Notes
The Fed's structure
- Created by the Federal Reserve Act (1913). A Board of Governors of 7 (14-year terms; the Chair serves 4-year terms), 12 regional Reserve Banks, and the FOMC, which makes key policy decisions.
- Designed to be independent of short-term politics.
What the Fed does
- Conducts monetary policy under a dual mandate: maximum employment and stable prices (a $2\%$ longer-run inflation goal since 2012).
- Supervises banks, provides services to banks, acts as the lender of last resort, serves as the government's bank and issues Federal Reserve notes.
Money creation and tools
- Lending creates money. Simple money multiplier $\displaystyle = \frac{1}{rr}$.
- Tools: open market operations (buy securities to lower rates, sell to raise them), the federal funds rate target, the discount rate, interest on reserve balances, reserve requirements (zero since 2020) and, in crises, quantitative easing.
Using monetary policy
- Expansionary: lower rates to fight recession. Contractionary: raise rates to fight inflation.
- $MV = PQ$ links money growth and prices.
- Challenges: time lags, stagflation, debates over rules versus judgment and over independence.
- Fiscal policy (spending and taxes) belongs to Congress and the President; monetary policy belongs to the Fed.
Topics in this unit
Each topic has its own short notes and practice.
Practice
Contractionary policy raises interest rates to slow borrowing and spending.
$\displaystyle \frac{1}{0.05} = 20$.
The FOMC has 12 voters: the 7 governors, the New York Fed president and 4 rotating Reserve Bank presidents.
Lower rates reduce the cost of loans, which encourages investment.
$\displaystyle V = \frac{PQ}{M} = \frac{20}{4} = 5$.
Taxes and government spending are set by Congress and the President.
Free response
Write your answer first, then open the scoring guide.
Free-response question
The economy is in a recession. The Federal Reserve decides to buy $5 billion of government securities from banks. Assume a required reserve ratio of $10\%$ and that banks lend all excess reserves.
(a) Identify the type of monetary policy and explain how buying securities affects bank reserves and interest rates.
Show the answer and scoring guide
This is expansionary monetary policy. When the Fed buys securities, it pays banks by adding $5 billion to their reserves. With more reserves available to lend, banks compete to make loans, so interest rates, including the federal funds rate, fall.
Check off the points you earned:
(b) Calculate the money multiplier and the maximum increase in deposits in the banking system.
Show the answer and scoring guide
Money multiplier $\displaystyle = \frac{1}{0.10} = 10$. Maximum increase in deposits $= 5 \times 10 = 50$ billion dollars.
Check off the points you earned:
(c) Explain how this policy could reduce unemployment, and describe ONE risk of the policy.
Show the answer and scoring guide
Lower interest rates make it cheaper for households to borrow for homes and cars and for businesses to borrow for equipment. More spending raises demand for goods and services, so firms increase output and hire more workers. A risk is that if the policy adds too much spending, it can cause inflation; another is that time lags mean the effect may arrive after the economy has already recovered.
Check off the points you earned: