Chapter 15: The Fed and Monetary Policy

Chapter 15.1: The Federal Reserve SystemChapter 15.2: Monetary Policy

Chapter 15.3: Monetary Policy, Banking, and the Economy

Chapter 15.1: The Federal Reserve System

The Fed provides financial services to the government, regulates financial institutions, maintains the payments system, enforces consumer protection laws, and conducts monetary policy.

Structure of the Fed:The Fed is publicly owned by “member banks”:

commercial banks that hold stock in the Fed. Individual & state banks have the choice to join. Nationally chartered banks have to join.

The Fed is run by a seven-member board of governors – these members are appointed by the President, approved by the Senate, and serve 14-year terms. Their job is to supervise & regulate the Fed.

The Fed itself is made up of 12 district banks spread throughout the U.S.

The Federal Open Market Committee makes the decisions about the size of the money supply and the level of interest rates. The FOMC is the Fed’s primary monetary policy-making body.

Three Advisory Committees

1. Federal Advisory Council - Advises the Govs on state of State of economy.

2. Consumer Advisory Council – oversees consumer credit laws.

3. Thrift Institutions Advisory Council – advises Govs on institutions that lend money (banks, savings & loans, credit unions).

Regulatory Responsibilities of the Fed:

All depository institutions (commercial, savings, credit, etc.) must answer to the Fed.

The Fed supervises/regulates foreign banks in the U.S. (250 branches/agencies) and U.S. banks in foreign countries.

The Fed clears checks, enforces consumer legislation, maintains currency/coins, and provides financial services to the government.

Clearing checks:

1. I write you a check and you deposit it in the bank.

2. The bank credits your account and send the check to the Fed.

3. The Fed sorts/processes your check, and sends the check and a true credit to your bank.

4. You bank puts real money into your account.

5. Your bank sends the check back to my bank and real money is taken out of my account.

6. Cleared checks are kept on file at my bank for future reference.

Chapter 15.2: Monetary Policy

The Fed defines money in one of two ways:

“M1”: the transactional components of money (“medium of exchange”) – currency, coins, checks, etc.

“M2”: “store of value” components – time deposits, saving deposits, money market funds, etc.

Monetary Policy:

One of the Fed’s biggest responsibilities is “monetary policy”: the expansion or contraction of the money supply in order to influence the cost and availability of credit.

Vs.

The U.S. has a “fractional reserve system”: requires banks to keep a fraction of their deposits in the form of legal reserves (cash/coin).

Under this system, banks have “reserve requirements”: rule that a % of each deposit must be set aside as legal reserves.

Today’s reserve requirement is 12%.

Reserve Requirement Example:

$100 is deposited.

$12 must be reserved/kept.

$88 are considered excess reserves.

“Excess Reserves” can be used to make loans to others.

Money Policy (2 Types):

“Easy Money Policies”: Fed increases money supply – interest rates on loans fall – economy increases.

“Tight Money Policies”: Fed decreases money supply – interest rates on loans rise – economy decreases.

Tools of Monetary Policy:

The Fed can increase/decrease the monetary supply using any of 4 methods:

1. Reserve Requirements

2. Open Market Operations

3. Discount Rates

4. Margin Requirements

1. Reserve Requirement

Remember, the reserve requirement is the % of each deposit that must be kept by a bank (can’t be loaned out).

A decrease in the reserve requirement increases the overall money supply (banks can lend more).

An increase in the reserve requirement decreases the overall money supply (banks can’t lend as much)

2. Open Market Operations:

The Fed can buy securities (stocks/ bonds) from the government.

If the Fed buys securities, more money enters the economy and the overall money supply increases.

If the Fed sells securities, money leaves the economy (it comes to the Fed) and the overall money supply decreases.

3. Discount Rate:

The Fed makes loans to common banks – the discount rate is the amount of interest they charge.

If the Fed decreases the discount rate (interest rates), more banks will take out loans and the overall money supply will increase.

If the Fed increases the discount rate (interest rates), less banks will take out loans and the overall money supply will decrease.

4. Margin Requirements:

The Fed sets the “margin requirement”: the amount of money that an investor must deposit to buy stock (today it’s 50%).

If margin requirement are decreased, more stock can be purchased, and the overall money supply increases.

If the margin requirement is increased, less stock can be purchased, and the overall money supple decreases.

Chapter 15.3: Monetary Policy, Banking, and the Economy

Monetary policy has a huge effect on the economy – it has long-run effects and short-run effects.

Short-Run Impact:

Monetary policy affects the interest rate (cost of credit).

An increase in money supply causes interest rates to go down (cheaper to borrow money).

A decrease in money supply causes interest rates to go up (more expensive to borrow money).

Long-Run Impact:

Monetary policy affects inflation.

An increase in the money supply causes inflation (prices).

A decrease in the money supply stabilizes inflation (prices).