The Federal Reserve & Monetary Policy

Monetary policy

Injecting and withdrawing money from the economy through the Federal Reserve Bank to expand or contract the economy

Federal Reserve definition

• The central bank of the United States. 

  • As the nation’s main authority on money, it works to promote stable prices, full employment and economic growth

How is the Fed organized?

• The Board of Governors and Chairman are appointed by the President with Senate approval, but neither the President nor Congress have direct control over their actions.

Why independent?

• So Fed can make monetary policy based on economics and not based on influence from interest groups or politicians

• Because Fed can act more quickly than Congress

The Four Duties of the Federal Reserve

• Conducting monetary policy by controlling the amount of money in the economy to monitor economic health, keep inflation low, promote maximum employment

• Facilitating (helping) the circulation of new bills into the economy

• Shredding old and worn out bills

• Supervising banks by requiring them to keep a fraction (or “reserve requirement) that is not loaned out to other people

What is contractionary monetary policy?

• The Fed takes money out of circulation to slow the economy down - used when the economy is growing too quickly and high inflation 

• Called the “tight money policy” because it takes money out of circulation by making it harder for consumers to borrow and spend $. 

What is expansionary monetary policy?

• The Fed uses its tools to grow the economy by putting more money into circulation… used when economy is contracting

• Called the “easy money policy” because it puts more money into circulation by making it easier for borrowers to get loans and spend $

Contractionary Monetary Policy is called

Tight money policy

Expansionary Monetary Policy is called

Easy money policy

The Feds Monetary Tools

Open Market Operations

Adjusting the Reserve Requirement

Adjusting the discount rate

A bond is

Basically the receipt proving that loan exists

Fed buying bonds from banks on open market

Giving money to banks - increasing amount of money in circulation

Fed selling bonds on open market

Taking money from banks - decreasing amount of money in circulation

What happens when the Fed BUYS bonds

• Banks give the Fed bonds (loans they owned)

• The Fed gives banks cash

What happens when the Fed SELLS bonds

• Banks give the Fed cash

• The Fed gives banks bonds

When the Fed BUYS bonds

The Fed buys those bonds/IOUs (an informal document acknowledging debt) from banks.

Example:

• Bank gives the Fed $200 bond

• Fed gives the bank $200 cash

Now the bank has more money to lend.

Economy speeds up

When the Fed SELLS bonds

The Fed sells bonds/IOUs (an informal document acknowledging debt) to banks.

Example:

• Bank gives the Fed $200 cash

• Fed gives the bank $200 bond

Now the bank has less cash to lend.

Economy slows down

Open Market Operations Definition

The Fed buys and sells government bonds 

Open Market Operations Expansionary Monetary Policy

The Fed buys bonds from banks… banks use that money to make loans = more consumer spending

Open Market Operations Contractionary Monetary Policy

The Fed sells bonds to banks… banks have less money to loan = less consumer spending

Adjusting the Reserve Requirement Definition

Required percentage of deposited money banks have to have in reserve that can’t be loaned out

Adjusting the Reserve Requirement Expansionary Monetary Policy

Fed decreases the reserve requirement 

Banks will lend more money, increasing the amount of money in the economy.

Adjusting the Reserve Requirement Contractionary Monetary Policy

Fed increases the reserve requirement 

Banks will  lend less money, taking  money out of the economy

Adjusting the discount (intrest) rate definition

The interest rate the Fed charges when lending money to commercial banks - called the Discount Rate

Adjusting the discount (interest) rate Expansionary Monetary Policy

- The Fed lowers the discount (intrest) rate

- Banks borrow more money because it is cheaper

- Banks then loan more $ out to their customers, increasing AD 

Adjusting the discount rate (interest) Contractionary Monetary Policy

- The Fed raises the discount (intrest) rate

- Banks borrow less money because it is more expensive

- Banks then loan less $ out to their customers, decreasing AD