Transcript powerpoint file

Chapter 15
The Federal Reserve and Monetary Policy
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The Federal Reserve
• The Federal Reserve is the United States
Central Bank.
• Founded in 1913 after four severe banking
panics.
• Chartered by the federal government but is
largely independent of the authority of the
Congress and President.
• Primary role is to conduct monetary policy and
to act as a lender of the last resort to banks to
stabilize the financial system.
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Structure of the Fed
• The unique structure of the Federal Reserve is a
consequence of history and politics.
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Structure of the Fed
• The Board of Governors
– is the highest governing body of the Federal
Reserve.
– It consists of seven members including the
chairperson--currently Alan Greenspan.
• The Twelve District Banks provide regional
check clearing, bank supervision, payments
processing, and economic analysis.
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Structure of the Fed
• The F.O.M.C. (Federal Open Market
Committee)
– is responsible for directing monetary policy.
– consists of 12 members, the seven from the Board
of Governors plus five Presidents of the District
Banks who serve on a rotating basis, one of which
is always from the New York Fed.
– meets about every six weeks to discuss monetary
policy and decide what course of action to take.
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Tools of Monetary Policy
•
•
The Federal Reserve's attempt at stabilization
policy is referred to as monetary policy.
Tool include:
1. Open Market Operations (OMO),
2. Change in the discount rate, and
3. Change in the reserve requirement ratio.
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Tool #1: Open Market Operations
• An Open Market Operation is
– the Fed's purchase (open market purchase) or sale
(open market sale) of government securities via
transactions in the open market.
– by far the most important tool of the Fed and it is
used daily to target the federal funds rate.
– An open market operation impacts the banking
system by changing bank reserves initially and,
ultimately, the money supply.
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Tool #1: Open Market Operations
•Example: the
Fed purchases
$100 million of
government
securities from
commercial
banks.
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Tool #2: Change in the Discount Rate
• The discount window is where depository
institutions go to borrow funds from the Fed.
– The discount rate is the interest rate at which the
Federal Reserve lends funds to banks.
– Borrowings from the discount window are shortterm, usually lasting only a week or two.
– Changes to the system were implemented recently,
establishing primary credit and secondary credit
programs.
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Tool #2: Change in the Discount Rate
• Suppose the Fed
decreases the
discount rate by one
percentage point,
say, from six
percent to five
percent. This
change induces
banks to borrow $5
million more in
reserves from the
Fed to fund
additional loan
opportunities.
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Tool #3: Change in the Required Reserve
Ratio
• The required reserve ratio is the minimum
amount of reserves that a bank must hold
relative to its deposit base.
– Reserves include vault cash and reserves held at the
Federal Reserve.
– Currently in the U.S. banking system, the required
reserve ratio is 10 percent.
– Lowering the ratio frees up reserves, while raising
the ratio reduces reserves.
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Tool #3: Change in the Required Reserve
Ratio
• Example: the Fed
lowers the
required reserve
ratio from 12.5
percent to 10
percent, freeing
up $2,500 in
excess reserves.
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Summary of Monetary Policy Tools
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Impacts of Monetary Policy on the
Economy
• How do Federal Reserve actions impact the
behavior of output, inflation, and
unemployment?
• Monetary policy ultimately works by changing
interest rates in the loanable funds market,
which change the level of demand for goods
and services in the economy.
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The Loanable Funds Market
• Demand for loanable funds comes borrowers. The supply of
loanable funds comes from savers.
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The Loanable Funds Market
• Expansionary
monetary policy,
by increasing
bank the quantity
of bank reserves,
increases the
supply of
loanable funds,
which lowers
interest rates.
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The Impact of Monetary Policy on the
Economy
• The final piece of the puzzle is that the lower
interest rates increase investment, which shifts
the Aggregate Demand curve to the right.
– Both the level of output and the price level
increase.
– Contractionary policy reduces the price level and
the level of output.
– Remember that monetary policy affects Aggregate
Demand, not Aggregate Supply.
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Expansionary Monetary Policy
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