The Federal Reserve Functions Monetary Policy Tools Why

The Federal Reserve: Functions & Monetary Policy Tools

Why You Should Care About the Fed • • Fed decisions affect how much it costs banks (and you) to borrow money The Fed's federal funds rate directly affects yields on savings accounts and CDs. Their actions determine the interest rates for most of the variable-rate credit cards in the U. S. The rate of your next auto loan or home mortgage will be determined in part by the Fed's interest-rate moves. Decisions by the Fed can have a major influence on how hard or easy it is to find a job. The Fed influences inflation. So if you don't plan on having an auto loan, a mortgage, interest-bearing deposits, a job, a single dollar of American currency, or pretty much any financial product at all, you can safely ignore the Fed. Everyone else, though, might want to check in every once in a while.

Functions of the Fed • Provides banking/financial services to the federal government • Provides banking services to other banks • Regulates the banking industry • Tracks & manages the national money supply

Monday, December 1 Announcements • Test on the Fed & Monetary Policy this FRIDAY (more info coming today & Wednesday) • Completed Stock Portfolios are due Wednesday, December 10 Agenda • Warm-up: Stock Market Project wrap-up • Presentation: Monetary Policy Tools • Assignments: Case Study, Stock Market current events & reflection

Monetary Policy • The actions the Fed takes to influence the real GDP and inflation

Money Creation • Does not mean simply printing money • Banks create money by loans. • The required reserve ratio (RRR) determines how much of a deposit a bank can lend out

Creating Money • The bank could lend out $900 of your $1000 deposit. • Now, let’s say the bank loans out the $900 to someone else, who then deposits it. That customer has a $900 balance. • The bank has increased the money supply by $900.

Money Multiplier • The amount of new money created by this process is given by the money multiplier formula • Increase in money supply= Initial cash deposit X 1/RRR

Example • If the RRR is. 1, how much money will an initial deposit of $1000 lead to?

Reserve Requirements • Changing the RRR is the tool most used by the Fed. • Reducing reserve requirements decreases reserves for banks, allowing them to loan out more money, increases the money multiplier and leads to an increase in the money supply.

Reserve Requirements • Increasing the RR forces banks to hold more money. • They lend less, which causes the money supply to shrink. • This tool is not used often because it disrupts the banking system. • Banks might have to call in loans, or require the borrower to pay the entire balance immediately.

Discount Rate • The discount rate is the interest rate the Fed charges on loans to member banks. • Banks borrow from the Fed to maintain reserves. • Changes in the discount rate affect the cost of borrowing from the Fed, which then affects the prime rate- the rate banks give their best customers.

Discount Rate • Reducing the discount rate encourage banks to lend their reserves because they can borrow from the Fed to maintain them. • Increasing the discount rate reduces the money supply because banks are less willing to borrow from the Fed. • They reduce loans to keep required reserves.

Open Market Operations • OMO are the buying and selling of government securities to alter the money supply. • When the FOMC choose to increase the money supply, it orders the Federal Reserve Bank to purchase government securities • Government securities are bonds issued by a government authority

Buying Securities • The bank buys the securities with a check from the Federal Reserve funds. • When the check is deposited by the seller, new funds enter the money supply.

Selling Securities • If the FOMC wants to reduce the money supply, they sell the securities back to the dealers and receive checks from their own banks. • This takes money out of circulation and results in a decrease in the money supply because banks reduce loans to keep reserves.

Easy Money v. Tight Money Fiscal Policy v. Monetary Policy Chapter 16, Section 4

Easy Money • Lower interest rates encourage MORE spending. • If the economy is contracting, the Fed will follow an easy money policy, which is an increase in the money supply. • The increase will reduce interest rates and encourage spending.

Tight Money • If the economy is rapidly expanding, the Fed will introduce a tight money policy. • They will reduce the money supply by pushing interest rates higher. • Spending will decrease.

Policy Type Easy Money Tight Money Interest Rates Spending Money Supply

Fiscal Policy v. Monetary Policy Fiscal Policy Contractionary Tools Expansionary tools 1. 2. Monetary Policy 1. 2. 3.

Assignments • Complete Case Study on back page of notes. Notes due Friday. • Ensure you have 4 stock market current events. • Your completed portfolio is due on December 10.

Major Economic Indicators • Real GDP • M 2 - Money Supply • Consumer Price Index (CPI) • Consumer Confidence Surveys • Current Employment Statistics • Housing Starts • S&P 500