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*reserve requirements*

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the amount of reserves that banks are required to keep on hand

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National Monetary Commission (NMC) (1908)

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created to propose solutions to the nation's banking problems - based on the NMC's recommendations, Congress passed the Federal Reserve Act in 1913

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monetary policy

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the actions the Federal Reserve takes to influence the level of real GDP and the rate of inflation in the economy

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Board of Governors

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the seven-member board that oversees the Federal Reserve System - headquartered in Washington, D.C. - members are appointed for staggered fourteen-year terms by the Pres. of the U.S. with the advice and consent of the Senate - terms are staggered to prevent any one President from appointing a full Board of Governors and to protect board members from day-to-day political pressures - members cannot be reappointed after serving a full term - geographical restrictions on these appointments ensure that no one district is over-represented

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chair of the Board of Governors

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appointed by the President with Senate approval - serve four-year terms, which can be renewed - acts as main spokesperson for monetary policy for the country - ex. Alan Greenspan was a notable chair of the Fed; he lowered interest rates, which improved the economy - recent chairs have been from business, academia, or govt.

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Federal Reserve System (The Fed)

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composed of a group of 12 independent regional banks - this central group of banks could lend to other banks in times of need - helped restore confidence in banking system

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Federal Reserve Districts

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the twelve banking districts created by the Federal Reserve Act - one Federal Reserve Bank is located in each of the 12 districts - each Fed. Reserve Bank monitors and reports on economic and banking conditions in its district - each Fed. Reserve District is made up of more than one state

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Federal Reserve Bank's Board of 9 Directors

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member banks elect three bankers and three leaders industry, commerce, or other businesses to their district boards - remaining three directorships, appointed by the Board of Governors of the Federal Reserve, represent broad interests - district president is then elected from these 9 directors

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Federal Advisory Council (FAC)

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the research arm of the Federal Reserve that collects information about each district and reports to the Board of Governors about economic conditions within their districts - consists of one member from each Federal Reserve District -- 12 members in all - main function: to provide feedback and advice to the Board of Governors concerning the overall financial health of each district - meets w/ the Board of Governors four times a year - banks own Federal Reserve > political independence > easier to make decisions that best suit the interests of the country as a whole

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Federal Open Market Committee (FOMC)

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Federal Reserve committee that makes key decisions bout interest rates and the growth of the United States money supply - meets about 8 times a year in private to discuss the cost and availability of credit, for business and consumers, across the country - announcements of the FOMC's decisions can affect the financial markets, the rates for home mortgages, and many other economic institutions around the world - all 7 members of the Board of Governors sit on the FOMC - five of twelve district bank presidents sit on the committee - pres of the New York Federal Reserve Bank is a permanent member - other four district presidents serve one-year terms on a rotating basis

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Federal Reserve Functions

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(in general) 1. provides banking and fiscal services to the federal govt. 2. provides banking services to member and nonmember banks 3. regulates the banking industry 4. tracks and manages the national money supply to meet current demand and to stabilize the economy

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Federal Reserve Function: Serving Govt.

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- serves as a banker for the U.S. govt.: it maintains a checking account for the Treasury Dept. - processes payments such as social security checks, IRS refunds, etc. - serves as a financial agent for the Treasury Dept. and other govt. agencies: sells, transfers, and redeems govt. bonds, bills, and notes, or securities; also makes interest payments on these securities - district federal Reserve Banks issue paper currency (Federal Reserve Notes), which is printed at the Bureau of Engraving and printing; as bills become worn or torn, the Fed. Reserve takes them out of circulation and replaces them with fresh ones

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Federal Reserve Function: Serving Banks

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- check clearing - monitors bank reserves throughout the system; each of the 12 Fed Reserve Banks sends out bank examiners to check up on lending and other financial activities of member banks; also study proposed bank mergers and bank holding company charters to ensure competition in the banking and financial industries - serves as a lender of last resort; banks borrow from the Fed in financial emergencies such as severe recessions; discount rate

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Federal Reserve Function: Regulating Banking System

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- each financial institution that holds deposits for customers must report daily to the Fed about its reserves and activities - Fed uses these reserves to control how much money is in circulation at any one time - examine banks periodically to make sure that each institution is obeying laws and regulations; may make unexpected visits - bank examiners can force banks to sell risky investments or to declare loans that will not be repaid as losses; problem banks (banks that take excessive risks) will be forced to undergo more frequent examinations - any bank that goes to the Fed for emergency loans too often will be subject to financial review and close govt. supervision

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check clearing

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the process by which banks record whose account gives up money and whose account receives money when a customer writes a check - Fed can clear millions of checks at any one time using high-speed equipment - most checks clear within two days

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bank holding company

answer

a company that owns more than one bank

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truth-in-lending laws

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require sellers to provide full and accurate information about loan terms - under a provision called "Regulation Z", millions of consumers receive information about retail credit terms, auto loans, and home mortgages every year

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federal funds rate

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interest rate banks charge each other for loans - banks lend each other money on a day-to-day basis, using money from their reserve balances (federal funds)

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discount rate

answer

rate the Federal Reserve charges for loans to commercial banks

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fractional reserve banking system

answer

a banking system that keeps only a fraction of its funds on hand and lends out the remainder

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net worth

answer

total assets minus total liabilities

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M1

answer

a measure of funds that are easily accessible or in circulation

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M2

answer

funds counted in M1 as well as money market accounts and saving instruments

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M3

answer

large time deposits and some govt. securities

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Factors that Affect the Demand for Money

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1. cash needed on hand: people and firms need to have a certain amount of cash on hand to make economic transactions, i.e. to buy groceries 2. interest rates: as interest rates rise, people and firms will generally keep their wealth in assets that pay returns; they demand less money in the form of cash 3. price levels in the economy: as price levels rise, so does the demand for cash 4. general level of income: if you make more money, you are more likely to keep more of your wealth/income in cash

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inflation

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a general rise in prices, which can be caused by too much money in the economy; a glut of dollars lessens their value

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money creation

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the process by which money enters into circulation; it is carried out by the Fed and by all banks around the country - DOES NOT MEAN PRINTING OF MONEY - Ex: 1. you deposit $1,000 into your checking acct 2. $100 held in reserve, $900 available for loans 3. the $900 is loaned to person A, who gives it to person B 4. person B deposits $900 5. $90 held in reserve, $810 available for loans - At this point, the money supply has increased by $2,710 ($1,000 + $900 + $810)

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multiplier effect

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(in fiscal policy) every one dollar change in fiscal policy creates a change greater than one dollar in the economy

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required reserve ratio (RRR)

answer

ratio of reserves to deposits required of banks by the Federal Reserve; the fraction of deposits that banks are required to keep in the reserve - the amount that the bank is allowed to lend is determined by the RRR - the RRR, established by the Fed Reserve, ensures that banks will have enough funds to supply customers' withdrawal needs

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money multiplier formula

answer

amount of new money that will be created with each demand deposit, calculated as 1 / RRR - money multiplier tells us how much the money supply will increase after an initial cash deposit to the banking system increase in money supply = initial cash deposit * 1/RRR

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excess reserves

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reserves greater than the required amounts - ensure that banks will always be able to meet their customers' demands and the Fed's reserve requirements

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Reserve Requirements

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1. an increase in reserve requirements cause banks to increase reserves > banks reduce lending, causing the money supply to contract; can be disruptive to banking system, often not used 2. a reduction in reserve requirements causes banks to decrease reserves > banks increase lending, causing the money supply to expand; increase money multiplier

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Setting Rates

answer

in the past, the discount rate (interest rate that the Fed Reserve charges on loans to financial institutions) was changed to increase or decrease the money supply - today, the discount rate is primarily used as a mechanism to insure that sufficient funds are available in the economy; acts as a safety net (loans at discount rates) during financial crisis - Fed Reserve keeps the discount rate above the funds rate - when the Fed Reserve increases or decreases the federal funds rate, the discount rate will rise or fall with it - changes in the federal funds rate and the discount rate affect the cost of borrowing to banks or financial institutions; in turn, these changes in interest rates affect the prime rate

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prime rate

answer

rate of interest that banks charge on short-term loans to the best customers-- usually large companies with good credit ratings - changes in the federal funds rate and discount rate are reflected in the prime rate

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federal funds rate scenarios

answer

1. an increase in the federal funds rate makes banks less willing to borrow from other banks > banks reduce lending in order to build reserves, causing the money in the supply to contract 2. a decrease in the federal funds makes banks more willing to borrow from other banks > banks increase lending, causing the money supply to expand

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open market operations

answer

the buying and selling of government securities to alter the supply of money - most-used monetary policy tool - buying bonds: seller of bond deposits money in bank > increase money supply - bond sales: Fed sells govt. securities to bond dealers > money is out of circulation, decreasing the money supply

question

open market scenarios

answer

1. through bond sales, the Fed removes reserves from the banking system > banks reduce lending, causing the money supply to contract 2. the Fed's purchase of bonds increases reserves in the banking reserve system > banks increase lending, causing the money supply to expand

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monetarism

answer

the belief that the money supply is the most important factor in macroeconomic performance

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Effects of Monetary Policy

answer

1. Money supply increases, interest rate decreases [think of it in terms of supply & demand; if the supply is higher, the price (interest rate) is lower] 2. Money supply decreases, interest rates increase 3. Aggregate demand increases, real GDP increases 4. Aggregate demand decreases, real GDP decreases

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easy (loose) money policy

answer

monetary policy that increases the money supply - used when the macro-economy is experiencing a contraction -- declining income -- the Fed may want to expand, or stimulate, it - increased money supply will lower interest rates, thus encouraging investment spending (may lead to cutbacks and layoffs)

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tight money supply

answer

monetary policy that reduces the money supply - used when economy is experiencing rapid expansion that may cause high inflation - reduce money supply to push interest rates upward > investment spending declines > real GDP declines

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aggregate demand

answer

represents the relationship between price levels and quantity demanded in the overall economy

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Problem of Timing

answer

- if policies are enacted at the wrong time, they could intensify the business cycle, rather than smooth it out - goal of stabilization is to smooth out fluctuations in business cycles; to make peaks a little bit lower and troughs not quite as deep - bad timing: > ex. policymakers are slow to recognize contraction > ex. takes time to enact expansionary policies; by the time this takes place, the economy may already be coming out of the recession on its own > ex. if expansionary policies are enacted too late, the economy may have slowed down so much that businesses are reluctant to borrow at any rate for new investment; this dilemma, in which the central bank is unable to encourage lending with rate cuts, is called "pushing on a string"

question

inside lag

answer

delay in implementing monetary policy - occurs b/c of 2 reasons: 1. it takes time to identify a problem 2. once a problem has been recognized, it can take additional time to enact policies (more severe for fiscal than monetary policy b/c fiscal policies require actions of Congress & Pres.)

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outside lag

answer

the time it takes for monetary policy to have an effect - can be much longer for monetary policy, since they primarily affect business investment plans - firms may require several months or even years to make large investment plans, esp. those involving new physical capital, such as a new factory - a change in interest rates may not have its full effect on investment spending for several years

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fiscal policy

answer

changes in govt. spending and taxation to influence economy

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interventionist policy

answer

a policy encouraging action - likely to make an economy worse if the economy self-adjusts quickly

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Expansionary policy tools

answer

(Fiscal) 1. increase govt. spending 2. cut taxes (Monetary) 1. open market operations; bond purchases 2. decrease federal funds rate 3. decrease reserve requirements

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Contractionary policy tools

answer

(Fiscal) 1. decrease govt. spending 2. raise taxes (Monetary) 1. open market operations; bond sales 2. increase federal funds rate 3. increase reserve requirements

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Monetarists

answer

- main proponent: Milton Friedman - money supply is linked to nation's economic health - changes in govt. spending have no real effect - fiscal policy is bad because it leads to govt. deficits & debt - the economy is inherently stable and does not need govt. intervention - the velocity of money also remains constant - ex. Ronald Reagan, Bill Clinton

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Keynesians

answer

- based on theories of John Maynard Keynes - the marginal propensity to consume stays constant over time - give consumers money, and they will spend it - govt. needs to take action in a recession or a depression to create jobs to prevent economic hardships - monetary policies takes too much time in order to have an impact - govt. spending changes aggregate demand - gov. spending improves the country's infrastructure (bridges, highways, schools, etc.) - deficits and debt can be reduced during good times

Econ: Ch. 16 – Flashcards

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