[MUSIC] Now, from a global perspective, the Fed is a somewhat peculiar central bank in at least one sense. Rather than being one big bank directly controlled by the federal government, Like in Germany or Japan, the Fed is both very decentralized and privately owned. It consists of 12 regional banks spread throughout the country, and they are owned by the commercial banks. While legally these 12 regional banks are private, in reality, the Fed as a whole behaves as an independent government agency. This regional structure of the Fed, was originally designed in an age of populism. The populist goal was to avoid too great a concentration of central backing powers in the hands of Eastern establishment bankers or Washington bureaucrats. This figure, shows the structure of the Fed. The board of governors consists of seven members, nominated by the President, and confirmed by the Senate, to serve overlapping terms of 14 years. Members of the board are generally bankers, or economists. The key policy making body at the fed is the federal open market committee. This committee consists of 12 people. The 7 members of the feds board of governors, plus the president of the New York federal reserve district bank, plus four rotating members of the other 11 federal reserve district banks. At the pinnacle of the system is the chairman of the board of governors, often called the second most powerful individual in America. He acts as public spokesperson for the Fed and exercises enormous power over monetary policy. Besides issuing currency, and being the lender of last resort, the Fed has four other functions. Including regulating our financial institutions, providing banking services to the federal government, providing financial services to the nation's banks, and most importantly, conducting monetary policy. The Feds stated objectives for the use of monetary policy include: economic growth in line with the economy's potential to expand. And a high level of employment, stable prices and moderate long term interest rates. Federal Reserve conducts monetary policy through its open market committee. This open market committee meets periodically to discuss monetary policy. And a conducts such monetary policy through the use of three major policy instruments. The first, and least used of these instruments, is setting the reserve ratio or the reserve requirement. As we've learned from our discussion of the money multiplier above, the Fed can increase the money supply by lowering the reserve requirement. Or decrease the money supply by raising the reserve requirement. As a practical matter, the Fed rarely uses changes in the reserve requirement to conduct monetary policy. The primary function of the requirement is to ensure that banks don't fall below a safe level of reserves and thereby undermine the stability of the system. The second instrument of monetary policy is the discount rate. The discount rate is the interest rate that the fed charges banks when the borrow money from the fed. Lowering the rate makes it cheaper for banks to borrow money and expand the money supply. In contrast, raising the discount rate, makes it more expensive for banks to borrow from the Fed and is contractionary. The third, and by far the most important instrument of monetary policy, is open market operations. Open market operations involve the buying and selling of government securities, to expand or contract the money supply. In a nutshell, the Fed buys government securities when it wants to expand the money supply. And it sells government securities when it wants to contract the money supply. As illustrated in this figure, in step one, the Fed's Open Market Committee purchases government bonds and pays for the bonds with a Federal Reserve check. Step two, the seller of the bond, deposits the fed's check in a private bank. Then in step 3, the bank deposits the check, at a federal reserve bank, as a reserve credit, and this allows it to expand its reserves. Now the point is this. By altering its holdings of government securities, the Fed can change bank reserves. And, through the money supply multiplier, thereby trigger the sequence of events that ultimately determine the total supply of money. In this regard, open market operations represent the Fed's most potent tool. So let's see how such operations work. Suppose then, that the Fed thinks the economic winds are blowing up a little inflation. At it's next open market committee meeting, the committee votes to sell 1 billion dollars of treasury bills from the Fed's portfolio to tight money. And this action, is unanimously approved, by a vote of the Board of Governors. Now, to whom are the Bonds sold? The open market, which includes dealers in government bonds, who then resell them to commercial banks, big corporations, other financial institutions, and individuals. The purchasers usually buy bonds by writing checks to the Fed, drawn from an account in a commercial bank. For example, if the Fed sells $10,000 worth of bonds to Linda Smith, she writes a check on the Coyote Bank of Santa Fe. The Fed then presents this check at the Coyote Bank. And here's the important point, when the Coyote Bank pays the check, it will reduce its balance of reserves with the Fed and the reserves in the entire commercial banking system by $10,000. From this example, you can see how open market operations can be used to close either recessionary or an inflationary gap. This is illustrated with the help of a five step monetary policy sequence, called the monetary transmission mechanism, shown here for closing and inflationary gap The Fed reduces reserves R, through open market operations. Money supply M contracts, and causes interest rates I, to rise. This rise, not only reduces investment I, it also reduces consumption expenditure C, and net exports X. For example, consumers may respond to higher mortgage interest rates by buying a smaller home, or renovating their old home, rather than purchasing a new one. Similarly, as we'll learn in a later lesson, in an economy open to international trade, higher interest rates may raise the foreign exchange rate of the dollar. And this will in turn depress net exports. The total effect of a fall in I, C and X is to push aggregate expenditures or aggregate demand down in doing so real GDP and inflation likewise go down. Thereby achieving the desired policy goal. A similar sequence for closing a recessionary gap can be illustrated in an aggregate supply - aggregate demand framework. This figure shows how an expansion of the supply of money causes a rightward shift of the aggregate demand curve from AD to AD prime. Note that in the range of this shift, the aggregate supply curve is relatively flat. This Keynesian range reflects the presence of unemployed resources and ressionary forces. In this region, we get a very small increase in the price level from the Feds expansionary monetary policy and a large increase in real GDP as equilibrium moves from P to P. Suppose, however, that the Fed decides to expand the economy even further and tries to push the aggregate demand out even more to say e double prime. This is well past the economies level of potential output or potential GDP, and in this case we are in the so-called classical range of the economy. Here, the slope of the aggregate supply curve turns steeply upward. In this fully employed economy, the higher money stock would be chasing the same amount of output so that the major impact of the Fed's expansionary policy would be to significantly raise the price level. With little increase in real GDP. This table summarizes how monetary policies may be used to combat recession and inflation. Take a few minutes to study it. Note that easy money policies are used to expand the economy and fight recession, while tight money policies are used for contraction, to fight inflation.
