Module 27 The Federal Reserve: Monetary Policy

1. Module 27 The Federal Reserve: Monetary Policy

2. Module 27 Essential Questions • What are the functions of the Federal Reserve System? • What are the major tools the Federal Reserve uses to serve its functions?

3. The Federal Reserve System Review • Central Bank of U.S. • Board of Governors • 12 Federal Reserve Banks

4. What are the Functions of the Federal Reserve System? Provide Financial Services Supervise and Regulate Banking Institutions ****Conduct Monetary Policy**** Maintain the Stability of the Financial System

5. What are the Functions of the Federal Reserve System? Provide Financial Services The Federal Reserve is the “banker’s bank” because it holds reserves, clears checks, provides cash, and transfers funds for commercial banks—all services that banks provide for their customers. The Federal Reserve also acts as the banker and fiscal agent for the federal government. The U.S. Treasury has its checking account with the Federal Reserve, so when the federal government writes a check, it is written on an account at the Fed. Supervise and Regulate Banking Institutions The Federal Reserve System is charged with ensuring the soundness of the nation’s banking and financial system. The regional Federal Reserve banks examine and regulate commercial banks in their district. The Board of Govalso engages in regulation and supervision of financial institutions. Maintain the Stability of the Financial System The Fed is charged with maintaining the integrity of the financial system. As part of this function, Federal Reserve banks provide liquidity to financial institutions to ensure their safety and soundness. ****Conduct Monetary Policy**** One of the Federal Reserve’s most important functions is the conduct of monetary policy. The Federal Reserve uses the tools of monetary policy to prevent or address extreme macroeconomic fluctuations in the U.S. economy.

6. What Are the 3 Tools of the Fed? • R_____________________ • D_____________________ • O_____________________ • What tool is typically used today more than the others? Why?

7. What Are the 3 Tools of the Fed? • Reserve Requirement • Discount Rate • Open-Market Operations • What tool is typically used today more than the others? OMO’s to set the FFR is what is typically used today. RR’s are for stability and DR is used for liquidity needs in unique circumstances.

8. How does the Reserve Requirement Work? Banks that fail to maintain at least the 10% required reserve ratio on average over a two­ -­ week period face p______________ from the Fed. 1. What if a bank looks as if it has insufficient reserves to meet the Fed’s reserve requirement? What can a bank do? The federal funds rate,aka the i____________ r______at which funds are borrowed and lent in the federal funds market, plays a key role in modern monetary policy. 2. To alter the money supply, the Fed can change the reserve requirements. How& what happens to the money multiplier? #1: #2: Under current practice, however, the Fed doesn’t use changes in reserve requirements to actively manage the money supply. The last significant change in reserve requirements was in 1992.

9. How does the Reserve Requirement Work? Banks that fail to maintain at least the 10% required reserve ratio on average over a two­ -­ week period face penalties. 1. What if a bank looks as if it has insufficient reserves to meet the Fed’s reserve requirement? What can a bank do? The bank can borrow additional reserves from other banks via the federal funds market, a financial market that allows banks that fall short of the reserve requirement to borrow reserves (usually just overnight) from banks that are holding excess reserves. The federal funds rate,aka the interest rate that funds are borrowed and lent in the federal funds market, plays a key role in modern monetary policy. 2. To alter the money supply, the Fed can change reserve requirements. How? #1: the Fed reduces the required reserve ratio, banks will lend a larger percentage of their deposits, leading to more loans and an increase in the money supply via the money multiplier. #2: If the Fed increases the required reserve ratio, banks are forced to reduce their lending, leading to a fall in the money supply via the money multiplier. Under current practice, however, the Fed doesn’t use changes in reserve requirements to actively manage the money supply. The last significant change in reserve requirements was in 1992.

10. How Does the Discount Rate Work? 1. Alternatively, banks in need of reserves can b________ from the F________ itself via the D______________ w___________, instead of other banks. 2. The d___________ rate is the rate of interest the Fed charges on those loans. 3. The discount rate is set ____ p_____________ p__________above the f_________funds rate in order to discourage banks from turning to the Fed when they are in need of reserves. This is called the “s________”. 4. To alter the money supply, the Fed can change the spread between the discount rate and the federal funds rate. How & what happens to money supply? #1: #2: The Fed normally doesn’t use the discount rate to actively manage the money supply.

11. How Does the Discount Rate Work? 1. Alternatively, banks in need of reserves can borrow from the Fed itself via the discount window, instead of other banks. 2. The discount rate is the rate of interest the Fed charges on those loans. 3. The discount rate is set 1 percentage point above the federalfunds rate in order to discourage banks from turning to the Fed when they are in need of reserves. This is called the “spread”. 4. To alter the money supply, the Fed can change the spread between the discount rate and the federal funds rate. How? #1: If the Fed reduces the spread between the discount rate and the federal funds rate, the cost to banks that are short of reserves decreases; banks respond by increasing their lending, and the money supply increases via the money multiplier. #2: If the Fed increases the spread between the discount rate and the federal funds rate, bank lending falls—and so will the money supply via the money multiplier. The Fed normally doesn’t use the discount rate to actively manage the money supply.

12. How Does Open-Market Operations Work? 1. In an 0_____­ -­ m_______ o___________the Federal Reserve b______or s_______ U.S. Treasury bills, normally through a transaction with c_____________ b___________—banks that mainly make b____________ loans, as opposed to home loans. 1. To alter the money supply, the Fed can buy or sell U.S. Treasury bills. How? #1(BUY): Ex: The Fed buys $100 million of U.S. Treasury bills from commercial banks. What does this do to the monetary base? What stage of the business cycle would this be used? #2 (SELL):. EX: The Fed sells $100 million of U.S. Treasury bills. What happens to bank reserves and the monetary base? What stage of the business cycle would this be used?

13. How Does Open-Market Operations Work? In an open­ -­ market operationthe Federal Reserve buys or sells U.S. Treasury bills, normally through a transaction with commercial banks—banks that mainly make business loans, as opposed to home loans. 1. To alter the money supply, the Fed can buy or sell U.S. Treasury bills. How? #1: When the Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s reserve account by an amount equal to the value of the Treasury bills. Ex: The Fed buys $100 million of U.S. Treasury bills from commercial banks. What does this do to the monetary base? What stage of the business cycle would this be used? Increases the monetary base by $100 million because it increases bank reserves by $100 million, recession #2: When the Fed sells U.S. Treasury bills to commercial banks, it debits the banks’ accounts, reducing their reserves. EX: The Fed sells $100 million of U.S. Treasury bills. What happens to bank reserves and the monetary base? What stage of the business cycle would this be used? Decreases both by 100 million, inflation

14. Open-Market Operations p.265

15. How Does Open-Market Operations Work? A change in bank reserves caused by an open­ -­ market operation doesn’t directly affect the money supply. Instead, it starts the money multiplier in motion. • What has to happen before the money multiplier its set in motion? • Who decides if this is done? • During the Great Recession did the Fed give banks access to reserves? • What was done with these reserves? • How did that contribute further to the recession?

16. Module 27 Review Questions 266-267 • Read Module 28 p. 268 - 275