The Federal Reserve System
and Monetary Policy
Organization and Functions of
the Federal Reserve System
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The Fed is responsible for monetary policy.
Monetary policy: involves the changing rate of
growth of the supply of money in circulation in
order to affect the amount of credit, which affects
business activity in the economy.
The Board of Governors oversees 12 district
Federal Reserve banks and regulates activity of
member banks and all other depository
institutions.
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The Federal Advisory Council reports to the
board of governors on general business
conditions in the country.
The Federal Open Market Committee decides
what the Fed should do to control money
supply.
Twelve Federal Reserve banks are set up as
corporations owned by member banks.
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Member Banks—all national banks, those
chartered by the federal government, must join
the Federal Reserve System.
State chartered banks may join if they choose.
All institutions that accept deposits from
customers must keep reserves in their district
Federal Reserve bank.
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The fed has many functions, including check
clearing, supervising member banks, holding
reserves, and supplying paper currency.
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Clearing checks is the method by which money is
deposited from one bank to another.
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Supervising member banks means the Fed must
regulate federally chartered commercial banks.
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The Fed maintains the nation’s paper money.
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Its most important function is to regulate the
money supply.
The Fed determines the amount of money in
circulation.
 More money in circulation means lenders are more
likely to offer money for loans.
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The Fed sets standards for consumer
protection, mainly truth-in-lending legislation.
Money Supply and the
Economy
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Monetary policy involves changing the growth
rate of the money supply in order to change the
cost and availability of credit.
Loose money means credit is plentiful and
inexpensive.
Used to encourage economic growth.
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Tight money means credit is in short supply
and expensive.
Used to control inflation.
The goal of monetary policy is to strike a
balance between tight and loose money.
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Many banks are required to keep a percentage
of their total deposits in cash reserves in their
vaults or with the Federal Reserve bank.
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This enables the bank to provide funds for customers
who might suddenly want to withdraw large
amounts of cash from their accounts.
Currently most financial institutions are
required to reserve 10 percent of their
checkable deposits and none on their interestpaying deposits.
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Banks can use non-reserved deposits to create
new money.
Money banks lend and receive is usually spent
or deposited in another bank who can also use
the deposits to create new money.
This process is known as the multiple
expansion of money.
Regulating the Money
Supply
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The lower the percentage of deposits in
reserve, the more money available to loan out.
When the Fed raises its reserve requirements,
banks can call in loans, sell off investments, or
borrow from another bank (or the Federal
Reserve).
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Raising the reserve decreases the amount of
money in the economy and slows it down.
Because of the extreme effect on money supply,
the Fed has not been raising the reserve
recently.
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Discount Rate: interest rate that the Fed charges
on loans to member banks
Prime Rate: rate of interest that banks charge on
loans to their best business customers
A higher discount rate means that member
banks charge their customers higher interest,
reducing the money supply.
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Federal Funds Rate: interest rate that banks
charge each other on loans (usually overnight)
Used to help a bank to increase its reserves by
borrowing from another bank.
If the Fed decreases the federal fund rate,
banks will borrow more and, thus, lend more.
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This increases business activity.
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The buying and selling of government
securities is called open-market operations.
When the Fed buys securities, it makes a
deposit into the reserve account of the security
dealer’s bank, giving that bank more money to
lend out because its reserve account is higher
than necessary.
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When the Fed sells securities, the purchasing
bank buys them with money from its reserves,
leaving the purchasing bank with less reserve
funds.
This shows the multiple expansion of money
working in reverse because more money is
taken out of circulation than just the initial
withdrawal.
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It is difficult to gather and evaluate information
about the money supply.
Some critics of the Fed want to stop the Fed
from engaging in any monetary policy at all.
Taxing and spending by the government affect
the economy, and the Fed has to consider this
also in the changes they can make.