The Federal Reserve and Monetary Policy

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The Federal Reserve and Monetary Policy
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Chapter 16 The Federal Reserve Monetary Policy

• 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.

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Creating the Fed
The Federal Reserve System

• govt struggled to stabilize economy until Federal
  Reserve Act
• Central banka nations monetary authority
• monetary means relating to money
• Federal Reserve Systemcentral bank of the U.S.,
  called the Fed
• independent organization within govt established
  1913

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The Structure of the Fed

• Elements of the Fed
• Board of Governorssets policy supervises
  operations of the Fed
• chairman is most influential member and
  spokesperson
• 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

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The Structure of the Fed

• Elements of the Fed
• Federal Open Market Committeesupervises govt
  security sales

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Serving the Banking System
Functions of the Federal Reserve

• 1 Check Clearing
• 2 Lending Money
• 3 Regulating Supervising Banks

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Serving the Federal govt

• 1 Paying govt Bills
• 2 Selling govt Securities
• 3 Distributing Currency

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Creating Money

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

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The Feds Monetary Tools
Monetary Policy

• Monetary policyactions the Fed takes to change
  money supply
• purpose is to influence the economy
• Fed has 3 courses of action to take individually
  or in combination

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The Feds Monetary Tools

• Action 1 Open Market Operations
• Open market operationssales and purchase of
  govt securities
• Fed buys securities to expand money supply sells
  to contract supply
• Federal funds rate (FFR)interest rate banks
  charge one another
• Fed signals intent to buy or sell by announcing a
  target for the FFR
• if lowers target, Fed buys bonds if raises
  target, it sells bonds

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The Feds Monetary Tools

• Action 2 Adjusting the Reserve Requirement
• Fed changes required reserve ratio to change the
  money supply
• increase in RRR reduces money supply decrease
  expands it
• RRR averages 1012 for transaction deposits,
  03 for time deposits

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The Feds Monetary Tools

• Action 3 Adjusting the Discount Rate
• Discount rateinterest rate Fed charges on loans
  to other banks
• affects money supply because it determines
  reserves banks have to lend
• Prime rateinterest rate banks charge their best
  customers
• other borrowers pay 2-3 percentage points above
  prime
• If discount rate rises, so do prime, business
  consumer rates

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Approaches to Monetary Policy

• Expansionary monetary policyplan to increase
  the money supply
• Contractionary monetary policyplan to reduce
  the money supply

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Approaches to Monetary Policy

• 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

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Approaches to Monetary Policy

• 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

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Impacts and Limitation of Monetary Policy

• 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

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Impacts and Limitation of Monetary Policy

• 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

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Impacts and Limitation of Monetary Policy

• Timing Issues

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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