Unit 6: Federal Reserve System and Monetary Policy.

Unit 6: Federal Reserve System and Monetary Policy

Topic 1: Money

Functions of Money

1. Medium of Exchange

It is accepted as a form of payment

2. Unit of accounting

• helps to determine the value of an item and allows comparison

3. Store of value

• Money can be saved for use in future

Characteristics of money ?

1. Durable2. Divisible 3. Scarce 4. Portable .

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Money Systems: 1. Barter system

• People trade one object for another

2. Commodity money system

• An item with intrinsic value is used as money

Examples:

Cigarettes used in prison

Animal furs used in colonial times

3. Representative Money System

Money “backed” by somethingExample: The Gold standard; people didn’t

carry around the gold, they had a gold certificate that represented the gold

*4. Fiat money system

• Money that is declared so by the government

• It is not “backed” by anything

Topic 2: The Federal Reserve and the Banking System

The Federal Reserve System (the FED)

- The FED is the central bank of the U.S.

- Created in 1913

Jobs of the FED

• Print money

• Clear checks

• Supervise banks

• Act as a bank to banks

• Manage money supply

Organization of the FED

Member banks

Board of Governors

• - Head of the Federal Reserve System

• Chairman of the Board of Governors???

Federal Reserve System

• 12 Districts

Federal Reserve Banks: 12 Districts

Member Banks

FDIC insured (Federal Deposit Insurance

Corporation)

Insures money in banks up to $250,000

• FDIC – Bank run “It’s a Wonderful Life”

– 60 minutes video: FDIC

Topic 3: Banks and the Money supply

Fractional Reserve Banking

If you have a bank account, where is your money?

Only a small percent of your money is in the safe. The rest of your money has been loaned

out.

This is called “Fractional Reserve Banking”

The FED sets the amount that banks must hold

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Demand DEPOSIT

• Money placed in banks by customers

• Banks take these deposits and loan them out to people who want to borrow money

Reserve Requirement

• Amount of money a bank is required to hold of a person’s deposit

EXCESS RESERVE

• Deposit that is not part of the required reserve

Practice:

• If a $100 deposit is placed in a bank and the reserve requirement is 20%, how much money does the bank have to hold?

• How much can they loan out?

Practice

• If $50 is deposited into a bank and the reserve requirement is $10%, how much is the bank required to hold?

• How much can they loan out?

• If $10 is deposited into a bank and the reserve requirement is 10%, how much money must the bank hold?

• How much money can they loan out?

The process of how banks “create” money

Banks only influence the amount of $ in the economy if they make loans.

When a loan is taken out, it is spent and ends back up in the bankingSystem

Example: complete the chart assuming the reserve requirement is 10% Bank Deposit Reserve

requirement Loan

A $1000 $100 $900

B

C

The process of how banks “create” money

Bank Deposit Reserve requirement

Loan

A $1000 $100 $900.00

B $900 $90 $810.00

C $810 $81.10 $728.90

MoneyMultiplier Reserve Requirement (ratio)

1=

The Money Multiplier

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• Used to determine how much a loan can impact the overall economy

What is the Money multiplier on the following reserves?

• 10%

• 20%

• 5%

Maximum change in the money supply =

Money multiplier X Deposit = total - deposit

Example: Billy deposits $400 in his bank and the

reserve requirement is 10%.

What is the money multiplier?

What is the maximum change in the money

supply?

THE MULTIPLE EXPANSION of money will be less if:

• 1. Banks DO NOT loan out all of their excess • 2. People DO NOT spend all the money that they

borrow • 3. When money is spent, it is NOT placed back

into a bank

Practice:

1. $50 is deposited into a bank and the reserve requirement is 10%. What is the total expansion of the money supply

Money multiplier = ?

Money multiplier X deposit (-deposit) = ?

2. $20 is place as a deposit into a bank and the reserve requirement is 25%. What is the total expansion of the money supply?

Money multiplier = ?

Money multiplier X deposit (-deposit) =?

• 3. $100 is deposited into a bank and the reserve requirement is 5%, what is the multiple expansion of money?

Money multiplier = ?

Money multiplier X deposit (-deposit) = ?

• Video: Inside the Fed

Topic 4: Monetary Policy

• What the FED does to regulate the money supply

• The FED controls the money supply by adjusting Nominal interest rates

Expansionary monetary policy

Implemented during Recession

Goal is to speed up the economy; they want people to get out and spend $ in economy

Contractionary Monetary Policy

• Implemented during INFLATION

• Goal = slow down the economy; want less spending to occur in the economy

Video:

Monetary policy: Part Art, Part Science

Tools of monetary policyThe FED adjusts the money supply by

changing any one of the following:

1.Change the reserve requirement

2. Changing the Discount rate Discount Rate- Interest rate the FED

charges banks to borrow money

**3. Open Market Operations•Buying and selling Bonds (securities)

Expansionary monetary policy

• Implemented during RECESSION

• Goal is to SPEED UP

How can the Fed speed up the economy?

• 1. BUY BONDS using open market operations (BUY = BIG)

• 2. LOWER the reserve requirement

• 3. LOWER the discount rate of interest

Impact of expansionary monetary policy

1. Banks have more money to lend

2. Interest rates go down

3. People borrow more money due to low interest rates

4. People save less money due to low interest rates

5. People spend more money

Contractionary Monetary Policy

• Implemented during INFLATION

• Goal is to SLOW DOWN economy

How can the Fed slow down the economy???

• 1. SELL BONDS using open market operations (SELL = SMALL)

• 2. RAISE the reserve requirement

• 3. RAISE the discount rate of interest

Impact of Contractionary Policy

1. Banks have less money to lend

2. Interest rates go up

3. People borrow less money due to high interest rates

4. People save more money due to high interest rates

5. People spend less money