The Federal Reserve System“the Fed”

Reference Chapter 11

12 Federal Reserve DistrictsCommercial banks’ banker

Board of Governors

Board of Governors

• 7 members– appointed by president– approved by Senate– 14 yr. term– chairman

• Ben Bernanke• formerly

– Alan Greenspan

6 Major Jobs of the Fed

• Supply the economy with paper money Supply the economy with paper money and coins.and coins.

• Hold bank reserves.Hold bank reserves.• Provide check-clearing servicesProvide check-clearing services• Supervise member banksSupervise member banks• Serve as lender of last resort.Serve as lender of last resort.• Control the money supplyControl the money supply

1.Supply the economy with paper money and coins.

““U.S. Mint”U.S. Mint”Bureau of Engraving and PrintingBureau of Engraving and Printing

2. Hold bank reserves

reserves at the Fed + vault cash =total reserves

3.Provide check-clearing services

• Facilitates check-cashing between commercial banks.– for example, Wells-Fargo and Bank of America

Between banks, cities

• EXAMPLE:EXAMPLE:• Pete pays Sue for a used car. He gives her a Pete pays Sue for a used car. He gives her a

check for $2,000. check for $2,000. • Sue deposits the check in her bank and is Sue deposits the check in her bank and is

credited with $2,000 in her account.credited with $2,000 in her account.• Sue’s bank sends the check to FRB who Sue’s bank sends the check to FRB who

increases the bank’s reserve account by $2,000.increases the bank’s reserve account by $2,000.• FRB decreases Pete’s bank’s reserve by FRB decreases Pete’s bank’s reserve by

$2,000$2,000• FRB notifies Pete’s bank to reduce Pete’s FRB notifies Pete’s bank to reduce Pete’s

account by $2,000. account by $2,000.

4. Supervise member banks5. Serve as lender of last resort

• Fed may “audit” a bank– check that the loans it made are good– be sure it has followed banking rules– verify the accuracy of its accounting.

• Fed can lend funds to struggling banks.– Glass-Steagall Act (1933) establishes FDIC

6. Control the money supply.I kept the most important for last!

• Tools for changing the money supply– Reserve Requirement– Discount Rate– Open Market Operations

Why is changing the money supply important?TO CONTROL INFLATION and/or UNEMPLOYMENT

Monetary PolicyMonetary Policy

Prepare Section Review Answers

11.1 page 292

1. Federal Open Market committee: major decision maker in the FRB.

2. Federal Reserve System : US Central Bank

3. Board of Governor’s : controls and coordinates fed activities (7 members)

4. Reserve account: funds required to be held in the FRB

Review

Describe the structure of the Federal Reserve System.

7 member Board of Governors7 member Board of Governors appointed by president, ratified by Senateappointed by president, ratified by Senate 14 year term, chairman14 year term, chairman12 districts12 districts

In what year was it founded?In what year was it founded?

19131913

Review

1. 6 major jobs?• Supply the economy with paper money Supply the economy with paper money

and coins.and coins.• Hold bank reserves.Hold bank reserves.• Provide check-clearing servicesProvide check-clearing services• Supervise member banksSupervise member banks• Serve as lender of last resort.Serve as lender of last resort.• Control the money supplyControl the money supply

Review

• Why would a bank choose to join the Federal Reserve System?

• FRB helps maintain bank stabilityFRB helps maintain bank stability

• Consumers want their accounts to be Consumers want their accounts to be covered by FDICcovered by FDIC

Review

• Describe the check-clearing process.

• Pete pays Sue for a used car. He gives her a check for Pete pays Sue for a used car. He gives her a check for $2,000. $2,000.

• Sue deposits the check in her bank and is credited with Sue deposits the check in her bank and is credited with $2,000 in her account.$2,000 in her account.

• Sue’s bank sends the check to FRB who increases the Sue’s bank sends the check to FRB who increases the bank’s reserve account by $2,000.bank’s reserve account by $2,000.

• FRB decreases Pete’s bank’s reserve by $2,000FRB decreases Pete’s bank’s reserve by $2,000• FRB notifies Pete’s bank to reduce Pete’s account by FRB notifies Pete’s bank to reduce Pete’s account by

$2,000. $2,000.

The Money Creation Process

Reference 10.2

Think of our banking simulation for fractional reserve banking

The Money Creation Process

• Read 10.2 p. 293

• Complete Section Review p. 300 #1-5

11.3

“Fed” Tools for Changing the Money Supply

These tools are used to implement

MONETARY MONETARY

POLICYPOLICYMonetary policy has two basic goals:

to promote "maximum" sustainable output and employment to promote "stable" prices

Why would the Fed want to change the money supply?

• Slow INFLATION INFLATION • (too much money chasing too few goods)(too much money chasing too few goods)

• Lower UNEMPLOYMENTUNEMPLOYMENT• (too many people out of work)(too many people out of work)

• Promote Growth in the Economy• Slow down an “over-heated” economy

– Adjusting for the normal business cycle

Typical Business Cycle

Long Term Growth

Monetary PolicyMonetary Policy• Fed is responsible for maintaining price stability

and employment• “Expansionary Monetary Policy”

– goal is to increase money supply• to reduce unemployment• to avoid deflation

• “Contractionary Monetary Policy”– goal is to decrease the money supply

• to reduce inflation• To prevent “bubbles”

3 Important Tools

1. Changing the Reserve Requirement

2. Changing the Discount Rate

3. Conducting “Open Market Operations”

The three tools are interactive

1. Reserve Requirementcurrently: 3-10%

• Raise the reserve requirementRaise the reserve requirement = LessLess money in circulation– slows the economy

• eventually brings price stability (lowers inflation)

• Lower the reserve requirementLower the reserve requirement = MoreMore money in circulation– More money to buy goods and services

• requiring more jobs to produce them

(lowers unemployment)

2. Changing the discount rate

• discount rate = interest rate on fed to bank loans (set by Fed)

• federal funds rate = interest rate on bank to bank loans (set by fed funds market)Raising the interest rate influences how much banks will decide to borrow from the fed (who will lend them money “out of thin air”, increasing money supply)

Keeping the discount rate low encourages borrowing

federal funds rate=interest rate on bank to bank loansdiscount rate=interest rate on fed to bank loans

When the federal funds rate is lower than When the federal funds rate is lower than the discount rate, who would you borrow the discount rate, who would you borrow from?from?

When the discount rate is lower than the When the discount rate is lower than the federal funds rate, who would you borrow federal funds rate, who would you borrow from? from?

• The Fed can encourage borrowing by The Fed can encourage borrowing by keeping rates lowkeeping rates low

Another bank

The fed

currently:currently: discount rate discount rate - .75%- .75%federal funds rate federal funds rate - 0-.25%- 0-.25%

2006 discount rate - 6.25% federal funds rate - 5.25%

What is the Fed trying to do?

Federal Open Market Committee Federal Open Market Committee (FOMC)(FOMC)

• controls controls Open Market OperationsOpen Market Operations– Open Market Purchases Open Market Purchases buysbuys government government

securities = securities = increasesincreases money supply money supply– Open Market Sales Open Market Sales sellssells government government

securities = securities = reduces reduces the money supplythe money supply

11

Important Background Information

• U.S. Department of the Treasury– the agency of government responsible for

paying for government and its actions• collects taxes• borrows money if needed

– It borrows from the public by offering securities» securities: promises to repay with interest at some

future time

Open Market PurchasesOpen Market Purchases

• Fed offers to buy your Fed offers to buy your government security. government security. – ““Thin air” money is Thin air” money is

given to you.given to you.– Money supply Money supply

increasesincreases

Open Market Sales

• Fed offers to sell Fed offers to sell government securities government securities it holds. it holds. – You pay for it.You pay for it.– Your money Your money

“disappears” into the “disappears” into the FedFed

– Decreases the money Decreases the money supply.supply.

Review

• What are three ways the Fed can control the money supply?

Reserve RequirementDiscount RateOpen Market Operations

Review

• Why does the Fed want to control the money supply?

• Monetary Policy: maintain employment control inflation

Review

• What is the “reserve requirement”?What is the “reserve requirement”?– If the Fed wants to reduce the money supply, If the Fed wants to reduce the money supply,

what does it do to the reserve requirement?what does it do to the reserve requirement?

• What is the discount rate?What is the discount rate?– What is the federal funds rate?What is the federal funds rate?– If the Fed wants to increase the money If the Fed wants to increase the money

supply, what does it do to the discount rate?supply, what does it do to the discount rate?

Review

• What is the difference between an Open Market Sale and an Open Market Purchase?

• action?• goal?

Complete 11.3 Section Review, p. 306 # 2-4

Homework

• Read and note Chapter 13.1 “Inflation”– Include definitions from Section Review #1,

highlightedhighlighted

• Section Quiz Section Quiz next class.next class.