-A Little History:

-In 1790, the Federalists (guys that wanted a strong central government) tried to set up a central bank, but people were afraid that a strong central government could turn into a Monarchy.

Because banks were “independent,” it was possible to have a bank run where too many people went to get their money and the bank literally ran out. Some banks even closed and people lost everything.

-In 1913, the Government (under Wilson) passed the Federal Reserve Act and created 12 independent, regional banks. These banks were intended to be the big brothers of all banks in the U.S.

-The Banks were intended to stop things like the Great Depression, but they failed because they were independent and often contradicted each other’s actions.

-By 1935, the Government decided to increase the power of these Banks and created the Federal System we know today. In nerd-speak, we call it “The Fed.”

So this is how it works:

-1st, there is the Board of Governors

-These 7 chaps (and chapettes) basically serve as the big bosses of the Federal Reserve system. No two Governors come from the same district.

-They are appointed by the President, approved by Congress, and serve staggered 14-year terms.

-They meet and decide all the Monetary Policy for the United States and one (the Chair) acts as spokesman.

-2nd, we have the 12 District Federal Reserve Banks:

-Each bank has its own district and monitors the banking and economic conditions in its area.

-Each district is composed of more than one state.

-Lastly, we have the 4,000 member banks and 25,000 other depository institutions

-All nationally chartered banks must be a part of the Federal Reserve System and most State-Chartered banks join voluntarily.

-Each of the appx. 4,000 member banks contributes money to the system and receives stock in Fed in return. This bank ownership of the Fed gives the system a high degree of Independence.

The Fed has four main functions:

1.) Serving Government –

- Federal Government Banker (Treasury Checking Account)

- Government Securities Auctioneer (Bonds to finance Gov’t activity)

2.) Serving Banks –

- Check Clearing (20 billion checks a year!)

- Supervises Lending Practices

- Lender of Last Resort (Anti-Bank Runs System)

3.) Regulating Banking System –

- Reserves

- Bank Examinations

4.) Regulating the Money Supply**

- A. Cash Needed on Hand (easy economic transactions)

- B. Interest Rates (higher interest makes cash more expensive)

- C. Price Levels (goin’ out gets more expensive)

- D. Income Level (mo money means mo lettuce)

- E. Stabilizing the Economy (ahem, next slide)

Just like Fiscal Policy, Monetary Policy uses tools too:

1.) Money Creation

- NOT “printing” money

- Think like the multiplier effect

- Banks must keep a Required Reserve Ration (RRR) [10%]

Winston gets a $1000 loan and

puts it in his WaMu checking

account.

Franky gets a $900 loan from

WaMu and puts it in his Chase

checking account.

Joe gets a $810 loan from Chase and puts it in his

US Bank checking account.

= $2,710 in Money Supply

The Money Multiplier:

Initial Cash Deposit X

1

RRR

Just like Fiscal Policy, Monetary Policy uses tools too:

2.) Reserve Requirements:

- Reserve Requirement Ratio: Ratio of reserves to deposits required of

banks by the Federal Reserve. (inc. = less lending, $ supply dec.)

- Federal Fund Rate: Interest rate banks charge one another for loans. (Always lower than the Discount Rate) (inc = less lending, $ supply dec.)

- Discount Rate: The interest rate the Federal Reserve charges for loans to commercial banks. (Tied to Federal Funds Rate)

- Prime Rate: Rate of interest banks charge on short-term loans to their

best customers.

3.) Open Market Operations

- When committee decides for more money, they order Fed. Reserve Bank of NY to buy securities and put them into banks. (sets “money creation” into motion)

What’s yer aRRR Ratio?

Basically, Monetary Policy uses The Money Supply and the Interest Rate to control the macroeconomy.

1.) Easy Money Policy: Increase money supply, lower interest rates and encourage investment spending (AD). As spending increases (AD), so does GDP. Good to try to fix a recession.

2.) Tight Money Policy: Decrease money supply, increase interest rates and discourage investment spending (AD). As spending decreases (AD), so does GDP. Good for trying to slow inflation.

PROBLEMS WITH MONETARY POLICY:

Timing Lagging Prediction