Transcript Ch16 Federal Reserve and Monetary Policy

Ch16 Federal Reserve and
Monetary Policy
Federal Reserve Bank History
• The Federal Reserve Bank is the central
bank of the U.S., created by the Federal
Reserve Act of 1913 as a compromise
between those who believed that a
central bank was necessary to create
stability in the banking system, and
those who feared too much control over
the economy held by the federal
government.
What is the Fed?
• The Federal Reserve (known as the Fed) is
composed of 12 district reserve banks (by
geographical area), and some 4000 private banks
and 25,000 other depository institutions under
some government control. The control comes
from a board of governors appointed by the
president with advise and consent of the senate.
Members of the board serve for 14 years, and the
chairman of the board is selected from among
them to serve for 4 years.
What the Fed Does
• The Federal Reserve can be considered a
regulatory agency, in that it polices its
member’s banks, and the Fed makes
decisions regarding key banking operations.
These decisions are referred to as Monetary
Policy, (or you might want to think of it as
the policies of money.) Among these
decisions are key interest rates, and the
money supply.
Bank of the U.S.
• The Fed is the bank of the U.S. government,
and holds the money collected in taxes for
the government, as well as make payments
for the government, sells government
securities (Treasury Bills, Notes, and
Bonds), and reclaims them.
Regulation
• The Fed regulates the banking industry in several
ways. It serves the banks by clearing checks,
supervising lending practices, and being a lender
of last resort. As a lender to other banks, the Fed
sets the rates at which banks lend to each other
(federal funds rate), and the rates at which the Fed
will lend to commercial banks (discount rate), and
the Prime Rate for best customers.
Demand for
money
• One of the principal jobs of the Fed is to
control the money supply. Because the
economy is almost always growing, the Fed
needs to create more cash for people to use.
The Fed balances the amount of money
demanded by the public against inflationary
pressures. If too much money is made,
inflation rises. Too little money, and the
economy can stall or go into recession.
How Rates Work
• Rates (or Interest Rates) determine how
much interest will be paid on a loan. When
interest rates go higher, the demand for
loans decreases, lowering the availability of
cash in the economy. When rates go down,
this increases the money supply.
Reserve Ratio
• As part of their operations, the
Fed also sets the required
reserve ratio that banks need to
comply with. The reserve ratio
is the amount of money each
bank needs to hold in its vault
compared to the amount it loans
out to others. If a bank finds
that it has loaned out too much,
it can usually go to the Fed to
borrow money to cover its
reserve requirement. When the
reserve ratio is low, banks can
lend more money, increasing the
money supply.
Money Multiplier
• By loaning money, banks
actually multiply the
amount of money
available in the economy
using the simple formula
deposit x 1/RRR
(Required Reserve Ratio).
The current ratio is 10%
Monetary Policies
• Putting all of this together, the Fed has enormous
power over the economy. By using the tools of
interest rates, printing money, and setting reserve
rates, the Fed can institute tight money policies, or
easy money policies that will determine the
amount of economic activity taking place. These
policies take time to have effect though, and the
Fed needs to watch the market carefully and
predict if either recessionary or inflationary
pressures are going to be affecting the economy
months and years ahead of time to smooth out the
economy.