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The Federal Reserve and Monetary Policy The Federal Reserve & Monetary Policy Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession. Creating the Fed govt struggled to stabilize economy until Federal Reserve Act Central bank—a nation’s monetary authority monetary means “relating to money” Federal Reserve System—central bank of the U.S., called the Fed independent organization within govt; established 1913 The Structure of the Fed Elements of the Fed Board of Governors—sets policy; supervises operations of the Fed chairman is most influential member and spokesperson 12 district banks carry out policy; serve as central bank for regions Member banks: all nationally-chartered banks; state banks may apply must buy district bank stock; cannot sell in open market Serving the Banking System 1: Check Clearing 2: Lending Money 3: Regulating & Supervising Banks Serving the Federal govt 1: Paying govt Bills 2: Selling govt Securities 3: Distributing Currency Creating Money Creating money—how money enters circulation through deposits, loans Fed establishes required reserve ratio (RRR) for banks fraction reserve of bank’s deposits that it must keep in The Fed’s Monetary Tools Monetary policy—actions the Fed takes to change money supply purpose is to influence the economy The Fed’s Monetary Tools Open Market Operations Open market operations—sales and purchase of govt securities Fed buys securities to expand money supply; sells to contract supply Federal funds rate (FFR)—interest rate banks charge one another Fed signals intent to buy or sell by announcing a target for the FFR if lowers target, Fed buys bonds; if raises target, it sells bonds The Fed’s Monetary Tools Adjusting the Reserve Requirement Fed changes required reserve ratio to change the money supply increase in RRR reduces money supply; decrease expands it RRR averages 10–12% for transaction deposits, 0–3% for time deposits The Fed’s Monetary Tools Adjusting Discount rate—interest rate Fed charges on loans to other banks affects money supply because it determines reserves banks have to lend Prime rate—interest rate banks charge their best customers the Discount Rate other borrowers pay 2-3 percentage points above prime If discount rate rises, so do prime, business & consumer rates Approaches to Monetary Policy Expansionary monetary policy—plan to increase the money supply Contractionary monetary policy—plan to reduce the money supply Approaches to Monetary Policy Expansionary Policy In recession, Fed increases money supply to increase aggregate demand Fed can buy bonds on open market, decrease RRR or discount rate most common practice is to buy bonds to make interest rates fall Approaches to Monetary Policy Contractionary Policy Fed decreases money supply to check aggregate demand, inflation Fed can sell bonds on open market, increase RRR or discount rate most common action is to sell bonds to raise interest rates Impacts and Limitation of Monetary Policy Short-Term Effects The short-term effect is a change in the price of credit Open market operations influence FFR fairly quickly change loanable reserves banks have Easy-money policy lowers interest rates; tight-money raises them Impacts and Limitation of Monetary Policy Other Issues Monetary policy more effective if coordinated with fiscal policy Goals of Fed may clash with those of Congress or President governors serve 14 years; have less political pressure than politicians
