THE FEDERAL RESERVE: Monetary Policy

1. THE FEDERAL RESERVE: Monetary Policy MODULE 27

2. OBJECTIVES OF MONETARY POLICY • The Fed’s Board of Governors formulates policy, and the twelve Federal Reserve Banks implement policy. • The fundamental objective of monetary policy is to aid the economy in achieving full-employment output with stable prices. • To do this, the Fed changes the nation’s money supply. • To change money supply, the Fed manipulates size of excess reserves held by banks.

3. CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANKS The Fed’s balance sheet contains two major assets: Securities which are Treasury Bills (bonds) purchased by the Fed from commercial banks, and Loans to banks. The balance sheet contains three major liabilities: Reserves of banks held as deposits at Federal Reserve Banks, US Treasury deposits of tax receipts and borrowed funds, and Federal Reserve Notes outstanding, the paper currency.

4. THREE MAJOR “TOOLS” OF MONETARY POLICY Open market operations, The reserve ratio, and The discount rate.

5. OPEN MARKET OPERATIONS • Open-market operations refer to the buying and selling of Treasury bills (or bonds). • Buying securities will increase bank reserves. • If the Fed buys directly from banks, then bank reserves will go up by the price of the securities sold to the Fed. • If the Fed buys from the general public, people will receive a check from the Fed when they sell the securities to the Fed, then they will deposit this check at their bank. Checkable deposits will rise and therefore bank reserves by the same amount. • Bank’s lending potential rises with new reserves. • Money supply rises directly with increased deposits by the public.

6. OPEN MARKET OPERATIONS • Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves. • Note: When the Fed sells securities, bank reserves will decrease, and eventually the money supply will go down by a multiple of the bank’s decrease in reserves.

7. HOW DOES THE FED BET PEOPLE OR BANKS TO BUY OR SELL BONDS? • When the Fed buys, it raises demand and price of the Treasury Bills, which in turn lowers effective interest rate on the bonds. The higher price and lower interest rates make selling bonds to the Fed attractive. • When the Fed sells, the bond supply increases and the bond prices fall, which raises the effective interest rate yield on the bonds. The lower price and higher interest rates make buying bonds from the Fed attractive.

8. THE RESERVE RATIO • The reserve ratio is the percentage of reserves required for banks to back up their customer deposits. • Raising the reserve ratio increases required reserves and shrinks excess reserves. Loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves. • Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.

9. THE RESERVE RATIO • Changing the reserve ratio has two effects: • It affects the size of excess reserves, and • It changes the size of the monetary multiplier. 4. Changing the reserve ratio is very powerful and could create instability, so the Fed rarely changes it. The last time it was changed was in February 1992, when the ratio was lowered from 12 percent of demand deposits to 10 percent, at which level it continues.

10. THE DISCOUNT RATE • The discount rate is the interest rate that the Fed charges financial institutions that borrow from the Fed. • An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. • A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.

11. MONETARY POLICY “Easy” monetary policy occurs when the Fed tries to increase the money supply by expanding excess reserves in order to stimulate the economy (expansionary policy). The Fed will enact one or more of the following measures: • The Fed will buy Treasury Bills, • The Fed may reduce the reserve ratio (although this is rare because of its powerful impact), or • The Fed could reduce the discount rate (although this has little direct impact on the money supply).

12. MONETARY POLICY “Tight” monetary policy occurs when the Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period (contractionarypolicy. The Fed will enact one or more of the following policies: • The Fed will sell Treasury Bills, • The Fed may raise the reserve ratio (although this is rare because of its powerful impact), or • The Fed could raise the discount rate (although this has little direct impact on the money supply).

13. OPEN MARKET OPERATIONS ARE THE FED’S MOST IMPORTANT CONTROL • Changing the discount rate has little direct effect on the money supply, since only 2-3 percent of bank reserves are borrowed from the Fed. • The Fed can manipulate reserves by buying and selling Treasury Bills directly and frequently. • Open-market operations are flexible because securities can be bought or sold quickly and in great quantities.