Monetary Policy AP Macroeconomics

Relating Money to GDP Nominal GDP = Economist Irving Fisher postulated The Money Supply X Money’s Velocity

Equation of exchange MV = PQ M = money supply V = velocity of money P = price level Q = quantity of output (real output) Where’s George?

The equation P x Q represents the expenditure on goods in a year, which must equal the amount of money multiplied by the number of times/year the money is spent. V is highly predictable and stable. Changes in M result in changes in nominal GDP (P x Q)… Monetarists believe output is relatively fixed. What does that mean about the Federal Reserve Bank creating money?

The Monetary Equation of Exchange MV=PQ M=$2 trillion V = 7 PQ = $14 trillion LRAS SRAS PL P AD QF GDPR

Factors that affect income velocity Stable, but not constant Shorter pay periods Widespread use of credit cards Faster means of making payments We hold less money and turn it over more rapidly Velocity doesn’t change in response to the money supply. Activity 4-8

What is the Fed? Central bank of the United States Established in 1913 Purpose is to ensure a stable economy for the nation What is the Fed? The Federal Reserve is the central bank of the United States and its purpose is to help ensure a stable economy for the nation. Established as a result of the Federal Reserve Act, signed in 1913. Receives no congressionally appropriated funds. Its operations are financed primarily from the interest earned on the U.S. government securities it acquires in the course of its monetary policy actions. Another major source of income is derived from the fees received for certain services provided to depository institutions. After payment of certain expenses, all the net earnings of the Federal Reserve Banks are transferred to the U.S. Treasury. In 2004, for example, the Fed paid approximately $18.1 billion to the U.S. Treasury. 7

stlouisfed.org/education_resources/in-plain-english-video/ As you watch, write down the STRUCTURE of the Fed and the Fed’s ROLES & RESPONSIBILITIES CHAPTER 29 THE MONETARY SYSTEM

Money Supply Basically, the Fed is charged with controlling the amount of money in circulation. Fed policy can increase or decrease the money supply, which increases or decreases interest rates. Decrease Interest Rates Decrease Money Supply Increase Money Supply Increase Interest Rates Leads to Leads to

Key Tools of Monetary Policy Reserve Requirements Discount Rate Fed Funds Rate Open Market Operations We’ll chat about all 4 types… No yelling! The tools the Fed utilizes to influence the economy (or affect the amount of funds in the banking system) are: Discount Rate: Rate of interest charged to banks that need to borrow from the Fed to cover temporary deposit drains (short-term “discount window” loans). Reserve Requirements: Portions of deposits that banks must hold in reserve, either in their vaults or on deposit at a Reserve bank. Federal Open Market Operations: The most frequently used and most flexible tool is that of Open Market Operations, which involves the buying and selling of U.S. government securities. This tool is directed by the FOMC and carried out at the domestic trading desk at the Federal Reserve Bank of New York 11

Reserve Requirement With a 10% reserve requirement, banks must hold 10% of deposits in reserves and they can loan out 90% of their deposits. Raising the reserve requirement to 12% means banks have less money to loan out Increasing Interest Rates → Reducing the Quantity Demand for Money → Contracting the Money Supply Lowering the reserve requirement to 8% means banks have more money to loan out Decreasing Interest Rates → Increasing the Quantity Demand for Money → Expanding the Money Supply Contractionary Expansionary

Discount Rate The rate of interest the Fed charges financial institutions to borrow money from the Fed Overnight loans to help banks meet their reserve requirements The discount rate is a “base” rate for other interest rates Interest Rates Consumer Prime Rate Discount Rate Fed Funds Rate

Discount Rate Lower discount rates decrease the cost of borrowing money – for banks and for consumers Increases the quantity demand for money Expands the money supply Lowers interest rates Higher discount rates increase the cost of borrowing money -- for banks and consumers Decreases the quantity demand for money Contracts the money supply Raises interest rates Expansionary Contractionary

Fed Funds Rate The rate of interest banks charge for loaning excess reserves to other banks Overnight loans Another “base” rate for interest rates “Controlled” by the Fed, but not “set” by the Fed

Open Market Operations Buying and selling of government securities (bonds) in the “open market” All open market operations are based at the NY Fed The Fed open market desk buys and sells with approximately 30 primary dealers

Open market operations The Fed buys government securities Increases the money supply Lowers the interest rates Increases the quantity demand for money The Fed sells government securities Decreases the money supply Increases interest rates Decreases the quantity demand for money Expansionary Contractionary

Summary of Monetary Policy Reserve Requirement Discount Rate Open Market Operations Expansionary Decrease RR Decrease DR Buy Government Securities Contractionary Increase RR Increase DR Sell Government Securities Expansionary Contractionary 4.4.38

Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy FEATURES of the process CONDITIONS necessary for the process to take place Ways the process SUPPORTS progress INHIBITS progress PROCESS 1 Expansionary Monetary Policy PROCESS 2 Contract’ary Monetary Policy Conclusion

Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy FEATURES of the process CONDITIONS necessary for the process to take place Ways the process SUPPORTS progress INHIBITS progress PROCESS 1 Expansionary Monetary Policy PROCESS 2 Contract’ary Monetary Policy Conclusion Increase money in circulation. Lower interest rates: decrease RR, target FFR, DR. Buy OMO. Recession, low rGDP. Must be demand-deficient in order for policy to work. FOMC must act, and the policy has long outside lag. Reduce money in circulation. Raise interest rates: increase RR, target FFR, DR. Sell OMO. Inflationary period. Must be too much demand in order for policy to work.

Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy FEATURES of the process CONDITIONS necessary for the process to take place Ways the process SUPPORTS progress INHIBITS progress PROCESS 1 Expansionary Monetary Policy PROCESS 2 Contract’ary Monetary Policy Conclusion Increase money in circulation. Lower interest rates: decrease RR, target FFR, DR. Buy OMO. Recession, low rGDP. Must be demand-deficient in order for policy to work. FOMC must act, and the policy has long outside lag. Reduce money in circulation. Raise interest rates: increase RR, target FFR, DR. Sell OMO. Inflationary period. Must be too much demand in order for policy to work. Tradeoff is economic contraction. AD shifts to right. Money is injected into the economy and spent several times through circular flow. Tradeoff will be inflation. AD shifts to left. Money is removed from economy, cooling the spending by all.

Money Market Money Market MS 3 reasons to demand $: Transactions Precaution Speculation MD also depends on the PL and the level of rGDP Nominal interest rate nir MD Quantity of Money Activity 4.5.39

Fisher Equation r = i – p real interest rate = nominal interest rate - inflation rate Short run: MS↑=>↓i & r Long run: MS↑=>↑PL and only i↓ (not r) Activity 4.6.41

Returning… the TRIFECTA!!!

Contractionary monetary policy Aggregate S & D Money Market Investment rGDP Quantity of money Quantity of investment PL Nom. Int. rate Real Interest rate

Expansionary monetary policy Aggregate S & D Money Market Investment rGDP Quantity of money Quantity of investment PL Nom. Int. rate Real Interest rate 4.6.42

Expansionary fiscal policy Aggregate S & D Loanable Funds Market Investment rGDP Quantity of loanable funds Quantity of investment PL Real Int. rate Real Interest rate

Open Market Operations In an open­ -­ market operation the Federal Reserve buys or sells U.S. Treasury bills, normally through a transaction with commercial banks—banks that mainly make business loans, as opposed to home loans.   To alter the money supply, the Fed can buy or sell U.S. Treasury bills. How? When the Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s reserve account by an amount equal to the value of the Treasury bills. For example, if the Fed buys $100 million of U.S. Treasury bills from commercial banks, this increases the monetary base by $100 million because it increases bank reserves by $100 million. When the Fed sells U.S. Treasury bills to commercial banks, it debits the banks’ accounts, reducing their reserves. For example, when the Fed sells $100 million of U.S. Treasury bills, bank reserves and the monetary base decrease. Note: Remind the students that the change in bank reserves caused by an open­ -­ market operation doesn’t directly affect the money supply. Instead, it starts the money multiplier in motion. If the Fed buys $100 million in T-bills from the commercial banks, the banks would lend out their additional reserves, immediately increasing the money supply by $100 million. Some of those loans would be deposited back into the banking system, increasing reserves again and permitting a further round of loans, and so on, leading to a rise in the money supply. An open­ -­ market sale has the reverse effect: bank reserves fall, requiring banks to reduce their loans, leading to a fall in the money supply.