Monetary Policy

1. Monetary Policy Chapter 15

2. GOALS OF MONETARY POLICY …to assist the economy in achieving a full-employment, noninflationarylevel of total output

3. CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANKS ASSETS • Securities • Loans to Commercial Banks LIABILITIES • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes

4. TOOLS OF MONETARY POLICY Open-Market Operations Buying Securities From commercial banks... • Bank gives up securities • FED pays bank • Banks have increased reserves From the public... • Public gives up securities • Public deposits check in bank • Banks have increased reserves

5. TOOLS OF MONETARY POLICY Open-Market Operations Selling Securities To commercial banks... • FED gives up securities • Bank pays for securities • Banks have decreased reserves To the public... • FED gives up securities • Public pays by check from bank • Banks have decreased reserves

6. FEDERAL RESERVE PURCHASE OF BONDS New reserves $800 Excess Reserves $200 Required reserves Purchase of a $1000 bond from a bank... $1000 Initial Deposit $4000 Bank System Lending Total Increase in Money Supply ($5000)

7. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio • Raising the Reserve Ratio • Banks must hold more reserves • Banks decrease lending • Money supply decreases • Lowering the Reserve Ratio • Banks may hold less reserves • Banks increase lending • Money supply increases

8. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate-Interest rate Charged to member banks for loans • Easy Money Policy • Buy Securities • Decrease Reserve Ratio • Lower Discount Rate

9. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate • Tight Money Policy • Sell Securities • Increase Reserve Ratio • Raise Discount Rate

10. Federal Funds Rate • Interest rate banks charge each other for overnite loans • Prime interest rate-interest rate charged by Fed • Fed. Funds rate is prime + 1 or 2 % points • If Fed wants to decrease FFR, then it buys bonds • Increases S of reserves----FFR drops

11. Monetary Policy & International trade • Net Export effect • Easy $ policy---decreases interest rate • ___securities, ___ RR, ____DR • What happens to imports? • Exports? • AD? • GDP? • Balance of trade-- • Tight $ policy • ___securities, ___RR, ___DR • Imports? • Exports? • AD? • GDP? • Balance of trade

12. MONETARY POLICY AND EQUILIBRIUM GDP Sm1 Sm2 Sm3 Investment Demand 10 8 6 0 10 8 6 0 Real rate of interest, i Dm Quantity of money demanded and supplied Amount of investment, i If the Money Supply Increases to Stimulate the Economy… AS • Interest Rate Decreases P3 Price level • Investment Increases P2 • AD & GDP Increases • with slight inflation AD3(I=$25) P1 AD2(I=$20) • Increasing money supply • continues the growth – • but, watch Price Level. AD1(I=$15) Real domestic output, GDP

13. Strengths Isolated from politics Quickly “fix” econ 1980’s/1990’s budget deficit meant FP was not used Weaknesses Increasing globalization makes MP harder No guarantee that banks will loan excess—leakage MP can’t totally move US out of recession Change in velocity Effectiveness of MP

14. Artful Management Alan Greenspan Manage Supply of Money based on data Inflation Targets Goal 1-2% inflation for 2 years Increased accountability instead of just based on personality DIFFERENT VIEWS OF MP

15. EFFECTIVENESS OF POLICIES • Depends on demand for money • The steeper the demand for money—more interest rates will have impact • Most direct policy—Open Market Operations • Others—more time; depends on banks