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UNit 4.3 THE FEDERAL RESERVE and the Banking System “The FED” is the central banking system of the U.S. * * * Established – 1913 Governing Body – board of governors Presidentially-appointed Chairman – JANET YELLEN Functions - Uses monetary policy to manage money market/economy - Regulates public/private banks through money supply - Maintains the stability of financial system - Provides finances to depository institutions & government clearing things up! the fed and the Banking System the federal reserve open market committee This Committee oversees the buying & selling of bonds through Open Market Operations board of governors The Board oversees all operations of the Fed, including the Discount rate & the reserve ratio 12 regional reserve banks These banks oversee distribution of funds to all banks/ depository institutions, public & private the different types of monetary policy Remember This?... monetary policy 1. Setting the reserve ratio “Fractional Reserve Banking” reserve requirements are portions or a percentage of all deposits that banks must hold in reserve and cannot lend Here’s the deal! • • • Say the Fed announces that the Reserve Ratio for all banks is 0.2 Banks are mandated to hold 20% of all new deposits in reserve to manipulate the money supply The other 80% will be taken and loaned out or withdrawn and will become deposits in other banks or used for consumption The Secret?... The Reserve Ratio works just like the MPC and MPS! The higher the Reserve Ratio...the lesser the money supply! The lower the Reserve Ratio...the greater the money supply! monetary policy 2. lending at the discount rate The discount rate is the interest rate that the Federal Reserve charges commercial banks to borrow from the Treasury The catch?... The discount rate can influence... interest rates AND money supply Example • 2% to ____ 4% The Fed increases the Discount Rate from ____ • Several banks & depository institutions borrow from the Fed to cover affairs • 7% To ensure a profit on loans, banks offer their loans at a rate of _____ and the money supply DECREASES ______________ due to high opportunity costs monetary policy 3. open market operations The Open market committee can vote to use one of two options to influence the market money supply & interest The Options? buying or selling TREASURY BONDS Example Example • The Fed announces it is selling $10 million T-Bonds at 5% int. • The Fed announces it is buying back T-bonds from the public • Investors who like the interest buy up the bonds, handing over • Anxious investors hand over their bonds and the Fed releases $100B _______ in M1, M2 & M3 per bond $200B _______ in M1, M2 & M3 per bond Wait! What is this... federal funds rate The federal funds rate is the interest rate at which depository institutions loan federal funds and excess reserves to other banks The Federal reserve commonly influences the federal funds rate through open market operations! Example • • A bank has over-lended and cannot meet it’s reserve ratio, so it requests a loan from a bank that has excess reserves To change the Federal Funds Rate, the Fed buys bonds in the open market, INCREASING ______________ the money supply and DECREASING ______________ interest rates, DECREASING the federal funds rate! thus also ________________ Ok...Let’s break down monetary policies the different types of monetary policies expansionary monetary Policy “easy monetary policy” lowering the discount rate lowering the reserve ratio buying bonds in the open market lowering the federal funds rate contractionary monetary Policy “tight monetary policy” raising the discount rate raising the reserve ratio selling bonds in the open market raising the federal funds rate ok, we’re good. LET’S PRACTICE! Nominal rate of interest, i 10 8 6 Dm 0 Nominal rate of interest, i #1. MONEY MARKET Sm2 Sm1 Quantity of money demanded and supplied Price level LRAS AS P1 P2 AD AD2 Real domestic output, GDP #3. AGGREGATE ECONOMY 10 #2. INVESTMENT DEMAND 8 6 DI 0 Amount of investment, I The Fed SELLS Treasury Bonds in the open market… + Interest Rate Increases + Investment Decreases + AD & Real GDP Decreases with slight deflation #1. MONEY MARKET 10 8 6 Dm 0 Nominal rate of interest, i Nominal rate of interest, i Sm1 Sm2 Quantity of money demanded and supplied Price level LRAS AS P2 P1 AD AD2 Real domestic output, GDP #3. AGGREGATE ECONOMY 10 #2. INVESTMENT DEMAND 8 6 DI 0 Amount of investment, I The Fed BUYS Treasury Bonds in the open market… + Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation #1. MONEY MARKET 10 8 6 Dm 0 Nominal rate of interest, i Nominal rate of interest, i Sm1 Sm2 Quantity of money demanded and supplied Price level LRAS AS P2 P1 AD AD2 Real domestic output, GDP #3. AGGREGATE ECONOMY 10 #2. INVESTMENT DEMAND 8 6 DI 0 Amount of investment, I The Fed lowers the Reserve Ratio to 0.1... + Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation Nominal rate of interest, i 10 8 6 Dm 0 Nominal rate of interest, i #1. MONEY MARKET Sm2 Sm1 Quantity of money demanded and supplied Price level LRAS AS P1 P2 AD AD2 Real domestic output, GDP #3. AGGREGATE ECONOMY 10 #2. INVESTMENT DEMAND 8 6 DI 0 Amount of investment, I The Fed RAISES the discount rate from 2.5% to 3.5%… + Interest Rate Increases + Investment Decreases + AD & Real GDP Decreases with slight deflation #1. MONEY MARKET 10 8 6 Dm 0 Nominal rate of interest, i Nominal rate of interest, i Sm1 Sm2 Quantity of money demanded and supplied Price level LRAS AS P2 P1 AD AD2 Real domestic output, GDP #3. AGGREGATE ECONOMY 10 #2. INVESTMENT DEMAND 8 6 DI 0 Amount of investment, I The Fed lowers the Federal Funds Rate by BUYING Treasury Bonds in the open market... + Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation