Please listen to the audio as you work through the slides Monetary Policy Please listen to the audio as you work through the slides

Monetary Policy Learning Objectives: Students will be able to thoroughly and completely explain: The 3 tools used by the Federal Reserve to operate Monetary Policy. Easy money policy and tight money policy, when to use each, the 3 tools associated to each. How monetary policy works using the cause and effect chain approach. The impact of the net export effect on monetary policy The strengths and weaknesses of monetary policy. How to use the tools of Monetary Policy to address the problems of Inflation and Recession.

Goals of Monetary Policy …to assist the economy in achieving a full-employment, noninflationary level of total output

Review of Monetary Policy Interest Rates Discount rate - the interest rate that the Federal Reserve Banks charge on the loans they make to commercial banks and thrift institutions. This rate is directly established by the Fed. Federal Funds rate – the interest rate banks and other depository institutions charge one another on overnight loans made out of their excess reserves. This rate is established by the changes in the money supply (caused by the Fed).

Federal Reserve Tools Open Market Operations Reserve Ratio Buy or sell used bonds Reserve Ratio Raise or lower Discount Rate

Create a study guide for all six tools

Open Market Operations Recession Fed buy bonds What happens next? Inflation Fed sells bonds What happens next?

Fiscal Policy Recession Inflation Expansionary Fiscal Policy Contractionary Fiscal Policy Use Tool # 1 - Use Tool # 1 Then what happens? Then what happens?

Tools of Monetary Policy 1. Open market operations Buying of government securities from Commercial banks and the general public (bonds) Selling of government securities to Commercial banks and the general public Used to influence the money supply When the Fed sells securities to banks, commercial bank reserves are reduced When the Fed buys securities from banks, commercial bank reserves are increased

Tools of Monetary Policy 2. The reserve ratio Changes the money multiplier 3. The discount rate The Fed as lender of last resort for banks Short term loans

Federal Reserve Policies Easy Money Policy – fight recession Easy Money Policy – increase reserves, increase money supply, lower interest rates, Increase AD, and employment, control recession. Tight Money Policy – fight inflation Tight Money Policy – reduce money supply, increase interest rates, to reduce spending, control inflation.

From commercial banks... How it works Tools of Monetary Policy Open-Market Operations 1. Fed Buying Securities – easy money policy to fight recession increase reserves (increase money supply) From commercial banks... How it works Bank gives up securities (sells them) FED pays bank – by increasing their reserves Banks have increased reserves (increased excess reserves) – can lend more (increase money supply) From the public... How it works Public gives up securities (sells them) Public deposits check from FED in bank (increase check account balances) Banks have increased reserves (increased excess reserves) - (increase money supply)

Open-Market Operations Tools of Monetary Policy Open-Market Operations 2. Fed Selling Securities – tight money policy to fight inflation decrease reserves (decrease money supply) To commercial banks... How it works FED gives up securities (sells them) Bank pays for securities (out of excess reserves) Banks have decreased excess reserves (decrease money supply) To the public... How it works FED gives up securities (sells them) Public pays by check drawn on a bank (decrease demand deposit balances) Banks have decreased reserves (decrease money supply) – (remember the check clearing process)

Open-Market Operations Tools of Monetary Policy Open-Market Operations The Reserve Ratio 1. Raising the Reserve Ratio – tight money policy to fight inflation reduce money supply Banks must hold more reserves – (lower excess reserves) Banks decrease lending Money supply decreases 2. Lower the Reserve Ratio – easy money policy to fight recession Increase money supply Banks may hold less reserves – (higher excess reserves) Banks increase lending Money supply increases

Open-Market Operations Tools of Monetary Policy Open-Market Operations The Reserve Ratio The Discount Rate – rate Fed charges Commercial banks. Raise or lower Easy Money Policy – fight recession increase reserves, increase money supply, lower interest rates, Increase AD and employment Fed Buy’s Securities (pay bond holders who sell) Decrease Reserve Ratio (increase excess reserves) Lower Discount Rate (encourage borrowing by banks from each other)

Open-Market Operations Tools of Monetary Policy Open-Market Operations The Reserve Ratio The Discount Rate Tight Money Policy – fight inflation Decrease reserves, reduce money supply, raise interest rates, to reduce spending, control inflation. Fed Sells Securities (take money out of our hands) Increase Reserve Ratio (decrease excess reserves) Raise Discount Rate (discourage bank borrowing)

Monetary Policy, Real GDP and the Price Level Cause-Effect Chain Money supply impacts interest rates Interest rates affect investment Investment is a component of AD Equilibrium GDP is affected by AD

Monetary Policy and GDP Equilibrium real GDP and the Price level (a) The market for money (b) Investment demand Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Sm1 Sm2 Sm3 Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) AS 10 8 6 P3 AD3 I=$25 P2 AD2 I=$20 Dm ID AD1 I=$15 $125 $150 $175 $15 $20 $25 Q1 Qf Q3

Expansionary Monetary Policy Problem: unemployment and recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, lowers the discount rate Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises

Restrictive Monetary Policy Problem: inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, increases the discount rate Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines

Monetary Policy in Action Strengths of monetary policy Speed and flexibility Isolation from political pressure Target the Federal Funds Rate The Federal Funds Rate – rate banks charge each other for overnight loans of reserves. Tighter policy higher rate. The Prime Interest Rate – a benchmark rate banks use The Fed does not set either of these. They are equilibrium rates that result from open market operations to change reserves.

Problems and Complications Lags Recognition lag – same as fiscal policy – for recession Administrative lag – very short relative to fiscal policy Operational lag : Approximately 12 to 24 months for interest rate changes to have full impact on I, AD, Real GDP, price level. Changes in Velocity Number of times per year average dollar is spent on goods and services. Velocity x money supply = total spending Cyclical Asymmetry Monetary policy effective in slowing expansions and controlling inflation but less reliable at curing a significant recession. “Artful Management” or “Inflation Targeting”

Expansionary Monetary policy versus expansionary fiscal policy Net Export Effect Expansionary Monetary policy versus expansionary fiscal policy Expansionary monetary policy increases net exports and strengthens Monetary policy. Expansionary fiscal policy decreases net exports and weakens the fiscal policy. The steps for expansionary fiscal policy: Expansionary fiscal policy financed by borrowing (deficit financing) Selling bonds (increasing the supply of bonds – bond prices dropping and interest rates rising) Dollar appreciates – higher demand for dollars Imports rise and exports fall – net exports fall AD falls and dampens the expansionary fiscal policy

Monetary policy and the Net Export Effect Easy money policy Problem – recession Easy money policy to lower interest rate Decreased foreign demand for dollars Dollar depreciates (takes more dollars to buy a foreign currency) Net exports increase (aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.)

Monetary policy and the net Export effect Easy money policy Problem – recession Easy money policy to lower interest rate Decreased foreign demand for dollars Dollar depreciates (takes more dollars to buy a foreign currency) Net exports increase (aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.) Tight money policy Problem – inflation Tight money policy (higher interest rates) Increased foreign demand for dollars Dollar appreciates (takes fewer dollars to buy a foreign currency) Net exports decrease (aggregate demand decreases, equilibrium GDP contracts, strengthening the tight money policy.)

Monetary policy and the net Export effect Easy money policy Problem – recession Easy money policy to lower interest rate Decreased foreign demand for dollars Dollar depreciates (takes more dollars to buy a foreign currency) Net exports increase (aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.) Tight money policy Problem – inflation Tight money policy (higher interest rates) Increased foreign demand for dollars Dollar appreciates (takes fewer dollars to buy a foreign currency) Net exports decrease (aggregate demand decreases, equilibrium GDP contracts, strengthening the tight money policy.) Expansionary monetary policy increases net exports and strengthens Monetary policy. Expansionary fiscal policy decreases net exports and Weakens The fiscal policy.

monetary policy open-market operations reserve ratio discount rate easy money policy tight money policy Federal funds rate prime interest rate velocity of money cyclical asymmetry inflation targeting KEY TERMS

Tools Exercise Recession Explain how the problem of recession will be solved by lowering taxes and having the Fed lower the reserve ratio.

Tools Exercise Recession Explain how the problem of recession will be solved by lowering taxes and lowering the discount rate.

Tools Exercise Recession Explain how the problem of recession will be solved by increasing government spending and by having the Fed buy bonds from Commercial Banks or the public.

Tools Exercise Inflation Explain how the problem of Inflation will be solved by lowering government spending and by having the FED sell bonds.

Tools Exercise Inflation Explain how the problem of inflation will be solved by raising taxes and the Fed raising the discount rate.

Tools Exercise Inflation Explain how the problem of inflation will be solved by raising taxes and the Fed raising the Reserve ratio.

Tools Exercise Inflation Explain how the problem of inflation will be solved by raising taxes and the Fed selling bonds.