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Unit 21 — The Federal Reserve

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Purpose:

To show how the responsibilities and powers of the Federal Reserve have been broadened over the years, and indicate how the Fed can control the money supply and influence the level of interest rates and inflation.

Objectives:

  1. One of the most important functions of the Federal Reserve System is to ensure that the amount of money in the U.S. economy is consistent with noninflationary growth.
  2. The Fed controls the amount of money in the economy by controlling the reserves in the banking system. This is done in three ways:

    1. Most often, the Fed injects or removes bank reserves by buying or selling government bonds in open market operations.
    2. The Fed can also encourage or discourage bankers in their attempts to borrow reserves by lowering or raising the discount rate, which is the interest rate the Fed charges for its loans to banks.
    3. The Fed can change the required reserve ratio or the percentage of deposits that a bank must keep in its vaults as reserves.
  3. If the rate of growth of the money supply is slowed, interest rates will initially rise and both economic activity and inflation will tend to slow down. The Fed cannot control how much the reduction in the growth of the money supply will affect economic activity and how much it will affect inflation.

Audio and Transcripts

Meet the Series Experts

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Bejamin Bernanke

Benjamin Bernanke

Chairman of the Board of Governors of the Federal Reserve System, since 2006, and Chairman of the Federal Open Market Committee, the System’s principal monetary policy-making body.

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Andrew Brimmer

Andrew Brimmer

Economist and expert on the world banking system, specializing in foreign debt obligations of Third World countries.

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Lester Chandler

Lester Chandler

Adviser to the federal government during World War II, valued for his expertise in monetary policy.

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Donald Kohn

Donald Kohn

Vice Chairman of the Board of Governors of the Federal Reserve System, 2006–2010, and Member of the Board of Governors, 2002–2008.

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WHAT’S YOUR
ECONOMICS IQ?

  1. In the United States today, which of the following functions as the central bank?

    The Federal Reserve

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  2. Which of the following is an example of a government security?

    government bonds

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  3. George W. is president of the newly chartered national bank, the Golddust. George has been presented with several interesting investment opportunities during the past week, but a review of the balance sheets indicates that reserves are not sufficient to allow the Golddust to make the loans. The promise of profits is very tempting even though some risk is involved. Based on current interest rates, George calculates he will need collateral valued at about $2 million for the size loan he wants. The net worth of the Golddust currently stands at $1 million. George applies for a loan with the Fed, but it is denied. Which of the following is the MOST LIKELY reason?

    The Fed issues loans to help banks through hard times, not to encourage profits. The third response is partially correct, since the Fed will obviously favor low-risk investments over high-risk ones. But the more important point by far is that the Fed does not provide assistance to banks so that they can turn around and use the money to make a profit; the purpose of the loans is to keep banks solvent when they run into difficulty.

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  4. According to the balance sheet below for the Fed and the member banks, we can infer that the Fed has:

    Effect on Fed’s Balance Sheet
    Assets Liabilities and Net Worth
    Government securities (+ $1 million) Government bank reserves (+ $1 million)
    Effect on Banks’ Balance Sheet
    Assets Liabilities and Net Worth
    Reserves (+ $1 million) Demand deposits (+ $1 million)

    purchased government securities, thereby increasing the money supply.

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  5. Based on the information in the previous question, in order to raise the reserves of banks above the $1 million mark, the Fed should probably:

    purchase more securities.

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  6. The Banking Act of 1935 has been called the “single most important piece of banking legislation since the original Federal Reserve Act.” Probably the MAIN reason for this is that the Act:

    gave the Fed authority to take a leadership role in setting monetary policy.

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