Chapter 16: Monetary Policy Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy Monetary policy consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy. The goal is to achieve and maintain price- level stability, full employment, and economic growth. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Selected U.S. Interest Rates, April 2005

Tools of Monetary Policy The Federal Reserve can change the money supply and therefore alter interest rates in the economy. The three tools of monetary control are: Open-market operations Reserve ratio Discount rate Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Open Market Operations Open market operations consists of the buying and selling of U.S. government securities by the Fed for the purpose of carrying out monetary policy. Open market operations are the most important instrument for influencing the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Open Market Operations Buying securities increases the reserves of commercial banks. Excess reserves allow the banking system to expand the money supply through loans. Selling securities reduces the reserves of commercial banks. Lower reserves result in a multiple contraction of the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio Changing the reserve ratio is a powerful technique of monetary control, although it is seldom used by the Fed. Manipulation of the reserve ratio influences the ability of the commercial banks to lend. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio If the Fed raises the reserve ratio, the amount of required reserves that banks must keep increases. Banks will either lose excess reserves, diminishing their ability to create money by lending, or reduce its checkable deposits due to deficient reserves, and therefore the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio If the Fed lowers the reserve ratio, the banks’ required reserves will decrease. Banks with more excess reserves are able to create new money by lending. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate The discount rate is the interest rate the Federal Reserve Banks charge on the loans they make to commercial banks and thrifts. Occasionally, Federal Reserve Banks makes short-term loans to commercial banks in their district; the Fed is considered the “lender of last resort.” Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate In providing loans, the Federal Reserve Bank increases the reserves of the borrowing bank, enhancing its ability to extend credit. From the commercial banks’ perspective, the discount rate is the cost of acquiring reserves. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate Increasing the discount rate discourages commercial banks from obtaining additional reserves through borrowing from the Federal Reserve Banks. When the Fed raises the discount rate, it wants to restrict the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Easy Money Policy Easy money policy (or expansionary monetary policy) are Fed actions designed to increase the money supply, lower interest rates, and expand real GDP. These include buying securities, lowering the reserve ratio and lowering the discount rate. Its purpose is to make loans less expensive and more available and thereby increase aggregate demand, output and employment. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Tight Money Policy The Fed can try to reduce aggregate demand by limiting or contracting the money supply. These actions are called a tight money policy (or restrictive monetary policy). These include selling securities, increasing the reserve ratio and raising the discount rate. The objective is to tighten the money supply in order to reduce spending and control inflation. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of an Easy Money Policy If real output in the economy is below the full-employment output, the economy must be experiencing a recession (a negative GDP gap) and unemployment; therefore, the Fed should institute an easy money policy. To increase the money supply, the Fed can buy government securities, lower the legal reserve ratio, and lower the discount rate. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of an Easy Money Policy Increasing the money supply will reduce interest rates and will boost investment. This will cause the aggregate demand curve to shift rightward, eliminating the negative GDP gap. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of a Tight Money Policy If real output in the economy is above the full-employment output, the economy has a positive GDP gap and demand-pull inflation; the Fed should institute a tight money policy. The Fed will direct Federal Reserve Banks to undertake some combination of the following actions: (1) Sell government securities, (2) increase the legal reserve ratio, (3) increase the discount rate. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of a Tight Money Policy Decreasing the money supply will raise interest rates and cause investment to decline. The decrease in investment will shift the aggregate demand curve leftward, eliminating the excessive spending and halt demand-pull inflation, closing the positive GDP gap. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy in Action Monetary policy, a dominant component of U.S. national stabilization policy, has two key advantages over fiscal policy: Speed and flexibility Isolation from political pressure Monetary policy can be quickly altered and is a more subtler and more politically neutral measure. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Homework, Due May 15! Using F=P(1+i)^t compute: The Future value of $2,000 today 40 years from now at an interest rate of 10%. The Present value of $1 million 30 years from now at 6%. Use the rule of 72 to compute how many years it would take $1,000 to reach $1M at 12% interest. Study Questions: 15:1,8,10 16:3,6,7.