Explorations in Economics

Explorations in Economics Alan B. Krueger & David A. Anderson

Chapter 17: The Federal Reserve and Monetary Policy • Module 50: The Federal Reserve System • Module 51: The Federal Reserve and Traditional Monetary Policy • Module 52: Extraordinary Times, Extraordinary Tools

Do Now – The Most Powerful Woman in America – Who is She? Chapter 17-Mods 50-52

MODULE 50:THE FEDERAL RESERVE SYSTEM KEY IDEA: As the nation’s central bank, the Federal Reserve acts to maintain the safety of the banking system and the stability of the economy. OBJECTIVES: • To explain why the Federal Reserve System was created. • To identify the structure of the Federal Reserve System. • To describe the functions of the Federal Reserve System. • To explain the role of the Federal Reserve System in formulating and executing monetary policy.

THE CREATION OF THE FEDERAL RESERVE SYSTEM The Federal Reserve Act of 1913 • Panic of 1907 convinced Americans that a central bank could provide stability. • The “Fed” becomes the bankers’ bank. • Owned by the U.S. Government • But run by an independent board of governors.

Fed’s Role and Structure Fed In Plain English Chapter 17-Mods 50-52

THE PURPOSE OF THE FEDERAL RESERVE SYSTEM • Sets monetary policy – full employment and price stability to promote economic growth. • Maintains stable banking system by regulating banks, and by making loans to member banks. • Provide financial services (check clearing house) for the federal government and banking for commercial banks.

Fed Organization Board of Governors The Federal Reserve Bank 12 Regional Banks Open Market Committee Chapter 17-Mods 50-52

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Board of Governors of the Federal Reserve is made up of seven members appointed by the president. Key idea: Fed is independent of politics. • Manage the operations of the Federal Reserve System • Serve 14-yr terms; appointed by President • Oversees operations of the Federal Reserve Banks • Chair and Vice Chair chosen by members • Set Monetary Policy for the nation

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Federal Reserve Banks implement Federal Reserve policies and provide services to member banks and federal government agencies. • 12 District and 24 branch banks; each has 9- member board of directors • Hold cash reserves and make loans for depository institutions • Act as agent for federal government • Supervise and act as bank examiner of the Fed

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM Member banks of the Federal Reserve System include all nationally chartered banks and many state- chartered banks. They are stockholders in their district bank and help elect the district’s board of directors.

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM The Federal Open Market Committee is the group within the Federal Reserve that creates monetary policy.

What is Monetary Policy? • Actions to smooth out the ups and downs of the business cycle by controlling the money supply and interest rates. • In the USA, monetary policy is set by the Federal Open Market Committee (FOMC) of the Federal Reserve Bank. Chapter 17-Mods 50-52

Pair - Share • What happens to business investment when interest rates rise? When they fall? • What happens to consumer borrowing when interest rates rise? Fall? Based on the above, what happens to the economy when interest rates rise / fall? Chapter 17-Mods 50-52

Money Supply and Interest Rates By increasing or decreasing the money supply, we can increase or decrease interest rates.

Monetary Policy Chapter 17-Mods 50-52

Monetary Policy Organizer With your desk partner, complete the contractionary vs. expansionary chart. Chapter 17-Mods 50-52

How does the Fed change the money supply? • It uses the money creation ability of the fractional reserve system! • By increasing or decreasing bank reserves, the Fed can increase or decrease the money supply. • Changes in money supply increase or decrease interest rates. • Reserves can be changed through “open market operations” Chapter 17-Mods 50-52

How the Fed increases the money supply (easy money) Buys treasury bonds from banks Banks Fed Payment to banks increases bank reserves and the money supply Chapter 17-Mods 50-52

How the Fed decreases the money supply (tight money) Sells treasury bonds from banks Banks Fed Banks pay the Fed decreasing bank reserves and the money supply Chapter 17-Mods 50-52

TRADITIONAL MONETARY POLICY TOOLS The discount rate is the interest rate that the Fed charges financial institutions for short- term loans. Reserve Requirements-the percentage of demand deposits that banks must keep. The Fed does not change this often but it is powerful when they do. Other tools of monetary policy

Fed Funds Rate Fed funds: bank deposits at the Fed. Fed funds rate: interest rate that banks charge other banks to borrow their deposits at the Fed. JPM lends excess reserves Citibank needs reserves JP Morgan has excess reserves Citi pays interest Chapter 17-Mods 50-52

Summary • The Fed is the banker’s bank. • Major jobs – keep banking system stable, inflation low and unemployment low, provide financial services to member banks. • Controls money supply through open market operations. • Tight money leads to higher interest rates, lower spending and slows economy. • Easy money leads to lower interest rates, higher spending and faster growing economy. Chapter 17-Mods 50-52

Review – Big Ideas Federal Budget: • Deficit, balance, surplus, national debt • Mandatory vs. discretionary • Entitlement vs. means tested Fiscal Policy: • Expansionary – taxes & spending • Contractionary – taxes & spending • Limitations of fiscal policy • Pros & Cons of national debt. Chapter 17-Mods 50-52

Review – Big Ideas Money & Banking: • 3 uses • 3 types • Excess vs. required reserves • Fractional reserve system • Money creation Chapter 17-Mods 50-52

Review – Big Ideas Federal Reserve & Monetary Policy: • 3 roles of the Fed • 3 parts of the Fed • Expansionary monetary policy • Contractionary monetary policy • Advantages of monetary policy Chapter 17-Mods 50-52

Explorations in Economics