The Federal Reserve System

The Fed and Monetary Policy

The Fed

• 1913 the Federal Reserve or the Fed was setup to act as the central bank of the US

• Provides financial services to the US

• Regulates financial institutions

• Conducts monetary policy

StructureCorporation

• The Fed is a corporation owned by banks that own shares

• National Banks chartered by the US government must belong

Board of Governors

• 7 member board appointed by the President approved by Senate 14 year terms

• Regulates and supervises member banks

• Reports directly to Congress

Federal Reserve District Banks

• 12 Federal Reserve and 25 District Banks act as Banks for Banks.

• Provide deposit locations and loan institutions for commercial banks

• Strategically located to be near the commercial banks they serve

Federal Open Market Committee• Decide growth of money

Supply and level of interest rates

• 12 voting Members– 7 from the board of Governors– President of the New York

District– 4 other district presidents serve

one year– Other district presidents are

nonvoting members

Federal Open Market Committeecontinued

• Meet 8 times a year to make decisions about cost and credit availability

• Primary monetary policy making body

Advisory Committees

• Federal Advisory Council- advice on the health of the economy representatives from all 12 district banks

• Consumer Advisory Council- consumer credit law issues 30 members – educators, legal specialists and

consumer and financial industry group representatives

Advisory Committeescontinued

• Thrift Institutions Advisory Council– Representatives from Savings

and loans, Banks and Credit Unions

– Advise on matters dealing with thrift industry

Regulatory Responsibility

• State Member Banks- monitors the reserves of members – How much money they must

have on hand

– Way the money supply is controlled

Regulatory Responsibilitycontinued

• Bank Holding Companies- corporations that own one more banks

• Holding companies were ways to get around banking laws

Regulatory Responsibilitycontinued

• International Operations- Foreign Banks control 20% of US banks Fed has ability regulate them

• Member Bank Mergers- bank mergers require Fed approval

Other Reserve Services

• Check Clearing• Enforcing consumer

Legislation• Maintaining Currency and

Coins(issues and destroys money)

• Providing Financial services to the government( Bonds, IRS accounts)

Monetary Policy

Monetary Policy

• The expansion and contraction of the money supply in order to influence the cost and availability of credit

Fractional Reserve System

• Requires banks and other institutions to keep a fraction of their deposits in legal reserves

• Legal reserves- coins and currency that must be kept in the vault, and deposits in the fed district banks.

• Reserve requirement rule stating the percentage of total deposits that the bank must have in legal reserves

Fractional Reserve Systemcontinued

• Banks operate at 12 % rate• For every $100 deposited the

bank must set aside $12• The other $88 is excess

reserves that the bank can lend to others

Making Loans

• Banks make loans on all of its excess reserves

• If a bank charged 12% interest on a loan of $100 it would earn $12 each time it was compounded

• To make loans Banks need to offer savings accounts and time deposits

Tools of Monetary policy• Reserve Requirement-

– Lowering- more money can be loaned (more credit avail. and Interest rates lower)

– Raising- less money can be loaned (less credit avail. and interest rates higher)

• Open Market Operations- buying and selling government Securities– Buying increases the supply of money forcing

interest rates down

– Selling decreases the money supply forcing up interest rates

Discount Rate

• The interest the Fed charges on loans to other financial institutions

• If the discount rate is raised then banks will be less likely to borrow money, and less will be loaned to customers

• Rates charged by banks will follow the discount rate

The Evolution of MoneyBanking and Monetary Standards

Money

• Any substance that serves as a medium of exchange, a measure and store of value

• Without money we would have a barter economy based on trade alone

Functions of Money

• Medium of exchange- accepted by all parties as payment for goods or services

• Measure of Value- can be used to express worth in terms that all individuals can understand

• Store of Value- allows it to be saved until needed

Characteristics of Money

• Portability- easy to transfer from one person to another

• Durability- it has to last and be able to be handled can not deteriorate when being used as a store of value

• Divisibility- easy to divide into smaller units

• Limited Availability- loses value when there is too much of it

Monetary Standard

• Mechanism designed to keep the money supply portable, durable, divisible and limited in supply

• US has had a number of monetary standards

Privately Issued Bank Notes

• Federal government did not issue paper money until the Civil War

• State Banks Issued their own paper money which could be exchanged for gold or silver at that bank

• Problems included hundreds of different notes all different, counterfeiting, and not all accepted

Greenbacks

• 1861 Paper currency printed by the Union Government

• Declared Legal Tender- must be accepted as payment for debts (printed with green ink)

• Became United States Notes• Confederate Government did

the same

GreenbacksNational Currency

• System of national banks established

• These banks issued new National Bank Notes or National Currency

• 1865 State banks forced to join the system and withdraw their privately issued notes

Certificates and Coin Notes

• Gold Certificates- paper currency backed by gold deposited in the US Treasury

• Silver Certificates- backed by silver on deposit

• Treasury Coin Notes- backed by both gold and silver

Modern Money

• Since 1968 US money is no longer backed by gold or silver

• Money is controlled by the actions of the Federal Reserve System

Government Taxes and Spending

Economic Impact of Taxes• Tax placed on a good at the

factory increases production costs

• Taxes can encourage or discourage activities (sin Tax)

• Incidence of the tax is the person who eventually pays for it. (consumer)

Criteria For Effective Taxes• Equity- is the tax fair are

there exceptions, deductions and exemptions

• Simplicity- are the laws easy to understand

• Efficient- easy to administer and generate revenue

Principles of Taxation• Benefit principle- those who

benefit from government services should pay in proportion to those services

• Ability to pay principle- people taxed according to their ability to pay

Types of Taxes• Proportional Tax- same

percentage is paid by everyone• Progressive Tax- higher

percentage on higher incomes• Regressive tax higher

percentage on lower incomes

Individual Income Taxes• 45% taxes come from

individuals (Highest amount)• Withheld from paychecks sent

by employers to the Government

• Taxes filed by April 15th refund -paid over what is owed

• Income tax is progressive until a certain level then proportional

FICA Taxes• Federal Insurance

Contributions Act- pays Social Security and Medicare

• Called payroll taxes• Second largest amount of

tax

Corporate Income Taxes

• Corporation are considered legal entities and pay taxes on their profits

• Third largest source of government revenue

Other Federal Taxes• Excise tax- regressive tax on

the manufacture and sale of select items (gas liquor)

• Estate and Gift taxes- death or as a gift

• Customs duties- charges for bringing goods into the US

State and Local Taxes• Intergovernmental revenues- collected by one level of the government and distributed to another

• Sales Tax- consumer purchases for most products (mostly state level)

• Property Taxes (local level)• Fees, lotteries utilities

Two Kinds of Spending• Goods and services-

everything the government buys guns to butter

• Transfer payments- from one level of the government to another (grant-in-aid) and payments to individuals or subsidies (welfare, social security, unemployment)

Federal Budget• President drafts budget-sent to

Congress treated like a proposed law

• Budget has two parts– Mandatory spending- interest

payments, Social Security and Medicare

– Discretionary spending- programs approved by Congress

National Debt• Deficits- spending more than is

collected in revenues• Government sells bonds to raise

money results in debt• Debt takes purchasing power

from the government• Increasing taxes to pay debt takes

purchasing power from society

Taming the Deficit• Congress has passed a

number of resolutions to curb deficit spending and reduce the debt

• All resolutions have failed to work

• Government is currently operating under record deficits