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The Federal Reserve

The Federal Reserve. Or, How I learned to stop worrying and embrace MONETARY POLICY. The Fed. Operates as a Central Bank Uses the tools of monetary policy to influence the quantity of reserves (money) in the banking system Powerful influence over the money supply and general price level.

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The Federal Reserve

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  1. The Federal Reserve Or, How I learned to stop worrying and embrace MONETARY POLICY.

  2. The Fed • Operates as a Central Bank • Uses the tools of monetary policy to influence the quantity of reserves (money) in the banking system • Powerful influence over the money supply and general price level

  3. FOMC • Federal Open Market Committee: makes decisions to increase or decrease the # of dollars in the economy

  4. The Fed and the Economy • Central Banks (like the Fed) are very important b/c they can profoundly affect the economy • Prices rise when the government prints too much money (inflation) • Short run trade off of inflation and lower unemployment

  5. Three Monetary Tools • 1. Open Market Operations: buying and selling bonds • 2. Reserve Requirements: changing the reserve ratio at banks • 3. The discount rate

  6. OMO • Buying or selling of government bonds • To increase the money supply, the Fed will buy bonds from the public • Each new dollar held as currency increases the money supply by $1.00 • Each new dollar deposited into a bank increases the money supply to a greater extent • To decrease the money supply, the Fed sells gov’t bonds to the public • Used most often by the Fed

  7. Reserve Requirements • Regulations in the minimum amount of reserves that banks must hold against deposits • They rarely change this b/c it would disrupt business of banking

  8. How do Banks Work? • Banks hold your demand deposits and manage them for you • The behavior of banks can greatly influence the money supply • Reserves: deposits that banks have received but have not loaned out

  9. T-Accounts • An accounting statement • If banks hold all money in reserves, they don’t influence the money supply • Assets: the reserves the bank holds in its vaults • Liabilities: the amount it owes it’s depositors or customers

  10. Money Multiplier • the amount o money the banking system generates with each dollar of reserve • It is the reciprocal of your reserve ratio: • If your reserve ratio is 10% or 1/10 then your multiplier is 10 • The amount of money that banks creates depends on the reserve ratio • The higher the reserve ratio, the less of each deposit banks loan out and the smaller the multiplier

  11. Fractional Reserve Ratio • A banking system in which banks hold only a fraction of deposits as reserves • They want to loan out some of the money deposited in their bank and charge interest so that they can make money • Reserve ratio: the % of deposits that banks hold onto • Reserve Requirement: the minimum the Fed requires • Excess Reserve: if a bank if being conservative

  12. Discount Rate • The interest rate on loans the Fed makes to banks • If a bank has too few reserves to meet the requirement, they have to borrow from the Fed • A high discount rate discourages borrowing and lending

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