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CHAPTER 14. Monetary Policy and the Federal Reserve System. The Federal Reserve System. Began operation in 1914 to eliminate severe financial crises. 12 regional Federal Reserve Banks owned by private banks within each district i.e. Boston, New York, Philadelphia, etc.

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Chapter 14


Monetary Policy and the

Federal Reserve System

The Federal Reserve System

Began operation in 1914 to eliminate severe financial crises.

12 regional Federal Reserve Banks owned by private banks within each district i.e. Boston, New York, Philadelphia, etc.

Leadership of the Fed = Board of Governors in Washington, D.C.

Chairman of Board has considerable powers (4-yr term)

7 governors (14-yr terms) - appointed by the US President

The Federal Open Market Committee (FOMC)

Federal Open Market Committee (FOMC):

- decide on monetary policy

- consists of 7 governors + 5 presidents of the Federal Reserve Banks on a rotating basis (New York president always on the committee)

- meets 8 times a year but may meet more frequently if economic developments warrant.

The Fed's Balance Sheet

Balance Sheet:

- Largest asset is holdings of Treasury securities:

Owns gold, makes loans to banks, and holds other assets including foreign exchange and federal

agency securities.

- Largest liability is currency outstanding:

Some is held in bank vaults and is called vault cash.

The rest is held by the public.

Another liability is deposits by banks and other depository institutions.

Vault cash + banks' deposits at the Fed = banks' total reserves (RES).

Reserve Requirements

The Fed sets the minimum fraction of each type of deposit that a bank must hold as reserves.

An increase in reserve requirements forces banks to hold more reserves, thus reducing the money multiplier.

Discount Window Lending

Discount window lending:

“lending reserves to banks so they can meet depositors' demands or reserve requirements”

The interest rate is called the discount rate.

The Fed was set up to halt financial panics by acting as a lender of last resort through the discount window.

A discount loan increases the monetary base.

Discouraging Discount Window Borrowing

Increases in the discount rate discourage borrowing and reduce the monetary base.Instead, banks borrow from each other in the Federal funds market.

The interest rate in the federal funds market is the Fed funds rate.

The Fed funds rate is determined by supply and demand.

By contrast, the discount rate is set by the Fed.

Usually the Fed funds rate exceeds the discount rate, since banks are willing to pay more to avoid borrowing from the Fed.

Intermediate Targets

“to guide policy as a step between its tools or instruments and its goals or ultimate targets of price stability and stable economic growth.

Intermediate targets are variables the Fed can't directly control but can influence predictably, and they are related to the Fed's goals.

i.e. Monetary aggregates such as M1 and M2,

and short-term interest rates, (e.g. the Fed funds rate).

The Fed cannot target both the money supply and the Fed funds rate simultaneously: If Ms and the Fed funds rate both were above target, so the Fed needs to lower them. Since Ms↓ shifts the LM↑, the Fed funds rate will ↑.

Targeting The Fed Funds Rate

Works well if the main shocks to the economy are to the LM curve.

Stabilizes output, the real interest rate, and the price level, as it offsets the shocks to the LM curve completely.

End of Lecture 2 Week 13

The Federal Reserve System

The Federal Open Market Committee

The Fed’s Balance Sheet

Reserve Requirements

Discount Window Lending

Discouraging Discount Window Borrowing

Intermediate Targets

Targeting the Fed Funds Rate