Textbook PowerPoints = TMI Maurer’s PowerPoints = JEI

Chapter 15 – Monetary Policy Essential Question #1 What is monetary policy? When the Federal Reserve manipulates the money supply (increases it or decreases it).

Chapter 15 – Monetary Policy Essential Question #2 Why would the Fed want to manipulate the money supply? To change the interest rate. a. A lower interest rate will increase investment spending, shift AD to the right, increase real GDP, and decrease unemployment. b. A higher interest rate will decrease investment spending, shift AD to the left, and limit inflation.

The Money Market

Chapter 15 – Monetary Policy Essential Question #3 What are the tools of monetary policy? 1.Open-Market Operations – Buy or sell bonds on the open market. 2.The Reserve Ratio – They can raise it or lower it. 3. The Discount Rate – This is the interest rate at which commercial banks can borrow from the Federal Reserve.

#1 - Open-Market Operations By far, the most used and most important monetary policy tool the Federal Reserve has. When the federal reserve buys bonds, it increases banks reserves, increasing the money supply, lowering interest rates. When the Federal Reserve sells bonds, it decreases bank reserves, decreasing the money supply, increasing interest rates.

Open Market Operations Fed buys $1,000 bond from a commercial bank New Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) $1000 Excess Reserves LO2 33-7

Open Market Operations Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending LO2 33-8

#2 - The Reserve Ratio It should be obvious how lowering the reserve ratio would expand the money supply (banks could lend more, creating more money). Raising the reserve ratio would obviously have the reverse effect. Reserve ratio last changed in 1992

#3 – The Discount Rate This is the interest rate that the Federal Reserve charges commercial banks to borrow money. Commercial banks can borrow excess reserves from the Fed. A lower discount rate means banks will borrow more reserves from the Fed and be able to lend more. Higher discount rate does the opposite. The discount rate is a passive tool – the Fed mostly changes it to keep it in line with other short-term interest rates.

Expansionary Monetary Policy (Easy Money) Problem: Unemployment and Recession Fed buys bonds (or lowers RR, or lowers discount rate) Excess reserves increase Money supply rises (remember the money multiplier!) Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises, unemployment falls LO

Restrictive Monetary Policy (Tight Money) Problem: Inflation Fed sells bonds ( or raises R.R., or raises Discount Rate) Excess reserves decrease Money supply decreases (remember the money multiplier!) Interest rate increases Investment spending decreases Aggregate demand decreases Inflation declines LO

Price Level Real GDP YFYF LRAS SRAS AD P

The Federal Funds Rate The Federal Reserve conducts monetary policy to change the Federal Funds Rate. It cannot change the Federal Funds Rate directly. It does it by increasing or decreasing banks excess reserves.

Percent Year Prime interest rate Federal funds rate Monetary Policy 33-15

October, 2014 (in Billions) Source: Federal Reserve Statistical Release, H.4.1, Oct. 29, 2014, Securities Loans to Commercial Banks All Other Assets Total Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes (Outstanding) All Other Liabilities and Net Worth Total $4, $4,487 $ 2, , $4487 LO2 Federal Reserve Balance Sheet Assets Liabilities and Net Worth 33-16

Advantages over fiscal policy – Speed and flexibility – Isolation from political pressure LO