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Economics 4

Lecture 24 - The Federal Reserve

Federal Reserve System
tools of monetary policy
expansionary monetary policy
contractionary monetary policy

Federal Reserve System

Monetary policy involves control of the quantity of money in the economy. The Federal Reserve is responsible for monetary policy in the United States.

Click here for an introduction to the Federal Reserve System from the St. Lous Fed.

organization:

1. District Banks
2. Board of Governors (chairman is Alan Greenspan)
3. Federal Open Market Committee

functions:

1. issues paper currency
2. controls money supply
3. acts as the bankers' bank
   • accepts deposits from banks and makes loans to banks
   • clears checks by transferring funds between banks
4. supervises and inspects commercial banks
5. acts as the federal government's bank
   • handles the sale and repayment of government bonds
   • buys and sells foreign currency

Tools of Monetary Policy

1. open market operations

Open market operations is the buying and selling of government bonds by the Federal Reserve. When the Federal Reserve buys a government bond from a bank, that bank acquires excess reserves which it can lend out. The money supply will increase.

If the Federal Reserve purchases a bond from this bank for $150, the bank's total reserves rise to $250. However, since the deposits at this bank are unchanged, the entire $150 the bank received from the Fed is excess reserves. The bank can loan out these excess reserves and the multiple expansion of deposits will begin.

When the Fed sells a government bond, it takes reserves out of the banking system. The money supply will fall.

2. discount rate

When the Federal Reserve makes a loan to a member bank, the loan is called a discount loan. The interest rate on a discount loan is called the discount rate.

Suppose the bank receives a $75 discount loan from the Federal Reserve. The entire $75 is excess reserves. The bank can lend these out, starting the multiple expansion of deposits. Lowering the discount rate encourages banks to take out more discount loans while raising the rate discourages banks from borrowing from the Fed. Therefore, lowering the discount rate is expansionary; raising the discount rate is contractionary.

3. reserve ratio

The reserve ratio is the percentage of deposits banks are required to hold as reserves. Lowering the reserve ratio from 10% to 5% would immediately give this bank $50 in excess reserves. The bank could loan out these reserves and the money supply would increase. Raising the reserve ratio would cause the money supply to shrink.

Expansionary Monetary Policy

To increase the money supply, the Federal Reserve can

1. buy government bonds (an open market purchase)
2. lower the discount rate
3. lower the reserve ratio

Contractionary Monetary Policy

To decrease the money supply, the Federal Reserve can

1. sell government bonds (an open market sale)
2. raise the discount rate
3. raise the reserve ratio

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 DXL31@psu.edu www.yk.psu.edu/~dxl31