Business Finance: Unit 5: The Federal Reserve

The Role of the Federal Reserve

• Influence interest rates

  • Sets the Targeted federal funds rate/ federal funds rate

    • Money supply (drives everything)

      • Federal Funds Rate Definition: the interest rate that banks charge each other to borrow and lend money overnight.

• Functions

  • Inflation → CPI → Stable prices*

    • Interest rates

    • Stable prices drive what the Fed Reserve is doing

    • 2%

  • Unemployment → employment → low unemployment rate

    • 5% (of people are looking for a job)

  • GDP output → growing = C + G + I + X_N

    • 3%

• The US Central Bank

  • Purpose: to control the supply of money to achieve…

    • Stable prices

    • Full employment

    • Economic growth

Types of Unemployment

• Frictional: 

  • in-between jobs or just entering the labor force (just out of college)

• Structural:

  • when you have skills that don’t match an available job

• Cyclical: 

  • people are getting laid off and companies can’t afford to pay employees

    • The bad kind

What is the difference between…

• U.S. Treasury

  • Prints money

  • IRS…collects taxes

  • Finances Gov’t Debt

• Federal Reserve

Structure of the Federal Reserve

• Head of the Fed = Jerome Powell

• Board of Governors

  • 7 Boards of Governors

    • 14-year terms

    • President nominates them, but the Senate needs to confirm them

• Twelve district banks

  • 1 for each region of the country

  • 7 governors + 5 other district banks

• Federal Open Market Committee (FOMC)

  • Voters (12 total voters, vote 8 times a year)

    • 7 governors

    • 1 NY district bank

    • The other 4 district banks rotate 

  • Vote on federal fund rate = the interest rate that banks charge each other when lending money overnight

    • Interest Rate definition: the cost of borrowing money

Expansion of Money and Credit

• Fractional reserve banking

• Expansion (and contraction) of the money supply

• Importance of excess reserves

Reserve Requirement

• Percent banks must hold against deposit liabilities

• Changing commercial banks’ reserves leads to:

  • Multiple expansion

• OR

  • Multiple contraction

Multiple expansion

• Fractional Banking System

• Reserves are either:

  • Required 

  • Excess

• Process of loan creation

• Change in the money supply= change in excess reserves / reserve requirement ratio

  • EX. 

    • Reserve requirement = 10%

    • Reserves increase by $900

    • Possible increase in the money supply:   $900/0.1 = $9000

• EX explained:

Money supply = Money multiplier x Excess reserves

??? = 1/10% {0.1} x $900

• = 10 x $900

• = $9,000

Importance of the Federal Funds Market

• Market of reserves

• Lening reserves between banks

• Federal funds rate

  • Targeted federal funds rate - (def. the interest rate that banks charge each other to borrow and lend money)

    • Fed establishes a target rate

    • Fed uses open market operations to achieve target rate

3 ways the Fed Controls the Money Supply

• Reserve requirement

  • Funds that banks must hold against deposit liabilities

  • Reserve Requirement Ratio (RRR)

    • Percent banks must hold against deposit liabilities

• Discount rate

  • Rate the Federal Reserve charges banks to borrow reserves

    • Federal Reserve lends you money are an interest rate

• Open market operations (OMO)

  • Buying and selling Federal government securities

    • Securities =  bonds / treasury bills {less than a year}

  • By far, the most important tool of monetary policy

OMO: Expansionary Policy

• To expand the money supply, the Fed buys government securities

•  Paying for the securities puts reserves into the banking system

•  Purchases reduce interest rates

OMO: Contractionary Policy

• To contract the money supply, the Fed sells government securities

•  Receiving payment for the securities removes reserves from the banking system

•  Sales increase interest rates

Fiscal Policy

• The federal government’s 

  • Taxation

  • Spending

  • Debt management

• The possible impact of deficit spending of or a surplus on

  • The money supply

  • Reserves of the banking system

  • Securities prices

• Deficit: Government spending exceeds revenues

• Surplus: Government revenues exceed spending

Deficit Spending

• Sources of funds to finance the deficit

  • Commercial banks

  • Non-bank public

  • Federal Reserve

  • Foreign credit markets

Inflation

• Def. General increase in prices

• Consumer Price Index (CPI)

  • Measures the rate of inflation

• Fight inflation by…

  • Contracting the money supply

  • Raising interest rates

  • Raising taxes

Deflation

• Def. A general decline in prices

• Opposite impact of inflation

• Unexpected deflation hurts debtors and helps creditors

• Associated with higher levels of unemployment

Recession

• Increase in unemployment

• Reduction in the nation’s level of output