Chapter 11b

Federal Reserve and Monetary Policy

Central Banking

Functions of a central bank:

1. Serve as the bank for government accounts
It is a place for the government to store tax revenue
until it is spent
2. Regulate banks in a country
make sure that banks are not making too many risky
loans or engaging in embezzlement

Functions of a Central
Bank

3. Serve as a lender of last resort

lend money to banks when they face a liquidity
problem
4. Control monetary policy
Decide when to increase or decrease the money
supply to help keep inflation low and the
economy at full employment

First Bank of US

The first attempt at a central bank in the US, as

suggested by Alexander Hamilton:
First Bank of the United States
- Based in Philadelphia

(1792-1812)

- A privately owned bank with many foreign

(British) investors

First Bank of US
Continued

The First Bank didnt get its 20 year charter

renewed in 1812, so there was no central bank
until 1816
Some thought that the bank concentrated too
much power in private Philadelphia hands

Second Bank of US
Continued

Second Bank of the United States (1816-1836)

Like the First Bank, only bigger.
It was based in Philadelphia and was privately owned
President Andrew Jackson disliked the Second Bank
and took all government money out of it.
He placed the government money in pet banks.

Central Banking in
theUS
The US had no central bank from 1836 until
1913.
The bank panic of 1907 made people realize that
we needed a central bank.
Our third attempt at a central bank is called

Federal Reserve
Cities

The Federal Reserve is made up of 12 private

member banks in 12 different cities.
12 Federal Reserve Cities:
Boston New York
Philadelphia Richmond
Atlanta Cleveland
Chicago St. Louis
K.C. Minneapolis
Dallas San Francisco

Federal Reserve Map

Federal Open Market

Committee

Each bank used to conduct its own monetary policy

That led to chaos during The Great Depression as the
NY Fed increased the money supply while the
Chicago Fed decreased it
Monetary policy is now made by the Federal Open
Market Committee (F.O.M.C.)
It has 12 members an is located in Washington D.C.

F.O.M.C.

1 President of NY Fed
4 Rotating presidents of the other 11 Fed banks
7 Board of Governors (appointed by the US
President for alternating 14 year terms)
(The chairman serves a 4 year term and is from
the board of governors)

F.O.M.C. Chairman

Current Chairwoman Janet Yellen

The F.O.M.C. meets 8 times a year to set
monetary policy for the country

3 Primary Tools of the

F.O.M.C

1. Change the reserve ratio (rr)

rr = the minimum percentage of deposits a bank
must hold in reserves
current rr is .1

Changing the
Reserve Requirement

The more money that banks can loan out, the

more money they will make.
The Fed regulates how much banks can loan out
to guarantee that they hold onto sufficient cash
If the Fed increases the rr, then banks have to
hold onto more cash and make fewer loans. This
lowers the amount of checkable deposits in the
economy and therefore the money supply.

Lowering the Reserve

Requirement

If the Fed decreases the rr, then banks have to

hold onto less cash and can make more loans.
This increases the amount of checkable deposits
in the economy and therefore the money supply.
The Fed rarely changes the rr. Its like killing a
fly with a sledgehammer

Changing the
Discount
Rate

2. The Fed can change the discount rate

Discount rate the interest rate the Fed
charges banks to borrow money over night
(penalty for over-lending)

Increasing the
Discount
Rate

If the Fed increases the discount rate it becomes less

likely that banks will loan out too much money
M1 will fall as loans and checkable deposits fall
If the Fed decreases the discount rate it becomes
more likely that banks will loan out more money
M1 will increase as loans and checkable deposits
increase

Open Market
Operations

The discount rate is largely symbolic

If a bank borrows money from the Fed, it sends
bank regulators into a frenzy
3. The Fed can engage in open market
operations
The Fed can buy or sell government bonds

Buying and Selling

Bonds

If the Fed buys bonds, then it gives cash to banks

in exchange for government debt.
That cash gets loaned out and M1 increases.
If the Fed sells bonds, then it takes cash from
banks in exchange for government debt.
To free up this cash, banks make fewer loans so
M1 decreases.

Federal Funds Rate

When the F.O.M.C. meets it announces an interest

rate target rather than saying how many bonds it
will buy or sell
Federal Funds Rate - The interest rate banks
charge each other to borrow money over night
(Prime)
The Fed sets an interest rate target, they dont set
the interest rate.

Federal Funds Market

loanable funds
r
S
.25%
D
10
Quantity ($ millions)

Decrease in Money
Supply

loanable funds
r
S
.50%
S
.25%

D
9

10
Quantity ($ millions)

Expansionary
Monetary
Policy

Expansionary Monetary Policy Increasing the

money supply to increase RGDP
Increasing the money supply lowers interest rates
Lowering interest rates increases Investment
Increasing Investment increases Aggregate Demand
Increasing Aggregate Demand increases RGDP

Expansionary Policy

Price

Aggregate Supply

AD
AD = C + G + I + NX
RGDPc FE RGDP

Contractionary
Monetary
Policy

Contractionary Monetary Policy Reducing the

money supply to reduce RGDP
Decreasing the money supply increases interest rates
Raising interest rates decreases Investment
Decreasing Investment decreases Aggregate Demand
Decreasing Aggregate Demand decreases RGDP

Contractionary Policy

Price

Aggregate Supply

AD AD = C + G + I + NX
FE RGDPc RGDP