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Federal Reserve and Monetary Policy

Federal Reserve and Monetary Policy. Amount of money in economy determines amount of spending Too much = inflation Too little = recession. Fed manages money supply by….. Influence lending among banks and other financial institutions. 2. Monetary Policy

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Federal Reserve and Monetary Policy

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  1. Federal Reserve and Monetary Policy • Amount of money in economy determines amount of spending • Too much = inflation • Too little = recession

  2. Fed manages money supply by….. • Influence lending among banks and other financial institutions

  3. 2. Monetary Policy • Expansionary = expand credit, MS, growth (easy money) • Contractionary = restrict credit, MS, growth (tight)

  4. Three Tools • Open Market Operations (Federal Funds Rate) • Discount Rate • Reserve Requirement

  5. 4. OMO • Most used • Fed buys and sells US government securities -US Bonds • Expansionary- buy bonds • Fed buys $1000 bond from Joe • Joe now has $1000 = increase in MS c) Contractionary – sell bonds • Fed sells $1000 bond to Joe • Joe now has a bond but $1000 less in cash = decrease in MS

  6. (pg 1 ; last two paragraphs) Fed’s affect on INTEREST RATES Intro to Money Market Graphs (text 736,738,741) • Expansionary ; buy bonds ; increase MS ; decrease IR MS 1 MS 2 Int Rate MD Q of Money

  7. b) Contractionary ; sell bonds ; decrease MS ; increase IR MS 2 MS 1 MD

  8. (1st page ; last paragraph and 2nd page ; first paragraph) Federal Funds Rate (What is it?) • Federal Funds – reserve balances of financial institutions held at 12 Regional Fed Banks • If a bank can not meet its “reserve requirement” – it can borrow reserve funds from other banks • FFR – the interest rate banks pay when they borrow from each other

  9. 5. FOMC sets “TARGET” rate for FFR • Uses OMO to adjust MS to adjust FFR “at or near target” • How does this affect you, me, and the rest of the economy? Use of OMO and FFR……. “sets off a chain of events…..”

  10. 5 (bottom left column) • Expansionary Monetary Policy • FOMC buys securities • Increase MS • Decrease FFR…….which leads to • Increase banks lending and borrowing….leads to.. • Increase willingness of banks to let you borrow at lower rates ….which leads to • Decrease in other interest rates throughout the economy • Increase in MS • Increase Consumption, Investment…AD and LRAS

  11. 6. Discount Rate • Banks borrow directly from Fed • Least powerful of 3 tools – but a change in DR does signal a change and can create a desired reaction • Lower DR…….. • Lower other IR….increase MS

  12. 7. Reserve Requirement • Most powerful ; least used • Expansionary = lower RR

  13. Problems Controlling Money Supply • Can not control behavior of consumers • How much will they spend? Save? Borrow? • Can not control behavior of banks • Can not make the banks lend money

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