The Federal Reserve

Federal Reserve Basics:• Considered the Nation’s central bank• Does not serve individuals and businesses; its customers are

thousands of banks across the U.S.• GOAL: keep the entire banking system stable and healthy

Services provided by the Fed:• Holding Reserve: requires that all banks hold a fraction of its

deposits in reserve; some of the reserve is held at the local bank, while some of it goes into an account set up for the bank at the Fed. • The Fed serves as a bank for banks!

• Providing cash and loans: provides cash to banks from their reserve when needed; also provide loans to banks when they run short on funds

• Clearing Checks: The Fed transfers funds from one bank to another when checks are written

• Linking banks electronically: The Fed links all the banks together electronically, and that is how banks quickly transfer funds from one to another

Managing the Banking System• The Fed has an important job of controlling the nation’s

money supply• Set the reserve requirements (the minimum percentage that

banks must keep in reserve)• Fed also issues Federal Reserve notes (paper currency = dollars)

• Basic Structure:• Board of Governors (7 person committee in Washington, D.C. that

controls the Fed)• 12 districts, each with its own Federal Reserve Bank• FOMC (Federal Open Market Committee) composed of the

governors and five Federal Reserve presidents

How the Fed affects Monetary Policy

• Monetary policy: Central bank policy aimed at regulating the amount of money in circulation.

• When the Fed believes the economy is in danger of sliding into a recession, it adopts an expansionary monetary policy, also known as easy-money policy.• Increase the amount of money in circulation, interest rates drop

and borrowing becomes cheaper and easier• Easy money encourages individuals and businesses to take out

loans, which increases the demand for goods and services, which leads to more production, stronger economic growth, and drop in jobless rate

How the Fed affects Monetary Policy

• When the Fed believes the economy is growing too fast, or the inflation rate is growing too rapidly, then the Fed adopts a contractionary monetary policy, or known as a tight money policy• Less money is in circulation which causes interest rates to rise and

loans harder to get• Individuals and businesses cut back on borrowing as well as

spending, causing demand to shrink, leading to less production, weaker economic growth, and a drop in the inflation rate

Tools of the Federal Reserve• 1) Open-Market Operations• Involves the buying and selling of government securities in the

bond market (includes treasury bonds, notes, bills or other government bonds)

• Under an easy money policy, the Fed buys government securities – puts more money into circulation

• Under a tight money policy, the Fed sells securities in the bond market – takes money out of circulation

• The FOMC (Federal Open Market Committee) make decisions to use this tool

• Most commonly used tool to make small adjustments to the economy

Tools of the Federal Reserve• 2) The Reserve Requirement• Board of governors could expand or contract the money supply

by adjusting the required reserve ratio• Lowering the ratio would allow banks to make more loans and

create more money• Raising the ratio makes banks keep more cash in reserve and out

of money supply• This is the least-used tool of the Federal Reserve because of

potential negative impact on the economy if ratio changed too dramatically

Tools of the Federal Reserve• 3) The Discount Rate• The discount rate is the interest rate charged to banks to borrow

money from the Federal Reserve• The Federal Reserve board of governors controls the discount

rate• Low discount rate encourages banks to borrow money and make

more loans so it increases the money supply• Raising the discount rate discourages banks from borrowing,

creating less money in circulation because less loans being made• This tool isn’t used a lot because many banks prefer to borrow

from each other, and view the Federal Reserve as a last resort

Importance of the Federal Funds Rate

• Federal Funds Rate is the rate that banks charge one another for short loans

• The Federal Reserve doesn’t control this rate, but monitors it through the FOMC open-market operations

• FOMC focuses on the Federal Funds Rate for two reasons:• It is the easiest bank rate for the Fed to change using open-

market operations• Interest rates on everything from savings accounts, bonds,

mortgages, ad credit cards are affected by the federal funds rate• The Fed has two goals when monitoring the federal funds rate:• Control inflation• Maintain healthy economic growth

• Federal Reserve internet game:• http://www.frbsf.org/education/activities/chairman/

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