USC ECON 205 - The Monetary System (Continued)

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ECON 205 1st Edition Lecture 13 Outline of Last Lecture - What do we consider money?- What is the Federal Reserve?- What is the role of banks in the monetary system?Outline of Current Lecture - Continuation of chapter 16Current LectureFed’s Tools of Monetary Control- Fed can change the money supply by changing bank reserves or changing the money multiplier- Influence reserves- Change reserve ratioInfluencing the Reserve Ratio- Open-Market Operations (OMOs)- purchase and sale of US government bonds by the Fedo If Fed buys a gov bond from a bank, it pays by depositing new reserves in that bank’s reserve account Increase in reserves leads to the bank making more loans and, therefore, increasing money supplyo To decrease bank reserves and money supply, the Fed sells gov bonds- On any given day, banks with insufficient reserves can borrow from banks with excess reserveso Night loans when shy of reserve requirements at the end of the day- Federal Funds Rate- the interest rate on these loans- FOMC uses OMOs to target the fed funds rate- Changes in the fed funds rate causes changes in other rates and have a large impact on the economyGraph- F is the quantity of federal funds- Demand comes from banks below the reserve requirement- Supply comes from banks above the reserve requirement- Removes reserves from the banking system decreases the supply of federal funds which leads to the increase of r- Rf is the federal funds rateInfluencing the Reserve Ratio- Fed makes loans to banks, increasing their reserveso Traditional method: adjusting the discount rate to influence the amount of reserves banks can borrow Discount rate- the interest rate on loans the Fed makes to bankso New method: Term Auction Facility- the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans- The more banks borrow, the more reserves they have for funding new loans and increasing the money supply- Reserve ratio = reserves / deposits- Fed sets reserve requirementso Reserve requirements- regulations on the minimum amount of reserves banks must hold against deposits Decrease reserve requirements will cause a decrease in reserve ration and an increase in money multiplierProblems Controlling the Money Supply- If households hold more money as currency, banks have fewer reserves, make fewer loans, and money supply falls- If banks hold more reserves than required, they make fewer loans and money supply falls- Fed can compensate for household and bank behavior by retaining fairly precise control over the money supplyBank Runs and the Money Supply- Run on banks- when people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits- Banks don’t have enough reserves to pay off ALL depositors, so many have to closeo So even if bank isn’t really in trouble, the perception of trouble to depositors will create the problem- Federal deposit insurance helps prevent bank runs- We had bank runs during the Great

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