FS - Federal Reserve Lesson

Federal Reserve

Introduction

The Federal Reserve System is the central bank of the United States. A central bank is an institution that oversees and regulates the banking system and controls the money supply. The Federal Reserve System (known as “the Fed”) is made up of 12 privately owned District Federal Reserve Banks and a federal government agency that oversees the system, called the Board of Governors.

The Fed has four basic functions:

1. Provide financial services for commercial banks (like holding reserves, providing cash, and clearing checks)
2. Supervise and regulate banking institutions to ensure the safety and soundness of the nation’s banking and financial system
3. Maintain stability of the financial system by providing liquidity to financial institutions in order to maintain their safety and soundness
4. Conduct monetary policy to prevent or address extreme fluctuations in the economy.

 

The Fed Goal

The Fed’s goal is “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” A primary goal of the Fed is to stabilize prices, which is arguably the strongest contribution the Fed can make to promoting economic growth. Over time, it has become evident that monetary policy’s long-term influence over prices is strong but its influence over real output and real interest rates is mostly short term.

To promote employment and price stability, the Fed can use monetary policy to raise or lower interest rates through the money market. Lower interest rates promote spending and investment that leads to increased employment (this is called expansionary monetary policy). Higher interest rates prevent inflation and promote price stability (this is called contractionary monetary policy).

 

3 Main Policies

The Fed has three main policy tools it can use to control equilibrium interest rates in the money market: the reserve requirement, the discount rate, and open-market operations.

The Reserve Requirement

The Fed sets the percentages of bank deposits that must be held as reserves.

Greater excess reserves lead banks to expand credit, which expands the money supply. Fewer excess reserves lead banks to reduce credit, which decreases the money supply. Changes in the money supply change equilibrium interest rates in the money market. Because changes in the reserve requirement can have powerful impacts, the reserves requirement is seldom used as a tool of monetary policy.

The Discount Rate Open

The discount rate is the rate that commercial banks must pay to borrow from the Fed.

When it is cheaper to borrow from the Fed, banks will borrow more reserves; when it is more expensive to borrow from the Fed, banks will borrow less. More reserves lead banks to expand credit, which expands the money supply. Fewer reserves lead banks to reduce credit, which reduces the money supply. The discount rate is set by the Fed, generally a percentage point above the federal funds rates (which is the interest rate banks charge each other for overnight loans). The equilibrium federal funds rate established in the money market is the focus of monetary policy, not the discount rate set directly by the Fed.

Market Operations (OMO's)

OMOs refers to the Fed buying and selling U.S. Treasury bills, normally through a transaction with commercial banks that changes the banks’ reserves.

When the Fed buys Treasury bills, it increases the banks’ reserves, and when the Fed sells Treasury bills, it decreases the banks’ reserve. The change in the banks’ reserves leads to a change in the money supply. Changes in the money supply change equilibrium interest rates in the money market. OMOs are the most frequently used monetary policy tool.

• Open market operations include buying and selling government bonds. When you are asked about an open market operations, you should answer in terms of buying bonds or selling bonds.

 

The Federal Reserve Bank

The presentation below will cover the functions of the FED. 

 

Review

Review what you have learned by completing the activity below.

 

In Summary . . .

• The Fed, the central bank of the United States, acts as a bank for other banks and for the federal government. It also regulates banks, sets monetary policy, and maintains the stability of the financial system.
• The Fed sets reserve requirements and the discount rate and conducts open-market operations. Of these tools of monetary policy, open-market operations are the most important.
• Starting in 2007, the Fed began creating additional credit facilities to help to stabilize the financial system.
• The Fed creates new reserves and new money when it purchases bonds. It destroys reserves and thus reduces the money supply when it sells bonds.

 

 

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