Monetary Policy Involves controlling the money supply to change the level of GDP or the rate of inflation.

The Money Supply  The money supply is increased when banks make loans.  The more loans banks make the more money there is in circulation.  The banking system can create loans in multiples of an original loan.  The money supply is decreased when a bank or the public buys government bonds.

Banking Reserves  Reserves are the amount of deposits that a bank has accepted but not loaned out.  Required reserves are the amount a bank must keep on hand by law. The required reserve ratio determines this amount.  Excess reserves are whatever the bank has over and above the required reserves. It is the amount that a bank can loan out or use to purchase government securities (bonds).

Money Creation  Money creation (putting new money into circulation) occurs when banks make loans to the public.

Monetary Policy Tools  The Federal Reserve controls the amount of excess reserves and money creation through use of its three tools.  Reserve Requirements  Discount Rate  Open Market Operations

Federal Reserve Tools  Required Reserve Ratio – the percentage of demand deposits a bank must keep on hand for customers’ withdrawals.  It determines how much of a bank’s deposits are available for loans and the size of the money multiplier.  The money multiplier determines the amount of new money that will be created by the banking system (1/RR)  Least used of the Fed’s tools because it is the most powerful and disruptive.

Federal Reserve Tools  Discount Rate – the interest rate the Fed will charge a bank for a loan.  If the Fed lowers the discount rate banks would be encouraged to borrow from the Fed (the bank could loan that money out to the public at a higher rate and make money doing so).  The more loans a bank makes the more the money supply grows and vice versa.  Least effective tool.

Federal Reserve Tools  Open Market Operations – the Fed purchases or sells securities (government bonds) to banks and the public, which changes the amount of money available from the public and banks for loans.  The Fed would purchase securities to pump in money to increase economic growth.  The Fed would sell securities to soak up money from the economy (anti-inflationary). Banks or the public now have a bond instead of cash and spending is slowed down.  Most used tool.

Macroeconomic Effects of Monetary Policy  A change in the supply of money changes the interest rate.  Interest rates are the cost of borrowing money.  A high supply of money lowers the interest rate and gives businesses more opportunities for investment spending (buying capital goods) and vice versa.

Macroeconomic Effects of Monetary Policy  The Fed will follow an easy money policy (an increase in the money supply) when the economy is in a recession.  The Fed will follow a tight money policy (a decrease in the money supply) when the economy is experiencing inflation.  The goal of monetary stabilization policies are to smooth out fluctuations in the business cycles.

Problems of Timing  If expansionary policies take effect while the economy is already expanding, the result could be higher inflation.  Inside lags refer to the delay in implementing monetary policy.  It is difficult to accurately identify and recognize economic problems.  It takes additional time to enact the appropriate policy. (This is more of a fiscal policy problem, since the FOMC can act much more quickly)

Problems of Timing  Outside lags refer to the time it takes for monetary policy to have an effect.  The outside lag is short for fiscal policy but lengthy for monetary policy.  Monetary policy primarily affects business investment plans which are made far in advance.  Monetary policy is still preferred because of the inside lag caused by the President and Congress having to agree on budgetary matters.

Bank balance sheets or T-Accounts  Illustrates the relationship between assets and liabilities held by a bank.  They can be used to explain the money creating potential of banks through the fractional reserve system.  Assets – the property, possessions and claims on others held by the bank (reserves, loans, securities)  Liabilities – the debts and obligations of the bank to others (demand deposits, loans from the Fed)

Bank balance sheets or T-Accounts AssetsLiabilities reserves $10,000DDA $10,000

(reserve ratio 10%) AssetsLiabilities RR $1,000DDA 10,000 ER $9,000 BANK 1 AssetsLiabilities RR $1,000DDA 10,000 ER loans $9,000

AssetsLiabilities RR $900DDA $9,000 ER $8,100 Total money supply = $10,000+9,000 BANK 2 AssetsLiabilities RR $900DDA 9,000 ER Loans $8,100 Total Expansion of the money supply = $9,000 x 10 (1/.10) = $90,000