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GOVERNMENT POLICY:

MONETARY & FISCAL


POLICY

Adapted from James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts
University 2005 Thomson Business & Professional Publishing, A Division of Thomson
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Learning
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Monetary Policy - Policy that involves
changing the rate of growth of the
money supply in circulation in order to
affect the cost and availability of
credit.

Fiscal Policy - Using taxes and


spending to help the economy grow.

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THE FEDERAL RESERVE
SYSTEM: DEFINITIONS
Federal Reserve System: the central
bank of the United States
Board of Governors: the governing
body of the Fed
Federal Open Market Committee
(FOMC): the 12 member policymaking
group within the Fed. It has the
authority to conduct open market
operations
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THE FEDERAL RESERVE
SYSTEM: DEFINITIONS
Open Market Operations: the
buying and selling of government
securities (bonds) by the Fed
Monetary Policy: changes in the
money supply, or in the rate of
change of the money supply, to
achieve particular macroeconomic
goals
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FEDERAL RESERVE DISTRICTS AND
FEDERAL RESERVE
BANK LOCATIONS

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STRUCTURE OF THE
FEDERAL RESERVE

F. Mishkin, THE ECONOMICS OF MONEY AND THE ECONOMIC POLICY REVIEW.


(c) 1998 Frederic S. Mishkin. Reproduced by Addison Wesley Longman. All
rights reserved.
THE BOARD OF
GOVERNORS OF THE
FEDERAL RESERVE
Coordinates and controls the activities of the
Federal Reserve System
7 Members
14 Year Terms
Appointed by the President with Senate
approval
A governor is appointed every other year
President designates one member as
President for a 4 year term
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THE FEDERAL OPEN MARKET
COMMITTEE OF THE FEDERAL
RESERVE

The major policy making group within


the Fed is the Federal Open Market
Committee
Authority to Conduct Open Market
Operations (Buying and Selling of
Federal Securities)
12 Members
7 Board of Governors
5 District Bank Presidents (including New York)
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FUNCTIONS OF THE
FEDERAL RESERVE
SYSTEM
Control the Money
Supply
Supply the economy
with paper money
Provide check-
clearing services
Hold depository
institutions reserves
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FUNCTIONS OF THE
FEDERAL RESERVE
SYSTEM
Supervise Member
Banks
Serve as the
governments banker
Serve as the lender
of last resort
Serve as a fiscal
agent for the
Treasury

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THE CHECK-CLEARING
PROCESS

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FED TOOLS FOR CONTROLLING
THE MONEY SUPPLY: OPEN
MARKET OPERATIONS

Open Market Operations: Buying and


Selling U.S. Government Securities in the
Financial Markets
U.S. Securities: bonds and bond-like
securities issued by the U.S. Treasury
Open Market Purchase: The buying of
government securities by the Fed
Open Market Sale: The selling of
government securities by the Fed
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OPEN MARKET
PURCHASES
Assume Fed purchases securities from a
bank.
The Fed receives the securities from a
bank, and the banks reserves increase by
the amount of the purchase (Reserves =
Bank deposits at the Fed + Vault Cash).
When the banks have a reserve increase
and no other bank has a similar decline, the
money supply expands through a process
of increased loans and checkable deposits.
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OPEN MARKET SALES

Assume the Fed sells securities to a bank.


To pay for the securities, the Fed takes
reserves from the bank.
Because of the decrease in the banks
reserves, the bank reduces total loans
outstanding, which reduces the total
volume of checkable deposits and the
money supply.

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OPEN MARKET
OPERATIONS

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THE REQUIRED-RESERVE
RATIO
The Fed can also influence the money
supply by changing the required-reserve
ratio.
An increase in the required-reserve ratio
leads to a decrease in the money supply
A decrease in the required-reserve ratio
leads to an increase in the money
supply.

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THE DISCOUNT RATE
A bank can borrow from the federal funds
market or from the Fed.
Federal Funds Rate: The interest rate a
bank pays for a loan in the federal funds
market.
Discount Rate: The interest rate a bank
pays for a loan from the Fed.
When a bank borrows money from the Fed,
the money supply increases because its
reserves increase while the reserves of no
other bank decrease.
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THE SPREAD BETWEEN THE
DISCOUNT RATE AND THE
FEDERAL FUNDS RATE

Banks may believe that the Fed is


hesitant to extend loans to take
advantage of profit-making opportunities.
The bank may not want to deal with the
Fed bureaucracy that regulates it.
The bank realizes that acquiring a loan
from the Fed is a privilege and not a right,
and doesnt want to abuse the privilege.

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DISCOUNT RATE VS.
FEDERAL FUNDS RATE
If the discount rate is
significantly lower
than the federal funds
rate, most banks will
borrow from the Fed.
An increase in the
discount rate relative
to the federal funds
rate reduces bank
borrowings from the
Fed.

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WHICH TOOL DOES THE
FED PREFER TO USE?
Tools which can be used to influence the
money supply:
open market operations
the required-reserve ratio
the discount rate
The Fed prefers Open Market Operations
Open market operations are flexible
Open market operations can be reversed
Open market operations can be implemented
quickly
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FED MONETARY TOOLS & THEIR
EFFECTS ON THE MONEY
SUPPLY

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