Monetary Policy Regulating Money Supply

1.Discount Rate Changes Interest rate at which Banks borrow directly from the Fed It is only used in an “emergency” (currently 0.75%) Fed can simply raise or lower discount rate 2.Open Market Operations (to change MS which moves the federal funds rate) –Process of buying or selling government bonds to change money supply –Change in MS alters the federal funds rate (currently 0.0%) –Federal Funds Rate= rate banks borrow directly from each other at 2-Tools of Monetary Policy GDP

2 Types of Monetary Policy LOOSE Monetary Policy –Goal: to increase the money supply –MS ↑ => Short Term Interest rates ↓ => AD ↑ => GDP ↑ TIGHT Monetary policy –Goal: to decrease the money supply –MS ↓ =>Short Term Interest rates ↑ => AD ↓ => GDP ↓ GDP

T he Money Market MS MD Interest Rate Qty $ The Money Market Demand for money is downward sloping as interest rates ↓ more $ is demanded Supply of Money is fixed by the Fed Fed “controls” money supply through monetary policy Model of the federal funds interest rate

Monetary Policy Worksheet Graphing both MS & AD/AS

6 Step #1: Lower the discount rate Step #2: Use Open Market Operations to increase money supply--the Fed Buys government bonds Federal Reserve Government bonds Money supply ↑ Example: Loose Monetary Policy

Solution: Loose Monetary Policy Affects AD Inflation Real GDP AD 1 Economic Situation GDP growth = -1.0%, Unemployment = 10.0% Little to no inflation AS 1 MS i2i2 MD Interest Rate Qty of $ MS i1i1 AD 2 ↓ Discount Rate Buy Bonds => ↑ MS => ↓ Federal Funds Rate Lower interest rates => More Loans taken by Consumers & Business C ↑ + I ↑ => so AD ↑

8 Step #1: Raise the discount rate Step #2: Open Market Operations– to DECREASE money supply Fed SELLS government bonds Federal Reserve Government bonds Money supply ↓ Tight Monetary Policy

Solution: Tight Monetary Policy Affects AD Inflation Real GDP AD 2 Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3.0% AS 1 MS 1 MD Interest Rate Qty of $ MS i1i i2i2 AD 1 End Result: Lower GDP & less inflation! ↑ Discount Rate Sell Bonds ↓MS => ↑ Federal Funds Rate Higher interest rates => Less Loans taken by Consumers & Business C ↓ + I ↓ => so AD ↓

Stimulus Debates Economists argue over the benefits versus costs of Loose Monetary Policy BenefitsCosts/Risks

Federal Reserve in action Loose Monetary Policy

Bernanke Interview #1 (2009) g=mncol;lst;1http:// g=mncol;lst;1 Please watch Part I if you were absent Friday 4/18 th

Bernanke Interview #2 (2010) Got Quantitative Easing?