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SSEMA2 THE STUDENT
WILL EXPLAIN THE ROLE
AND FUNCTIONS OF THE
FEDERAL RESERVE
SYSTEM.
• a. Describe the organization of
the Federal Reserve System.
The Federal Reserve System
• is the Unites States’ decentralized, central bank.
• It is both public and private in nature.
• It was created in 1913 to help instill trust in the country’s
banking system.
• Since the Federal Reserve can act as the “lender of last
resort” to help struggling banks meet their depositor’s
demand for money, people are less likely to fear bank
failure.
The following characteristics are the public
aspects of America’s Federal Reserve System:
• 1. It was created by an act of Congress, so it can be dissolved
by an act of Congress. In this way, the Federal Reserve is
checked by those elected by the people.
Board of Governors
• 2. The seven members of the Board of Governors of the
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Federal Reserve System are nominated by the President
and confirmed by the Senate.
They are the public part of the Federal Open Market
Committee that makes monetary policy decisions.
A full term is fourteen years.
One term begins every two years, on February 1 of evennumbered years.
The Chairman and the Vice Chairman of the Board are
named by the President from among the members and
are confirmed by the Senate.
They serve a term of four years.
Board of Governors
• 3. The Federal Reserve is the fiscal agent for the United
States government.
• 4. The United States paper currency is called a Federal
Reserve Note because it is backed by the assets of the
Federal Reserve mainly the government securities
(bonds) it holds.
• 5. Profits earned by the Federal Reserve System are
transferred to the United States government. In 2011, the
Federal Reserve transferred over $79 billion in profits to
the U.S. Treasury.
The following characteristics are the private aspects of
America’s Federal Reserve System:
• 1. The system is decentralized with 12
district banks serving the needs of different
regions of the country.
• 2. The board of directors for each of the 12
district banks includes two-thirds of
directors elected by the privately controlled
member banks of that district as well as
one third of the directors elected by the
Board of Governors
• 3. There are five district bank presidents serving as voting
members of the FOMC at any given time. The New York
Federal Reserve Bank President is always a voting
member of the FOMC and four other district Federal
Reserve Presidents serve as voting members on a
rotating basis.
• 4. Each district Federal Reserve Bank is organized as a
private corporation and it self-financed through interest
earned on securities held or payments for services like
check-clearing.
b. Define monetary policy.
Monetary policy
• refers to the tools used by the Federal Open Market
Committee to stabilize the economy.
• Since the Great Recession, the tools of monetary policy
have expanded.
• However, the three main monetary policy tools with which
students should be familiar are open market operations,
changes in the discount rate, and changes in the reserve
requirement.
• Open market operations refer to the buying and selling of
government securities (bonds) on the open market.
The Discount Rate
• is the interest rate the Federal Reserve charges banks on
money they borrow from the Federal Reserve
• The Reserve Requirement is the percentage of customer
deposits banks cannot loan to borrowers.
• For example, if a bank has $10,000 in deposits and the
reserve requirement is 10%, then the bank can only make
loans up to $9,000. The other $1,000 must be held in
vault cash or in the bank’s reserve account at the Federal
Reserve.
c. Describe how the Federal Reserve
uses the tools of monetary policy to
promote price stability, full
employment, and economic growth.
price stability
• If the Federal Reserve is concerned about price stability, it
is usually worried that the inflation rate is increasing. This
means the Federal Reserve needs to use monetary policy
that will decrease the money supply.
Open Market Operations
• The most common tool used by the Federal Reserve is Open
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Market Operations.
If the Federal Reserve wants to reduce the money supply to
decrease the rate of inflation, it will sell bonds (securities).
An open market sale of bonds means that banks and
individuals will use their money to purchase the security.
This money will no longer be in the banking system to be
used for loans or spending.
Since there is less money available for lending, the price
banks charge each other for lending money (the Federal
Funds Rate) rises, reducing borrowing activity.
Discount Rate
• The next most commonly used tool of monetary policy
used by the Federal Reserve is the Discount Rate.
• When the Federal Reserve is concerned about inflation, it
will raise the discount rate.
• Usually, changes in the discount rate are a signal to banks
to raise the federal funds rate and borrow less from each
other to make loans. This reduces spending and helps to
bring price level (inflation) down
reserve requirement
• A change in the reserve requirement is the tool least often
used by the Federal Reserve.
• Changes to this factor in the banking system can create
very large changes in the money supply. T
• his occurs because changes in the reserve requirement
have what economists call a large multiplier effect.
• However, if the Federal Reserve decided to change the
reserve requirement to combat inflation, it would raise the
reserve requirement, reducing the amount of deposits
banks could lend.
promote full employment and economic
growth
• Monetary policy can also be used to promote full
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employment and economic growth.
Economists use the term full employment to describe the
level of employment when all factors of production are
being used efficiently.
It is the same as an economy operating on its production
possibilities curve.
Full employment can also refer specifically to labor
resources.
At full employment, the unemployment rate is equal to the
structural plus the frictional unemployment rates and there
is no cyclical unemployment in the economy.
expansionary (or loose) monetary policy.
• If the Federal Reserve wants to promote full employment
and economic growth, it will use expansionary (or loose)
monetary policy.
• It will buy bonds (securities), causing the Federal Funds
Rate to fall and encouraging more borrowing activity.
• In some cases, it will lower the discount rate as a signal to
banks to increase lending.
• And, finally, in rare cases, it could lower the reserve
requirement ratio, allowing banks to lend more of their
deposits.