Monetary Policy and "The Fed"
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Transcript of Monetary Policy and "The Fed"
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-A Little History:
-In 1790, the Federalists (guys that wanted a strong central government) tried to set up a central bank, but people were afraid that a strong central government could turn into a Monarchy.
Because banks were “independent,” it was possible to have a bank run where too many people went to get their money and the bank literally ran out. Some banks even closed and people lost everything.
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-In 1913, the Government (under Wilson) passed the Federal Reserve Act and created 12 independent, regional banks. These banks were intended to be the big brothers of all banks in the U.S.
-The Banks were intended to stop things like the Great Depression, but they failed because they were independent and often contradicted each other’s actions.
-By 1935, the Government decided to increase the power of these Banks and created the Federal System we know today. In nerd-speak, we call it “The Fed.”
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So this is how it works:
-1st, there is the Board of Governors
-These 7 chaps (and chapettes) basically serve as the big bosses of the Federal Reserve system. No two Governors come from the same district.
-They are appointed by the President, approved by Congress, and serve staggered 14-year terms.
-They meet and decide all the Monetary Policy for the United States and one (the Chair) acts as spokesman.
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-2nd, we have the 12 District Federal Reserve Banks:
-Each bank has its own district and monitors the banking and economic conditions in its area.
-Each district is composed of more than one state.
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-Lastly, we have the 4,000 member banks and 25,000 other depository institutions
-All nationally chartered banks must be a part of the Federal Reserve System and most State-Chartered banks join voluntarily.
-Each of the appx. 4,000 member banks contributes money to the system and receives stock in Fed in return. This bank ownership of the Fed gives the system a high degree of Independence.
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The Fed has four main functions:
1.) Serving Government –
- Federal Government Banker (Treasury Checking Account)
- Government Securities Auctioneer (Bonds to finance Gov’t activity)
2.) Serving Banks –
- Check Clearing (20 billion checks a year!)
- Supervises Lending Practices
- Lender of Last Resort (Anti-Bank Runs System)
3.) Regulating Banking System –
- Reserves
- Bank Examinations
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4.) Regulating the Money Supply**
- A. Cash Needed on Hand (easy economic transactions)
- B. Interest Rates (higher interest makes cash more expensive)
- C. Price Levels (goin’ out gets more expensive)
- D. Income Level (mo money means mo lettuce)
- E. Stabilizing the Economy (ahem, next slide)
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Just like Fiscal Policy, Monetary Policy uses tools too:
1.) Money Creation
- NOT “printing” money
- Think like the multiplier effect
- Banks must keep a Required Reserve Ration (RRR) [10%]
Winston gets a $1000 loan and
puts it in his WaMu checking
account.
Franky gets a $900 loan from
WaMu and puts it in his Chase
checking account.
Joe gets a $810 loan from Chase and puts it in his
US Bank checking account.
= $2,710 in Money Supply
The Money Multiplier:
Initial Cash Deposit X
1
RRR
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Just like Fiscal Policy, Monetary Policy uses tools too:
2.) Reserve Requirements:
- Reserve Requirement Ratio: Ratio of reserves to deposits required of
banks by the Federal Reserve. (inc. = less lending, $ supply dec.)
- Federal Fund Rate: Interest rate banks charge one another for loans. (Always lower than the Discount Rate) (inc = less lending, $ supply dec.)
- Discount Rate: The interest rate the Federal Reserve charges for loans to commercial banks. (Tied to Federal Funds Rate)
- Prime Rate: Rate of interest banks charge on short-term loans to their
best customers.
3.) Open Market Operations
- When committee decides for more money, they order Fed. Reserve Bank of NY to buy securities and put them into banks. (sets “money creation” into motion)
What’s yer aRRR Ratio?
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Basically, Monetary Policy uses The Money Supply and the Interest Rate to control the macroeconomy.
1.) Easy Money Policy: Increase money supply, lower interest rates and encourage investment spending (AD). As spending increases (AD), so does GDP. Good to try to fix a recession.
2.) Tight Money Policy: Decrease money supply, increase interest rates and discourage investment spending (AD). As spending decreases (AD), so does GDP. Good for trying to slow inflation.
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PROBLEMS WITH MONETARY POLICY:
Timing Lagging Prediction