The Federal Reserve System “the Fed” Reference Chapter 11 12 Federal Reserve Districts Commercial banks’ banker Board of Governors Board of Governors • 7 members – – – – appointed by president approved by Senate 14 yr. term chairman • Ben Bernanke • formerly – Alan Greenspan 6 Major Jobs of the Fed • • • • • • Supply the economy with paper money and coins. Hold bank reserves. Provide check-clearing services Supervise member banks Serve as lender of last resort. Control the money supply 1.Supply the economy with paper money and coins. “U.S. Mint” Bureau of Engraving and Printing 2. Hold bank reserves reserves at the Fed + vault cash =total reserves 3.Provide check-clearing services • Facilitates check-cashing between commercial banks. – for example, Wells-Fargo and Bank of America Between banks, cities • EXAMPLE: • Pete pays Sue for a used car. He gives her a check for $2,000. • Sue deposits the check in her bank and is credited with $2,000 in her account. • Sue’s bank sends the check to FRB who increases the bank’s reserve account by $2,000. • FRB decreases Pete’s bank’s reserve by $2,000 • FRB notifies Pete’s bank to reduce Pete’s account by $2,000. 4. Supervise member banks 5. Serve as lender of last resort • Fed may “audit” a bank – check that the loans it made are good – be sure it has followed banking rules – verify the accuracy of its accounting. • Fed can lend funds to struggling banks. – Glass-Steagall Act (1933) establishes FDIC 6. Control the money supply. I kept the most important for last! • Tools for changing the money supply – Reserve Requirement – Discount Rate – Open Market Operations Why is changing the money supply important? TO CONTROL INFLATION and/or UNEMPLOYMENT Monetary Policy Prepare Section Review Answers 11.1 page 292 1. Federal Open Market committee: major decision maker in the FRB. 2. Federal Reserve System : US Central Bank 3. Board of Governor’s : controls and coordinates fed activities (7 members) 4. Reserve account: funds required to be held in the FRB Review Describe the structure of the Federal Reserve System. 7 member Board of Governors appointed by president, ratified by Senate 14 year term, chairman 12 districts In what year was it founded? 1913 Review 1. 6 major jobs? • Supply the economy with paper money and coins. • Hold bank reserves. • Provide check-clearing services • Supervise member banks • Serve as lender of last resort. • Control the money supply Review • Why would a bank choose to join the Federal Reserve System? • FRB helps maintain bank stability • Consumers want their accounts to be covered by FDIC Review • Describe the check-clearing process. • Pete pays Sue for a used car. He gives her a check for $2,000. • Sue deposits the check in her bank and is credited with $2,000 in her account. • Sue’s bank sends the check to FRB who increases the bank’s reserve account by $2,000. • FRB decreases Pete’s bank’s reserve by $2,000 • FRB notifies Pete’s bank to reduce Pete’s account by $2,000. The Money Creation Process Reference 10.2 Think of our banking simulation for fractional reserve banking The Money Creation Process • Read 10.2 p. 293 • Complete Section Review p. 300 #1-5 11.3 “Fed” Tools for Changing the Money Supply These tools are used to implement MONETARY POLICY Monetary policy has two basic goals: to promote "maximum" sustainable output and employment to promote "stable" prices Why would the Fed want to change the money supply? • Slow INFLATION • (too much money chasing too few goods) • Lower UNEMPLOYMENT • (too many people out of work) • Promote Growth in the Economy • Slow down an “over-heated” economy – Adjusting for the normal business cycle Typical Business Cycle Long Term Growth Monetary Policy • Fed is responsible for maintaining price stability and employment • “Expansionary Monetary Policy” – goal is to increase money supply • to reduce unemployment • to avoid deflation • “Contractionary Monetary Policy” – goal is to decrease the money supply • to reduce inflation • To prevent “bubbles” 3 Important Tools 1. Changing the Reserve Requirement 2. Changing the Discount Rate 3. Conducting “Open Market Operations” The three tools are interactive 1. Reserve Requirement currently: 3-10% • Raise the reserve requirement = Less money in circulation – slows the economy • eventually brings price stability (lowers inflation) • Lower the reserve requirement = More money in circulation – More money to buy goods and services • requiring more jobs to produce them (lowers unemployment) 2. Changing the discount rate • discount rate = interest rate on fed to bank loans (set by Fed) • federal funds rate = interest rate on bank to bank loans (set by fed funds market) Raising the interest rate influences how much banks will decide to borrow from the fed (who will lend them money “out of thin air”, increasing money supply) Keeping the discount rate low encourages borrowing federal funds rate=interest rate on bank to bank loans bank discount rate=interest rate on fed to bankAnother loans When the federal funds rate is lower than the discount rate, who would you borrow from? When the discount rate is lower than the federal funds rate, who would you borrow from? The fed • The Fed can encourage borrowing by keeping rates low currently: discount rate - .75% federal funds rate - 0-.25% 2006 discount rate - 6.25% federal funds rate - 5.25% What is the Fed trying to do? Federal Open Market Committee (FOMC) 1 • controls Open Market Operations – Open Market Purchases buys government securities = increases money supply – Open Market Sales sells government securities = reduces the money supply Important Background Information • U.S. Department of the Treasury – the agency of government responsible for paying for government and its actions • collects taxes • borrows money if needed – It borrows from the public by offering securities » securities: promises to repay with interest at some future time Open Market Purchases • Fed offers to buy your government security. – “Thin air” money is given to you. – Money supply increases Open Market Sales • Fed offers to sell government securities it holds. – You pay for it. – Your money “disappears” into the Fed – Decreases the money supply. Review • What are three ways the Fed can control the money supply? Reserve Requirement Discount Rate Open Market Operations Review • Why does the Fed want to control the money supply? • Monetary Policy: maintain employment control inflation Review • What is the “reserve requirement”? – If the Fed wants to reduce the money supply, what does it do to the reserve requirement? • What is the discount rate? – What is the federal funds rate? – If the Fed wants to increase the money supply, what does it do to the discount rate? Review • What is the difference between an Open Market Sale and an Open Market Purchase? • action? • goal? Complete 11.3 Section Review, p. 306 # 2-4 Homework • Read and note Chapter 13.1 “Inflation” – Include definitions from Section Review #1, highlighted • Section Quiz next class.