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The Federal Reserve System

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Title: 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.
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