The Federal Reserve and Monetary Policy

1. Chapter 16 The Federal Reserve and Monetary Policy Chapter 16 Economics Mr. Moreno

2. The Federal Reserve and Monetary Policy Chapter 16 • What the Fed Does • Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession.

3. Creating the Fed Section 1 - The Federal Reserve System Chapter 16 • Government struggled to stabilize economy until Federal Reserve Act • Central bank—a nation’s monetary authority • monetary means “relating to money” • Federal Reserve System—central bank of the U.S., called the Fed • independent organization within government; established 1913

4. Duties of a Central Bank Chapter 16 • Most countries have a central bank- oversees banking system • Holding Reserves: reserves set aside for loans from the banks funds • Assuring Stability: in national banking and monetary system • Control the way money is circulated • Supervise banks • Lending Money: Unlike other banks The Central Bank lends without the purpose of making money. To serve private banks rather than individuals.

5. The Duties of the Fed Chapter 16 • Fed uses regulation, oversight to protect bank customers, borrowers • Banking services for private banks and government include • holding deposits, transferring funds, making loans • Helps finance wars, stabilize economy in national emergencies • Regulates money supply; distributes currency—coins and paper money

6. The Structure of the Fed Chapter 16 • Fed not a single national bank; has national and regional structure • has some independence from political influence; accountable to Congress

8. The Structure of the Fed Chapter 16 • Board of Governors—sets policy; supervises operations of the Fed • chairman is most influential member and spokesperson • Ben Bernanke • 12 district banks carry out policy; serve as central bank for regions • Member banks: all nationally-chartered banks; state banks may apply • must buy district bank stock; cannot sell in open market

10. The Structure of the Fed Chapter 16 • Federal Open Market Committee—supervises government security sales • Federal Advisory Council—represents commercial banking industry • Consumer Advisory Council—advises on consumer protection laws on borrowing • Thrift Institutions Advisory Council—needs of savings institutions • thrifts not regulated by Fed; must meet reserve requirements; may borrow

12. Questions • What are the three duties of a central bank? • How is the Fed different from other central banks? • What are the five elements of the Fed?

13. Chapter 16 Section 2 Functions of the Federal Reserve

14. Functions of the Federal Reserve • Lending Money • Banks often lend to each other on short-term basis • In natural disaster, all banks in region lack cash flow • Fed lends to banks with enough assets and capital to qualify • Small banks with seasonal cash flow needs may borrow from Fed • Fed serves as lender of last resort to prevent banking crisis

15. Functions of the Federal Reserve • Regulating and Supervising Banks • Fed banks supervise state-chartered members, bank holding companies • bank holding company owns, has controlling interest in several banks • Fed banks enforce truth-in-lending laws • Conduct bank exams—audit financial practices of banks in district • Monitor bank mergers to ensure competition

16. Serving the Federal Government • KEY CONCEPTS • Fed serves as federal government’s banker • helps carry out taxation and spending activities

17. Serving the Federal Government 3 Services of the Fed • Service 1: Paying Government Bills • Tax revenues are deposited with the Fed • Fed issues checks, makes electronic payments via U.S. Treasury • for transfer payments, employee wages, direct spending, tax refunds • deducts amounts from government’s account • Processes postal money orders, food stamps

18. Serving the Federal Government • Service 2: Selling Government Securities • Fed processes U.S. savings bonds, auctions other securities • provides information, collects payment, credits funds, delivers bonds • Pays interest on bonds • Federal Open Market Committee (FOMC) supervises sales of securities • purpose is to stabilize the economy

19. Serving the Federal Government • Service 3: Distributing Currency • Federal Reserve notes are official paper currency of U.S.: fiat money • Treasury Department prints notes that go to Fed district banks • Fed banks distribute notes to depository institutions in amounts needed • currency then goes to people and businesses • Fed also distributes coins produced by U.S. Mint

20. Creating Money • Creating money—how money enters circulation through deposits, loans • Fed establishes required reserve ratio (RRR) for banks • fraction of bank’s deposits that it must keep in reserve • Reserve may be stored as cash in bank’s vault or deposited with Fed

22. Creating Money • Example: Money Creation • Banking system creates money whenever banks get deposit and make loan • Level of the RRR determines how much money may be loaned • Money supply increases by total loans made after initial cash deposit • deposit multiplier formula tells how much money supply will increase

24. Questions • Why might the Fed help a small bank in an agricultural region stabilize its cash flow? • How are the banking services the fed provides to the government similar to the services it provides to banks? • If the Fed raised the RRR from 10% to 12%, how would it affect the money supply? • You have been planning your college finances and you know that you’ll have to take a bank loan to cover tuition costs. You read that the Fed intends to raise the RRR rate from 10% to 20%. How will this change affect the money supply and your ability to borrow money for college tuition?

25. Chapter 16 Section 3 The Fed’s Monetary Tools

26. Approaches to Monetary Policy • Policy 1: Expansionary Policy • Expansionary monetary policy also called easy-money policy • In recession, Fed increases money supply to increase aggregate demand • Fed can buy bonds on open market, decrease RRR or discount rate • most common practice is to buy bonds to make interest rates fall

27. Approaches to Monetary Policy • Policy 2: Contractionary Policy • Tight-money policy is another name for contractionary monetary policy • Fed decreases money supply to check aggregate demand, inflation • Fed can sell bonds on open market, increase RRR or discount rate • most common action is to sell bonds to raise interest rates

29. Alan Greenspan: Fighting Inflation • Managing Monetary Policy • Greenspan served as chair of Fed’s Board of Governors over 18 years • his insight and persuasiveness made him extremely influential

30. Alan Greenspan: Fighting Inflation • Was very successful at growing economy without inflation • great knowledge of tools of monetary policy and economic indicators • sense of timing: knew just when to expand or contract money supply

31. Impacts and Limitation of Monetary Policy • Purposes of monetary policy—curb inflation and halt recessions • Changes in monetary policy have both short-term and long-term effects

32. Impacts and Limitation of Monetary Policy • Impact 1: Short-Term Effects • The short-term effect is a change in the price of credit • Open market operations influence FFR fairly quickly • change loanable reserves banks have • Easy-money policy lowers interest rates; tight-money raises them

33. Impacts and Limitation of Monetary Policy • Impact 2: Policy Lags • Delays in getting information to identify problems delays Fed action • Policy adjustments may take a long time to take effect in the economy • example: businesses may delay expansion until interest rates drop

34. Impacts and Limitation of Monetary Policy • Impact 3: Timing Issues • Monetary policy must be coordinated with business cycle for stability • bad timing may exaggerate a phase of the business cycle • Monetarism holds that rapid changes in money supply cause instability • Milton Friedman found inflation goes with rapid growth in money supply • little or no inflation when money supply growth slow and steady

35. Impacts and Limitation of Monetary Policy • Other Issues • Monetary policy more effective if coordinated with fiscal policy • Goals of Fed may clash with those of Congress or President • governors serve 14 years; have less political pressure than politicians

36. Questions • Which open market operation causes the money supply to expand? Why? • Compare and contrast expansionary fiscal policy and expansionary monetary policy on the chart below. • What will happen to interest rates when the Fed sells bonds in open market operations? Why? • What are the Fed’s underlying assumptions about the state of the economy, based on these Fed actions? • The Fed’s open market operations caused the FFR to drop from 6.25% to 1%. • The FFR rose from 1% to 4.2%

37. Section 4: Monetary Policy Monetary Policy & Macroeconomic Stabilization

38. Applying Monetary and Fiscal Policy • Fiscal and monetary policies impact each other • Both have limitations: policy lags, political constraints, timing issues • timing also affected by people’s actions based on rational expectations • Opponents of discretionary policy favor a stable monetary policy • thus people, businesses will not make decisions ahead of policies

39. Policies to Expand the Economy • Example: Expansionary Monetary and Fiscal Policy • Expansionary policy meant to reduce unemployment, increase investment • Expansionary fiscal policy raises interest rates; monetary lowers them • actual change in rates depends on relative strength of the two policies • amount of investment spending depends on rates

41. Policies to Control Inflation • Goal of contractionary monetary policy is to stabilize economy • decrease inflation and increase interest rates

42. Policies to Control Inflation • Example: Contractionary Monetary and Fiscal Policy • Contractionary policies decrease aggregate demand, control inflation • Fiscal policy lowers interest rates; monetary policy raises them • actual change in rates depends on relative strength of the two policies • amount of investment spending depends on rates

44. Policies to Control Inflation • Example: Wage and Price Controls • Government may establish non-mandatory wage and price guidelines • Wage and price controls—limits on increases in wages and prices • mandatory and enforced by government • WWII: President Roosevelt used to control inflation due to shortages • 1970s: President Nixon used to try to combat stagflation

45. Policies in Conflict • Coordinated policies usually produce desired effect on economy • If uncoordinated, one policy can counter effects of the other • creates economic instability

46. Policies in Conflict • Example: Conflicting Monetary and Fiscal Policies • Example: CPI is 6% and rising; unemployment is 7% • Fed tries to fix inflation by selling bonds, raising discount rate • government tries to lower unemployment by cutting taxes, more spending • Only clear result of conflicting policies is higher interest rates

48. Interpreting Signals from the Fed • Background • Economists and financial observers scrutinize everything the Fed chairman says in an attempt to predict how his statements will affect the economy. A hint that the Fed might change interest rates can lead to a great deal of activity in the stock market. • What’s the Issue • How much does the market rely on signals from the Fed to make economic decisions? • Thinking Economically • How do articles A and C illustrate the rational expectations theory? • Based on these three sources and your own knowledge, how would you describe the differences and similarities between Greenspan and Bernanke and their impact on the market?

49. Questions • What effects would government borrowing to finance increased spending have on interest rates and why? • Why do tax cuts and increased government spending result in a rise in interest rates? • What are the results of each of the following? • Expansionary Policies - • Contractionary Policies - • Conflicting Policies -