Federal Reserve Functions, Monetary Policy, and Economic Growth
Central Banking and The Federal Reserve
What is a Central Bank?
A central bank is an institution that typically performs the following functions:
- Accepts deposits from and makes loans to commercial banks.
- Acts as the banker for the federal government.
- Controls the money supply.
- Performs certain regulatory functions for the financial industry.
Functions of the Federal Reserve (The Fed)
Fed’s Banking Services
- Supplies currency
- Holds bank reserves
- Processes and routes checks
- Makes loans to banks
- Supervises and regulates banks
- Acts as the banker for the U.S. government
Controlling the Money Supply
- The Fed manages the nation’s money supply, which helps keep interest rates less volatile.
- The Fed also changes the money supply to achieve policy goals set by the Federal Open Market Committee (FOMC).
Policy Goals of the Fed
Ultimate Goal of Monetary Policy
Economic growth with stable prices. This means achieving greater output (GDP) and maintaining a low, steady rate of inflation.
Intermediate Targets
The Fed establishes target growth rates for the money supply, which affects GDP and the overall price level.
Equation of Exchange
The equation of exchange relates the quantity of money to nominal GDP:
MV = PQ
- M = Money supply (specific aggregate)
- V = Velocity of money (for that aggregate)
- P = Price level
- Q = Real GDP
- PQ = Nominal GDP
The Quantity Theory of Money
Assuming constant velocity (V), changes in the quantity of money (M) lead to proportional changes in nominal GDP (PQ).
Fed’s Policy Tools
1. Reserve Requirements
Legal reserves consist of the cash a bank holds in its vault plus its deposits at the Fed. Reserves held by banks beyond their required amount are called excess reserves.
If the Fed lowers reserve requirements, banks hold excess reserves, which they can then lend. Such lending triggers the expansion multiplier, increasing the money supply.
Conversely, the Fed can decrease the money supply by raising reserve requirements.
2. Discount Rate
The discount rate is the interest rate a Federal Reserve District Bank charges a commercial bank in its district for borrowing from the Fed.
Higher discount rates can lead to lower levels of bank reserves, resulting in reduced lending and a smaller money supply.
3. Open Market Operations (OMOs)
Open Market Operations (OMOs) involve the buying and selling of government bonds by the Fed to control bank reserves, the federal funds rate, and the money supply.
If the FOMC aims to increase the money supply, it directs the Federal Reserve Bank of New York (FRB-NY) to buy bonds. This injects new reserves into the banking system via the bond sellers’ banks.
This increase in reserves leads to an increase in the money supply and typically a reduction in the federal funds rate.
Effects of Money Supply Changes
Changes in the money supply can affect GDP, interest rates, investment levels, and aggregate demand.
Understanding Economic Growth
Defining Economic Growth
Economic growth is generally defined as an increase in real GDP.
Note on the Rule of 72: The number of years required for an amount to double in value is approximately 72 divided by the annual rate of growth.
Economic growth is sometimes defined as an increase in Per Capita Real GDP, calculated as real GDP divided by the population.
Calculation Note: Be able to calculate the GDP growth rate and the growth rate of GDP per capita.
Determinants of Growth
- Size and quality of the labor force: More workers or better-skilled workers can produce more output.
- Capital: Increased quantity or quality of equipment, tools, and factories allows producers to increase output and better utilize labor.
- Land: Encompasses land surface, water, forests, minerals, and other natural resources. However, natural resources are not strictly necessary for growth, as they can be acquired through trade.
- Technology: Technological advances enable the production of more output from a given amount of resources.
Determinants of Productivity
- Labor Quality: Skills, education, and health of the workforce.
- Technological Innovation: Development and adoption of new technologies.
- Other factors:
- Energy prices
- Shift between Manufacturing vs. Services sectors
- Financial Market Development