The Federal Reserve System and Monetary Policy

The Federal Reserve System

• Commonly known as the Fed – Created in 1913 as the

central banking organization in the United States

– Its goal was to provide stability to the economy and end recessions.

What does the Fed do?

• The Fed is responsible for Monetary Policy– Involves changing the rate of growth of the supply

of money in circulation in order to affect the cost and availability of credit.

Functions of the Fed

• Regulating the money supply• Clearing checks• Acting as the government’s fiscal agent• Supervising Banks• Holding reserves and setting reserve

requirements• Supplying paper currency

Organization of the Fed

• Chairman of the Federal Reserve– Head of the Central Bank– Appointed by the

President– Current Chairman: Janet

Yellen

Organization of the Fed

• Board of Governors– Directs operations of the Fed– Seven members appointed by the president and

approved by congress• Federal Advisory Council– 12 members elected by directors of banks

• Federal Open Market Committee– 12 members who determine interest rates

Organization of the Fed

• The nation is divided into 12 Federal Reserve Districts, each with a federal reserve bank.

• 25 Federal Reserve Branch Banks• All national banks are required to become

members of the Federal Reserve System.• Members receive dividends on their stock of the

district bank.• Even if a bank is not a member, they must keep

their deposit reserves in the Fed district bank.

Monetary Policy

• Credit is a service that you pay for with interest.• How do you think the demand

for credit is influenced by interest rates?

The Law of Demand!

• If you charge higher interest rates, people will be less likely to take out loans.

• When the Fed keeps interest rates LOW it is called Loose Money Policy

• When the Fed makes interest rates HIGH it is called Tight Money Policy

Loose Money Policy

The Good• Borrowing is easy• Consumers buy more• Businesses expand• More people are employed• People spend more

The Bad• Inflation• Consumers are more likely

to go into debt• Can create economics

bubbles (bubbles tend to burst)

Tight Money Policy

Pros• Consumers are less likely to

go into debt• Higher interest for banks

Cons• Borrowing is difficult and

more expensive• Consumers borrow less• Businesses postpone

expansion• Production and

employment may decrease

Fractional Reserve Banking

• System in which only a fraction of the deposits in a bank is kept on hand, or in reserve; the remainder is available to lend.

• The Fed sets reserve requirements for banks.– Requires banks to keep a certain percentage of the

checkable deposits as cash in their own values or as deposits in the Federal Reserve district bank.

• What are some benefits of this system?• What are some potential problems?

How does this system affect the money supply?

• Bank A sells a government bond to the Fed and receives $1000.

• If the reserve requirement is only at 20% then Bank A can lend out $800.

• The $800 that Bank A lends to a business gets deposited to Bank B.

• So the $800 is technically in two places at one time

• This process is known as the multiple expansion of the money supply.

Regulating the Money Supply

• Main goal of the Fed: Keep the economy growing and efficiently control the money supply.

• How is this done?– Changing the reserve requirement can affect the

amount of money in circulation.– Changing the Federal Funds Rate• Interest rate that banks charge each other on loans.

Why would one bank borrow from another?

• If a customer makes a large withdrawal, the bank may not have enough money to meet the reserve requirement. (If it doesn’t it will have to pay a fine to the Fed)

So what does that bank do?!

• Option 1:Take a loan out from the Fed! (The Fed gets to collect interest!)

• Option 2: Take a loan from another bank! (The Fed gets to choose the interest rate regardless!)

How does the Federal Funds Rate Affect the Economy?

• If the Fed drops the rate…– Banks borrow and lend more!

• If the Fed raises the rate– Banks will borrow less and raise interest on the

funds they lend to make up the lost profit

Open-Market Operations

• Buying and selling of United States securities by the Fed to affect the money supply

• When the Fed buys securities (treasury bills, notes, and bonds) it pays for them by printing its own money. Increases money supply!

• When the Fed sells securities the dealers bank will have less money in their reserves and will either have to lend less or borrow more money from the Fed (that they can pay back with interest of course) Decreases the money supply!

Criticism of the Federal Reserve

“The Federal Reserve is not currently forecasting a recession”

-Ben Bernanke, Fed Chairman, 2008 (right before the recession)

Criticism of the Fed

• The Fed has a tendency to promote inflation and debt by keeping the reserve requirements and federal funds rates so low.– Since the creation of the

Fed, the dollar has lost 96% of its value.

• Because the Fed is run by private bankers, not the government, many people have compared it to a cartel

Oooooo Cartel…Sounds Scary…

• Cartel: Formal agreement among competing firms. An organization of producers that agree to fix prices, marketing, and production.

• Remember, the Federal Reserve gets to choose the reserve requirements and interest rates at which all banks lend to each other (even if the banks are not members)

Say hello to my little interest rate!

Criticism of the Fed• The Fed has little to no

accountability– Leaders of the federal reserve

are appointed, not elected. The American people have no say whatsoever on the Fed’s policies.

– Because the Fed operates like a corporation, foreign countries and companies can own shares.

– The Fed does not have to report to congress or even the president

What should be done?

Is anybody going to do something!?

• Many conservatives believe the Federal reserve should be eliminated and the United States should return to the gold standard to keep the money supply stable.– What kind of money

would that be?

• Many liberals believe the Federal reserve should operated in a more democratic fashion to make it more accountable to the American people.– Instead the treasury

department could be in charge of monetary policy

Any chance of this getting done?

Good luck with that…