Federal Reserve

Policy
M and r I C + I + G + (X IM)
1 2 3 4
Y and P

1. central bank is bank for banks.
2. The Federal Reserve System is Americas central bank.
There are 12 Federal Reserve banks, but most of the
power is held by the Board of Governors in Washington
and by the Federal Open Market Committee.
3. The Federal Reserve acts independently of the rest of the
government. Over the past 20 to 25 years, many countries
have decided that central bank independence is a
good idea and have moved in this direction.
4. The Fed has three major monetary policy weapons:
open-market operations, reserve requirements, and its
lending policy to banks. But only open-market operations
are used frequently.
5. The Fed increases the supply of bank reserves by purchasing government securities in the open
market.
When it pays banks for such purchases by creating new
reserves, the Fed lowers interest rates and induces a
multiple expansion of the money supply. Conversely,
open-market sales of securities take reserves from banks,
raise interest rates, and lead to a contraction of the
money supply.

6. When the Fed buys bonds, bond prices rise and interest
rates fall. When the Fed sells bonds, bond prices fall and
interest rates rise.
7. The Fed can also pursue a more expansionary monetary
policy by allowing banks to borrow more reserves, perhaps
by reducing the interest rate it charges on such loans
(the discount rate) or by reducing reserve requirements.
8. None of these weapons, however, gives the Fed perfect
control over the money supply in the short run, because it
cannot predict perfectly how far the process of deposit creation
or destruction will go. The Fed can, however, control
the interest rate paid to borrow bank reserves, which is
called the federal funds rate, much more tightly.
9. Investment spending (I), including business investment
and investment in new homes, is sensitive to interest
rates (r). Specifically, I is lower when r is higher.
10. Monetary policy works in the following way in the Keynesian
model: Raising the supply of bank reserves leads
to lower interest rates; the lower interest rates stimulate
investment spending; and this investment stimulus, via
the multiplier, then raises aggregate demand.
11. Prices are likely to rise as output rises. The amount of inflation
caused by expansionary monetary policy depends
on the slope of the aggregate supply curve. Much
inflation will occur if the supply curve is steep, but little
inflation if it is flat.
12. The main reason why the aggregate demand curve
slopes downward is that higher prices increase the demand
for bank deposits, and hence for bank reserves.
Given a fixed supply of reserves, this higher demand
pushes interest rates up, which, in turn, discourages
investment.