History of the Federal Reserve

  • In 1913, the Federal Reserve System was established

  • The fed has a monopoly of money supply in the United States

  • The Fed is a private institution with a public component

  • The Board of Governors oversees the system

    • 7 members who are appointed 14 year terms by the president and approved by the Senate

    • Chairs are appointed to renewable 4-year terms

The Federal Reserve Structure

Cleveland 12 San Francisco Minneapolis@ Chicago Kansas City 10 St.
  Louis @BOSton New York Philadelphia Board of Richmond Governors
  Atlanta Dallas 11

  • 12 Federal Reserve Banks each in charge of their district

    • Audit books of private-sector banks to ensure banks are financially sound

    • New York Fed plays the special role of carrying out open-market operations

  • Federal Open Market Committee (FOMC) makes decisions about monetary policy

    • Board of Governors plus the New York Fed Presidents and 4 rotating Bank Presidents of the other 11 Districts


Function of the Federal Reserve

  • Provide Financial Services

    • Serve as the "banker's bank" as well as the bank for the United States

    • The government has a checking account with the Fed through the U.S. Treasury

  • Supervise and Regulate Banking Institutions

    • Charged with ensuring the soundness of the nation's banking and financial system

    • Both the District Banks and Board of Governors examine and regulate commercial banks

  • Maintain the Stability of Financial System

    • Provide liquidity to financial institutions

    • Provided a "discount window" for banks after the evens of 9/11

  • Conduct Monetary Policy

    • Chief function of the Federal Reserve

    • Board of Governors use monetary policy tools to address the macroeconomic fluctuations that occur in the economy

Reserve Requirement and Discount Rate

  • Reserve Requirement

    • Banks are required to hold on to 10% of its checkable bank deposits

    • The Fed will rarely change this rate. Last change occurred in 1992

    • If money falls below, then banks will borrow from other banks through the federal funds markets

    • Interest rate that banks borrow from other banks rate is the federal fund rate

    • If RRR increase, the money supply decreases

    • If RRR decrease, the money supply increase

  • Discount rate

    • Interest rate the Fed charges directly

    • Rarely used to actively manage money supply

Open Market Operations


  • The Fed will buy or sell U.S. Treasury bills through a commercial bank

    • When the Fed buys bonds, the money supply increases

    • Buying bonds will "bloat" the money supply

    • When the Fed sells bonds, the money supply decreases

    • Selling bonds will "shrink" the money supply

  • How does the Fed purchase U.S. Treasury bills from banks?

    • Fed will create money that heretofore never existed into existence

    • Remember, we have a fiat currency

    • Money supply increases via the monetary base

    The Fed buys securities in the open market Bank reserves increase,
and the quantity of money increases Interest rates fall The dollar
falls on the foreign exchange market Net Consumption exports and
investment Increase Increase Aggregate demand Increases Real GDP
growth and inflation speed up The Fed sells securities in the open
market Bank reserves decrease, and the quantity of money decreases
Interest rates rise The dollar rises on the foreign exchange market
Consumption Net and investment exports decrease decrease Aggregate
demand decreases Real GDP growth and inflation slow down

The Financial Crisis of 2008



Practice Questions

  • Which of the following is NOT a role of the Federal Reserve System?

    a. Controlling monetary policy

    b. Controlling fiscal policy

    c. Setting a target federal funds rate

    d. Supervising and regulating banks

    e. Determining the Required Reserve Ratio

    Answer: b

  • When the Fed makes a loan to a commercial bank, it charges

    a. No interest

    b. The federal funds rate

    c. The discount rate

    d. The prime rate

    e. A fixed interest rate of 10%

    Answer: c

  • If the Fed purchases U.S. Treasury bills from a commercial bank, what happens to bank reserves and the money supply?

    a. Both increase

    b. Both decrease

    c. Bank reserves increase, money supply decreases

    d. Bank reserves decrease, money supply increases

    e. Bank reserves increases, no change in money supply

    Answer: a

    2 MSO An increase in the money supply lowers the interest rate 3.0
MS2 MD 3.1 Real money (trillions of 2000 dollars) (a) Money market

105 Increase in interest-sensitive expenditure 9.8 LAS Multiplier
  effect SAS ADI ADO ADO+ Al 10.0 Real GDP (trillions of 2000 dollars)
  (c) Real GDP and the price level

  • What are the three traditional tools of monetary policy used by the Fed? Which method is preferred?

    • Discount Rate

      • rate that banks are charge directly by the Fed

      • ↑ Discount Rate, ↓ money supply

      • ↓ Discount Rate, ↑ money supply

    • Required Reserve Ration (RRR)

      • ↑ RRR, ↓ money supply

      • ↓ RRR, ↑ money supply

    • Open-Market Operation (Preferred method)

      • Buy government securities will increases money supply (BUY=BLOAT)

      • Sell government securities will decrease money supply (SELL=SHRINK)

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