5.
Chapter 5: Central Banking and Monetary Policy
(The Federal Reserve)
Lecture Notes
● The Role of the Central Bank (The Federal Reserve - The Fed):
○ Manages the nation's money supply and interest rates to achieve
macroeconomic objectives (stable prices, maximum sustainable
employment).
○ Acts as the "Lender of Last Resort" to prevent banking panics.
○ Supervises and regulates depository institutions.
○ Maintains the stability of the financial system.
● Structure of the Fed:
○ Board of Governors: Seven members appointed by the U.S.
President; sets reserve requirements and discount rate.
○ Federal Reserve Banks (12 District Banks): Each performs various
functions for its district (e.g., clearing checks, storing currency).
○ Federal Open Market Committee (FOMC): The primary monetary
policymaking body; composed of the seven Governors and five of
the twelve District Bank Presidents.
● The Fed's Balance Sheet:
○ Assets: Primarily holds U.S. Treasury Securities (the main tool for
open market operations) and Loans to Depository Institutions
(Discount Window).
○ Liabilities: Currency in Circulation and Reserves of Depository
Institutions (bank deposits at the Fed).
● Tools of Monetary Policy:
○ 1. Open Market Operations (OMO): The most frequently used and
most powerful tool.
■ Open Market Purchases: The Fed buys Treasury securities
from banks. Banks' reserves ↑, money supply ↑
(Expansionary/Loose Policy).
■ Open Market Sales: The Fed sells Treasury securities to
banks. Banks' reserves ↓, money supply ↓
(Contractionary/Tight Policy).
○ 2. The Discount Rate: The interest rate at which commercial banks
can borrow money directly from the Fed (the Discount Window).
■ Discount Rate ↑→Borrowing ↓→Money Supply ↓.
○ 3. Reserve Requirements: The fraction of deposits banks must hold
in reserve.
■ Reserve Requirement ↓→Money Multiplier ↑→Money Supply
↑ (Least frequently used due to its powerful, disruptive
effect).
○ 4. Interest on Reserves (IOR): The rate the Fed pays banks on
reserves held at the Fed.
■ IOR ↑→Banks hold more reserves →Lending ↓→Money
Supply ↓.
● The Policy Target: The Federal Funds Rate (FFR):
○ The FFR is the interest rate for interbank loans of reserves. The
Fed primarily uses OMO to influence the FFR to its target.
● Money Supply and Inflation:
○ Quantity Theory of Money: M×V=P×Y
■ M: Money Supply, V: Velocity of Money, P: Price Level, Y: Real
Output.
■ Assuming V and Y are constant, a growth in M must lead to
inflation (growth in P).
Summary (Chapter 5)
The Federal Reserve (The Fed) is the central bank, responsible for maintaining
financial stability and conducting monetary policy to achieve stable prices and
employment. The primary policymaking body is the FOMC. The Fed's most
powerful and frequently used tool is Open Market Operations (OMO)
(buying/selling Treasury securities) to target the Federal Funds Rate (the
interbank rate for reserves). Other tools include the Discount Rate (rate for
direct borrowing from the Fed), Reserve Requirements (percentage of deposits
banks must hold), and Interest on Reserves (IOR). The goal of using these
tools is to manage the money supply, which, according to the Quantity Theory
of Money, fundamentally impacts the rate of inflation.