The Federal Reserve System: Organization, Functions, and Monetary Policy

1. Chapter 15 The Federal Reserve System and Monetary Policy

2. Chapter 15Section 1 Organization and Functions of the Federal Reserve System

3. Organization • The Fed is responsible for monetary policy. • Monetary policy: involves the changing rate of growth of the supply of money in circulation in order to affect the amount of credit, which affects business activity in the economy. • The Board of Governors oversees 12 district Federal Reserve banks and regulates activity of member banks and all other depository institutions.

4. Organization • The Federal Advisory Council reports to the board of governors on general business conditions in the country. • The Federal Open Market Committee decides what the Fed should do to control money supply. • Twelve Federal Reserve banks are set up as corporations owned by member banks.

5. Organization • Member Banks—all national banks, those chartered by the federal government, must join the Federal Reserve System. • State chartered banks may join if they choose. • All institutions that accept deposits from customers must keep reserves in their district Federal Reserve bank.

6. Functions • The fed has many functions, including check clearing, supervising member banks, holding reserves, and supplying paper currency. • Clearing checks is the method by which money is deposited from one bank to another. • Supervising member banks means the Fed must regulate federally chartered commercial banks. • The Fed maintains the nation’s paper money.

7. Functions • Its most important function is to regulate the money supply. • The Fed determines the amount of money in circulation. • More money in circulation means lenders are more likely to offer money for loans. • The Fed sets standards for consumer protection, mainly truth-in-lending legislation.

8. Chapter 15Section 2 Money Supply and the Economy

9. Loose and Tight Money Policies • Monetary policy involves changing the growth rate of the money supply in order to change the cost and availability of credit. • Loose money means credit is plentiful and inexpensive. • Used to encourage economic growth.

10. Loose and Tight Money Policies • Tight money means credit is in short supply and expensive. • Used to control inflation. • The goal of monetary policy is to strike a balance between tight and loose money.

11. Fractional Reserve Banking • Many banks are required to keep a percentage of their total deposits in cash reserves in their vaults or with the Federal Reserve bank. • This enables the bank to provide funds for customers who might suddenly want to withdraw large amounts of cash from their accounts. • Currently most financial institutions are required to reserve 10 percent of their checkable deposits and none on their interest-paying deposits.

12. Money Expansion • Banks can use non-reserved deposits to create new money. • Money banks lend and receive is usually spent or deposited in another bank who can also use the deposits to create new money. • This process is known as the multiple expansion of money.

13. Chapter 15Section 3 Regulating the Money Supply

14. Changing Reserve Requirements • The lower the percentage of deposits in reserve, the more money available to loan out. • When the Fed raises its reserve requirements, banks can call in loans, sell off investments, or borrow from another bank (or the Federal Reserve).

15. Changing Reserve Requirements • Raising the reserve decreases the amount of money in the economy and slows it down. • Because of the extreme effect on money supply, the Fed has not been raising the reserve recently.

16. Changing the Discount Rate • Discount Rate: interest rate that the Fed charges on loans to member banks • Prime Rate: rate of interest that banks charge on loans to their best business customers • A higher discount rate means that member banks charge their customers higher interest, reducing the money supply.

17. Changing the Discount Rate • Federal Funds Rate: interest rate that banks charge each other on loans (usually overnight) • Used to help a bank to increase its reserves by borrowing from another bank. • If the Fed decreases the federal fund rate, banks will borrow more and, thus, lend more. • This increases business activity.

18. Open-Market Operations • The buying and selling of government securities is called open-market operations. • When the Fed buys securities, it makes a deposit into the reserve account of the security dealer’s bank, giving that bank more money to lend out because its reserve account is higher than necessary.

19. Open-Market Operations • When the Fed sells securities, the purchasing bank buys them with money from its reserves, leaving the purchasing bank with less reserve funds. • This shows the multiple expansion of money working in reverse because more money is taken out of circulation than just the initial withdrawal.

20. Difficulties of Monetary Policy • It is difficult to gather and evaluate information about the money supply. • Some critics of the Fed want to stop the Fed from engaging in any monetary policy at all. • Taxing and spending by the government affect the economy, and the Fed has to consider this also in the changes they can make.