Download Ch14-- Monetary Policy

The Federal Reserve System
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
The Federal Reserve System (“the Fed”) is
the central bank of the United States.
Central bank functions:
– Banks’ bank:
• accepts deposits from banks
• makes loans to banks.
– Banker for the government.
– It controls the money supply.
– Regulates banks
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– Clears checks
Structure of the
Federal Reserve System
The Board of Governors
 Alan Greenspan, Chair
 6 other governors
12 Regional Federal Reserve District Banks
(FRBs)
Federal Open Market Committee (FOMC)
 The Board of Governors (7)
 5 of 12 District Presidents (in Rotation) 2
The Federal Reserve System
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The Board of Governors
Seven members appointed by the
President and confirmed by the Senate
 14-year term
 Terms are staggered:
– one comes vacant every two years
 President appoints Chairman to serve a
four-year term
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Functions of the Fed
Banking Services and Supervision
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Supplies currency to banks through its 12 district
federal reserve banks.
Holds reserves of banks in the district bank of each
bank.
• These are commercial bank deposits at the Fed
Processes and routes checks to banks through its
district banks and processing centers.
Makes loans to banks—it is the “lender of last
resort”, the “banker’s bank”.
It supervises and regulate banks, ensuring that they
operate in a sound and prudent manner.
Banker for the U.S. government.
Manages sales of government securities for the U.S.
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Treasury.
Functions of the Fed

Controlling the Money Supply
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Vary money supply to meet seasonal
fluctuations in the demand for money.
• Helps keep interest rates steady.
• Example: 4th quarter holiday season
creates an increased demand for money
to buy gifts.
– Change
money supply to meet
policy goals of the FOMC.
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Policy Goals of the Fed
Ultimate Goal: Economic growth with
stable prices.
Intermediate Targets:
– The Fed establishes target growth rate
for the money supply, consistent with its
ultimate goals.
– The money supply growth rate is an
intermediate target
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Fed Policy Linkages
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Velocity of Money

Velocity of money: the average
number of times a dollar is spent on
final goods and services in a year.
Velocity = Turns per year
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Velocity of Money = $GDP/M
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Equation of Exchange: relates quantity of
money to nominal GDP
M = money supply (some aggregate)
– V = velocity of money (of the
aggregate)
– P = price level
– Q = real GDP
– PQ = nominal GDP
–
MV = PQ
(Note: V = PQ/M)
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Equation of Exchange and Inflation:
MV = PQ
Or in terms of growth rates:
M% + V% = P% + Q%
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If velocity is growing at 3% per year, the
money supply is growing at 5% per year,
and real GDP is growing at 2% per year,
what must the inflation rate (P%) be?
5% + 3% = P% + 2%
P% = 6%
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Operating Procedures

FOMC Directive: Instructions to the
Federal Reserve Bank of NY
Buy or sell government bonds to keep
the federal funds rate at a specific level.
– The federal funds rate (“fed funds
rate”): the interest rate banks charge
when they lend excess reserves to each
other.
– The buying and selling of government
bonds by the fed to achieve policy
objectives are open market operations
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The Fed’s Policy Tools
1) Reserve Requirements
2) Discount rate
“primary lending rate”
3) Open market operations
 Manage
the public’s expectations
Inflation Targeting?
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Reserve Requirement
Legal reserves: the cash a bank holds in
its vault plus its deposits at the Fed.
 When Fed lowers reserve requirements,
banks have excess reserves which they
can then lend.
 Such lending triggers the deposit
expansion multiplier, increasing the
money supply.
 Similarly, the Fed may decrease the
money supply by raising reserve
requirements.
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
Discount Rate (Primary Credit Rate)
The discount rate is the rate of interest a
Fed District Bank charges when a bank
borrows from it.
 When the Fed raises the discount rate, it
raises the cost of borrowing reserves,
reducing the amount of reserves
borrowed.
 Lower levels of reserves result in
reduced lending, and reduced money
supply.
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Open Market Operations

Open Market Operations (OMOs):
buying and selling of government
bonds by the Fed to control bank
reserves, the fed funds rate, and the
money supply.
Buy Ease Sell Tighten
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An increase in reserves results in an
increase in the money supply and a
reduction in the fed funds rate.
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Now to combine money supply with
money demand:
Transactions demand: hold money to
buy goods and services.
– Precautionary demand: cover
unplanned transactions or
emergencies.
– Speculative demand: deal with
uncertainty about the value of other
assets
… fear decline in the value of other
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assets, so hold money as a safeguard
.
–
Money
Demand
Interest rate is
opportunity
cost of
holding
money. The
higher the
interest rate
the lower the
quantity of
money
demanded.
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Effect of
a change in income
on money demand
Transactions
demand
increases with
income. As
nominal income
increases, the
volume of
transactions
increase,
requiring more
money.
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Money
Supply
Money supply
is controlled by
the Fed, and
therefore is not
a function of
interest rates.
As a result the
money supply
function is
vertical.
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Money
Market
Equilibrium
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How Money Supply Changes affect GDP
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Money Supply and Interest Rates
Interest
Rates
Interest
Rates
Fall
M1
M2
Fed Increases
Money Supply
r1
r2
Md
Money
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