Monetary Policy & The Federal Reserve System

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  • 0:03 Monetary Policy
  • 0:46 The Federal Reserve
  • 1:40 The Fed's Monetary Policy
  • 5:20 Lesson Summary
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Lesson Transcript
Instructor: Jason Nowaczyk
This lesson covers the Federal Reserve System's use of monetary policy to help promote the economy. A short quiz will follow the lesson to check your understanding.

The Economic Tool of Monetary Policy

When I was a little boy, I remember my teacher telling me about periods in U.S. history where the country was quite poor and going through some pretty tough times. I remember asking the teacher, 'Why was everyone poor?' And the teacher responded, 'It's because nobody had any money.' I then replied, 'Well, why doesn't the government just print more of it so that everyone has enough money?'

Little did I know that printing too much money can have some serious effects on the economy. The amount of money that is circulating at any given point must be carefully monitored. Controlling the growth rate of the money supply is called monetary policy. You may be surprised to also find out that it's not the U.S. government that controls the money supply. Rather, it's an organization called the Federal Reserve.

The Federal Reserve

The Federal Reserve, which is the nation's central bank, has total control over the money supply. It is also an independent body. The president can attempt to influence the board most directly by being the person who appoints the chairman of the Federal Reserve. Congress can also exert its influence by threatening to merge the Fed into the Treasury Department, but as long as the Fed retains its independence, its chairperson and governors can do what they please. Hence, any talk about the 'president's monetary policy' or 'Congress's monetary policy' is inaccurate.

To be sure, the Fed's chairperson has, on occasion, yielded to presidential pressure, and for a while, the Fed's chairperson had to observe a congressional resolution requiring him to report monetary targets over each six-month period. But now, more than ever, the Fed remains one of the truly independent sources of economic power in the government.

How the Fed Uses Monetary Policy

The Fed has three tools it uses to control the money supply:

  1. Buying U.S. treasury bonds on the open market
  2. Changing the reserve requirement in banks
  3. Changing the discount rate

Buying and Selling U.S. Treasury Bonds

When you buy a U.S. treasury bond, you are lending money to the federal government for a specified period of time. When the Fed buys these bonds, it gives the federal government money that it can use to help the economy by providing things like healthcare, public works projects, and educational initiatives. Thus, the Fed controls the money supply with treasury bonds by continually buying and selling them. Buying the bonds puts more money into the system and selling them takes more money out of it.

Changing the Reserve Requirement in Banks

Furthermore, not only was I surprised that the government couldn't just print out more money for people, I was even more surprised when I learned that the money I put into a bank isn't always physically there. I thought that when I walked into a bank and handed the cashier money, that he or she walks to the massive bank vault and places my money in there so that when I was ready to take it back, it would be waiting for me. This, however, is not the case.

Banks are actually like any other business. They want to make their own money, too. To do this, they ask you to deposit your money with them, which they then use for things that will help them grow a business, usually in the form of loans to other people. As an incentive for allowing them to use your money, they offer you an additional percentage on your money, called an interest rate.

So then what happens if you need to go over to the bank and withdraw money? Well, banks play a very complex game, hoping that not everyone withdraws all of their money at the same time. This mass withdrawal was actually a common occurrence during the outset of the Great Depression, which led to the collapse of many banks. Today, however, there are safeguards to ensure that your money is there when you want to withdraw it.

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