Chapter 11 Central Banking

The Federal Reserve System
Organization of the Federal Reserve
• 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
• 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
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
Functions of the Federal Reserve
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
• 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
• 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…

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