Explain basic balance sheets of the Fed, the banking system and the bank customers. The federal funds rate is the interest rate at which financial institutions can borrow from other financial institutions. Explain how changes are evidenced in the different balance sheets. If the Fed wants to increase the money supply, it will institute a policy to increase reserves giving banks an increased ability to make loans. B How much must the bank add to its reserves? Discount rate Lower the discount rate Raise the discount rate C. Banks have more money to loan to other banks, businesses and consumers, so the federal funds rate is likely to decrease. Identify each of the tools of the Fed and explain how changes in each tool affect the money supply.Next
Why do banks hold excess reserves, which pay no interest? Be sure to explain that the left side of a balance sheet shows the assets, and the right side shows the liabilities. What does it mean to say that the Fed changes the discount rate mostly as a signal to markets? A How much of this can the bank lend to new customers? Further, the two sides of the balance sheet, including net worth, must sum to each other — that is, net worth equals assets minus liabilities. Be sure to discuss the role of the chairman of the Federal Reserve. What is the deposit expansion multiplier? What will be the deposit expansion multiplier? The discount rate has no impact if banks do not borrow from the Federal Reserve; banks do not have to borrow because if they need funds, they can always go to the federal funds market. Underline the correct answer and explain why. Reserve requirements Lower the required reserve ratio Raise the required reserve ratio 14.Next
Describe the structure of the Federal Reserve System including the Board of Governors and the Federal Open Market Committee. The Fed has three tools it can use to control the money supply: open market operations, the discount rate and the required reserve ratio. It has regulatory authority for many financial institutions that hold checkable deposits. Describe the structure of the Federal Reserve System. It is difficult for financial institutions to adjust to changes in the required reserve ratio. Ask the students to explain, based on their knowledge of the money creation process, how each tool can be used to change the money supply. Have the students complete Activity 38.Next
Activity 38 provides the students with practice using T-accounts and the mechanics of implementing monetary policy. If banks are able to borrow from the Federal Reserve at a low interest rate and make loans at a higher rate, the banks will earn a profit and, hence, have an incentive to use the discount window. If the Fed decided to implement a policy action designed to increase the money supply, in which direction would bank reserves and the federal funds rate change and why? Changes in the required reserve ratio cause radical or strong changes in the monetary system. Open market operations Buy Treasury securities Sell Treasury securities B. . In a foreign country, the reserve requirement is 100 percent. Banks are required by law to hold required reserves; they hold some excess reserves as a precaution in case of sudden withdrawals or changes in economic conditions.Next
The Fed uses changes in reserves to affect the federal funds rate. In general, the Fed uses the tools of monetary policy to adjust the economy in smaller increments. Why is it that a bank might choose to borrow in the federal funds market, rather than getting the lower interest rate available through the discount window? Suppose the federal funds rate is 5 percent and the discount rate is 4. Borrowing from another financial institution will have fewer transaction costs, plus the bank will not have the added scrutiny of its business practices that borrowing from the Federal Reserve will generate. Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Next
What is the value of Treasury securities that need to be bought or sold? Indicate in the table in Figure 38. It signals to the banks and others how the Fed would like the money supply to change. Discuss each of the tools of the Fed. Will the Fed want to buy or sell existing Treasury securities? As vault cash or reserve accounts deposits at the District Federal Reserve Bank 7. The reserve requirement is 10 percent. The primary tool the Fed uses is open market operations, or the buying and selling of Treasury securities.
Review the answers with the students. Why does the Fed rarely use the reserve requirement as an instrument of monetary policy? It targets the federal funds rate because the Fed believes that this rate is closely tied to economic activity. Why does the Fed currently target the federal funds rate rather than the money supply? The Federal Reserve System is the central bank for the United States. Time Required One class period or 45 minutes Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N. . .Next
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