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The United States
Federal Reserve
By Dr. Paul Lockard
Professor
Black Hawk College
Fighting Inflation
• To understand the last two jobs of the
Federal Reserve, we need to understand the
monetary policy tools of the Federal
Reserve.
Monetary Policy Tools
• Change the reserve requirement
• Change the discount rate
• Open market operations
The Federal Reserve and the
Economy
• Federal reserve monetary policy actions
impacts bank reserves
• Bank reserves impact money supply
• Money supply impacts interest rates
• Interest rates impact the economy
Reserve Requirements
Changing Reserve Requirements
• Total Reserves = Total deposits of a bank
• Required reserves = a fixed percentage of
the total deposits of a bank
• Excess reserves = money available to a
bank for lending
Changing Reserve Requirements
• If the Federal Reserve increases the reserve
requirement, this reduces the excess
reserves of a bank.
• Fewer excess reserves means the bank has
less money to lend.
• Less lending means smaller money supply.
• This leads to slower economic growth or a
decline in the economy.
Discount Rate
Changing the Discount Rate
• When banks apply to the Federal Reserve
for loans, the Feds determine which banks
will receive them.
• The Federal Reserve also determines the
interest rate it will charge for these loans.
• That interest rate is called the discount rate.
Changing the Discount Rate
• If the Federal Reserve increases the
discount rate this will reduce the amount of
money banks have to lend out.
• With fewer reserves, bank lending will fall.
• Less bank lending leads to a smaller money
supply.
• This leads to slower economic growth or a
decline in the economy.
The Federal Funds Rate
The Federal Funds Rate
• Banks often find that they need extra funds,
either to make loans, or to have enough
required reserves.
• Banks used to borrow from the Federal
Reserves.
• Increasingly they borrow from other banks
The Federal Funds Rate
• The Federal Funds Rate is the interest rate
that lending banks charge to other banks.
• The Federal Funds Rate is influenced by
demand and supply of funds, and by the
actions of the Federal Reserve.
• The discount rate directly affects the federal
funds rate.
Open Market Operations
Why Open Market Operations?
• However, experience has shown that
changing reserve requirements is too drastic
a tool to use.
• And experience has shown that changing
the discount rate no longer works.
• Therefore the federal reserve now depends
upon open market operations to affect the
economy.
Open Market Operations
• Open market operations are the purchase
and sale of Treasury Bonds by the Federal
Reserve to influence the money supply.
Open Market Operations
• The Federal Reserve sells Treasury Bonds
to reduce the money supply.
• The Federal Reserve buys Treasury Bonds
to increase the money supply.
Open Market Operations
• The Federal Reserve has bought and sold
Treasury bonds at different times in the
past, depending upon how it wants the
economy to move.
• In the past 25 years, the Feds has more
often sold bonds to fight inflation.
Open Market Operations
• Using open market operations, the Federal
Reserve sells bonds.
• The sale of bonds leads to a fall in customer
deposits as investors write checks to buy
bonds.
• Banks now have fewer deposits.
• Since customer deposits fall, bank liabilities
and assets both fall.
Open Market Operations
• With fewer deposits, banks are able to lend
less.
• Banks now have to ration their lending by
raising prices.
• So they raise interest rates.
• Higher interest rates leads to fewer
consumers and businesses borrowing
money.
Open Market Operations
1) Affects economy through consumers’
demand.
2) Affects economy through business price
changes.
3) Affects economy through layoffs.
4) Affects economy through investment
changes.
1) Open Market Operations:
Change in Consumer Demand
• Since consumers borrow less to make
purchases, consumption falls.
• Falling consumption leads to falling
demand.
• The fall in demand reduces inflationary
pressures.
2) Open Market Operations:
Business Price Cuts
• Falling consumption also leads to a rise in
business inventories.
• Rising inventories force firms to cut prices,
or at least not to raise prices.
• And if large numbers of companies are
cutting prices, what happens to inflation?
3) Open Market Operations:
Layoffs
• If price cuts by businesses don’t lead to
increases in sales, businesses will be forced
to lay off people.
• Then the rising number of layoffs will lead
to a fall in consumption.
• The fall in consumption puts an additional
squeeze on inflation.
4) Open Market Operations:
Fall in Business Investment
• Rising interest rates also force businesses to
borrow less.
• This leads to a fall in investment.
• The fall in investment leads to a fall in the
purchases of all types of capital goods.
• The fall in the sale of capital goods forces
those companies to cut prices.
Open Market Operations
• As businesses that produce capital goods
cut their prices, this leads to a fall in
inflation.
• If cutting prices doesn’t help the company,
it can always lay people off.
• Increased layoffs lead to a reduction in
demand, which reduces inflation.
Open Market Operations and the
Fight Against Inflation
The sale of Treasury bonds through open
market operations is the tool the Federal
Reserve has for reducing inflation.
Open Market Operations and
Disciplining the Labor Force
• But open market operations have been
found to be useful for keeping wages lower
as well.
Open Market Operations and
Tight Labor Markets
Tight labor market
Defined as:
- lows levels of unemployment
- plenty of jobs
Open Market Operations and
Loose Labor Markets
Loose labor market
Defined as:
- higher levels of unemployment
- scarcity of jobs
Loose Labor Markets
• In times of rising layoffs and higher
unemployment, what happens to the ability
of unions to obtain wage and benefit
increases?
• What happens to ordinary people’s ability to
ask for, and obtain, raises?
• What happens to people’s ability to switch
jobs if they work for a bad employer?
Open Market Operations and
Loose Labor Markets
• The Federal Reserve has repeatedly
signaled that keeping wages down is what if
believes it should do.
• “The tightening labor market might lead to
inflationary expectations for the future.
Therefore to reduce the potential for future
inflation, interest rates will be raised.”
Open Market Operations and
Loose Labor Markets
• Translation: to prevent the possibility of
inflation, because tight labor markets might
lead to pay increases, we at the Federal
Reserve will increase interest rates now.
Loose Labor Markets
• Who is hurt by rising unemployment caused
by higher interest rates?
• Who benefits by the higher unemployment
caused by higher interest rates?
• Who else might benefit by high interest
rates?
Bondholders and
the Federal Reserve
• People buy bonds because they are the only
risk free investment that earns interest.
• However, the bonds have low rates of
interest, on the order of 3-7%.
• Bondholders are very sensitive to inflation.
(Recall how to find real rates of interest?)
Bondholders and
the Federal Reserve
• Approximately 89% of bonds directly or
indirectly owned by families are owned by
the richest 10% of the population.
• In periods of higher inflation, the value of
the income from their bonds falls.
• In periods of low inflation, (higher
unemployment) the value of their income
rises.
Bondholders and
the Federal Reserve
What class(es) might wish for very low levels
of inflation, regardless of the level of
unemployment required to achieve it?