The Federal Reserve
and Monetary Policy
Chapter 16
The Federal Reserve
System
Chapter 16, Section 1
Federal Reserve Act of 1913
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Created the Federal Reserve (FED)
System of federal banks
12 districts
Overseen by the Board of Governors
7 governors
 14 year terms appointed by the President
 Appoints a chair confirmed by the Senate
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Chairs serve a four year term that can be renewed
FED Districts
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12 districts
District bank reports on economic activity in the district to the
central bank
Member banks... All nationally chartered banks are required to
join the Fed. Member banks contribute funds to join the system,
and receive stock in and dividends from the system in return.
This ownership of the system by banks, not government, gives
the Fed a high degree of political independence.
The FOMC (Federal Open Market Committee), which
consists of The Board of Governors and 5 of the 12 district bank
presidents, makes key decisions about interest rates and the
growth of the United States money supply.
4,000 member banks and
25,000 other depository
institutions
Board of Governors
Federal Open Market Committee
12 District Reserve
Banks
Structure of the Federal Reserve System
Federal Reserve
Functions
Chapter 16, Section 2
Functions of the FED
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Banking and fiscal services to the government
Banking and fiscal services to member and
nonmember banks
Regulates the banking industry
Tracks and manages the money supply
Serving the Government
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Acts as the Government’s bank
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Maintains a checking account for the treasury
Sells securities
Issues currency
Coins are created at the US Mint
 Currency is created by the Bureau of Engraving and
Printing
 The FED issues the currency
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Serving Banks
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Check clearing
Loans to member banks
Stock to member banks
Supervise lending practices
Lender of last resort
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Banks loan money to each other and charge interest known
as the Federal Funds Rate
The FED can lend funds to banks in times of need and
charge interest
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This is called the discount rate
Regulating the Banking System
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The FED requires banks to report on their
reserves
Examine banks to ensure they are following
regulations
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Examiners look at the banks Net Worth to
determine if they are in trouble
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Net Worth represents total assets minus total liabilities
Regulating the Money Supply
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FED is best known for regulating the money
supply
Factors that affect demand for money
Cash needed on hand
 Interest rates
 Price levels in the economy
 General level of income
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The laws of supply and demand work the same
with the money supply
Monetary Policy Tools
Chapter 16, Section 3
Monetary Policy
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Monetary policy refers to the action the FED
takes to influence economic performance
The FED can use monetary policy in a number
of ways
Money creation...not making it but putting it into
circulation
 Changing reserve requirements
 Changing the discount (interest) rates
 Purchasing bonds
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Money Creation
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Banks keep a certain amount of funds on hand
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The required reserve ratio (RRR) is the amount that must be
kept by banks...this is established by the FED
After the RRR is kept, banks can loan money. This process,
along with gained interest creates money...or adds it to the
money supply
The money multiplier formula tells us how much money will
be created through this process
However, banks may keep excess reserves on hand
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More money than is required by the RRR
Reserve Requirements
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The FED can influence the economy by
changing the RRR
Raising the RRR will reduce the money in
circulation
Lowering it will increase the money in
circulation
FED does not do this today as it can be very
disruptive to the loan process
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Loans may have to be recalled
The Discount Rate
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Banks borrow from the FED and the interest charged
is known as the discount rate.
In turn, these banks loan to customers (you and me)
and the interest rate charged is known as the prime
rate.
By changing the discount rate, the prime rate changes
and affects our spending behaviors
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Raising the discount rate will slow borrowing, spending and
the economy
Lowering the discount rate will increase borrowing, spending,
and increase the economy
2nd most used form of Monetary Policy
Open Market Operations
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The most used monetary tool is open market
operations
The FED can purchase bonds to put money
into circulation
They sell government bonds to take money out
of circulation
Review
1. The required reserve ratio is
(a) the ratio of deposits to reserves required of banks by the Federal Reserve.
(b) the ratio of accounts to customers required of banks by the Federal Reserve .
(c) the ratio of reserves to deposits required of banks by the Federal Reserve.
(d) the ratio of paper currency to coins required of banks by the Federal Reserve.
2. All of the following will increase the money supply except
(a) increasing the required reserve ratio.
(b) bond purchases by the Fed.
(c) reducing the required reserve ratio.
(d) reducing the discount rate.
Monetary Policy and
Macroeconomic
Stabilization
Chapter 16, Section 4
Using Monetary Policy
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Monetarism...the belief that the money supply is
the most important factor in macroeconomic
performance
Money supply and interest rates
In basic terms, the interest rate is the cost of money
 Works under the principles of supply and demand
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When money supply is high, interest rates are low
 When money supply is low, interest rates are high
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Easy Money vs. Tight Money Policy
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When money is in low supply, the FED may
follow an easy money policy...or follow policy
that will increase the money supply
When money is in high supply, the FED will try
to lower the money supply or use tight money
policy
Timing of Monetary Policy
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Policies of Monetary Policy need to be carefully enacted
to have the desired effect...if they are not time
accordingly, they may have a negative effect on the
business cycle
Like with Fiscal Policy, Monetary Policy takes time to
put in place and take effect...lags
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Inside lag... Delay in implementing monetary policy
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The government takes time to recognize the problem and create a
solution
Outside lag...the time it takes for the policy to have an effect
Predictions of the business cycle is key in this process
Fiscal and Monetary Policy Tools
Fiscal and Monetary Policy Tools
Fiscal policy tools
Expansionary Tools
Contractionary Tools
1.
Increase government
spending
2.
Cutting taxes
1.
Decrease government
spending
2.
Raising taxes
Monetary policy tools
1.
Open market operations:
bond purchases
2.
Decreasing the discount
rate
3.
Decreasing reserve
requirements
1.
Open market sales: bond
sales
2.
Increasing the discount
rate
3.
Increasing reserve
requirements
Remember
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Fiscal Policy is how the government uses its
taxing and spending to influence the economy
Monetary Policy is how the FED uses its control
of the money supply to influence the economy
Review
1. Monetarism is
(a) the time it takes to enact monetary policy.
(b) the belief that the money supply means little to macroeconomic
performance.
(c) the time it takes for monetary policy to take affect.
(d) the belief that the money supply is the most important factor in
macroeconomic performance.
2. Tight money policies aim to
(a) increase the money supply and expand the economy.
(b) decrease the money supply and expand the economy.
(c) decrease the money supply and slow the economy.
(d) increase the money supply and slow the economy.