1. The FED and Monetary Policy1

2. Actions taken by Congress to stabilize the economy
Fiscal Policy
Actions taken by Congress to stabilize the economy
Business
Tools
Taxes
Spending 4

3. Actions taken by The Federal Reserve to stabilize the economy
Monetary Policy
Actions taken by The Federal Reserve to stabilize the economy
Monetary Policy =
Changes in
Money Supply
Federal Reserve
Business 4

4. How the Government Stabilizes the Economy14

5. How the FED Stabilizes the Economy
These are the three tools that the FED uses to shift Money Supply 15

6. All the physical money in the economy
Tools
Open Market Operations
Discount Rate
Required Reserve Ratio
What is Money Supply?
The FED uses all these tools specifically to affect the
Money Supply
All the physical money in the economy

7. The Money Market (Supply and Demand for Money)2

8. First, Let’s talk about the Demand for money
When we talk money, I mean liquid money, in your pocket or checking account, that you can use to buy goods and services.
First, Let’s talk about the Demand for money
Interest - The price paid for the use of borrowed money. Also, money earned by deposited funds.
Interest Rate - Percentage of interest collected on a debt or investment
So, if interest rates are high, do you want to invest your money, or do you want to keep it in your pocket to spend on goods and services?

9. The Demand for Money
At any given time, people demand a certain amount of liquid assets (money) for everyday purchases
The Demand for money shows an inverse relationship between interest rates and the quantity of money demanded
At 2% interest rate there is less incentive to invest, and more incentive to keep and use my money.
At 20% interest rate there is a strong incentive to invest my money in a savings account.
low demand for liquid money
high demand for liquid money 3

10. 2. What happens to the quantity demanded when interest rates decrease?
1. What happens to the quantity demanded of money when interest rates increase?
2. What happens to the quantity demanded when interest rates decrease?
Quantity demanded falls because individuals would prefer to have interest earning assets (investments)
Quantity demanded increases. There is less incentive to convert cash into interest earning assets
Interest rates are affected by the Federal reserve, the money supply, the economy, and business cycles.

11. Now let’s talk Monetary Policy
When the FED adjusts the money supply to achieve macroeconomic goals 8

12. 1. Open Market Operations 2. Discount Rate 3. Required Reserve Ratio
Tools of the FED
1. Open Market Operations
2. Discount Rate
3. Required Reserve Ratio
The FED uses all these tools specifically to affect the Money Supply

13. This is called Monetary Policy.
The Supply for Money
The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED)
Interest Rate (ir)
SMoney
The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy
This is called Monetary Policy.
20% 5% 2%
DMoney
200
Quantity of Money
(billions of dollars) 7

14. 11

15. Video: The FED Today 12

16. The role of the Fed is to “take away the punch bowl just as the party gets going”13

17. 2. Required Reserve Ratio 3.Open Market Operations
Tools of the FED
1. Discount Rate
2. Required Reserve Ratio
3.Open Market Operations
The FED uses all these tools specifically to affect the Money Supply

18. #1 Discount Rate
The FED acts as a lender of last resort when banks and the economy are in financial emergencies.
Discount Rate - The interest rate that the Federal Reserve charges other banks when they need to borrow money
Example:
If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it back with 3% interest.
To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy).
To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy).
Decrease
Increase

19. #2 The Required Reserve Ratio
Required Reserve Ratio - the fraction of deposits that banks must keep on reserve.
If you make a deposit at a bank, only some of that money has to be kept readily available in reserve. The bank may loan out the rest to individuals.
The Fed sets the
Reserve Ratio, the fraction of people’s money that must be kept available at the bank.
The excess of that money is loaned out to individuals, put back into the economy, and often ends up as deposits in other banks, possibly to be loaned out again!

20. The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
You deposit $1000 in the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Bob (excess reserves)
Bob deposits the $900 in his bank
Bob’s bank must hold $90. It loans out $810 to Jill
Jill deposits $810 in her bank
SO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob’s $900 + Jill’s $810)
Increasing the Required Reserve Ratio lowers the money supply.
Decreasing the Required Reserve Ratio increases the money supply.

21. #3 Open Market Operations
Open Market Operations - The buying and selling of government securities (bonds) to alter the supply of money
Buy Bonds = Increase Money Supply
Sell Bonds = Decrease Money Supply
Buying Bonds
from open market
increases money supply
More liquid money in the economy
Selling Bonds
brings new investors
decreases money supply
Less liquid money in the economy