Chapter 16
The Federal Reserve
and
Monetary Policy
Chapter 16
Economics
Mr. Moreno
The Federal Reserve and
Monetary Policy
 What the Fed Does
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.
Chapter 16
Section 1 - The Federal Reserve System
Creating the Fed
Chapter 16
 Government 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 government;
established 1913
Duties of a Central Bank
Chapter 16
 Most countries have a central bank- oversees banking system
 Holding Reserves: reserves set aside for loans from the banks
funds
 Assuring Stability: in national banking and monetary system
 Control the way money is circulated
 Supervise banks
 Lending Money: Unlike other banks The Central
Bank lends without the purpose of making money.
To serve private banks rather than individuals.
The Duties of the Fed
Chapter 16
 Fed uses regulation, oversight to protect bank
customers, borrowers
 Banking services for private banks and
government include
 holding deposits, transferring funds, making loans
 Helps finance wars, stabilize economy in national
emergencies
 Regulates money supply; distributes currency—
coins and paper money
The Structure of the Fed
Chapter 16
 Fed not a single national bank; has national and
regional structure
 has some independence from political influence;
accountable to Congress
The Structure of the Fed
Chapter 16
 Board of Governors—sets policy; supervises operations of
the Fed
 chairman is most influential member and spokesperson
 Ben Bernanke
 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
The Structure of the Fed
Chapter 16
 Federal Open Market Committee—supervises government
security sales
 Federal Advisory Council—represents commercial banking
industry
 Consumer Advisory Council—advises on consumer
protection laws on borrowing
 Thrift Institutions Advisory Council—needs of savings
institutions
 thrifts not regulated by Fed; must meet reserve
requirements; may borrow
Questions
 What are the three duties of a central bank?
 How is the Fed different from other central
banks?
 What are the five elements of the Fed?
Chapter 16 Section 2
Functions of the Federal Reserve
Functions of the Federal Reserve
 Lending Money
 Banks often lend to each other on short-term basis
 In natural disaster, all banks in region lack cash
flow
 Fed lends to banks with enough assets and capital to
qualify
 Small banks with seasonal cash flow needs may
borrow from Fed
 Fed serves as lender of last resort to prevent
banking crisis
Functions of the Federal Reserve
 Regulating and Supervising Banks
 Fed banks supervise state-chartered members,
bank holding companies
 bank holding company owns, has controlling
interest in several banks
 Fed banks enforce truth-in-lending laws
 Conduct bank exams—audit financial practices
of banks in district
 Monitor bank mergers to ensure competition
Serving the Federal Government
 KEY CONCEPTS
 Fed serves as federal government’s banker
 helps carry out taxation and spending activities
Serving the Federal Government
3 Services of the Fed
 Service 1: Paying Government Bills
 Tax revenues are deposited with the Fed
 Fed issues checks, makes electronic payments
via U.S. Treasury
 for transfer payments, employee wages, direct
spending, tax refunds
 deducts amounts from government’s account
 Processes postal money orders, food stamps
Serving the Federal Government
 Service 2: Selling Government Securities
 Fed processes U.S. savings bonds, auctions
other securities
 provides information, collects payment, credits
funds, delivers bonds
 Pays interest on bonds
 Federal Open Market Committee (FOMC)
supervises sales of securities
 purpose is to stabilize the economy
Serving the Federal Government
 Service 3: Distributing Currency
 Federal Reserve notes are official paper currency
of U.S.: fiat money
 Treasury Department prints notes that go to Fed
district banks
 Fed banks distribute notes to depository
institutions in amounts needed
 currency then goes to people and businesses
 Fed also distributes coins produced by U.S. Mint
Creating Money
 Creating money—how money enters circulation
through deposits, loans
 Fed establishes required reserve ratio (RRR) for banks

fraction of bank’s deposits that it must keep in reserve
 Reserve may be stored as cash in bank’s vault or
deposited with Fed
Creating Money
 Example: Money Creation
 Banking system creates money whenever banks
get deposit and make loan
 Level of the RRR determines how much money
may be loaned
 Money supply increases by total loans made
after initial cash deposit
 deposit multiplier formula tells how much money
supply will increase
Questions
 Why might the Fed help a small bank in an agricultural
region stabilize its cash flow?
 How are the banking services the fed provides to the
government similar to the services it provides to banks?
 If the Fed raised the RRR from 10% to 12%, how would it
affect the money supply?
 You have been planning your college finances and you know
that you’ll have to take a bank loan to cover tuition costs.You
read that the Fed intends to raise the RRR rate from 10% to
20%. How will this change affect the money supply and your
ability to borrow money for college tuition?
Chapter 16 Section 3
The Fed’s Monetary Tools
Approaches to Monetary Policy
 Policy 1: Expansionary Policy
 Expansionary monetary policy also called easy-
money 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
 Policy 2: Contractionary Policy
 Tight-money policy is another name for
contractionary monetary 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
Alan Greenspan: Fighting Inflation
 Managing Monetary
Policy
 Greenspan served as
chair of Fed’s Board of
Governors over 18
years
 his insight and
persuasiveness made
him extremely
influential
Alan Greenspan: Fighting Inflation
 Was very successful at
growing economy
without inflation
 great knowledge of
tools of monetary
policy and economic
indicators
 sense of timing: knew
just when to expand or
contract money supply
Impacts and Limitation of Monetary
Policy
 Purposes of monetary policy—curb inflation
and halt recessions
 Changes in monetary policy have both shortterm and long-term effects
Impacts and Limitation of Monetary
Policy
 Impact 1: 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
 Impact 2: Policy Lags
 Delays in getting information to identify
problems delays Fed action
 Policy adjustments may take a long time to take
effect in the economy
 example: businesses may delay expansion until
interest rates drop
Impacts and Limitation of Monetary
Policy
 Impact 3: Timing Issues
 Monetary policy must be coordinated with
business cycle for stability
 bad timing may exaggerate a phase of the business cycle
 Monetarism holds that rapid changes in money
supply cause instability
 Milton Friedman found inflation goes with rapid growth
in money supply
 little or no inflation when money supply growth slow
and steady
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
Questions
 Which open market operation causes the money supply to
expand? Why?
 Compare and contrast expansionary fiscal policy and
expansionary monetary policy on the chart below.
 What will happen to interest rates when the Fed sells bonds
in open market operations? Why?
 What are the Fed’s underlying assumptions about the state of
the economy, based on these Fed actions?
 The Fed’s open market operations caused the FFR to drop from
6.25% to 1%.
 The FFR rose from 1% to 4.2%
Section 4: Monetary Policy
Monetary Policy & Macroeconomic
Stabilization
Applying Monetary and Fiscal Policy
 Fiscal and monetary policies impact each other
 Both have limitations: policy lags, political constraints,
timing issues
 timing also affected by people’s actions based on
rational expectations
 Opponents of discretionary policy favor a stable
monetary policy
 thus people, businesses will not make decisions ahead
of policies
Policies to Expand the Economy
 Example: Expansionary Monetary and Fiscal Policy
 Expansionary policy meant to reduce
unemployment, increase investment
 Expansionary fiscal policy raises interest rates;
monetary lowers them
 actual change in rates depends on relative strength of
the two policies
 amount of investment spending depends on rates
Policies to Control Inflation
 Goal of contractionary monetary policy is to
stabilize economy
 decrease inflation and increase interest rates
Policies to Control Inflation
 Example: Contractionary Monetary and Fiscal
Policy
 Contractionary policies decrease aggregate
demand, control inflation
 Fiscal policy lowers interest rates; monetary
policy raises them
 actual change in rates depends on relative strength of
the two policies
 amount of investment spending depends on rates
Policies to Control Inflation
 Example: Wage and Price Controls
 Government may establish non-mandatory wage and
price guidelines
 Wage and price controls—limits on increases in wages
and prices
 mandatory and enforced by government
 WWII: President Roosevelt used to control inflation due to
shortages
 1970s: President Nixon used to try to combat stagflation
Policies in Conflict
 Coordinated policies usually produce desired
effect on economy
 If uncoordinated, one policy can counter effects
of the other
 creates economic instability
Policies in Conflict
 Example: Conflicting Monetary and Fiscal Policies
 Example: CPI is 6% and rising; unemployment is
7%
 Fed tries to fix inflation by selling bonds, raising
discount rate
 government tries to lower unemployment by cutting
taxes, more spending
 Only clear result of conflicting policies is higher
interest rates
Interpreting Signals from the Fed
 Background
 Economists and financial observers scrutinize everything the Fed
chairman says in an attempt to predict how his statements will affect
the economy. A hint that the Fed might change interest rates can lead
to a great deal of activity in the stock market.
 What’s the Issue
 How much does the market rely on signals from the Fed to make
economic decisions?
 Thinking Economically
 How do articles A and C illustrate the rational expectations theory?
 Based on these three sources and your own knowledge, how would
you describe the differences and similarities between Greenspan and
Bernanke and their impact on the market?
Questions
 What effects would government borrowing to finance
increased spending have on interest rates and why?
 Why do tax cuts and increased government spending result
in a rise in interest rates?
 What are the results of each of the following?
 Expansionary Policies  Contractionary Policies  Conflicting Policies -