The Federal Reserve
and Interest Rates
GDP Review
 What is GDP how is it calculated?
 National consumption = National Income
 GDP = C (consumption)+I (investment) +G (government)
+NX (Net Exports)
 What is Keynesian Fiscal Policy during a recession?
 Spend more government $$$ or cut taxes to attempt to
keep GDP constant
Objectives
 describe the relationship between bank reserves,
interest rates, and the economic goals of maximum
employment and price stability
 describe the key components of the Federal Reserve’s
dual mandate
 identify the ways in which monetary policy tools can be
used to achieve economic objectives
 Who has a savings or checking account?
 What do banks do with your deposits?
 Why do you put money in these accounts?
 Why do banks exist? How do they make money?
Banks
 make loans to earn profits.
 pay depositors interest for their deposits
 lend to borrowers at a higher interest rate then they
pay on deposits trying to earning profit.
Image from NYT
Banks Functions and
Regulations
• Deposit- money placed in a bank account
• Bank reserves – The sum of cash that banks hold in their vaults
in Cash
• Required reserves – The percentage of deposits that FDIC
insured banks must hold in cash reserve
• Excess reserves – A banks actual reserve minus required
reserves
• This is what banks can loan out to other people
Excess Reserve Example
 Wells Fargo has 100 customers with 10 dollars each.
 What is the total value of the deposits?
 $1000
 Wells Fargo has $500 dollars in their bank account in Cash.
 What is the value of their bank reserves?
 $500
 Wells Fargo has a required reserve rate of 10%
 What are their required reserves?
 $100
 What is the value of Wells Fargo’s excess reserves
 Total reserves- Required Reserves = excess reserves
 $500- $100= $400
What would happen if a bank wanted to make a loan but did
not have enough excess reserves to do so?
Federal
Funds Market
 Banks might want to make a loan they think will be
profitable.
 If they do not have enough excess reserves to make
the loan
 they can choose to borrow excess reserves from another
bank in the federal funds market.
 Federal funds market – The market in which banks
can borrow or lend reserves from other banks
 allowing banks temporarily short of their required
reserves to borrow from banks that have excess
reserves.
 Why would banks loan their money to another bank?
 Like any loan, in exchange for interest
 Federal funds rate – The interest rate at which a bank
lends funds that are immediately available to another
depository institution overnight.
The Federal Reserve System
 Banks can also borrow reserves from our central bank
Federal Reserve System
 also called the Federal Reserve or simply the Fed
 The Fed is known as the “lender of last resort” because
banks can borrow from the Fed when other funding
sources might not be available.
The Federal Reserve System
 The discount rate is the interest rate charged by the
Federal Reserve to banks for loans.
 The federal funds rate is usually lower than the
discount rate, so it is in banks’ financial interests to
borrow from other banks instead of the Fed.
 By changing the discount rate, the Fed can influence
other interest rates—for this reason, the discount rate is
regarded as a “tool” the Fed to influence the economy.
 Monetary policy- consists of the actions of a central
bank to influence the cost and availability of money and
credit to achieve the national economic goals.
 This is different than Fiscal policy
 the responsibility of Congress and the White House,
 enacted through changes in government spending and
taxes.
 If the demand for apples were to stay the same, but the
number of apples that growers had available doubled,
what would happen to the price of apples?
 The price would decrease
 If the demand for apples were to stay the same, but the
supply of apples were reduced by half, what would
happen to the price of apples?
 The price would increase
Interest Rates
 Interest rates (like other prices) fluctuate. One factor
affecting the price of a good is its supply.
 Interest – The price of using someone else's money.
 Bank Reserves are the supply of money that can be
lent out
Interest Rates
 If the supply of reserves increases interest rates will
decrease.
 If the supply of reserves decreases interest rates will
increase.
 The Fed uses open market operations to influence the
supply of reserves, therefore interest rate.
 Open market operations - the buying and selling of
government bonds by the Federal Reserve in order to
influence the supply of reserves in the banking system.
 Open market operations are an important monetary policy
tool.
The Fed’s Dual Mandate
 The Fed’s responsibility is to use monetary policy to
promote maximum employment and price stability.
 Price stability – A low and stable rate of inflation
maintained over an extended period of time.
 The Fed has a longer-run goal of 2 percent inflation.
 Maximum employment – The Fed does not have a
specific unemployment target
 regularly publishes its forecast for the longer-run rate of
unemployment.
Questions
 What would happened to the level of reserves in the
banking system if the Fed purchases government
bonds from banks?
 What likely happens to interest rates when more
excess reserves are available for loans in the banking
system?
 How will consumers and businesses likely respond?
 How will producers respond?
The Fed’s Toolbox
Slide 6: Expansionary Policy
Money
Primary
Federal
Dealers
Reserve Fed Buys Bonds
Investors
Banks
Bank
Reserves
Increase
Bonds
Expansionary monetary policy – Actions
taken by the Federal Reserve to increase the
growth of the money supply and the amount of
credit available.
Interest
Rates
Decrease
Borrowing
Increases
Questions
 What would happened to the level of reserves in the
banking system if the Fed sells government Bonds?
 What likely happens to interest rates when more
excess reserves are available for loans in the banking
system?
 How will consumers and businesses likely respond?
 How will producers respond?
The Fed’s Toolbox
Slide 7: Contractionary Policy
Bonds
Primary
Federal
Fed Sells Bonds Dealers
Reserve
Investors
Banks
Bank
Reserves
Decrease
Money
Contractionary monetary policy – Actions
taken by the Federal Reserve to decrease the
growth of the money supply and the amount of
credit available.
Interest
Rates
Increase
Borrowing
Decreases
Monetary Policy
 The Federal Reserve as 4 major Monetary Policy tools at its disposal
• Discount rate – The interest rate charged by the Federal
Reserve to banks for loans obtained through the Fed's discount
window.
• Open market operations – The buying and selling of
government securities through primary dealers by the Federal
Reserve in order to control the money supply.
• Reserve requirements – Funds that banks must hold in cash,
either in their vaults or on deposit at a Federal Reserve Bank.
(last changed in 1992)
• Interest on reserves – Interest paid by Federal Reserve Banks
on required and excess reserves held by banks at Federal
Reserve Banks.
Headline: Unemployment Soars While
Deflation Fears Grow
 What should the Fed do?
Headline: Prices Rising:
Inflation Worries Grow
 What should the Fed do?
NPR on Monetary vs Fiscal
 Keynes Versus Hayek Round 2
 Video Review on Monetary Versus Fiscal