Monetary Policy Tools

1. Monetary Policy Tools

2. Monetary Policy • Federal Reserve Act of 1913 created the Federal Reserve System • “The Fed” provides the U.S. banking system with the stabilizing influence of a central bank • 1977 amendment: to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” • The Fed conducts monetary policy • Creates quantity of money that responds to the demands of the economy • Changing short-term interest rates and quantity of money [Note: we will not have a discussion of institutional aspects of money.]

3. The Fed • Congress established as an independent organization • Income from investments and banking services • Three components: • The Board of Governors • sets overall direction of the Fed and its policies • 7 members appointed to 14 year terms by the president with the advise and consent of the Senate • The Federal Open Market Committee (FOMC) • conducts monetary policy • 12 members, 7 members from the Board plus 4 rotating district bank presidents and the president of the NY District Bank • The Federal Reserve Banks • regulates and provide a variety of services for banks • 12 regional banks

4. Open Market Operations • Primary tool to manage money supply • Currency—dollar bills and coins issued by the Federal Reserve System and the Treasury • Deposits at commercial banks and other depository institutions • Buy and sell government securities (Treasury bonds and bills) to commercial banks and general public • Does not issue government securities, can obtain in the open market • Open market operations put currency, Federal Reserve notes, into or out of circulation • Example: When you buy a bond from the Fed for $10,000, you write a check and take money out of the economy

5. Reserve Ratio • Used infrequently • Banks hold some fraction of deposits on reserve to meet customers’ cash needs • Banks must meet the Fed’s reserve requirements • Current reserve requirement: about 10% • Banks hold at least $10 for every $100 of deposits • Alter reserve requirement, change money supply • Decrease required reserves increases money in circulation • Increase required reserves decreases money in circulation • some banks sell securities or call in loans • disruptive to customers

6. Discount Rate • Discount Rate: interest rate at which the Fed loans money to banks • Many short term interest rates tied to it • Discount rate changes move money supply in opposite direction • Increases in discount rate decrease money supply by decreasing borrowing (interest rates rise) • Decreases in discount rate increase money supply by increasing borrowing (interest rates fall) • Changes in discount rates foreshadow the Fed’s policy intentions

7. Expansionary Monetary Policy • Increase money supply when economy “too slow” • Buy securities (open market operations) • Reduce reserve ratios (not likely) • Lower the discount rate • Works through interest rates (price of money) • Money supply increases, more money so price of borrowing (interest) falls • Discount rate decreases, banks borrow more money and money supply increases (interest rates tied to it fall) • Interest rates fall, spending increases • Plant and equipment (by firms) • New housing • Consumer durables (especially autos) • Increased spending stimulates production, which reduces unemployment and increases GDP, which increases income, which stimulates spending…

8. Contractionary Monetary Policy • Decrease money supply if economy “too fast” • Sell securities (open market operations) • Increase reserve ratio (not likely) • Raise discount rate • Contractionary monetary policy effective with rapidly increasing GDP and inflation • Decreases investment and slows economic expansion • If economy sluggish, recession will deepen • Cost-push inflation, tight (contractionary) policies have little impact on slowing inflation

9. Monetary Policy in Action • Many argue price stability is the Fed’s primary goal • If the economy tends toward full employment, monetary policy’s greatest impact is on price level • Tradeoffs can exist between unemployment and inflation • Unemployed means not enough money to spend and the Fed can stimulate spending through expansionary policies • But too much money chasing too few goods increases prices (inflation) • Excessive growth in money supply a root cause of inflation • Friedman argued that given long term impacts of fluctuations in money supply, best is constant increase • 3% per year “the rule”