15 C H A P T E R Monetary Policy FEDERAL RESERVE BANK OF THE U.S.

GOALS OF MONETARY POLICY …to assist the economy in achieving a full-employment, noninflationary level of total output

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

From individuals... From commercial banks... Open Market Operations TOOLS OF MONETARY POLICY Open Market Operations Buying Securities From commercial banks... Bank gives up securities FED pays bank Banks have increased reserves From individuals... Individual gives up securities Individual deposits check in bank Banks have increased reserves

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

Open Market Operations 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

Open Market Operations TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Buy Securities Decrease Reserve Ratio Lower Discount Rate

Open Market Operations TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate

Discuss relative importance of each control TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio Discuss relative importance of each control The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate

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 changed

Quantity of money demanded and supplied MONETARY POLICY AND EQUILIBRIUM GDP Sm1 Sm2 Investment Demand 10 8 6 10 8 6 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 Money Supply Increases Interest Rate Decreases Price level Investment Increases P2 P1 AD & GDP Increases with slight inflation AD1 AD2 Real domestic output, GDP

Quantity of money demanded and supplied MONETARY POLICY AND EQUILIBRIUM GDP Sm1 Sm2 Sm3 Investment Demand 10 8 6 10 8 6 Real rate of interest, i Dm Quantity of money demanded and supplied Amount of investment, i If the money supply increases again… AS More Money Supply P3 Lower Interest Rates Price level More Investment P2 P1 Still higher AD & GDP with significant inflation AD1 AD2 AD3 Real domestic output, GDP

MONETARY POLICY, REAL GDP AND THE PRICE LEVEL Effects of an easy money policy Effects of a tight money policy Monetary policy & aggregate supply

Strengths of monetary policy EFFECTIVENESS OF MONETARY POLICY Strengths of monetary policy Speed and flexibility Isolation from political pressure Successes in the 1980s & 1990s Shortcomings and problems Less control? Changes in velocity Cyclical asymmetry

Generalized Interest Rate Changes TARGETING THE FEDERAL FUNDS RATE Generalized Interest Rate Changes Money Supply Impact The Federal Funds Rate The Prime Interest Rate

MONETARY POLICY AND THE INTERNATIONAL ECONOMY Net export effect Macro stability and the trade balance The “Big Picture” Chapter Conclusions

open-market committee reserve ratio discount rate easy money policy monetary policy open-market committee reserve ratio discount rate easy money policy tight money policy velocity of money cyclical asymmetry Federal funds rate prime interest rate KEY TERMS Copyright McGraw-Hill/Irwin, 2002 BACK END

Extending the Analysis of Aggregate Supply Next Chapter 16