Federal Reserve System
What is Federal Reserve System?
The Federal Reserve is the central bank of the United States, responsible for monetary policy, bank supervision, and financial stability.
Created in 1913, the Fed sets the federal funds rate target and uses open market operations to influence the money supply and interest rates. Its dual mandate is maximum employment and stable prices. It is independent of day-to-day political control.
Federal Reserve System: a worked example
Let money demand in a hypothetical economy be Md = 900 - 20i, with quantities in billions of dollars and i the nominal interest rate in percent. If the Fed holds the money supply at 700 billion, then 700 = 900 - 20i, so 20i = 200 and i = 10 percent. The Federal Open Market Committee votes to ease and buys enough securities to lift the supply to 800 billion: 800 = 900 - 20i gives 20i = 100 and i = 5 percent. Suppose planned investment rises by 12 billion dollars for each percentage point the rate falls. Investment climbs by 5 x 12 = 60 billion. With a marginal propensity to consume of 0.8 the spending multiplier is 1 divided by 0.2, which is 5, so real output can rise by 60 x 5 = 300 billion dollars while the economy still has idle capacity.
The mistake students make with federal reserve system
Students swap the federal funds rate for the discount rate on free response questions. Both are rates the Fed discusses, which makes them easy to blur together. The federal funds rate is the overnight rate banks charge each other for reserves, and the Fed only targets it, steering the market toward that target through open market operations. The discount rate is what the Fed itself charges a bank borrowing directly from it, and that one the Fed sets outright. Label the money market graph with the funds rate.
Federal Reserve System questions
What is the Fed's dual mandate?
Congress directs the Federal Reserve to pursue maximum employment and stable prices, the pair known as the dual mandate. The governing statute also lists moderate long term interest rates, which policymakers treat as a consequence of achieving the other two. Maximum employment does not mean zero unemployment; it means the most employment the economy can sustain without pushing inflation upward. The two aims can pull in opposite directions, since raising rates to slow inflation tends to raise unemployment first.
Who controls the Federal Reserve?
A Board of Governors in Washington sits at the top, its members nominated by the President and confirmed by the Senate, while regional Reserve Banks around the country carry out operations. Monetary policy decisions belong to the Federal Open Market Committee, which combines the governors with regional bank presidents serving on a rotation, New York holding a permanent seat. Member commercial banks own stock in their regional bank but cannot direct policy, and the Fed funds itself from interest on the securities it holds.
How does the Fed change interest rates?
Open market operations do most of the work. Buying government securities from banks adds reserves, makes overnight lending between banks cheaper, and pushes the federal funds rate down toward the committee's target, while selling securities drains reserves and pushes the rate up. The Fed also sets the discount rate on direct loans and the rate paid on reserves held with it, and those act as guide rails. Mortgage and corporate bond rates then follow expectations about the target path.
This is the live Money Market sandbox. Drag the curves, or open the full version.
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