Federal Reserve: Monetary Policy and Market Operations

Chapter 4: The Federal Reserve's Responsibilities and Operations

Three Main Responsibilities of the Federal Reserve

1. Achieve full employment
2. Maintain price stability
3. Maximize economic growth

The Federal Reserve conducts the national monetary policy to achieve these goals.

Open Market Operations

Responsibilities:

• Control the money supply (MS)
• Set targets for MS growth and interest rate levels
• Influence the MS by buying or selling government securities (debt securities, Treasuries)

The Trading Desk

What they do: Purchase or sale of Treasuries

Impact on the economy:

• Money Supply: Purchasing government securities increases the money supply, while selling them decreases it.
• Interest Rates: An increased money supply puts downward pressure on interest rates, while a decreased money supply puts upward pressure on them.
• Loans and Savings: Lower interest rates encourage borrowing and discourage saving, while higher interest rates discourage borrowing and encourage saving.

When the Federal Reserve wants to increase the money supply, it purchases government securities. This is called "loosening money supply growth." Conversely, when it wants to decrease the money supply, it sells government securities. This is called "tightening money supply growth."

Process: The Federal Open Market Committee (FOMC) decides on changes to monetary policy and forwards a directive to the Trading Desk (Open Market Desk).

M1, M2, and M3

M3 (most liquid): Represents all the money supply circulating in the economy. It includes M2 plus accounts over $100,000, such as money market deposit accounts, money market mutual funds, and Jumbo CDs.

Dynamic vs. Defensive Open Market Operations

• Dynamic: Implemented when the Federal Reserve wants to change the level of funds.
• Defensive: Implemented to offset the impact of conditions that affect the level of funds.

Reserve Requirements

Impact on loanable funds:

• Decreased Reserve Requirement: More money is in circulation, and more loanable funds are available.
• Increased Reserve Requirement: Less money is in circulation, and fewer loanable funds are available.

The money multiplier effect amplifies these changes.

Repurchase Agreements

One party sells securities to another with an agreement to repurchase them at a specified date and price (most commonly one day). These are used very frequently.

Primary Credit Lending

Liquidity: Provided to financially sound and stable institutions, usually for increased liquidity.

Secondary Credit Lending

Rate always higher than the federal funds rate: Usually for financially struggling companies. Higher rates reflect the increased risk of bankruptcy.

Homework Problems

#3 How the Federal Reserve Increases Money Supply Through Open Market Operations

The Federal Reserve can increase the money supply by purchasing securities in the secondary market.

#6 How Money Supply Growth is Affected by an Increase in the Reserve Requirement Ratio

An increase in the reserve requirement ratio reduces the proportion of deposited funds that a financial institution can lend out. Consequently, it reduces the rate at which money can multiply.

#9 How the Federal Reserve Uses Open Market Operations to Reduce the Money Supply

The Federal Reserve can sell holdings of its existing Treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions.

#14 How the Federal Reserve's Monetary Policy Affects the Unemployment Level

The Federal Reserve's monetary policy affects interest rates, which in turn affect the cost of borrowing for households and businesses. This influences their spending on products and services. The aggregate demand for products and services affects the number of people employed by businesses and therefore affects the unemployment level.