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Chapter 15 The Federal Reserve and Monetary Policy © OnlineTexts.com p. 1 The Federal Reserve • The Federal Reserve is the United States Central Bank. • Founded in 1913 after four severe banking panics. • Chartered by the federal government but is largely independent of the authority of the Congress and President. • Primary role is to conduct monetary policy and to act as a lender of the last resort to banks to stabilize the financial system. © OnlineTexts.com p. 2 Structure of the Fed • The unique structure of the Federal Reserve is a consequence of history and politics. © OnlineTexts.com p. 3 Structure of the Fed • The Board of Governors – is the highest governing body of the Federal Reserve. – It consists of seven members including the chairperson--currently Alan Greenspan. • The Twelve District Banks provide regional check clearing, bank supervision, payments processing, and economic analysis. © OnlineTexts.com p. 4 Structure of the Fed • The F.O.M.C. (Federal Open Market Committee) – is responsible for directing monetary policy. – consists of 12 members, the seven from the Board of Governors plus five Presidents of the District Banks who serve on a rotating basis, one of which is always from the New York Fed. – meets about every six weeks to discuss monetary policy and decide what course of action to take. © OnlineTexts.com p. 5 Tools of Monetary Policy • • The Federal Reserve's attempt at stabilization policy is referred to as monetary policy. Tool include: 1. Open Market Operations (OMO), 2. Change in the discount rate, and 3. Change in the reserve requirement ratio. © OnlineTexts.com p. 6 Tool #1: Open Market Operations • An Open Market Operation is – the Fed's purchase (open market purchase) or sale (open market sale) of government securities via transactions in the open market. – by far the most important tool of the Fed and it is used daily to target the federal funds rate. – An open market operation impacts the banking system by changing bank reserves initially and, ultimately, the money supply. © OnlineTexts.com p. 7 Tool #1: Open Market Operations •Example: the Fed purchases $100 million of government securities from commercial banks. © OnlineTexts.com p. 8 Tool #2: Change in the Discount Rate • The discount window is where depository institutions go to borrow funds from the Fed. – The discount rate is the interest rate at which the Federal Reserve lends funds to banks. – Borrowings from the discount window are shortterm, usually lasting only a week or two. – Changes to the system were implemented recently, establishing primary credit and secondary credit programs. © OnlineTexts.com p. 9 Tool #2: Change in the Discount Rate • Suppose the Fed decreases the discount rate by one percentage point, say, from six percent to five percent. This change induces banks to borrow $5 million more in reserves from the Fed to fund additional loan opportunities. © OnlineTexts.com p. 10 Tool #3: Change in the Required Reserve Ratio • The required reserve ratio is the minimum amount of reserves that a bank must hold relative to its deposit base. – Reserves include vault cash and reserves held at the Federal Reserve. – Currently in the U.S. banking system, the required reserve ratio is 10 percent. – Lowering the ratio frees up reserves, while raising the ratio reduces reserves. © OnlineTexts.com p. 11 Tool #3: Change in the Required Reserve Ratio • Example: the Fed lowers the required reserve ratio from 12.5 percent to 10 percent, freeing up $2,500 in excess reserves. © OnlineTexts.com p. 12 Summary of Monetary Policy Tools © OnlineTexts.com p. 13 Impacts of Monetary Policy on the Economy • How do Federal Reserve actions impact the behavior of output, inflation, and unemployment? • Monetary policy ultimately works by changing interest rates in the loanable funds market, which change the level of demand for goods and services in the economy. © OnlineTexts.com p. 14 The Loanable Funds Market • Demand for loanable funds comes borrowers. The supply of loanable funds comes from savers. © OnlineTexts.com p. 15 The Loanable Funds Market • Expansionary monetary policy, by increasing bank the quantity of bank reserves, increases the supply of loanable funds, which lowers interest rates. © OnlineTexts.com p. 16 The Impact of Monetary Policy on the Economy • The final piece of the puzzle is that the lower interest rates increase investment, which shifts the Aggregate Demand curve to the right. – Both the level of output and the price level increase. – Contractionary policy reduces the price level and the level of output. – Remember that monetary policy affects Aggregate Demand, not Aggregate Supply. © OnlineTexts.com p. 17 Expansionary Monetary Policy © OnlineTexts.com p. 18