Money Supply & The Fed How the Fed “creates” money

Monetary Policy The Fed conducts Monetary Policy by changing the nation’s money supply which alters short term interest rates Dot-Com Crash 1.0% 0.0% Housing Bubble

SUPPLY OF MONEY Supply of Money is fixed by the Fed When the Fed changes money supply => short term interest rates change

Increasing Money Supply MD MS 2 Nominal Interest Rate Qty of $ MS 1 MD Nominal Interest Rate Qty of $ MS i1i i2i2 i1i i2i2 Decreasing Money Supply Graphing The Money Market Represents a short term, nominal interest rate Think of it as the Federal Funds Market Different than Loanable Funds Market! (don’t mix them up!)

3-Tools of Monetary Policy The Fed has 3-tools to change money supply: –reserve requirement (currently 10.0%) –discount rate (currently 0.75%) –open-market operations (currently 0.00% target) alters the Federal Funds Rate

Discount Rate & Federal Funds Rate Discount rate: the interest rate the Fed charges banks for loans –Banks borrow money directly from the Fed at the discount rate (0.75%) –The Fed is the “lender of last resort” in a financial crisis (very important in 2008!) Federal Funds Rate: the interest rate banks charge other banks for short term loans –This is the rate graphed in the money market ( currently 0.12%) –The Fed uses open market operations to alter it

Open-Market Operations What: The primary way the Fed changes money supply How: A process which involves the Fed buying & selling U.S. Government bonds –Bonds are also known as gov’t securities Result: the “open-market” process alters the Federal Funds Rate

Open-Market Operations “in action” To increase money supply: –the Fed buys government bonds (securities) from public To decrease money supply: – the Fed sells government bonds (securities) to public Federal Reserve Gov’t bonds Money Public Market & Banks

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