THE FEDERAL RESERVE. and the Banking System. Functions. The FED is the central banking system of the U.S.

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4 THE FEDERAL RESERVE and the Banking System The FED is the central banking system of the U.S. * Established 1913 * Governing Body board of governors * Presidentially-appointed Chairman JANET YELLEN Functions - Uses monetary policy to manage money market/economy - Regulates public/private banks through money supply - Maintains the stability of financial system - Provides finances to depository institutions & government

5 clearing things up! the fed and the Banking System the federal reserve open market committee board of governors 12 regional reserve banks This Committee oversees the buying & selling of bonds through Open Market Operations The Board oversees all operations of the Fed, including the Discount rate & the reserve ratio These banks oversee distribution of funds to all banks/ depository institutions, public & private

6 the different types of monetary policy Remember This?...

7 monetary policy 1. Setting the reserve ratio reserve requirements Fractional Reserve Banking are portions or a percentage of all deposits that banks must hold in reserve and cannot lend Here s the deal! Say the Fed announces that the Reserve Ratio for all banks is.2 Banks are mandated to hold 2% of all new deposits in reserve to manipulate the money supply The other % will be taken and loaned out or withdrawn and will become deposits in other banks or used for consumption The Secret?... The higher the Reserve Ratio... The Reserve Ratio works just like the MPC and MPS! the lesser the money supply! the greater The lower the Reserve Ratio... the money supply!

8 monetary policy 2. lending at the discount rate discount rate The is the interest rate that the Federal Reserve charges commercial banks to borrow from the Treasury The catch?... The discount rate can influence... Example interest rates AND money supply The Fed increases the Discount Rate from 2% to 4% Several banks & depository institutions borrow from the Fed to cover affairs 7% To ensure a profit on loans, banks offer their loans at a rate of DECREASES and the money supply due to high opportunity costs

9 monetary policy 3. open market operations Open market committee The can vote to use one of two options to influence the market money supply & interest The Options? buying or selling TREASURY BONDS Example Example The Fed announces it is selling $1 million T-Bonds at 5% int. Investors who like the interest buy up the bonds, handing over $1B in M1, M2 & M3 per bond The Fed announces it is buying back T-bonds from the public Anxious investors hand over their bonds and the Fed releases $2B in M1, M2 & M3 per bond

10 federal funds rate The is the interest rate at which depository institutions loan federal funds and excess reserves to other banks The Federal reserve commonly influences the federal funds rate through Example Wait! What is this... federal funds rate open market operations! A bank has over-lended and cannot meet it s reserve ratio, so it requests a loan from a bank that has excess reserves To change the Federal Funds Rate, the Fed buys bonds in the open market, INCREASING the money supply and DECREASING interest rates, thus also DECREASING the federal funds rate!

11 Ok...Let s break down monetary policies

12 the different types of monetary policies expansionary monetary Policy easy monetary policy lowering the discount rate lowering the reserve ratio buying bonds in the open market lowering the federal funds rate contractionary monetary Policy tight monetary policy raising the discount rate raising the reserve ratio selling bonds in the open market raising the federal funds rate

13 ok, we re good. LET S PRACTICE!

14 Nominal rate of interest, i 1 S m2 S m1 #1. MONEY MARKET D m Nominal rate of interest, i 1 #2. INVESTMENT DEMAND D I Price level P 1 P 2 Quantity of money demanded and supplied LRAS AS AD 2 AD #3. AGGREGATE ECONOMY Amount of investment, I The Fed SELLS Treasury Bonds in the open market + Interest Rate Increases + Investment Decreases + AD & Real GDP Decreases with slight deflation Real domestic output, GDP

15 Nominal rate of interest, i 1 S m1 S m2 #1. MONEY MARKET D m Nominal rate of interest, i 1 #2. INVESTMENT DEMAND D I Price level P 2 P 1 Quantity of money demanded and supplied LRAS AD AS AD 2 #3. AGGREGATE ECONOMY Amount of investment, I The Fed BUYS Treasury Bonds in the open market + Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation Real domestic output, GDP

16 Nominal rate of interest, i 1 S m1 S m2 #1. MONEY MARKET D m Nominal rate of interest, i 1 #2. INVESTMENT DEMAND D I Price level P 2 P 1 Quantity of money demanded and supplied LRAS AD AS AD 2 #3. AGGREGATE ECONOMY Amount of investment, I The Fed lowers the Reserve Ratio to Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation Real domestic output, GDP

17 Nominal rate of interest, i 1 S m2 S m1 #1. MONEY MARKET D m Nominal rate of interest, i 1 #2. INVESTMENT DEMAND D I Price level P 1 P 2 Quantity of money demanded and supplied LRAS AS AD 2 AD #3. AGGREGATE ECONOMY Amount of investment, I The Fed RAISES the discount rate from 2.5% to 3.5% + Interest Rate Increases + Investment Decreases + AD & Real GDP Decreases with slight deflation Real domestic output, GDP

18 Nominal rate of interest, i Price level 1 P 2 P 1 S m1 S m2 D m Quantity of money demanded and supplied LRAS AD #1. MONEY MARKET AS AD 2 Nominal rate of interest, i #3. AGGREGATE ECONOMY 1 Amount of investment, I #2. INVESTMENT DEMAND D I The Fed lowers the Federal Funds Rate by BUYING Treasury Bonds in the open market... + Interest Rate Decreases + Investment Increases + AD & Real GDP Increases with slight inflation Real domestic output, GDP

19 TAKE OUT morton activity 42 let s practice what you ve learned about monetary policy!