money Policy - reduces the money supply – case –
macroeconomy is experiencing expansion – causing inflation – the
Fed may want to reduce the money supply
The Problem of Timing
• Must be carefully timed if it is to help the economy
• Good timing – goal of stabilization is to smooth out those
fluctuations- in other words, to make the peaks a little bit lower
and trough not quite so deep
• Bad timing – stabilization, if not timed properly, can actually
worsen the business cycle
• Inside lag - time it takes to implement monetary policy; takes
time to identify the problem, and second it takes time to
implement legislation
• Outside lag - the time it takes for monetary policy to have an
effect
How does the Fed make monetary
policy?
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1. At some point in every business cycle, the economy will contract, or
go into decline. This phase generally causes unemployment to rise and
real GDP to fall.
2. It’s the job of the Fed to spur a sluggish economy. One way it does
this is by lowering the discount rate, the interest rate that the Fed
charges on loans to financial institutions.
3. With a lower discount rate and federal funds rate, it is much easier
for banks to borrow money. They are then able to lower the interest
rate some loans. Companies can borrow money to finance their
expansion plans.
4. Mortgage rates also drop, and people who previously could not
afford to buy a home now can enter the market.
5. The economy now enters a period of prosperity and expansion.
However, the Fed must be alert to the possibility that the economy may
overheat. In that, the Fed will have to consider whether to step in an
tighten the money supply
Predicting Business Cycles
• The Federal Reserve must not only react to current trends, but
must also anticipate change in the economy
• How do policy makers decide when to intervene in the economy?
– Monetary Policy and Inflation
• An inflationary period can be tamed by a tight money
supply, but timing is crucial (could turn into a full blown
depression)
• Decision is based partly on our expectations of the
business cycle
– How quickly does the Economy self correct
• Economists disagree on the answer to this question! The
estimate range from two to six years.
Responsibilities of the Federal Reserve
Responsibilities that serve
government
Maintain checking account for the
Treasury Department
Serve as financial agent for the
Treasury Department
Issue Currency
Responsibilities that serve the
banking system
Maintain check clearing system
Monitor bank reserves
Approve or disapprove proposed bank
mergers
Lend money to banks
Regulating Banks
Regulating the banking system
Regulating the money supply
Regulate the money supply to stabilize
the economy
After the discount rate
After the federal funds rate
Buy or sell government securities on
the open market