The Federal Reserve System

1
The Federal Reserve System

• What is the history of American banking?
• How did the Federal Reserve Act of 1913 lead to
  further reform?
• How is todays Federal Reserve System structured?

2
What Is Money?
Money is anything that serves as a medium of
exchange, a unit of account, and a store of
value.
3
The Three Uses of Money

• Money as Medium of Exchange
• A medium of exchange is anything that is used to
  determine value during the exchange of goods and
  services.
• Money as a Unit of Account
• A unit of account is a means for comparing the
  values of goods and services.
• Money as a Store of Value
• A store of value is something that keeps its
  value if it is stored rather than used.

4
The Six Characteristics of Money
The coins and paper bills used as money in a
society are called currency. A currency must
meet the following characteristics
Durability Objects used as money must withstand
physical wear and tear. Portability People need
to be able to take money with them as they go
about their business. Divisibility To be useful,
money must be easily divided into smaller
denominations, or units of value.
Uniformity Any two units of money must be
uniform, that is, the same, in terms of what they
will buy. Limited Supply Money must be available
only in limited quantities. Acceptability Everyone
must be able to exchange the money for goods and
services.
5
The Sources of Moneys Value

• Commodity Money
• Commodity money consists of objects that have
  value in themselves.

• Representative Money
• Representative money has value because the holder
  can exchange it for something else of value.

• Fiat Money
• Fiat money, also called legal tender, has value
  because the government decreed that is an
  acceptable means to pay debts.

6
American Banking Before the Civil War
Two Views of Banking

• Federalists believed the country needed a strong
  central government to establish economic and
  social order.
• Alexander Hamilton was in favor of a national
  bank which could issue a single currency, handle
  federal funds, and monitor other banks.

• Antifederalists were against a strong central
  government and favored leaving powers in the
  hands of the states.
• Thomas Jefferson opposed the creation of a
  national bank, and instead favored banks created
  and monitored by individual states.

7
Banking Services

• Banks perform many functions and offer a wide
  range of services to consumers.

Storing Money Banks provide a safe, convenient
place for people to store their money. Credit
Cards Banks issue credit cards cards entitling
their holder to buy goods and services based on
each holder's promise to pay. Saving Money Four
of the most common options banks offer for saving
money are 1. Savings Accounts 2. Checking
Accounts 3. Money Market Accounts 4.
Certificates of Deposit (CDs) Loans By making
loans, banks help new businesses get started, and
they help established businesses grow.
Mortgages A mortgage is a specific type of loan
that is used to purchase real estate.
8
How Banks Make a Profit

• The largest source of income for banks is the
  interest they receive from customers who have
  taken loans.
• Interest is the price paid for the use of
  borrowed money.

9
Anticipating the Business Cycle
The Federal Reserve must not only react to
current trends, but also must anticipate changes
in the economy.

• Monetary Policy and Inflation
• Expansionary policies enacted at the wrong time
  can push inflation even higher.
• If the current phase of the business cycle is
  anticipated to be short, policymakers may choose
  to let the cycle fix itself. If a recession is
  expected to last for years, most economists will
  favor a more active monetary policy.

• How Quickly Does the Economy
• Self-Correct?
• Economists disagree about how quickly an economy
  can self-correct. Estimates range from two to
  six years.
• Since the economy may take quite a long time to
  recover on its own, there is time for
  policymakers to guide the economy back to stable
  levels of output and prices.

10
Banking History

• A Central Bank?
• The issue of a central bank has been debated
  since 1790, when the first Bank of the United
  States was created.
• Debate has centered around the amount of control
  a central bank should have over the nations
  banking system.
• Following the Panic of 1907, a series of serious
  bank runs, Congress decided that a central bank
  was needed.

11
The Federal Reserve Act of 1913

• The Federal Reserve Act of 1913
• The Federal Reserve System, often referred to as
  the Fed, is a group of 12 regional, independent
  banks.
• Initially the Federal Reserve System did not work
  well because the actions of one regional bank
  would counteract the actions of another.

• A Stronger Fed
• In 1935, Congress adjusted the Federal Reserve
  structure so that the system could respond more
  effectively to crises.
• Todays Fed has more centralized powers so that
  regional banks can work together while still
  representing their own concerns.

12
Structure of the Federal Reserve

• The Board of Governors
• The Federal Reserve System is overseen by the
  seven-member Board of Governors of the Federal
  Reserve. Actions taken by the Federal Reserve are
  called monetary policy.
• Federal Reserve Districts
• The Federal Reserve System consists of 12 Federal
  Reserve Districts, with one Federal Reserve Bank
  per district. The Federal Reserve Banks monitor
  and report on economic activity in their
  districts.
• Member Banks
• All nationally chartered banks are required to
  join the Fed. Member banks contribute funds to
  join the system, and receive stock in and
  dividends from the system in return. This
  ownership of the system by banks, not government,
  gives the Fed a high degree of political
  independence.
• The Federal Open Market Committee (FOMC)
• The FOMC, which consists of The Board of
  Governors and 5 of the 12 district bank
  presidents, makes key decisions about interest
  rates and the growth of the United States money
  supply.

13
The Pyramid Structure of the Federal Reserve

• About 40 percent of all United States banks
  belong to the Federal Reserve. These members
  hold about 75 percent of all bank deposits in the
  United States.

14
Section 1 Assessment

• 1. The Federal Reserve System was created to
• (a) undermine the American banking system.
• (b) extend the powers of government.
• (c) stabilize the American banking system.
• (d) destabilize the American banking system.
• 2. Monetary policy is
• (a) the research arm of the Federal Reserve.
• (b) the twelve banking districts created by the
  Federal Reserve Act.
• (c) the actions the Federal Reserve takes to
  influence the level of real GDP and the rate of
  inflation in the economy.
• (d) the actions taken by the Bank of the United
  States.

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15
Section 1 Assessment

• 1. The Federal Reserve System was created to
• (a) undermine the American banking system.
• (b) extend the powers of government.
• (c) stabilize the American banking system.
• (d) destabilize the American banking system.
• 2. Monetary policy is
• (a) the research arm of the Federal Reserve.
• (b) the twelve banking districts created by the
  Federal Reserve Act.
• (c) the actions the Federal Reserve takes to
  influence the level of real GDP and the rate of
  inflation in the economy.
• (d) the actions taken by the Bank of the United
  States.

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16
Federal Reserve Functions

• How does the Federal Reserve serve the federal
  government?
• How does the Federal Reserve serve banks?
• How does the Federal Reserve regulate the banking
  system?
• What role does the Federal Reserve play in
  regulating the nations money supply?

17
Serving Government

• Federal Governments Banker
• The Fed maintains a checking account for the
  Treasury Department and processes payments such
  as social security checks and IRS refunds.
• Government Securities Auctions
• The Fed serves as a financial agent for the
  Treasury Department and other government
  agencies. The Fed sells, transfers, and redeems
  government securities. Also, the Fed handles
  funds raised from selling T-bills, T-notes, and
  Treasury bonds.
• Issuing Currency
• The district Federal Reserve Banks are
  responsible for issuing paper currency, while the
  Department of the Treasury issues coins.

18
Serving Banks

• Check Clearing
• Check clearing is the process by which banks
  record whose account gives up money, and whose
  account receives money when a customer writes a
  check.
• Supervising Lending Practices
• To ensure stability in the banking system, the
  Fed monitors bank reserves throughout the system.
  The Fed also protects consumers by enforcing
  truth-in-lending laws.
• Lender of Last Resort
• In case of economic emergency, commercial banks
  can borrow funds from the Federal Reserve. The
  interest rate at which banks can borrow money
  from the Fed is called the discount rate.

19
The Journey of a Check

• After you write a check, the recipient presents
  it at his or her bank.

20
Regulating the Banking System
The Fed generally coordinates all banking
regulatory activities.

• Reserves
• Each financial institution that holds deposits
  for its customers must report daily to the Fed
  about its reserves and activities.
• The Fed uses these reserves to control how much
  money is in circulation at any one time.

• Bank Examinations
• The Federal Reserve examines banks periodically
  to ensure that each institution is obeying laws
  and regulations.
• Examiners may also force banks to sell risky
  investments if their net worth, or total assets
  minus total liabilities, falls too low.

21
Measuring the Money Supply

• M1
• M1 consists of assets that have liquidity, or the
  ability to be used as, or easily converted into,
  cash.
• Components of M1 include all currency, travelers
  checks, and demand deposits.
• Demand deposits are the money in checking
  accounts.

• M2
• M2 consists of all of the assets in M1, plus
  deposits in savings accounts and money market
  mutual funds.
• A money market mutual fund is a fund that pools
  money from small investors to purchase government
  or corporate bonds.

The money supply is all the money available in
the United States economy.
22
Regulating the Money Supply
The Federal Reserve is best known for its role in
regulating the money supply. The Fed monitors
the levels of M1 and M2 and compares these
measures of the money supply with the current
demand for money.

• Factors That Affect Demand for Money
• 1. Cash needed on hand (Cash makes transactions
  easier.)
• 2. Interest rates (Higher interest rates lead to
  a decrease in demand for cash.)
• 3. Price levels in the economy (As prices rise,
  so does the demand for cash.)
• 4. General level of income (As income rises, so
  does the demand for cash.)

• Stabilizing the Economy
• The Fed monitors the supply of and the demand for
  money in an effort to keep inflation rates stable.

23
Section 2 Assessment

• 1. The Federal Reserve provides all of the
  following services to the government except
• (a) issuing currency
• (b) acting as the federal governments banker
• (c) handling government securities auctions
• (d) combining all banks into a single, central
  bank
• 2. The Fed provides banks with all of the
  following services except
• (a) issuing interest free loans
• (b) check clearing
• (c) acting as a lender of last resort
• (d) supervising lending practices

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24
Section 2 Assessment

• 1. The Federal Reserve provides all of the
  following services to the government except
• (a) issuing currency
• (b) acting as the federal governments banker
• (c) handling government securities auctions
• (d) combining all banks into a single, central
  bank
• 2. The Fed provides banks with all of the
  following services except
• (a) issuing interest free loans
• (b) check clearing
• (c) acting as a lender of last resort
• (d) supervising lending practices

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25
Monetary Policy Tools

• What is the process of money creation?
• What three tools does the Federal Reserve use to
  change the money supply?
• Why are some tools of monetary policy favored
  over others?

26
Money Creation

• How Banks Create Money
• Assume that you have deposited 1,000 dollars in
  your checking account. The bank doesnt keep all
  of your money, but rather lends out some of it to
  businesses and other people.
• The portion of your original 1,000 that the bank
  needs to keep on hand, or not loan out, is
  called the required reserve ratio (RRR). The RRR
  is set by the Fed.
• As the bank lends a portion of your money to
  businesses and consumers, they too may deposit
  some of it. Banks then continue to lend out
  portions of that money, although you still have
  1,000 in your checking account. Hence, more
  money enters circulation.

Money creation is the process by which money
enters into circulation.
27
The Money Creation Process
To determine how much money is actually created
by a deposit, we use the money multiplier
formula. The money multiplier formula is
calculated as 1/RRR.
28
Reserve Requirements
The Fed has three tools available to adjust the
money supply of the nation. The first tool is
adjusting the required reserve ratio.

• Reducing Reserve Requirements
• A reduction of the RRR would free up reserves for
  banks, allowing them to make more loans.
• A RRR reduction would also increase the money
  multiplier. Both of these effects would lead to
  a substantial increase in the money supply.

• Increasing Reserve Requirements
• Even a slight increase in the RRR would require
  banks to hold more money in reserve, shrinking
  the money supply.
• This method is not used often because it would
  cause too much disruption in the banking system.

29
Discount Rate
The discount rate is the interest rate that banks
pay to borrow money from the Fed.

• Reducing the Discount Rate
• If the Fed wants to encourage banks to loan out
  more of their money, it may reduce the discount
  rate, making it easier or cheaper for banks to
  borrow money if their reserves fall too low.
• Reducing the discount rate causes banks to lend
  out more money, which leads to an increase in the
  money supply.

• Increasing the Discount Rate
• If the Fed wants to discourage banks from loaning
  out more of their money, it may make it more
  expensive to borrow money if their reserves fall
  too low.
• Increasing the discount rate causes banks to lend
  out less money, which leads to a decrease in the
  money supply.

30
Open Market Operations
The most important monetary tool is open market
operations. Open market operations are the
buying and selling of government securities to
alter the money supply.

• Bond Purchases
• In order to increase the money supply, the
  Federal Reserve Bank of New York buys government
  securities on the open market.
• The bonds are purchased with money drawn from Fed
  funds. When this money is deposited in the bank
  of the bond seller, the money supply increases.

• Bond Sales
• When the Fed sells bonds, it takes money out of
  the money supply.
• When bond dealers buy bonds they write a check
  and give it to the Fed. The Fed processes the
  check, and the money is taken out of circulation.

31
Section 3 Assessment

• 1. The required reserve ratio is the ratio of
• (a) deposits to reserves required of banks by the
  Federal Reserve.
• (b) accounts to customers required of banks by
  the Federal Reserve.
• (c) reserves to deposits required of banks by the
  Federal Reserve.
• (d) paper currency to coins required of banks by
  the Federal Reserve.
• 2. All of the following will increase the money
  supply except
• (a) increasing the required reserve ratio
• (b) bond purchases by the Fed
• (c) reducing the required reserve ratio
• (d) reducing the discount rate

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32
Section 3 Assessment

• 1. The required reserve ratio is the ratio of
• (a) deposits to reserves required of banks by the
  Federal Reserve.
• (b) accounts to customers required of banks by
  the Federal Reserve.
• (c) reserves to deposits required of banks by the
  Federal Reserve.
• (d) paper currency to coins required of banks by
  the Federal Reserve.
• 2. All of the following will increase the money
  supply except
• (a) increasing the required reserve ratio
• (b) bond purchases by the Fed
• (c) reducing the required reserve ratio
• (d) reducing the discount rate

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33
Monetary Policy and Macroeconomic Stabilization

• How does monetary policy work?
• What problems exist involving monetary policy
  timing and lags?
• How can predictions about the length of a
  business cycle affect monetary policy?
• What are the expansionary and contractionary
  tools of fiscal and monetary policy?

34
How Monetary Policy Works
Monetarism is the belief that the money supply is
the most important factor in macroeconomic
performance.

• The Money Supply and Interest
• Rates
• The market for money is like any other, and
  therefore the price for money the interest rate
  is high when the money supply is low and is low
  when the money supply is large.

• Interest Rates and Spending
• If the Fed adopts an easy money policy, it will
  increase the money supply. This will lower
  interest rates and increase spending. This
  causes the economy to expand.
• If the Fed adopts a tight money policy, it will
  decrease the money supply. This will push
  interest rates up and will decrease spending.

35
The Problem of Timing

• Good Timing
• Properly timed economic policy will minimize
  inflation at the peak of the business cycle and
  the effects of recessions in the troughs.

• Bad Timing
• If stabilization policy is not timed properly, it
  can actually make the business cycle worse.

36
Policy Lags
Policy lags are problems experienced in the
timing of macroeconomic policy. There are two
types

• Inside Lags
• An inside lag is a delay in implementing monetary
  policy.
• Inside lags are caused by the time it actually
  takes to identify a shift in the business cycle.

• Outside Lags
• Outside lags are the time it takes for monetary
  policy to take affect once enacted.

37
Fiscal and Monetary Policy Tools

• The federal government and the Federal Reserve
  both have tools to influence the nations economy.

38
Section 4 Assessment

• 1. Monetarism is
• (a) the time it takes to enact monetary policy.
• (b) the belief that the money supply means little
  to macroeconomic performance.
• (c) the time it takes for monetary policy to take
  affect.
• (d) the belief that the money supply is the most
  important factor in macroeconomic performance.
• 2. Tight money policies aim to
• (a) increase the money supply and expand the
  economy.
• (b) decrease the money supply and expand the
  economy.
• (c) decrease the money supply and slow the
  economy.
• (d) increase the money supply and slow the
  economy.

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39
Section 4 Assessment

• 1. Monetarism is
• (a) the time it takes to enact monetary policy.
• (b) the belief that the money supply means little
  to macroeconomic performance.
• (c) the time it takes for monetary policy to take
  affect.
• (d) the belief that the money supply is the most
  important factor in macroeconomic performance.
• 2. Tight money policies aim to
• (a) increase the money supply and expand the
  economy.
• (b) decrease the money supply and expand the
  economy.
• (c) decrease the money supply and slow the
  economy.
• (d) increase the money supply and slow the
  economy.

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40
Types of Financial Institutions

• Commercial Banks
• Commercial banks offer checking services, accept
  deposits, and make loans.
• Savings and Loan Associations
• Savings and Loan Associations were originally
  chartered to lend money for home-building in the
  mid-1800s.
• Savings Banks
• Savings banks traditionally served people who
  made smaller deposits and transactions than
  commercial banks wished to handle.
• Credit Unions
• Credit unions are cooperative lending
  associations for particular groups, usually
  employees of a specific firm or government
  agency.
• Finance Companies
• Finance companies make installment loans to
  consumers.