1. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 1 of 30 The Federal Reserve System 15 - 3 Federal Reserve Districts Federal Reserve System: The central bank of the United States, established in 1913 as lender of last resort to avoid bank panics and manage the money supply.

2. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 2 of 30 The Federal Reserve System Bank run: Many depositors simultaneously decide to withdraw money from a bank. Bank panic: Many banks experiencing runs at the same time. In the U.S., mitigated by the Federal Deposit Insurance Corporation (FDIC) established by Congress in 1933.

3. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 3 of 30 The 2001 Bank Panic in Argentina 15 - 3 The Argentine central bank was unable to stop the bank panic of 2001.

4. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 4 of 30 How the Federal Reserve Manages the Money Supply Monetary policy: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Fed uses three monetary policy tools:  Open market operations  Discount policy  Reserve requirements

5. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 5 of 30 How the Federal Reserve Manages the Money Supply OPEN MARKET OPERATIONS Federal Open Market Committee (FOMC): The Federal Reserve committee responsible for open market operations and managing the money supply. Open market operations: The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. “Printing more money” »Buying U.S. Treasury securities increases the money supply. »Selling U.S. Treasury securities decreases the money supply.

6. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 6 of 30 How the Federal Reserve Manages the Money Supply DISCOUNT POLICY Discount loans: Loans the Federal Reserve makes to banks. Discount rate: The interest rate the Federal Reserve charges on discount loans. »Lower interest rate encourages banks to take on loans. »Raising interest rate has reverse effect RESERVE REQUIREMENTS »Reducing reserve requirement increases excess reserves. »Increasing reserve requirements has reverse effect.

7. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 7 of 30 What Is Monetary Policy? Monetary policy: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives. The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: 1. PRICE STABILITY 2. HIGH EMPLOYMENT 3. ECONOMIC GROWTH 4. STABILITY OF FINANCIAL MARKETS AND INSTITUTIONS

8. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 8 of 30 The Money Supply & Interest Rates The Demand for Money Monetary Policy Targets

9. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 9 of 30 Shifts in the Money Demand Curve Monetary Policy Targets

10. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 10 of 30 When the Fed increases the money supply, the short- term interest rate must fall until it reaches a level at which households & firms are willing to hold the additional money. Equilibrium in the Money Market 16 - 4 The Impact on the Interest Rate When the Fed Increases the Money Supply

11. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 11 of 30 Equilibrium in the Money Market 16 - 5 The Impact on Interest Rates When the Fed Decreases the Money Supply

12. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 12 of 30 Federal funds rate: The interest rate banks charge each other for overnight loans. »Affects short term treasury bills »Affects interest rates on long term financial assets, such as corporate bonds and mortgages. The Importance of the Federal Funds Rate

13. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 13 of 30 How Interest Rates Affect Aggregate Demand Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways:  Consumption  Investment  Net exports Monetary Policy and Economic Activity

14. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 14 of 30 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level Expansionary monetary policy: The Federal Reserve’s increasing the money supply and decreasing interest rates in order to increase real GDP. Contractionary monetary policy: The Fed’s adjusting the money supply to increase interest rates to reduce inflation.

15. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 15 of 30 The Fed Responds to the Terrorist Attacks of September 11, 2001 16 - 2 The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

16. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 16 of 30 Monetary Policy and Economic Activity A Summary of How Monetary Policy Works

17. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 17 of 30 Why Does Wall Street Care about Monetary Policy? 16 - 4 The stock market reacts when the Fed either raises or lowers interest rates.

18. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 16: Monetary Policy 18 of 30 16 - 11 The More Independent the Central Bank, the Lower the Inflation Rate Is the Independence of the Federal Reserve a Good Idea?