B.  Controlling the Money Supply

1.  Federal Reserve System (Fed)

• Central bank of the United States

• List of world central banks

• Implements U.S. monetary policy, regulates and operates financial system, provides economic information (Beige Book)

• Structure:

- 7 members of Board of Governors

• 14-year non-renewable terms

• One appointed every two years by the President

• Chair and vice chair appointed by President, confirmed by Senate, for four-year terms

- 12 Federal Reserve District Banks

• Involved in bank regulation

• Handles some check clearing

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- Federal Open Market Committee (FOMC)

• Primary responsibility for conducting monetary policy

• 7 members of Board of Governors, president of the Federal Reserve Bank of New York, 4 other Federal Reserve Bank presidents

- 2,800 member banks

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• Fed independent from Congress, President - may be different in other countries

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2.  Implementing monetary policy

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a.  Open market operations

• Federal Reserve Bank of New York buys and sells government securities

• Affects money supply and federal funds rate (rate banks charge each other for reserves)

(1)  Increasing money supply

• FRB New York buys securities => bank reserves increase (money supply increases as more loans are made) => need of banks to borrow decreases => federal funds rate decreases

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(2)  Decreasing money supply

• FRB New York sells securities => bank reserves decrease (money supply decreases as fewer loans are made) => need of banks to borrow increases => federal funds rate increases

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• Repurchase agreements (repos) increasingly used

- Sell security, buy back later at a higher price

- Difference is the effective interest

- Reverse repurchase agreement (reverse repo) - buy security, sell back later at a higher price

- Done when government budget deficits are low and government securities market is small

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b.  Discount rate

• Interest rate Fed charges member banks that borrow reserves

- Increase discount rate => less borrowing from Fed => less reserves => fewer loans => money supply decreases

- Decrease discount rate => more borrowing from Fed => more reserves => more loans => money supply increases

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• Largely symbolic as discount borrowing low, open market operations more important

• Interest rates

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c.  Reserve requirement

• Amount banks must keep in reserve

- Increase reserve requirement => less reserves can be loaned => money supply decreases

- Decrease reserve requirement => more reserves can be loaned => money supply increases

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d.  Other actions

(1)  Foreign exchange market intervention

• Buy and sell foreign currency

- Buy foreign currency => money supply increases

- Sell foreign currency = > money supply decreases

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(2)  Change margin requirements

• Margin requirement - percent of the value of a security that must be deposited, rest can be borrowed

• Doesn't affect money supply - affects types of loans that are made

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(3)  Quantitative easing

• Similar to open market operations

• Used when interest rates are near zero

• Includes long-term government bonds and corporate bonds

=> longer term rates impacted

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3.  Impact of monetary policy

a.  Effects

• Expansionary monetary policy - increase money supply

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• Contractionary monetary policy - decrease money supply

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b.  Lags

• Delay between when problem starts and when policy has impact on problem

(1)  Recognition lag - takes time to recognize that a problem exists

• About 3 - 6 months

(2)  Implementation lag - takes time to take action

• 1 day to 2 months

(3)  Impact lag - takes time for policy to have an impact

• 3 months to 2 years

• Liquidity trap - low interest rates fail to stimulate investment (I)

- Due to lack of confidence in economy

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