hw micro and macro economy

LO 1: How the Federal Reserve is organized

LO 2: The Fed’s major policy tools

LO 3: How open market operations work

Monetary Policy: the use of money and credit controls to influence macroeconomic outcomes

Pres Wilson, Fed Reserve Act, Dec. 1913

Federal Reserve System: 12 Fed Reserve Banks: each acts as central banker for private banks in region.

· Clearing checks between private banks

· Hold bank reserves – fraction of deposits in local banks, rest in fed reserve banks

· Providing currency –

· Providing loans

Fed’s control of money supply is exercised by use of 3 policy tools:

· Reserve requirements

· Discount rates

· Open market operations

Money supply )M1) currency held by public, plus balances in transactions accounts

Money supply (M2) M1+ balances in most savings accounts and money market mutual funds

Required reserves: minimum amount of reserves a bank is required to hold; equal to required reserve rations x transaction deposits

Excess reserves: bank reserves in excess of required reserves

Money multiplier: # deposit (loan) dollars that banking system can create from $1 of excess reserves; equal to 1/required reserve ratio

Lending capacity = excess reserves x money multiplier

By raising the required reserve ration, the Fed can immediately reduce the lending capacity of the banking system

The discount rate

Federal funds rate: the interest rate for interbank reserve loans

Discounting; Federal Reserve lending of reserves to private banks

Discount rate: rate of interest the Federal Reserve charges for lending reserves to private banks

Open market operations – federal Reserve purchases and sales of government bonds for purpose of altering bank reserves

Open market operations are the principal mechanism for directly altering the reserves of the banking system

Portfolio decision: the choice of how (where) to hold idle funds

Bond: a certificate acknowledging a debt and the amount of interest to be paid each year until repayment; an IOU

Yield: the rate of return on a bond; the annual interest payment divided by the bond’s price.

Bond prices and yields move in opposite directions; If Fed sells bonds, bond prices fall and yields (interest rates) rise

The Fed can Increase the Money Supply by:

· Lower reserve requirements

· Reduce the discount rate

· Buy bonds

The Fed can decrease the money supply by:

· Raise reserve requirements

· Increase discount rate

· Sell bonds

1