The Federal Reserve

1. The Federal Reserve

2. The Federal Reserve has two jobs • It’s first job is to regulate banks and ensure the health of the banking system • The fed acts as a banks bank • The fed makes loans to banks when banks themselves want to borrow • The Federal Reserve acts as a lender of last resort: a lender to those who cannot borrow from anywhere else

3. Two Jobs (continued) • The Second job is to control the quantity of money that is made available in the economy • M1: assets that have liquidity • M2: consists of all the assets in M1 plus several additional assets that are not as liquid as M1

4. Monetary Policy • The actions the Federal Reserve takes to influence the level of real GDP and the rate of inflation in the economy. • Monetary policy is made by the FOMC which is a committee of the Federal Reserve

5. Fed’s Primary Monetary Policy tool: Open Market Operations • Open market Operations is the buying and selling of bonds. • You have to ask yourself, Where is the money going? • The Fed can increase or decrease money supply by buying or selling U.S. Government Bonds

6. Increasing Money Supply using OMO • If the Fed wants to increase Money Supply the Fed buys bonds from the public. After this purchase, these dollars are in the hands of the public. • Where is the money going? • From the government to the public and therefore increasing money supply in the economy (b/c its in the hands of the public and not in a bank)

7. Decreasing Money Supply using OMO • If the Fed wants to decrease money supply, the government will sell bonds. After the sale the dollars the government receives for the bonds are out of the hands of the public • Where is the money going? • From the hands of the public to the vault of the government. Therefore the money was in circulation not it’s not, decreasing money supply.

8. Fed’s Secondary Monetary Policy Tool: Changing the Required Reserve Ratio • What is the Required Reserve Ratio (RRR)? • The fraction of the deposit that must be kept in reserve. • When you put money in the bank, some of it then goes in to the stock market, some goes out to other bank customers in the form of loans. The amount that says in the bank that is available for withdrawal is the RRR.

9. Increasing Money Supply by Changing the RRR • When the Fed wants to increase money supply in the economy they decrease the required reserve ratio. • This frees up more money to the bank and allows them to make more loans out to the public. • Where does the money go? • Back out to the public, increasing money supply.

10. Decreasing Money Supply by changing the RRR • If the Fed wants to decrease the money supply in the economy they will increase the required reserve ratio. • This forces banks to hold on to more money in reserves and does not allow them to make many loans • Where does the money go? • Out of the hands of the public, back in the bank’s vault, therefore decreasing money supply.

11. Fed’s Third Monetary Policy Tool:Changing the Discount Rate • What is the discount rate? • The discount rate is the rate the Federal Reserve charges for loans to commercial banks (banks borrow from the Fed to maintain reserves at the required level) • Changes to the discount rate affect the cost of borrowing from the Fed (which is the lender of last resort).

12. When banks have to pay more for the money that they borrow from the Fed, they have to make up the loss by charging customers a higher prime rate on customer loans.

13. Increasing Money Supply by Changing the Discount Rate • When the Fed wants to increase MS, they will decrease the discount rate. • Banks are charged less for borrowing money from the Fed • They lower their prime rate for public or commercial loans • People and firms take out more loans because it is cheaper to do so • Money supply in the market increases

14. Decreasing the Money Supply by changing the Discount Rate • When the Fed wants to decrease MS, they will increase the discount rate • Banks are charged more for the money they borrow from the Fed • They raise their prime rate for public or commercial loans • People and firms take out less loans because it is more expensive to do so • Money Supply in the market decreases

15. Tools for Fiscal Policy Raising/lowering Taxes Raising/lowering Government Spending Tools for Monetary Policy Open Market Operations (buying/selling bonds) Changes to the Required Reserve Ratio Changes to the Discount Rate Quick Review

16. The Fed uses its Monetary Policy tools differently based on whether they want to expand or contract the economy • Expansionary Monetary Policy = increase Money Supply • Also called Easy Money • Contractionary Monetary Policy = decrease Money Supply • Also called Tight Money

17. Timing Problems with Monetary Policy • There are problems with Timing when implementing policy because of lags in the economy. • Inside Lags: delay in implementing monetary policy • We do not know for sure if the economy is heading into a new phase of the business cycle until we are already there • Outside Lags: the time it takes for monetary policy to have an effect • Maybe more than 2 years before we see the maximum impact of monetary policy