overview of the Federal Reserve's structure, powers and responsibilities - focus on the three tools that control the money supply

1. The FedThe Fed
Powers and responsibilitiesPowers and responsibilities

2. Federal Reserve System:Federal Reserve System:
structurestructure
• Board of GovernorsBoard of Governors
• 7 members/14 year7 members/14 year
termsterms
• President appoints;President appoints;
Senate approvesSenate approves
• 1 is Fed Chair –1 is Fed Chair –
appointed by Pres. forappointed by Pres. for
a 4-year terma 4-year term
• Federal Reserve isFederal Reserve is ∴∴
independent of politicalindependent of political
motivationmotivation
• Board overseesBoard oversees
actions of the Fedactions of the Fed
• Note FOMC is madeNote FOMC is made
up of Board of Gov’sup of Board of Gov’s
and Fed Reserve Bankand Fed Reserve Bank
PresidentsPresidents
• Member banks ownMember banks own
stock in the Fed
Fed Chair Janet Yellen

3. Fed responsibilitiesFed responsibilities:
• Act as the nation’s bankAct as the nation’s bank
• Hold gov’t fundsHold gov’t funds
• Gov’t draws $ from FedGov’t draws $ from Fed
• Cover emergenciesCover emergencies
• Clear checks/debitsClear checks/debits
• Control size of money supplyControl size of money supply
• Dual Mandate:Dual Mandate:
• High employmentHigh employment
• Stable pricesStable prices
• Stable long-term interest ratesStable long-term interest rates
• RegulateRegulate……
• To protect competitionTo protect competition
• Consumer legislationConsumer legislation
• Currency [old/new]Currency [old/new]
• Margin requirements for buyingMargin requirements for buying
stocks with borrowed moneystocks with borrowed money

4. Fed tools of monetary policy:Fed tools of monetary policy:
• Reserve requirementReserve requirement – what % of money on– what % of money on
deposit must be held in reserve [i.e. notdeposit must be held in reserve [i.e. not
loaned back out; rather complex formula]loaned back out; rather complex formula]
• Decreasing the requirement means thatDecreasing the requirement means that
banks will lend more $ out,banks will lend more $ out, ∴∴ more $ inmore $ in
circulationcirculation
• Increasing the requirement will have theIncreasing the requirement will have the
opposite effectopposite effect
• Only used inOnly used in extreme emergenciesextreme emergencies

5. • Discount or Prime rateDiscount or Prime rate – rate of interest banks– rate of interest banks
must charge each other for short-term loansmust charge each other for short-term loans
• Raising the rateRaising the rate: more expensive for banks to borrow,: more expensive for banks to borrow, ∴∴
they lend out LESS money and charge higher ratesthey lend out LESS money and charge higher rates
• Amount of money in circulation DECREASESAmount of money in circulation DECREASES
• DangerDanger: If rates remain high for too long, credit gets tight: If rates remain high for too long, credit gets tight
and could lead to a recessionand could lead to a recession
• Lowering the rateLowering the rate: costs less for banks to borrow from one: costs less for banks to borrow from one
another,another, ∴∴ they can lend out MORE moneythey can lend out MORE money
∀ ∴∴ lowering the rate INCREASES the amount of money inlowering the rate INCREASES the amount of money in
circulationcirculation
• Danger: prices may rise too fast as spending increases;prices may rise too fast as spending increases;
inflation ensues, fewer people can afford stuff and theinflation ensues, fewer people can afford stuff and the
economy slows downeconomy slows down

6. • Federal Open MarketFederal Open Market
Committee:Committee:
• FOMC buys and sells debtFOMC buys and sells debt
securities, such as U.S. Savingssecurities, such as U.S. Savings
Bonds or Treasury Bills [T-bills]Bonds or Treasury Bills [T-bills]
• This Fed tool is used every dayThis Fed tool is used every day
• The FOMC is a customer, in that it:The FOMC is a customer, in that it:
• spends money to buy securitiesspends money to buy securities
– sending money into circulation– sending money into circulation
• Receives money in exchange forReceives money in exchange for
the sale of those securities –the sale of those securities –
pulling money out of circulationpulling money out of circulation
• Since the Fed has trillions $ itSince the Fed has trillions $ it
can have a profound effect oncan have a profound effect on
the money supplythe money supply

7. Fed activity:Fed activity:
• Fed uses its tools to set monetary policyFed uses its tools to set monetary policy
• Tight money policy:Tight money policy:
• Restricts money supply, thus raising interest ratesRestricts money supply, thus raising interest rates
• Slows economic growthSlows economic growth
• Easy money policy:Easy money policy:
• Increases money supply, lowering interest ratesIncreases money supply, lowering interest rates
• Spurs economic growthSpurs economic growth
• Discount rate directly affects interest rates on loans asDiscount rate directly affects interest rates on loans as
banks pass on cost or savings to borrowersbanks pass on cost or savings to borrowers
• Selling and/or buying bonds and T-bills puts more moneySelling and/or buying bonds and T-bills puts more money
in circulation or takes money out of circulation. Interestin circulation or takes money out of circulation. Interest
rates will rise if banks have less money to lend out, or fallrates will rise if banks have less money to lend out, or fall
if banks have more money to lend outif banks have more money to lend out
• Reserve requirement not changed often or by muchReserve requirement not changed often or by much

8. How effective is all that?How effective is all that?
• Can be effective at times, but…Can be effective at times, but…
• Affect of such actions may not be felt for 6 months toAffect of such actions may not be felt for 6 months to
2 years! [this is true of2 years! [this is true of fiscal policyfiscal policy as well]as well]
• Usually, indications of an economic downturn are 3 toUsually, indications of an economic downturn are 3 to
6 months out, so…6 months out, so…
• There’s usually a time lag from a prediction of aThere’s usually a time lag from a prediction of a
downturn, to action being decided upon, to thedownturn, to action being decided upon, to the
actions actually beginning to have an effect on things.actions actually beginning to have an effect on things.
• Therefore, even after action is taken, even if it’s theTherefore, even after action is taken, even if it’s the
right action, things will continue to get worse beforeright action, things will continue to get worse before
they can get betterthey can get better
∀ ∴∴ It’s often the case that sitting presidents or otherIt’s often the case that sitting presidents or other
officials are blamed for the economic conditionsofficials are blamed for the economic conditions
brought on by actions of their predecessorsbrought on by actions of their predecessors

10. The Story of a CheckThe Story of a Check