Chapter 15: The Fed and Monetary Policy
Chapter 15.1: The Federal Reserve System
Chapter 15.2: Monetary Policy
Chapter 15.3: Monetary Policy, Banking, and the Economy
Chapter 15.1: The Federal Reserve System
The Fed provides financial
services to the government,
regulates financial
institutions, maintains the
payments system, enforces
consumer protection laws,
and conducts monetary
policy.
Structure of the Fed:
The Fed is publicly owned by “member banks”:
commercial banks that hold stock in the
Fed.
Individual & state banks have the choice to
join. Nationally chartered banks have to
join.
The Fed is run by a seven-member board of
governors – these members are appointed
by the President, approved by the Senate,
and serve 14-year terms.
Their job is to supervise & regulate the Fed.
The Fed itself is made up of 12 district banks
spread throughout the U.S.
The Federal Open Market Committee makes
the decisions about the size of the money
supply and the level of interest rates. The
FOMC is the Fed’s primary monetary policymaking body.
Three Advisory Committees
1. Federal Advisory Council Advises the Govs on state of
State of economy.
2. Consumer Advisory Council –
oversees consumer credit laws.
3. Thrift Institutions Advisory Council
– advises Govs on institutions
that lend money (banks, savings
& loans, credit unions).
Regulatory Responsibilities of the Fed:
All depository institutions (commercial, savings,
credit, etc.) must answer to the Fed.
The Fed supervises/regulates foreign banks in the
U.S. (250 branches/agencies) and U.S. banks in
foreign countries.
The Fed clears checks, enforces consumer
legislation, maintains currency/coins, and
provides financial services to the government.
Clearing checks:
1. I write you a check and you deposit it in the bank.
2. The bank credits your account and send the check to the Fed.
3. The Fed sorts/processes your check, and sends the check and a
true credit to your bank.
4. You bank puts real money into your account.
5. Your bank sends the check back to my bank and real money is
taken out of my account.
6. Cleared checks are kept on file at my bank for future reference.
Chapter 15.2: Monetary Policy
The Fed defines money in one of two
ways:
“M1”: the transactional components
of money (“medium of exchange”)
– currency, coins, checks, etc.
“M2”: “store of value” components –
time deposits, saving deposits,
money market funds, etc.
Monetary Policy:
One of the Fed’s biggest
responsibilities is
“monetary policy”: the
expansion or contraction of
the money supply in order
to influence the cost and
availability of credit.
Vs.
The U.S. has a “fractional reserve
system”: requires banks to keep a
fraction of their deposits in the
form of legal reserves (cash/coin).
Under this system, banks have
“reserve requirements”: rule that
a % of each deposit must be set
aside as legal reserves.
Today’s reserve requirement is 12%.
Reserve Requirement Example:
$100 is deposited.
$12 must be reserved/kept.
$88 are considered excess reserves.
“Excess Reserves” can be used to make loans to others.
Money Policy (2 Types):
“Easy Money Policies”: Fed
increases money supply –
interest rates on loans fall –
economy increases.
“Tight Money Policies”: Fed
decreases money supply –
interest rates on loans rise –
economy decreases.
Tools of Monetary Policy:
The Fed can increase/decrease the
monetary supply using any of 4
methods:
1. Reserve Requirements
2. Open Market Operations
3. Discount Rates
4. Margin Requirements
1. Reserve Requirement
Remember, the reserve requirement is the % of each
deposit that must be kept by a bank (can’t be
loaned out).
A decrease in the reserve requirement increases the
overall money supply (banks can lend more).
An increase in the reserve requirement decreases the
overall money supply (banks can’t lend as much)
2. Open Market Operations:
The Fed can buy securities (stocks/ bonds) from the
government.
If the Fed buys securities, more money enters the
economy and the overall money supply increases.
If the Fed sells securities, money leaves the economy (it
comes to the Fed) and the overall money supply
decreases.
3. Discount Rate:
The Fed makes loans to common banks – the discount
rate is the amount of interest they charge.
If the Fed decreases the discount rate (interest rates),
more banks will take out loans and the overall money
supply will increase.
If the Fed increases the discount rate (interest rates),
less banks will take out loans and the overall money
supply will decrease.
4. Margin Requirements:
The Fed sets the “margin requirement”: the amount of
money that an investor must deposit to buy stock
(today it’s 50%).
If margin requirement are decreased, more stock can be
purchased, and the overall money supply increases.
If the margin requirement is increased, less stock can be
purchased, and the overall money supple decreases.
Chapter 15.3: Monetary Policy, Banking, and the Economy
Monetary policy has a huge
effect on the economy – it
has long-run effects and
short-run effects.
Short-Run Impact:
Monetary policy affects the
interest rate (cost of credit).
An increase in money supply
causes interest rates to go
down (cheaper to borrow
money).
A decrease in money supply
causes interest rates to go up
(more expensive to borrow
money).
Long-Run Impact:
Monetary policy affects inflation.
An increase in the money supply
causes inflation (prices).
A decrease in the money supply
stabilizes inflation (prices).