The Fed and Monetary Policy

The Federal Reserve was created in 1913 by Congress: main
function is to control the money supply.
A. The Fed is owned by member banks
B. The Board of Governors establishes policies for the Federal
Reserve and member banks to follow
- 7 Members appointed by president for 14 years
- Chairman of the Board – leader of the Fed
C. 12 Federal Reserve district banks & 25 branch banks
D. Federal Open Market Committee (FOMC) – establishes
monetary policy
- 7 Board Members + 5 District Bank Presidents (4 rotate
through, New York President is permanent)
E. The Federal Advisory Council, the Consumer Advisory
Council, and the Thrift Institutions Advisory Council advise
the Board of Governors
II. Regulatory Responsibilities: the Fed is politically independent
Goal is to regulate and stabilize
the nation’s $$ supply
A. Monitors member banks’ reserves
B. Oversees bank holding companies
C. Oversees foreign banks operating in the US and
international operations of US member banks and
holding companies operating abroad
D. Approves bank mergers
III. Other Federal Reserve Services
A. Check clearing
B. Truth-in-lending disclosures
C. Issues paper currency
D. Provides financial services to the federal government
I. Fractional Bank Reserves
A. The Federal Reserve requires that member banks keep a
certain percentage of their deposits in the form of legal
B. A bank’s balance sheet shows its assets, liabilities, and
net worth
C. Every time a bank customer makes a deposit, the bank
must set aside a portion of the deposit as reserves
D. Banks earn money by lending out that portion of their
deposits that need not be held as reserves
E. To earn its profits, a bank usually needs to charge 2-3 percent
more for its loans than the rate of interest it pays for its saving
accounts and time deposits
II. Three Major Tools of Monetary Policy: Goal is to strike a
balance between tight and loose money to control inflation
and keep purchasing power stable
A. Reserve Requirement
1. Total Reserves ÷ Reserve Requirement = Money Supply:
example $100 ÷ .20 = $500
2. A system of fractional reserve banking allows banks to
make a large volume of loans
3. A change in the money supply is equal to the change in
reserves divided by the reserve requirement
(∆ Money Supply = ∆ Reserves ÷ Reserve Requirement)
B. The Discount Rate = rate of interest banks must pay to the
Fed for loans
1. The higher the rate, the less $ banks may borrow from
the Fed, leading to “Tighter $” in circulation
2. Higher discount rates = higher
Prime Rates (rates charged
to business customers of banks),
which discourages borrowing
and decreases growth of the $$
3. The opposite is true when the discount rate is low.
C. Open Market Operations = The main instrument by which the
Fed affects monetary policy
1. Buying and selling of government securities in financial
markets (not government controlled)
2. Influences short-term interest rates
3. When the Fed buys securities on the Open Market, $$
supply increases
4. When the Fed sells securities on the Open Market, $ supply
III. Minor tools of the Federal Reserve
A. The Fed can affect the money supply by changing margin
* Margin requirements rarely used by the Fed today
B. Moral suasion
C. Selective credit controls
IV. Tight $$
Loose $$
Tight Money = Credit is expensive and in short supply
Borrowing difficult
Consumers buy less
Expansion delayed
Unemployment increases THEN recession begins
Loose Money = Credit inexpensive and abundant
Easy Money
Spending increases
Businesses expand
Jobs created
prices increase THEN
purchasing power declines and INFLATION occurs
V. Measuring the Money Supply
A. Money supply is all the money available in the United States
2. M2 = broader definition of the money
supply and = all the M1 assets PLUS any
assets that can be converted to cash fairly
(market mutual fund balances, and savings deposits) also
called near moneys (near moneys are assets that are
almost, but not exactly like money and have high
What is Monetary Policy??
The expansion or contraction of the $$ supply
in order to influence the cost and the
availability of credit.
It is a structured process.
What are the three major
tools of Monetary Policy???
Reserve Requirement
The Discount Rate
Open Market Operations