1. The Federal Reserve System

1. Structure of the Fed
   
   

• Board of Governors
  
  
• District banks
  
  
• The Federal Open Market Committee
  
  

Teaching Strategy: Point out that 5 of the 12 voting members of the FOMC (the regional Fed presidents) are not subject to government approval.

1. Functions of the Fed
   
   

• Banking services and supervision
  
  
• Controlling the money supply
  
  

2. Implementing Monetary Policy

1. The ultimate goal of monetary policy is economic growth with stable prices.
   
   Teaching Strategy: The goals of monetary policy are often in conflict, and you may wish to point this out to your students. For example, as we will see in Chapter 16, low unemployment often comes at the cost of less price stability.
   
   
   • Intermediate targets are variables that the Fed can directly control, which are linked to its ultimate goals, and on which it focuses because it cannot directly control gross domestic product and prices. Recently, the Fed has focused on the Fed funds rate.
     
     
   • Inflation rate targeting is being pursued by some countries instead of intermediate targets like money supply growth. Inflation targeting requires the monetary authorities to have independence from political influence.
     
     
2. Operating procedures
   
   
   • Tools of monetary policy that can be used by the Fed include the reserve requirement, the discount rate, and open market operations to change reserves and thereby control the money supply.
     
     

Teaching Strategy: Point out that because it has such a powerful effect on the multiplier, the reserve requirement is seldom used as a policy tool.

• FOMC directives: The tools, targets, and goals of monetary policy create a feedback loop in which policy is gradually adjusted to affect targets, which subsequently affects goals.
  
  

Teaching Strategy: Point out that the Fed must frequently adjust its tools to its operating target in response to changes in the position of the target and aggregate supply and demand shocks.

1. Foreign exchange market intervention
   
   

• Mechanics of intervention: Foreign exchange market intervention is the buying and selling of foreign exchange by a central bank in order to move exchange rates up or down.
  
  
• Effects of intervention: If the Federal Reserve is concerned about the domestic impact of its foreign exchange market intervention, it can sterilize the intervention with an open market purchase or sale of bonds.
  
  

3. Monetary Policy and Equilibrium Income
To understand the workings of monetary policy, we use the money supply and demand framework.

1. Money demand has three broad categoriesthe transactions demand for money, precautionary demand for money, and speculative demand for money.
   
   

• The money demand function is the function where changes in the money demanded are caused by changes in the interest rate. Changes in nominal income cause shifts in the money demand function.
  
  
• The position of the money supply function is determined by the Federal Reserve.
  
  
• Equilibrium in the money market is determined by an interest rate that equates the quantity of money demanded and the quantity of money supplied.
  
  
• Equilibrium income is affected by monetary policy, as it affects both investment and consumption spending.
  
  

Teaching Strategy: Note the large number of links between a change in the money supply and a change in equilibrium income. It is little wonder that many Keynesian economists questioned the effectiveness of monetary policy.


4. The European Central Bank
After agreeing to adopt a common currency, the euro, the 12 European countries needed a new central bank.

1. The 12 national central banks needed a European Central Bank (ECB) because with a common currency, they could no longer control their national money supplies.
   
   
2. The ECB has a six-member Executive Board located in Frankfurt, Germany. ECB policy is directed by the 18-member Governing Council, which includes the six executive board members plus the 12 central bank governors of the euro countries.
   
   
3. The main ECB policy target is to keep inflation below 2 percent per year.