The Federal Reserve System and Monetary Policy

Lesson Purpose:

Acting as the central bank of the United States, the Federal Reserve monitors the economy and initiates monetary policies designed to promote growth while maintaining stability and full employment.  Through their ability to make loans, commercial banks provide the means to create money, and thereby help the economy grow.  Congress created the Federal Reserve System to oversee commercial banking practices and control the money supply, which it does largely by targeting interest rates. Changing interest rates alter demand, income, and employment throughout the economy.  Additionally, monetary policies interact with fiscal policies and the fiscal impacts of Congressional legislation, so the effective functioning of the Federal Reserve is vitally important to citizens’ well-being.

Key Terms:

Federal Reserve System	federal deficit	money supply
monetary policy	required reserves	fiscal policy
reserve requirement	excess reserves	quantity theory of exchange
open market operations	government securities	“crowding out”

Content Standards:

Standard 20:  Students will understand that:  Federal government budgetary policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

Benchmarks:
grade 12:

• Monetary policies are decisions by the Federal Reserve System that lead to changes in the supply of money and the availability of credit.  Changes in the money supply can influence overall levels of spending, employment, and prices in the economy by inducing changes in interest rates charged for credit and by affecting the levels of personal and business investment spending.
• The major monetary policy tool that the Federal Reserve System uses is open market purchases or sales of [U.S.] government securities.  Other policy tools used by the Federal Reserve System include increasing or decreasing the discount rate charged on loans it makes to commercial banks and raising or lowering reserve requirements for commercial banks.
  

Session Objectives

• Briefly review the history and development of the Federal Reserve System. 
• Explain the purposes of the Fed and tie-in to previous discussions of national economic goals. 
• Explain the role of the Fed with regard to runs on banks.
• Introduce and explain the powers and tools of the Fed. Discuss the potential economic impact of each tool.
• Define and explain monetary policy, and relate it to the business cycle model developed in previous lessons. (Review the definition of the money supply and the money multiplier as necessary.)
• Develop and explain several monetary policy scenarios, emphasizing how the Fed decides on a course of action and how it uses specific tools to implement its decisions.
• Explain how the Fed “targets” (rather than “sets”) interest rates.  Identify and differentiate among interest rates that are the focus of policy (federal funds rate, LIBOR, etc.)
• Explain how the Fed works with the U.S. Treasury to finance government deficits. Develop alternative scenarios for funding a federal deficit, and the explain effects of each alternative on the larger economy and on national economic goals.
• Illustrate the relationship between fiscal and monetary policy.
• Identify and discuss controversies and limitations on monetary policy (including lag time problems, crowding out, MV = PQ, rational expectations, etc.)

Key Content:

• The Federal Reserve System was created in 1913 in response to calls for regulation of the banking system, and to act as a central bank for the federal government of the United States.
• The tools of the Federal Reserve include the reserve requirement, the discount rate, and open market operations.
• The Federal Reserve System’s monetary policy is intended to control the money supply and promote the achievement of the economic goals of stability and full employment.
• When the federal government runs a deficit, the Federal Reserve System determines how the debt is financed.
• The Quantity Theory of Money is expressed in the identity:  MV = PQ

Mythconceptions:

• The discount rate is the most important tool of the Federal Reserve in regulating the money supply.
• The Federal Reserve is just a big bank.  Individuals and businesses can bank there.
• The actions of the Fed are independent of politics and public opinion.
• Monetary and fiscal policy operate independently.
• Monetary and fiscal policy are coordinated and reinforce one another.

Frequently Asked Questions:

• What is the Federal Reserve and why is it so important?
• What is the purpose and what are the powers of the Federal Reserve system with regard to banks? 
• How can the Fed prevent (or stop) a run on a bank?
• What is monetary policy?
• What is the Fed Open Market Committee and what does it do?
• How are the banking system and the Federal Reserve related to interest rates, employment, and income levels?
• What is the relationship between the U.S. Treasury and the Federal Reserve?
• What is the Quantity Theory of Money and what does it have to do with Fed financing of the deficit?
• What is the relationship between fiscal and monetary policy, in theory and in practice?
• How independent is the Federal Reserve chairman?  How much can the chairman influence the course of the national economy?
• What role(s) does the Fed play in financing a federal deficit?  How might deficit financing affect economic activity and national economic goals?
• What role did the Fed play in the Great Depression?  Could we have another great depression?  Why was the Fed inactive from the Depression until the early 1950s?

Classroom Activity Options

• Illustrate and provide practice problems dealing with changes in required reserves, excess reserves (loanable funds), and the money supply.
• Provide practice scenarios in which students must decide upon the appropriate Fed policy.
• Introduce the Fed Beige Book.  Have students research the economic conditions for their region of the country and propose Fed policies that would improve economic conditions.
• Provide students with current event news stories and ask them to analyze /predict probable responses of the Fed and/or how the events are likely to impact current Fed policies.