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Monetary Policy
Role of the Federal Reserve
Est. by President Wilson in 1913
• Supervises member banks
• Holds Cash Reserves
• funds available for short-term
borrowing by commercial
banks or government
• guarantees that money is
available in the economy when
needed
• Moves money into and out of
circulation
Characteristics of the Federal Reserve
(independent of elected officials)
• Lack of a Single Central Bank
• most countries have single central bank
• Fed relies on district banks to carry out
national policies
• Ownership and Control by the Member
Banks
• in countries with a central bank gov’t
owns all shares of stock, allowing tight
control
• member banks own stock in Fed;
resulting in political independence
• Optional membership in the Fed for some
banks
• nationally chartered banks must be
members; state chartered banks are
optional
• less than 40% of banks nationally are
Fed members; 5800 Member Banks
Organization of the Fed
• Board of Governors (another mechanism for independence)
• highest policy making body in Fed regulating money supply
• 7 member board appointed by President; serve 14 years; new
appointment every 2 years; each serves 4 year terms
• 7 members and Chairman (Ben Bernanke) are permanent
members of the Federal Open Market Commission
• Federal Open Market Commission—12 member committee; decides
whether to buy or sell gov’t securities
• Board of Governors plus 4 district bank presidents that rotate
• Federal Reserve Banks—1913,
• 12 F.R. district banks that deal only with government and
financial institutions that serve a designated geographic region
• 25 branch offices
• Member Banks
• 2750 national member banks
• 1000 state member banks
Organization of the Federal Reserve
Federal Reserve District Banks
Services to Banks:
12 district banks don’t have checking, savings
accounts; they service member banks
• Clearing Checks
• Americans write 40 billions checks a year
• Fed tracks this by crediting and debiting reserve accounts
• Loans to Banks
• we get loans from banks; banks get loans from Fed
• banks need loans to cover increased withdrawals or loans
• most are short-term to cover immediate problem
• farm loans, natural disasters, financial emergencies
• participating banks face strict monitoring and scrutiny
Services to Government
Dept. of Treasury is Gov’t banker; collect taxes through IRS and Customs;
produces money with U.S. Mint; Fed is gov’t bank
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Serving as the Government’s Bank
• serves as depository for federal revenues; deposited by Treasurer
• holds a Treasury checking account
• records the deposits and withdrawals of federal funds
• advises Congress and President on economic policy
Supervising member banks “banking systems watchdog”
• monitors loans and investments and reviews bank records of reserves
• regulates bank mergers
Regulating the Money Supply—amount of money circulating in the economy
• Dollars—printed by Bureau of Engraving and Printing
• Coins—printed by U.S. Mint
• Fed distributes currency
• Currency is put into distribution for 2 reasons:
• replace old and worn out notes
• increase amount of money in circulation by buying or selling
government securities (T-bills and bonds)
Money Supply:
Economists way to measure the nation’s money
supply
• M1—easiest way to measure only easily accessible
• counts all currency in circulation + travelers checks + checking
account deposits
• checking accounts are 63% of M1
• M2—a broader measure used by those who feel M1 doesn’t
measure all accessible money
• Counts M1 + mutual funds + savings deposits + time deposits <
$100, 000
• M3 and L—both are broader measures than M2
• M3 counts M2 + large time deposits
• L counts M3 + savings bonds + short term T-Bills + any other
Near money
Questions
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Who is the current Chairman of the Federal Reserve?
What are the three roles of the Federal Reserve?
The Federal Reserve is broken into 4 levels of organization. What are the four
levels, and what is the role of each?
What services does the Fed offer to member banks?
What services does the Fed provide the federal government?
What events led to the creation of the Federal Reserve System?
How is the Federal Reserve System designed to be largely independent of the
federal government? Why would this separation from elected representatives be
desirable?
How would Fed policy change if Mr. Bernanke were an elected official instead of
appointed?
What services does the Fed provide to banks?
How does the Fed serve the government?
What are the four different measurements of the U.S. money supply? Which
funds are included in each measurement?
Monetary Policy
• Monetary Policy—plan to expand or contract the money
supply in order to influence the cost and availability of
credit
• done by regulating money supply and interest rates;
• Policy is based on the Federal Reserve measures of
the money supply and Aggregate Demand
• Policy is enacted by the Federal Reserve
Monetary Policy: Strategies
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Easy-Money Policy—designed to expand money supply, increase
aggregate demand, reduce unemployment, and promote economic
growth during recessions
• Charges banks lower interest rates, encourages borrowing
(spending)
• Fed can expand money supply by buying securities
Tight-Money Policy—Slows business activity and helps stabilize
prices to reduce aggregate demand
• Results from inflation when too much money is circulating and
credit is too easily accessible
• Fed can raise interest rates to make credit less accessible
• Fed can decrease the money supply by selling securities
Monetary Policy:
Tools—ways to affect aggregate demand
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Open-Market Operations—buying and selling of securities
• To contract money supply Fed sells government securities. Cash paid for
securities is withdrawn from bank reserves, shrinking money supply and
decreasing aggregate demand
• To expand money supply Fed buys government securities. Money makes it way
into individual and business accounts increasing cash reserves and loan pools.
This increases aggregate demand which leads to an increase in production
Discount Rate—interest rate that the Fed charges member banks for the use of its
reserves.
• a lower interest rate encourages banks to borrow more for their reserves. They
then loan this to businesses and consumers to spend, increasing aggregate
demand
• increasing interest rates discourages banks from borrowing. Banks will pass this
increased interest onto businesses and consumers by raising the prime rate,
ultimately decreasing the amount of loans that are made, decreasing aggregate
demand.
• prime rate—interest rates banks charge on loans to their most reliable business
customers
• law of demand—as price to borrow money increases (prime rate) demand
decreases; as price decreases demand increases
Monetary Policy:
Tools—ways to affect aggregate demand
• Reserve requirements—changes affect lending capacity
of banks
• increase reserve requirement—less money available
for loans
• decrease reserve requirement—more money
available for loans
• “Moral Suasion”—attempts by the Federal Reserve to
put pressure on the member banks either to increase or
decrease all or certain kinds of loans. Takes form of
news releases, letters of appeal, Congressional
testimony and conferences.
Summary of Monetary Policy Tools
Formal Tool
Fed Action
Effects on Economy
Money
Supply
Open Market
Securities
Buys gov’t
securities
Bank reserves increase;
aggregate demand & production
increases
Expands
Sells gov’t
securities
Bank reserves shrink; aggregate
demand decreases
Contracts
Lowers discount
rate
Encourages banks to borrow
from the Fed; bank reserves
increase
Expands
Raises discount
rate
Discourages banks to borrow
from Fed; bank reserves
decrease
Contracts
Lowers the
reserve
requirement %
Banks hold fewer reserves &
extend more loans; interest
rates fall; Aggregate demand
increases
Expands
Raises the
reserve
requirement %
Banks hold more reserves &
extend fewer loans; interest
rates rise; Aggregate demand
decreases
contracts
Discount Rate
Reserve
Requirement
Challenges to Monetary Policy
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Economic Forecasting
• U.S. economy has millions of economic actors buying, selling,
producing
• Forecast can be difficult, and if incorrect could harm economy
Time Lags
• collection and analysis of economic data
• discussion and debate to reach consensus on data
• consumers/ producers need time to adjust their economic activity
Priorities and Trade-offs
• easy-money policy fights recession, but increases inflation
• tight-money policy fights inflation, but contributes to recession
Lack of Coordination
• sometimes Monetary Policy will conflict with Fiscal Policy
Conflicting Opinions
• economics is not an exact science and can be influenced by personal
economic philosophies of conservative v. liberal
Questions!
• How does Monetary Policy affect investment spending in
factories and equipment? The housing market?
Consumer spending?
• Who enacts Monetary Policy? Why is Monetary Policy
easier to enact than Fiscal Policy during periods of
inflation?
• What are the tools of Monetary Policy?
• What Monetary Policy should be enacted during a
recession? Inflation?
• What are some challenges to enacting Monetary Policy?
• Considering our current economic situation, would you
expect the Fed to enact easy money or tight money
policies?