CHAPTER 11 CENTRAL BANKING The Federal Reserve System Organization of the Federal Reserve System • Proverbs 22:7 and Haggai 2:8 (Let’s get it straight as to whom owns what) • Central Banking: refers to the government’s use of this bank to control and accommodate the nation’s finances through the banks various functions. • The Federal Reserve System: “the Fed” is a governmental institution responsible for overseeing the issue of currency, regulating bank activity, and providing banking services to the nation’s commercial banks. It was created in 1913 (The Federal Reserve Bank Act). • Federal Reserve District Banks: Congress divided the nation into “12“ districts and gave each its own central bank. Each one has an operations center that sorts millions of checks and supplies the currency and coins to commercial banks. Pg 213 Graphic Map The Federal Reserve • J.P. Morgan: Formidable Financier. Pg 212 read and discuss • Board of Governors: A 7 member team that guides the Federal Reserve System and acquire their seats through a selection and confirmation process. The maximum term for a member is 14 years, but the average term is 6 yrs. • Reserve Requirement: American banks must keep a specified percentage of their deposits on hand. • Other Functions (B.of Gov): supervising and regulating commercial banks, supervising the 12 District Fed Reserve banks, and administering financial consumer protection laws (i.e. equal credit opportunity and fair housing and lending). Federal Reserve • Federal Open Market Committee: affects the money supply by buying and selling governmental securities, such as Treasury bills, notes and bonds. This is the Fed’s most important tool in changing the quantity of money in the money supply. The FOMC has twelve members (7 from the Board of Gov). • Independence of the Federal Reserve: 3 ways: A. the Fed is politically independent. B. Financially independent and C. Operationally independent. • Checks on the Federal Reserve: 2 checks on power: 1. Congress may remove members “for cause” and 2. Congress can abolish the Fed by making a law doing just that. Functions of the Federal Reserve System • • • • • • To provide for a uniform currency To regulate member banks To clear checks and debit card transactions To act as the nation’s fiscal agent To serve as the banker’s bank To create money Functions of the Federal Reserve System • Elastic currency: a money supply that can expand as the economy grows • How checks are cleared: Pg 218-219 • Glory without Gold pg 220 • Run on the Bank and Lender of Last Resort. The Money Multiplier Effect and $$$ creation 11B • Creating Money: the Money Multiplier Effect is the expansion of the money supply as a result of commercial banks’ lending their depositors money to others. The factor 1/rr is the money multiplier. Figure 11-1 pg 223 • The tools of money creation: 3 ways • 1. Changing the discount rate: Discounting: lending money to banks through lowering or raising the discount rate (the interest rate it charges on loans it grants to banks). • 2. Changing the reserve requirement: If the Fed wanted to increase the money supply they could lower the reserve requirement. For example, if the reserve requirement were lowered to 5 percent the money multiplier would rise to twenty. • 3. Using open market operations: an action whereby the Fed purchases or sells governmental securities in the open market to inject money into or withdraw money form the economy. 0 Money and the Economy 11C • Monetary Policy: is the increasing or decreasing of the money supply to influence the economy. • Tight monetary policy: using one or more of the policy tools to “REDUCE” the money supply. Tends to curb inflation but increases the risk of slower economic growth and unemployment. • Loose monetary policy: using one or more of the policy tools to “INCREASE” the money supply. Encourages economic growth but makes inflation more likely. The Money Supply • The Money Supply and Prices: As a nation increases the production of goods and services the money supply must increase to the same extent. If the money supply grows more quickly it will require more dollars, thereby causing inflation. If the supply of money grows more slowly than goods/services then prices will decline (a recession may happen). • The Money Supply and Interest Rates: the intersection of the demand and supply curves for money determines the price of money, or the interest rate: Figure 11-3 pg 226. If interest rates rise, normally people will borrow (demand) less money. If interest rates fall, there will be an increase in borrowing. • The Fed Policy Tradeoff: Why doe the Fed not continually print more money to stimulate the economy? Because it would accelerate the economy too much and cause inflation (or a general rise in the price level): remember scarcity… QUESTIONS?