Chapter Fifteen: Module Summary -- The Federal Reserve and Monetary Policy

  • The Federal Reserve ("the Fed") was founded in 1914 after four severe banking panics. The Fed is largely independent of the authority of the Congress and President.

  • The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks in order to prevent financial disasters like those that occurred during the Great Depression.

  • The Board of Governors is the highest governing body of the Federal Reserve. It consists of 7 members including the chairperson, currently Ben Bernanke.

  • The Twelve District Banks perform numerous functions in their Districts. They regulate and supervise banks, run a check-clearing service, do research and monitor the economic activity in their areas, circulate the currency in their districts, sell savings bonds, and so on.

  • The F.O.M.C. (Federal Open Market Committee) is responsible for directing monetary policy. The committee is made up of 12 members, 7 from the board of governors plus 5 Presidents of the District Banks who serve on a rotating basis.

  • There are three "tools" that the Fed can use to conduct monetary policy. They are Open Market Operations (OMO), a change in the discount rate, and a change in the reserve requirement ratio.

  • An Open Market Operation is the purchase or sale of government securities via transactions in the open market. An open market purchase injects excess reserves into the banking system, and leads to an expansion of the money supply. An open market sale, on the other hand, removes reserves from the system and reduces the money supply.

  • The discount rate is the interest rate at which the Federal Reserve lends funds to banks. If the Fed lowers the discount rate, it is signaling to banks that it is easing up the money supply.

  • If the Fed lowers the reserve requirement ratio (RRR), then it is allowing banks to lend out funds that they previously had to hold as reserves. Therefore, a lowering of this ratio is expansionary.

  • Expansionary monetary policy shifts the supply curve for loanable funds to the right. This increases the quantity of loanable funds, and decreases interest rates. Lower interest rates stimulates Aggregate Demand, in particular investment and consumption, leading to higher levels of production and employment. Contractionary monetary policy, on the other hand, leads to higher interest rates, lower levels of Aggregate Demand, and lower levels of production and employment.

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