Lecture Outline – The Federal Reserve System and Open Market OperationsThe role of money in an economy•Monetary growth causes inflation•Monetary growth influences spending growth (shifts the dynamic AD curve)•Without money, trade would require barter (the exchange of one good for another)•Money is anything that is widely accepted as a means of payment•Currency - paper bills and coins•Demand deposits: balances in bank accounts that depositors can access by writing a check•Savings deposits: money market mutual funds, small time deposits (they sit in a savings ac-count)•Total Reserves held by banks at the FedA. What is the Federal Reserve Systema. Board of Governors: 7 members located in Washington, DC Janet Yellenb. 12 regional Fed banks located around the U.S.c. Federal Open Maret Committee (FOMC): includes the Board of Governors and presidents of some of the regional Fed banks. The FOMC decides monetary policy1. They take information from regional banks and they use info to de-termine whether to increase of decrease the growth of money sup-ply in the economy.2. Who produces the money we use in the United States?3. How does the Fed create money?a. Money supply is not the base of currency that exists, its amultiple of that monetary base. A nations money supply exists al the money that ex-ists in checking and savings accounts.b. Money is created by lending and borrowing from banks excess re-serves and new deposits that are made from lending and borrowing4. Who are the Fed’s customers?5. What are some of the Fed’s duties?1B. The U.S. Money Supplies1. What assets serve as money? Define each one.2. What is a liquid asset?a. The ease in which it can be used to turn into payment. More liquid:currency and checkable deposits. Less liquid: money in savings accound, money mutual finds, small time deposits3. What is the relationship between liquidity and money?4. There are several definitions of the money supply. a. Name the three most important definitions of the money supply. Which is largest? Which is smallest?1. Monetary Base (MB): Currency and total reserves at the Fed2. M1: Outstanding currency and checkable (i.e. demand) deposits3. M2: M1 + savings deposits, money market mutual finds, and small-time depositsb. What types of assets are included in each definition of the money supply?c. Which definition of the money supply does the Fed have direct control over?1. Central Bank: an institution that Oversees the banking system and regulates the money supply2. Monetary policy: the act of setting the money supply by policy-makers in the central bank3. Federal Reserve: the central bank of the U.S.a. Created in 1913 to regulate by the Federal Reserve Act of 1913b. Main responsibility in 1913: to regulate and ensure the health of the U.S. banking systemc. Over time the Fed was given the responsibility of conduct-ing monetary policy.d. Which components of the money supply influence AD?C. Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier1. What is fractional reserve banking?21. Fractional Reserve Banking: when banks are required to keep only a fraction of their total depositits on reserve. Excess reserves can be loaned to borrowers who can invest and spend the money in the economy2. What are bank reserves?3. What is the opportunity cost of the bank holding reserves?4. What is the reserve ratio (RR)? What influences a banks’ RR?5. What is the money multiplier (MM)? How is MM related to RR?a. 1/Reserve Ratio. There is a multipliers when there is change in the money supply.b. Explain how a bank creates money by making a loan.c. Explain how the Fed can change the money supply by creating new reserves.1. Subtract out initial deposit from the change in the money supply. Total change in the money supply will be a multiple of any initial change in deposits in a commercial bank.2. Change in money supply= initial deposit x money multiplier3. Commercial banks must hold only a fraction of their reservesd. If MM is 10 and reserves increase by $2000, then what is the maximum amount that deposits could increase?D. How the Fed Controls the Money Supply1. What are the 3 major tools the Fed uses to control the money supply?a. Open market operations: geared toward short term interest ratesb. Discount rate lending and auction facility: Federal reserve lending to banks and other financial institutionsc. Required Reserve and payment of interest on reserves: changin the minimum RR; paying interest on any reserves held by banks at the Fed.2. What are the primary type of assets the Fed buys and sells in order to control the money supply?3. Although the Fed has direct influence over the money supply, why does it face difficulty in controlling broader measures of the money supply (e.g. M1 and M2)?4. What is an open market operation?3a. Buying and selling of U.S. government bonds on the open market. If the Fed wants to increase the money supply, they will buy T-Bills from the public. Fed buys bonds and injecting money into the economy by in-creasing reserves. MB goes up. Banks have more money available for loans = increase in monetary growth rateb. If the Fed wants to decrease money supply, they SELL t-bills to thepublic. Fed sells bonds and removes money from the economy by decreas-ing the banks reserves. MB decreases. Banks have less money available for loans, decrease the monetary growth rate5. What is the relationship between bond prices and interest rates?a. Buying bonds: When demand for bond increases, the price of the bond will increase. When Demand goes up, Price goes up and Interest rate FALLSb. Open market sale: Fed is selling bonds. Decrease in demand for bonds driving the price of bonds down. D goes down, Price goes down, In-terest rate will RISE. at Higher interest rates there will be less investment and less aggregate spending. AD curve shifts left6. If the Fed buys bonds (i.e. open-market purchase), what happens to interest rates? Through what channels do open-market purchases stimulate the economy?7. If the Fed sells bonds (i.e. open-market sales), what happens to interest rates? Through what channels do open-market purchases slow the economy?8. Generally, does the Fed buy and sell short-term or long-term bonds? 9. Timing of Monetary Policy is difficult: The Fed must assess Whether banks are going to lend out all of their new reserves or simply hold higher reservesa. How quickly increases in the monetary base will translate into new bank loans and thus