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Chapter 16 The Federal Reserve and Monetary Policy 1. 2. 3. 4. 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 • 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 • • • 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 Fed era s Rate d n l Fu s ent m e ir equ ation R e re erv Res oney C M Fed e Sys ral Res tem erve ar nM e p O ket s tion a r Ope 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. • • • • 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 • • • • • 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 • • • • • 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? • • • • • 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