Transcript Chapter 16 2

Federal Reserve and
Monetary Policy
What does the Money Supply
consist of?
M1 = cash, checking account deposits, and
traveler’s checks
M2 = M1 + savings accounts & money
market accounts
M3 = M2 +large deposits and other large,
long-term deposits.
Examples
1.
2.
3.
4.
$100 in wallet = M1
$800 in checking account = M1
$1,000 in savings account = M2
A $20 traveler’s check from last business trip to
China = M1
5. A $300 outstanding credit card bill = Neither
6. $3,000 in a small certificate of deposit = M2
7. A car worth $5,000 = Neither
What is the Money Supply (M1)?
1. Currency (cash and coins)
2. Checkable account balances
Money in checking accounts
3. Traveler’s Checks
The Federal Reserve can make the money
supply increase (expand) or decrease
(contract)
Bank Reserves
Banks are required to keep a certain
amount of funds in reserves to meet
unexpected outflows.
Banks may hold their reserves either as
cash in their vaults or as deposits at the
Fed.
Types of Bank Reserves
Total reserves = Deposits at the Fed + vault cash
Ex: Reserve Acct. ($10 m) + vault ($5 m) = TR ($15 m)
Required reserves = Reserve requirement X
checking account deposits
Ex: RR (10%) x Ck Acct ($50 m) = Required R ($5 m)
Excess Reserves = Total reserves – Required
reserves
TR ($15 m) – Required R ($5 m) = ER ($10 m)
The Fed Funds Market
Banks that have less than required reserves
can borrow from other banks (Federal Funds
Market)
The interest charged on the borrowed funds
is the Federal Funds Rate (Currently 0 -.25%)
The Federal Reserve can control the supply of
federal funds by using Monetary Policy
By comparison, in May 2006 the rate was 5%
Creation of “The Fed”
The Bank Panic of 1907 convinced Congress to
look hard at banking
Consumers and businesses needed access to
increased sources of funds to encourage expansion
Banks needed a source of emergency cash to
present depositors’ panics that result in bank runs
Tah! Dah! – Federal Reserve Act of 1913
Federal Reserve Act of 1913
Created the Federal Reserve System
Originally 12 independent regional
banks that could lend to one another
Didn’t prevent Great Depression
because they didn’t act together
Reform brought about a new structure
Structure of the Federal Reserve
Who Conducts Monetary Policy?
1. Board of Governors: 7 members
2. Federal Open Market Committee (FOMC):
(Board of Governors + 5 District Bank Presidents)
3. 12 Regional Banks = 4,000 Member banks
1. Board of Governors
Federal Reserve Board
Federal government agency
Seven members appointed by President for 14 year
terms, staggered two years apart
Guide the Federal Reserve’s policy actions
General oversight of all 12 regional banks
Chairman: Ben Bernake – appointed for four years –
reports to Congress twice a year. Job is up January
31st, and Janet Yellen has been nominated.
2. Federal Open Market Committee
FOMC makes key decisions about interest
rates:
Discount rate: interest rate Fed charges banks for
loans (.75%)
Federal funds rate: interest rate banks charge
each other for loans (0 -.25%)
FOMC oversees U.S. money supply
Meets every 6 weeks
3. 12 Federal Reserve Districts
Federal Reserve: The Banker’s Bank
Operate independently
Under general oversight of Bd. Of Gov.
Serve three audiences:
Bankers: Store commercial banks excess
currency and coins
U.S. Treasury: Sell U.S. securities
Public: Process and settle their checks and
electronic payments
Take out a Dollar Bill
Monetarists
Economists who follow Monetary Policy as a
way to control business cycles
Believe competitive markets provide the
market with a high degree of economic
stability
Less government intervention the better
When the government intervenes, one way
is through the Federal Reserve changing the
money supply
What is the Purpose of Monetary Policy?
Tries to keep our economy healthy by
regulating the money supply
Economy performs well if inflation is low
Economy performs well when interest rates are low
These two ideals foster low unemployment and a
growing economy
Three tools to achieve economic health
The Three Monetary Policy Tools
Change discount rate: interest rate
Reserve banks charge banks for short-term
loans (Currently .75)
Change Reserve Requirements: portions
of deposits that banks must hold in reserve,
either in their bank vault or in the Reserve
bank (Currently 10%)
Open Market Operations: The Federal
Reserve buys and/or sells U.S. government
securities (bills, bonds, notes) - most used
Open Market Operations: Increase
The Fed buys government Treasuries
Pays for the bonds with a check drawn on
itself
Seller deposits check in a bank
Bank presents the check to the Fed
Fed honors the check by increasing the
reserve balance
To decrease: sells bonds thus reversing the
process
Money Creation
Money creation is the process by which
money enters into circulation.
By using one of the three tools the money
supply is either increased or decreased
Increased if the Fed wants the economy to
expand (loose monetary policy)
Decreased if the Fed wants to contract the
economy (tight monetary policy)
Money Multiplier
Adding money to the money supply
This process will continue until no new loans are made
A $5,000 deposit into a checking account could
change the money supply by as much as $50,000
Δ in MS = 1/RR% X Δ in bank reserves
Δ in MS = 1/.10 (10%) X $5,000 = $50,000
Debt
Our money supply is based on debt
Yep – that’s right
No gold, no silver, no collateral
Just good ole’ American debt
Think about that for awhile
Fiscal and Monetary Policy Tools
Fiscal Policy
Tools
Expansionary
Tools:
1.  Govt
spending
2.  taxes
Monetary
Policy Tools
1. OMO: bond
purchases
2.  Discount
rate
3.  RR
Fiscal and Monetary Policy Tools
Fiscal Policy
Tools
Contractionary 1.  Govt
spending
Tools
2.  taxes
Monetary
Policy Tools
1. OMO: bond
sales
2.  Discount
rate
3. RR