CHAPTER 15
The Fed and Monetary Policy
Section 1: The Federal Reserve System
• Main Idea: The Federal Reserve works to
strengthen and stabilize the nation’s monetary
system.
• Objectives:
• Describe the structure of the Federal Reserve System.
• Explain the major regulatory responsibilities of the Fed.
Section 1 Introduction
• On December 23, 1913, Congress created the
Federal Reserve System, or “Fed,” as the central
bank of the United States.
• Today, the Fed provides financial services to the
government, regulates financial institutions,
maintains the payments system, enforces
consumer protection laws, and conducts
monetary policy.
• Because everyone uses money, and because
interest rates affect the overall level of economic
activity, the Fed’s activities affect us all.
Structure of the Fed
• The Federal Reserve System is owned by its
member banks
• The Board of Governors establishes policies
for the Federal Reserve and member banks to
follow, regulates certain operations, and
controls the money supply.
• The 12 Federal Reserve district banks and 25
branch banks are located near the commercial
banks they serve.
Structure of the Fed (cont.)
• The Federal Open Market Committee (FOMC)
makes decisions about the growth of the
money supply.
• The Federal Advisory Council, the Consumer
Advisory Council, and the Thrift Institutions
Advisory Council advise the Board of
Governors.
Structure of the Fed (cont.)
Figure 15.1
Regulatory Responsibilities
• The Fed monitors member banks’ reserves.
• The Fed oversees bank holding companies.
• The Fed oversees foreign banks operating in
the United States as well as the international
operations of U.S. member banks and holding
companies operating abroad.
• The Fed approves bank mergers.
Other Federal Reserve Services
• The Federal Reserve is responsible for check clearing.
• The Federal Reserve is responsible for extending truthin-lending disclosures to millions of individuals who
purchase or borrow from corporations, retail stores,
automobile dealers, and lending institutions.
• The Federal Reserve is responsible for issuing paper
currency.
• The Federal Reserve is responsible for providing
financial services to the federal government.
•
Other Federal Reserve Services (cont.)
Figure 15.2
Section 2: Monetary Policy
• Main Idea: Federal Reserve actions intended
to stabilize the economy make up what is
called monetary policy.
• Objectives:
• Describe the use of fractional reserves.
• Understand the tools used to conduct monetary policy.
Section 2 Introduction
• One of the Federal Reserve System’s most important
responsibilities is that of monetary policy.
• Monetary policy is the expansion or contraction of the
money supply in order to influence the cost and
availability of credit.
• The Fed does not hesitate to change interest rates
whenever the economy’s health is threatened.
• Monetary policy is a structured process. In order to
understand it better, it helps to understand the
fractional reserve system that our banking system is
based on.
Fractional Bank Reserves
• The Federal Reserve requires that member banks
keep a certain percentage of their deposits in the
form of legal reserves.
• A bank’s balance sheet shows its assets,
liabilities, and net worth. Balance sheets are
sometimes referred to as T-accounts, because the
accounts form a T when written.
• Every time a bank customer makes a deposit, the
bank must set aside a portion of the deposit as
reserves.
Fractional Bank Reserves (cont.)
• Banks earn money by lending out that portion
of their deposits that need not be held as
reserves.
• To earn its profits, a bank usually needs to
charge 2-3 percent more for its loans than the
rate of interest it pays for its saving accounts
and time deposits, interest bearing deposits
that cannot be withdrawn by check.
Fractional Bank Reserves (cont.)
Figure 15.3a
Figure 15.3b
Figure 15.3c
Fractional Reserves and Monetary
Expansion
• A system of fractional reserve banking allows
banks to make a large volume of loans.
• A change in the money supply is equal to the
change in reserves divided by the reserve
requirement.
Figure
15.4
Tools of Monetary Policy
• The Fed can affect the money supply by changing the
reserve requirement.
• The Fed can affect the money supply by buying and
selling government securities (open market
operations).
• The Fed can affect the money supply by changing the
discount rate, the interest rate the Fed charges on
loans to financial institutions.
• The Fed can affect the money supply by changing
margin requirements.
• The Fed can affect the money through moral suasion
and selective credit controls.
Tools of Monetary Policy (cont.)
Figure 15.6
Section 3: Monetary Policy, Banking,
and the Economy
• Main Idea: Changes in the money supply
affect the interest rate, the availability of
credit, and the price level.
• Objectives:
• Explain how monetary policy affects interest rates in
the short run.
• Relate monetary expansion to inflation in the long run.
• Identify the two major definitions of money.
• Describe how interest rates are affected by political
pressure.
Section 3 Introduction
• The impact of monetary policy on the economy is
complex.
• In the short run, monetary policy affects interest
rates and the availability of credit. In the long run,
it affects inflation and economic growth, which is
one of the Fed’s major concerns.
• In addition, no one can be sure how long it will
take for the effects of monetary policy to impact
the economy.
Short-Run Impact
• Changes in the money supply affect interest
rates.
• Sometimes the Fed’s long-term objectives
force it to keep interest rates above or below
the desired level in the short run.
Short-Run Impact (cont.)
Figure 15.7a
Short-Run Impact (cont.)
Figure 15.7b
Long-Run Impact
• Changes in the money supply affect the
general level of prices.
• Monetizing the government’s debt means
creating enough extra money to offset deficit
spending in order to prevent interest rates
Figure 15.8
from changing.
Long-Run Impact
• In 1980 the Fed decided to control inflation by
restricting the growth of the money supply.
• The real rate of inflation is the market rate of
interest minus the rate of inflation.
Other Monetary Policy Issues
• A tight monetary policy can hurt some
industries, like homebuilding and
automobiles, more than other industries.
• High interest rates encourage people to forgo
consumption today and increase their savings;
low interest rates encourage people to borrow
money today, which will reduce their ability to
consume in the future.
Other Monetary Policy Issues (cont.)
• M1 includes traveler’s checks, coins, currency,
demand deposits, and other checkable accounts; M2
includes M1 plus small denomination time deposits,
savings deposits, and money market funds.
Figure 15.9
The Politics of Interest Rates
• The Fed is an independent monetary
authority, but it comes under political
pressure to raise or lower interest rates.
• The president and Congress can affect the
Board of Governors by appointing new
members when governors’ terms expire.